Prudential Financial, Inc. Q4 2009 Earnings Call Transcript

Feb.11.10 | About: Prudential Financial, (PRU)

Prudential Financial, Inc. (NYSE:PRU)

Q4 2009 Earnings Call Transcript

February 11, 2010 11:00 am ET

Executives

Eric Durant – SVP, IR

John Strangfeld – Chairman, President and CEO

Rich Carbone – EVP and CFO

Mark Grier – Vice Chairman

Bernard Winograd – EVP and COO, U.S. Businesses

Ed Baird – EVP, International Businesses

Analysts

Andrew Kligerman – UBS

Suneet Kamath – Sanford Bernstein

Nigel Dally – Morgan Stanley

Tom Gallagher – Credit Suisse

Eric Berg – Barclays Capital

John Nadel – Sterne, Agee

Ed Spehar – Bank of America/Merrill Lynch

Colin Devine – Citigroup

Operator

Ladies and gentlemen, thank you for standing by and welcome to the Prudential fourth quarter 2009 earnings call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. Instructions will be given to you at that time. (Operator Instructions) As a reminder today's conference call is being recorded.

I would now like to turn the conference over to Mr. Eric Durant. Please go ahead.

Eric Durant

Cynthia, thank you very much and good morning to all of you. Thank you for joining our call.

In order to help you to understand Prudential Financial, we will make some forward-looking statements in the following presentation. It is possible that actual results may differ materially from the predictions we make today. Additional information regarding factors that could cause such a difference appears in the section titled forward-looking statements and non-GAAP measures of our earnings press release for the fourth quarter of 2009 which can be found on our website at www.investor.prudential.com.

In addition, in managing our businesses we use a non-GAAP measure we call adjusted operating income to measure the performance of our financial services businesses. Adjusted operating income excludes net investment gains and losses as adjusted and related charges and adjustments as well as results from divested businesses. Adjusted operating income also excludes reported changes in assets values that are expected to ultimately accrue to contract holders and recorded changes in contract holder over liabilities resulting from changes in related asset values. The comparable GAAP presentation and the reconciliation between the two for the fourth quarter are set out in our earnings press release on our website. Additional historical information relating to the company's financial performance is also located on our website.

Okay. We will begin today with comments from John Strangfeld and then Rich Carbone, our Chief Financial Officer and Mark Grier, who will walk you through the fourth-quarter results. After that Bernard Winograd, Ed Baird and Peter Sayre will join John, Rich and Mark for the Q&A. John?

John Strangfeld

Thank you, Eric and good morning everyone. Thank you for joining us. Now that we have closed the books on 2009, I will kick things off with some high-level comments regarding the year as a whole. All in all, we feel we have succeeded in meeting the challenges of a very difficult environment.

First, earnings. Our earnings for 2009 more than doubled from 2008 based on after-tax adjusted operating income of the financial services businesses.

Return on equity recovered to 11.3%. Excluding from earnings the items, we consider discrete or market driven, the full-year result would equate to just under a 10% ROE. While we expect to do better over time, this is a step in the right direction.

Second, capital. Net income for the year amounted to 3.4 billion including the 1.4 billion after-tax gain on sale of our investment in Wachovia Securities. Even without that gain, net income would have been a healthy $2 billion.

We sold 1.4 billion in common shares in June and our flagship life insurance company issued exchangeable surplus notes to raise an additional 500 million.

Total debt for the financial services businesses declined by $6 billion during the year. Book value increased by 5.5 billion. Book value per share increased over 15% from 46.91 to 54.18 in the last 12 months. These measures exclude the impact of unrealized gains and losses on investments and pension and post-retirement benefits.

As you know, we did not participate in TARP. All in all, a very strong capital story.

And then finally, business momentum. We have emerged from this difficult period in excellent shape as strong sales or flows virtually across the board will attest. For the year individual annuities had record gross sales. Full-service retirement had record gross deposits and sales and international insurance recorded its highest ever annualized new business premium.

In short, we believe we have enhanced our longer-term strategic trajectory while taking significant actions during the year to make our company stronger. Looking forward, we view our financial strength as an enabler to pursue exceptional organic growth opportunities just as you have seen. We will also consider opportunities to enhance Prudential's financial performance and strategic positioning through acquisitions. But we will evaluate potential acquisitions with our customary great care, fully cognizant of the risks they present and of the need to generate returns that are appropriate for those risks.

We have often described Prudential as a balanced portfolio of businesses and risks. We actively manage this portfolio and that's very evident when you look at our actions over a longer time horizon. Over the years, we have acquired significant businesses including Gibraltar, American Skandia and CIGNA Retirement.

We have also divested businesses such as our healthcare company and P&C. And this quarter, we sold our stake in Wachovia Securities for $4.5 billion in cash. The overall return to Prudential on the Wachovia investment equates to an annual after-tax rate of return of roughly 25% on our initial $1 billion investment at a time when the S&P was in the single digits.

To sum up, we have never been stronger in terms of our individual businesses and their prospects, our overall balance and mix of those businesses, our financial strength and the quality of our talent and the leadership team. Our sales and flows demonstrate our business momentum. As clearly have attractive internal growth prospects we will also consider acquisitions or do so with the same care that is reflected in our track record.

With that, now Rich and Mark will walk you through the details of the fourth quarter and then welcome your questions. Rich?

Rich Carbone

Thanks, John and good morning, everyone. I have got a little cold so I may be interrupted with sips of tea. As you have seen from yesterday's release, we reported common stock earnings per share of $1.07 for the fourth quarter based on adjusted operating income for the financial services business. This compares to a loss of $2.04 for the year-ago quarter.

Let me start with some high-level comments on the current quarter. We are benefiting from solid performance in our major businesses as well as improvements in financial markets. Strong sales and net flows virtually across the board have also helped drive growth in our account values. Mark will talk more about this later on.

On the other hand, commercial real estate market conditions are continuing to have a negative impact on the results of our asset management business. In addition, the cost of holding excess liquidity, which is showing up as a negative spread mostly in corporate and other and we will talk about that later, was a drag on results from the current quarter.

The list of significant market-driven or discrete items affecting current quarter results is very short, probably the shortest in the last two years and all within the annuity business. And I will go through these items now.

Mark-to-market of hedges and embedded derivatives, including breakage on our living benefit hedging, the market-based adjustment for our own non-performance risk and the hedge we put on to protect capital from adverse winds in the equity markets had a negative impact of about $0.17 per share. We had a benefit of about $0.07 per share from the release of a portion of our reserves for guaranteed minimum death and income benefits. And we had a benefit of about $0.05 per share from a positive unlocking of DAC, which reduced amortization of deferred policy acquisition and other costs.

In total, the items I just mentioned had a net favorable impact of about $0.05 on our earnings per share for the fourth quarter. Stripping out these items from adjusted operating income would bring us to earnings per share of about $1.12 for the fourth quarter of 2009.

For the year as a whole, a similar calculation would bring us to $4.80 per share. This full-year result would equate to an ROE just under 10% consistent with the baseline we showed at our Investor Day in December.

As we mentioned at Investor Day, we don't plan to revisit earnings guidance on a quarterly basis. That said, there are a few items to keep in mind when thinking about our prospects for 2010 in light of the quarter we just reported.

After payment of current taxes, we will have roughly 3.7 billion of investable proceeds from the sale of our investment in the Wachovia Securities joint venture, 3.3 billion is at Prudential Insurance and about 400 million is at the parent company. We expect to deploy a significant portion of these funds over the course of the year in some combination of financing of business growth and longer-term investments.

Total cash and short-term investments at the parent, net of short-term intercompany borrowing and commercial paper amounted to roughly 2.8 billion. We expect to utilize about 1.3 billion of this amount for tax payments and intercompany tax settlements. That leaves about 1.5 billion, 500 million above the $1 billion cushion that we believe is appropriate.

Results for our international insurance business will be bolstered by our more favorable yen/dollar exchange rate in 2010 in comparison to 2009 as a result of our currency hedging program.

As I mentioned at Investor Day, our Japanese yen earnings will translate at a rate of 99 yen to the dollar in 2010 compared to 106 yen to the dollar for 2009. We also expected to benefit from growth in many of our businesses and from reasonably stable financial markets. While conditions remain challenging in the commercial real estate market, we are starting to see signs of improvement.

As an overall comment, we ended 2009 much in the position we expected when we gave our views on 2010 at Investor Day. Our situation has not changed much in eight weeks.

Moving to the GAAP results of our financial services business, we reported net income of 1.8 billion or $3.79 per share for the fourth quarter. This compares to the net loss of 1.7 billion or $3.89 per share in the fourth quarter of 2008.

Our net income for the current quarter includes an after-tax gain net of related expenses of 1.4 billion or $2.95 per share from the sale of our investment in the Wachovia JV on December 31. This excludes the after-tax gain of 1 billion we recorded directly to equity in 2008 as a result of the combination of the A.G. Edwards business with the joint venture.

We think of the performance of this investment in terms of its overall return to Prudential. The realization of 4.5 billion of cash proceeds we received, together with cash flows during our period of ownership equates to an annual after-tax return of roughly 25% on our initial $1 billion investment.

Moving to investment results, GAAP pretax results for this quarter include amounts characterized as net realized investment gains of 38 million. Realized gains from general portfolio activities during the quarter together with positive mark-to-market on externally managed European securities more than offset impairments and credit losses which came in at the lowest level in the past eight quarters.

Impairments and credit losses from the -- for the current quarter amounted to 225 million including 201 million from impairments and credit losses on fixed maturities and 25 million from the impairments of equity securities and other investments. The 201 million of impairments and credit losses for fixed maturities includes roughly 70 million of credit losses on subprime securities.

The remainder, including sales of credit-impaired securities, is spread across public and private corporate holdings and our other securities. And I will give you an update on where we stand on capital.

We began the year with a solid capital position and it has been essentially enhanced over the year by many of the actions we have taken including the realization of the value of our investment in the Wachovia Securities JV and by market recovery.

I will focus first on the insurance companies. We are continuing to manage these companies to capital levels consistent with what we believe are AA standards. Our closing of the sale of our stake in the Wachovia JV on December 31 added about 2.4 billion to the statuary capital of Prudential Insurance contributing 100 basis points as we had expected, about 100 basis points.

The 500 million exchangeable note we issued out of Prudential Insurance in September also bolstered our statutory capital position. The 23% increase in the S&P for the year reversed the portion of the capital erosion that we experienced from the 2008 decline in the equity markets. Most of this capital erosion took place in our annuities business relating to our older products that don't have the auto rebalancing feature we package with our current living benefits. We estimate that in 2009 about 900 million of statutory capital returned to the annuity business due to the market recovery which led to reserve releases.

Going the other way, credit migration and impairments were consistent with our expectations. Excuse me, one second. Recent changes in statutory guidance including the accounting for deferred taxes and capital charges for subprime securities and mortgage loans were a modest net benefit for the capital position of our insurance companies.

We expect the implementation as of year-end 2009 of the new rules for statutory reserving for variable annuities, known as VA CARVM did not have a significant impact on our statutory capital position. Giving effect to everything I just mentioned, we estimate that RBC for Prudential Insurance as of year-end 2009 will be in the mid-500.

Our Japanese insurance companies, Prudential of Japan and Gibraltar Life, each reported solvency margins for their most recent fiscal year-end March 31, 2009. Comfortably above their benchmarks for a AA rating. We are confident that the solvency margins will be maintained or improved through the end of this current fiscal year.

Now, I will move to our overall capital position for the financial services business. We measure our capital capacity by starting with the capital we need to run the company, which we call required equity and comparing this amount to what we have on the balance sheet including actual equity and long-term debt that we classify as capital debt.

The required equity we consider assumes the amount of capital we need to maintain a 400 RBC ratio, percent that is of course, at Prudential Insurance and solvency margins at our international insurance companies which we believe are consistent with or above AA rating targets.

On that basis, we estimate on balance sheet capital capacity at year-end 2009 is in the range of 3.5 to $4 billion. Capital capacity serves two purposes. It is a buffer against the effects of stress conditions arising from the markets and it provides for business growth. We have historically maintained on balance sheet capital capacity in the range of 2 to $3 billion and would expect to hold a reasonable level going forward.

Now Mark will comment on the investment portfolio for our financial services business and review our results for the quarter.

Mark Grier

Excuse me, thank you, Rich. Good morning, good afternoon, good evening, good night, whatever time it is where you are. Thanks for joining us.

Financial market conditions improved in the fourth quarter with credit spreads continuing to tighten for many asset classes. As Rich mentioned, our general account credit losses and impairments were at their lowest quarterly level of the past two years. While we may not have seen the last of volatility, we have a very high quality, diversified investment portfolio and remain comfortable with our risk position.

I will start with our fixed maturity portfolio. Our general account fixed maturity portfolio is in a net unrealized gain position, roughly $1 billion at year-end. This compares to net unrealized losses of $6.6 billion a year earlier.

Gross unrealized losses on fixed maturities in our general account stood at 4.4 billion at year end. This represents a recovery of about $7 billion from $11.3 billion a year earlier. Roughly $1.3 billion of total gross unrealized losses at year-end relate to subprime holdings. This compares to $1.5 billion at the end of the third quarter and $1.8 billion a year earlier.

Total subprime holdings were roughly $4.3 billion at year-end based on amortized costs. This represents a decrease of about $300 million from the third quarter, reflecting over $200 million of paydowns during the quarter and the $70 million of impairments that Rich mentioned.

The insurance regulators have changed their ratings approach for non-agency residential mortgage-backed securities effective with year-end 2009 reporting. Under the new approach quality classifications and statutory capital charges are based on evaluation by an independent third party of loss exposure on a security-by-security basis and consider the insurance companies carrying value as well as the risk of loss given the securities' cash flow priorities.

Since these NAIC categories drive the capital requirements for our holdings, we have adapted new displays to the new approach and now distinguish between high and highest-quality fixed maturity holdings or NAIC categories 1 and 2 and those in lower NAIC categories 3 through 6 rather than distinguishing between investment-grade and below investment grade.

Based on amortized costs and the NAIC categories, about 7% of our $135 billion general account fixed maturity portfolio ranks below high and highest-quality as of year-end 2009. A year earlier, about 7% of the fixed maturity portfolio was classified as below investment grade when rating agency and NAIC categories were essentially equivalent.

One last comment on the investment portfolio. We had $22 billion of general account commercial mortgage and other loan holdings as of year-end based on principal balances. At December 31 the average loan-to-value ratio for our commercial mortgage holdings is 65% and the average debt service coverage ratio is 1.8 times. And I remind you of our comments on investor day with respect to the conservative cap rates reflected in the loan-to-value ratio. Delinquencies are still light, amounting to less than 1% of the holdings.

Now I will cover our business results for the quarter starting with the U.S. business.

Our annuity business reported adjusted operating income of $88 million for the fourth quarter compared to a loss of just over $1 billion a year ago. Results for the current quarter reflect several discrete largely market driven items that Rich mentioned with a net unfavorable impact of $30 million.

Current quarter results include a net charge of $109 million from mark-to-market of hedging positions and embedded derivatives for our living benefit guarantees. This charge includes $71 million representing the breakage between changes in the value of our living benefit guarantees and the related hedging instruments included changes in the market-based measure of our nonperformance risk, reflecting the tightening of our credit spreads during the quarter.

The remainder represents mark-to-market on hedges we put on in 2009 to help protect our capital from exposure to lower equity prices and was driven by the uptick in the equity markets during the quarter. Going the other way, current quarter results include a benefit of $47 million from the release of a portion of our reserves for guaranteed minimum death and income benefits and a further benefit of $32 million from reduced amortization of deferred policy acquisition and other costs, in both cases reflecting favorable market performance.

Results for the year-ago quarter included a $907 million negative effect from unfavorable unlockings, reserve strengthening and market-driven true-ups, $130 million of negative hedging breakage and a charge of $97 million for a goodwill write-off.

Stripping all of these items out of the comparison, annuity results were up $23 million from a year ago reflecting higher fees due to growth in our account values over the past year driven by improving financial markets and over $9 billion of positive net flows.

Our gross variable annuity sales for the quarter amounted to $4.8 billion compared to $2.1 billion a year ago. Our highest daily or HD living benefit guarantees have provided us with a substantial competitive advantage in the variable annuity market. These products include an auto rebalancing feature that shifts customer funds to fixed income investments to protect account values and support our guarantees in market downturns.

We have completed our transition to our new HD 6 Plus living benefit product feature which was introduced in August. About $1 billion of the current quarter's sales, substantially all in the first month of the quarter, represented spillover sales of the earlier HD 6 product -- of the earlier product, HD 7 Plus. Significantly, monthly sales continued at a similar level in November and December suggesting that our new product is still attractive in the marketplace.

Our take-up rate for HD features, the percentage of eligible premiums where the customer has elected the benefit, was over 90% for the fourth quarter. The popularity of these features has driven the growth of our auto rebalancing book of business, reducing our risk profile and limiting our exposure to changes in hedging costs.

As of year-end about two-thirds of our account values with living benefits are subject to auto rebalancing compared to just over half of the account values a year earlier. The auto rebalancing algorithm is functioning as intended, returning customer funds to participate in market appreciation as account values become adequate to support our guarantees.

With the improving financial markets about $6.3 billion of account values that had been rebalanced to fixed income investments during the market downturn returned to client selected investments over the past three quarters. As a result, less than one-quarter of account values for auto rebalancing products were in our fixed income rebalancing accounts as of year-end, compared to nearly 80% a year earlier.

Net variable annuity sales were very strong in the quarter amounting to $3.2 billion, bringing net sales for the year to more than $10 billion. The retirement segment reported adjusted operating income of $133 million for the current quarter, unchanged from a year ago.

Results for the year-ago quarter benefited by $33 million from refinement of our reserve, for a block of traditional group annuity business, based on an actuarial review of the beneficiary population.

Stripping out reserve refinement out of the comparison, results for the retirement business were up $33 million from a year ago driven mainly by higher investment spreads. The higher spreads reflect crediting rate reductions coupled with growth imbalances in our full-service, stable value business and the maturity of a guaranteed investment contract dating back to before our demutualization that was generating a negative spread.

Current quarter full-service gross sales and deposits were $4 billion compared to $6.5 billion a year ago, which included two large case wins totaling $2.4 million. The current quarter gross sales and deposits brought our full-service gross inflows for the year to a record high of $23 billion, up more than 20% from 2008. Our full-service persistency was 98% and net flows were $900 million for the quarter, bringing our positive net flows for the year to $8.8 billion, also a record high.

The asset management segment reported a loss of $6 million for the current quarter, compared to a loss of $69 million a year ago. The reduction in the loss reflected improved investment results associated with proprietary investing activities, which contributed income of about $10 million in the current quarter compared to losses of about $150 million a year ago. The year-ago quarter losses came mainly from investments in fixed income and equity funds that we manage, which we later redeemed.

The reduction in proprietary investing losses was partly offset by unfavorable results from commercial mortgage operations, largely driven by charges on interim loans we hold in the asset management portfolio, resulting in current quarter reserve expense of about $100 million.

Adjusted operating income from our individual life insurance business was $141 million for the current quarter compared to $9 million a year ago.

Results for the year-ago quarter were negatively affected by accelerated amortization of DAC and other items together with related costs, driven by unfavorable separate account performance linked to the 22% decline in the S&P 500.

We estimate that the swing in these largely market-driven charges had a favorable impact of about $115 million in the comparison of current quarter results to a year ago. The remainder of the improvement in results came mainly from more favorable mortality experienced in the current quarter.

Sales amounted to $91 million in the current quarter, compared to $86 million a year ago. The increase was driven by strong performance of our universal life and term products.

Our sales have benefited from market opportunities due to the retrenchment of some carriers and from our competitive position. Pricing in this market has generally trended upward and we began to implement a new round of price increases for universal life and term during the fourth quarter.

The group insurance business reported adjusted operating income of $69 billion in the current quarter, unchanged from a year ago. We have not seen a measurable impact on our reporting results from general economic conditions.

Our current quarter benefit ratios for both group life and group disability are reasonably consistent with the levels of a year ago and two years ago.

Sales for the quarter were $62 million, compared to $102 million a year ago. Group insurance sales don't follow a linear pattern but large case sales following a lengthy bid process and most of our sales are recorded in the first quarter, based on the effective dates of the business.

Turning to our international businesses. Within our international insurance segment Gibraltar Life's adjusted operating income was $151 million in the current quarter, compared to $160 million a year ago. Results for the year-ago quarter, benefited by $9 million from the sale of a branch office property.

Current quarter results include income of $11 million from the Yamato Life business we acquired in May of 2009. Contribution of the acquired business was essentially offset in the current quarter by expenses of roughly the same amount under an ongoing technology improvement program.

Sales from Gibraltar Life based on annualized premiums in current dollars were $151 million in the current quarter, up $49 million from $102 million a year ago. Bank channel sales were $47 million in the current quarter, up from $12 million a year ago. The increase was driven almost entirely by sales of life insurance protection products that we began to distribute through banks late in 2008. Sales from the Life Advisor channel were up by $14 million or 16% from a year ago, also driven mainly by sales of life insurance protection products.

Our life planner business reported adjusted operating income of $302 million for the current quarter, up $41 million from a year ago. The increase came mainly from continued business growth and more favorable mortality experienced in the current quarter.

Sales from our life planner operations based on annualized premiums in constant dollars were $224 million in the current quarter, up $38 million from $186 million a year ago, a 20% increase.

Sales outside of Japan were up by $25 million, mainly driven by increased sales of retirement-focused products in Korea in advance of a repricing. Sales in Japan were up $13 million, reflecting a resurgence from the year-ago quarter when sales were negatively affected by generalized market concerns about U.S. companies.

International insurance sales on an all-in basis including Life Planners, Life Advisors and the bank channel, amounted to $375 million for the fourth quarter. For the year, sales reached a record $1.4 billion, an 11% increase over 2008. The sales growth reflects our expanding distribution and our continuing emphasis on products that meet life insurance protection and retirement needs. Foreign currency translation was not a major factor in the comparison of our international insurance results due to our currency hedging programs.

The international investment segment reported adjusted operating income of $4 million for the current quarter, compared to a loss of $420 million a year ago. The loss in the year-ago quarter was driven by impairments of joint venture investments and goodwill write-offs totaling $426 million. Stripping out these charges, results were essentially unchanged from a year ago.

Corporate and other operations reported a loss of $199 million for the current quarter, compared to $288 million a year ago. Results for the year-ago quarter included a charge of $117 million to write-off all of the goodwill in our real estate and relocation business and a $32 million gain from early redemption of convertible debt. Stripping out these items, the loss from corporate and other operations was essentially unchanged from a year ago.

Our results are bearing the cost of negative spread on the liquidity we are holding and higher interest expense on capital debt within corporate and other results. Interest expense net of investment income produced a negative variance in corporate and other results of about $75 million compared to a year ago.

The increase in net financing cost was essentially offset by a $36 million reduction in the loss from our real estate and relocation business, excluding the goodwill charge and by lower expenses.

And briefly, in our Closed Block Business. Results of the Closed Block Business are associated with our Class B Stock. Closed Block Business reported net income of $77 million for the current quarter, essentially unchanged from $74 million a year ago. We measure results for the closed block business only based on GAAP.

To wrap up, I would like to turn back to the financial services businesses and sum up where we came out for the year.

Each of our operating divisions recorded strong results. Pretax adjusted operating income for our three divisions was over $4 billion for the year, more than double the level of 2008. We have enhanced our competitive position and we are building our franchise with strong sales and net flows virtually across the board.

Growth in net sales for variable annuities and full-service retirement were at record high levels for the year and international insurance sales also reached a record high, up 11% from 2008. We realized the value from our investment in the Wachovia Securities joint venture with cash proceeds of $4.5 billion and an after-tax net gain of $1.4 billion, or $2.95 per common share.

Our strong operating results together with the gain on the Wachovia joint venture contributed to our net income per common share of $7.63 for the year. We bolstered our financial strength and flexibility during the year with issues of common equity and long-term debt totaling more than $4 billion.

With our strong balance sheet we are well-positioned for business growth and market opportunities.

Thank you for your interest in Prudential. Now we look forward to hearing your questions.

Question-And-Answer Session

Operator

Thank you. (Operator Instructions) And our first question will come from the line of Andrew Kligerman from UBS. Please go ahead.

Andrew Kligerman – UBS

Hey. Good morning. First question revolves around acquisitions. Can you remind me of your priority list of what areas you would like to acquire in if you do? And then give a sense of the environment – is there a lot of opportunity to do something right now? And then thirdly, debt to capital of 21.6%, can you give me a sense of what your excess debt capacity is given that debt-to-capital-ratio?

Eric Durant

Okay. Do you want to take the third one first, Rich? Andrew, we will start with Rich on the third question and then we will come back to that one and two.

Andrew Kligerman – UBS

Sure.

Rich Carbone

A 25% targeted debt-to-capital-ratio. Our debt capacity which includes capital debt and hybrid is $5.3 billion.

Andrew Kligerman – UBS

Great.

John Strangfeld

And as far as the environment, let me take that first in a broader context and then more specific to M&A, because I think it's an important part of our story and understanding how we see ourselves right now. And clearly, in times like these there is a lot of upside associated with a strong brand and a strong capital position. It clearly expands existing opportunities and it also creates new opportunities. And converting these opportunities into a reality is the charge of our business leaders and as you can see from the fundamentals they are definitely succeeding at this.

We feel very good about the inside opportunities and we feel intrigued by the outside opportunities. The inside are the type of things you are seeing in market share gains, which in some cases have to do with product and in other cases have to do with distribution and in other cases have to do with both. And when you look at some of the progress we are making in some of these areas organically, they are in some sense in terms of magnitude the market share gains that you would normally associate with M&A, without the operating risks that you also have that comes along with M&A. So that's the organic piece.

As for M&A, Andrew, to come more specifically to this. First, there are obviously a number of well-publicized franchises in flux with timelines that are uncertain. Whether we buy them and whether we simply compete with them is going to be a function of a wide variety of considerations and market dynamics. It is no doubt an interesting time in terms of supply and demand and there are a limited number of counterparties that have the scale, the scope, the management and financial capacity that we do which we think should make us an attractive buyer.

And areas in particular would be areas in international such as some of the things you have seen us do historically. Areas in retirement in the U.S. would be two of the primary areas of attractiveness and other associated lines of business. The reality is we can't predict the likelihood or the timing of M&A. We never have. It's hard to do and it's kind of binary as to how and when it happens. But we are very proud of our track record in this area and we also view our skills as being a distinctive confidence.

So I guess the bottom line of this is that while we think there are a lot of encouraging things about the market dynamics, I would summarize it by saying kind of the phrase we used I think at investor day is, 'We shall see.' That was an important final comment on this, what is important to say is we don't think of our prospects as being M&A dependent. We have a lot of momentum on the organic side of our business is very real and we think in most cases, quite sustainable. So in other words, M&A is an opportunistic overlay on what we view as being a very healthy organic strategy.

Andrew Kligerman – UBS

So it doesn't sound John, like there is anything really transformational that you want to do. It sounds like there are certain areas that you would like. Is that fair?

John Strangfeld

I think I would be reluctant Andrew, to be very specific about that. But I think you can imagine that in terms of the types of things we do, the types of things we consider and the manner in which we approach them would be consistent with what you have seen us do in the past.

Andrew Kligerman – UBS

Got it. And then just lastly, I think Mark was talking about some incremental universal life and term insurance pricing increases. Could you give us a ballpark of the magnitude? Just a little color on what is driving that and what we can expect down the road in terms of pricing.

Bernard Winograd

Hi. Andrew, it's a Bernard Winograd. We are looking at margins in this business carefully. As I think you fully appreciate, the cost of financing of reserves is an incremental cost to the business that the environment has created. We have done well over the years in terms of profitability of our life franchise in the U.S. by being very disciplined about the ROE targets that we set and the pricing that we ask for in order to get to those targets and letting the market share sort of fall out as a result. And so what we are doing here in the fourth quarter or excuse me, what we did in the fourth quarter was move back to where we need it to be in our view in our to compensate for the increases in costs.

With any increase of this kind it's sort of a complex spreadsheet but call it in the 5% to 10% range depending on the sell and we feel like at that point we have made up or compensated for what we need to in terms of cost. We will have to see whether the market will sustain it but our expectation is that others in the industry may have similar views. And judging by reactions since some have opposite views. So we will just have to let the market share fall out where it this.

Andrew Kligerman – UBS

And Bernard this puts you at what ROE level by getting the 5% to 10% range across these products?

Bernard Winograd

No. We don't generally discuss what the ROE was on any given product but you can certainly see that the ROEs of the segment have been somewhat extraordinary actually compared to the industry as a whole.

Andrew Kligerman – UBS

Okay. Thanks a lot.

Operator

Thank you. Our next question comes from the line of Suneet Kamath from Sanford Bernstein. Please go ahead.

Suneet Kamath – Sanford Bernstein

Thank you and good morning. Just for Rich, wanted to get just very specific on balance sheet capital capacity and the redeployment of capital capacities. So just very simplistically I think you said 3.5 billion to 4 billion on balance sheet capital capacity. I think you said historically you have maintained 2 billion to 3 billion of capital capacity on the balance sheet. So subtracting one from the other we are talking about $1 billion to $2 billion of on-balance sheet capital capacity that you could redeploy today. Is that right?

Rich Carbone

That is correct.

Suneet Kamath – Sanford Bernstein

Perfect. And then two other questions. First, again for Rich in terms of the capital. In the past pre-crisis, you have talked about I think 60% of your operating earnings as something that we could think about as free cash flow. Given that now we are post-crisis that the significant growth that you are seeing in the business is that 60% still a number that we should think about or is there an update to that?

Rich Carbone

That is probably a little high right now. The growth particularly in the annuities business is attracting but holding on to their cash in order to finance their DAC. So I think it's a good story that the business organic growth is reducing that 60, 40 payout ratio, if you will, from the subs. We will refine that during the year and get a clearer picture on that.

Mark Grier

And just one comment on that, remember that that is an over time number. When there is a big divergence between operating earnings and net income there is a difference there because it's net income that drives the capital accounts.

Suneet Kamath – Sanford Bernstein

Understood. And then the very last related question. Roughly 3 billion of net flows in variable annuities in the quarter was much bigger than we have seen from a lot of your competitors. The question is and I think this relates to some comments that John made at investor day about balancing the growth in VAs with the growth in the rest of the franchise, would you think that a $3 billion per quarter run rate is something that you would be comfortable with for 2010 or at some point do you start to throttle that back? Thanks.

Bernard Winograd

Suneet. This is Bernard. Let me take a shot at that. I think what we feel at the moment is that we have an unusual opportunity in the marketplace. Because of our financial strength and because of the unique design of our products and the fact that it's relatively less risky than a lot of competitors products and risk is a big cost in this activity, we are able to make pretty extraordinary sales and market share gains at the moment and be very comfortable with what we are selling. We have also got the benefit here of on an ongoing basis that a lot of the sales are coming from the creation of new relationships and distributors who did not sell our products before. So there is a kind of run rate effect that is building here in the marketplace with every passing quarter.

The overall question of what kind of limit we would put on our position in this market is a little bit of a moving target because it depends upon, not just the growth here but the growth elsewhere. But the risk-controlled nature of what we’re adding to the balance sheet here makes us much more comfortable than we would have been if we were adding the kind of products that we used to sell and that others in the industry are still selling.

Mark Grier

Yeah. Suneet. It’s Mark. Let me just add two things. One is that we are very comfortable with the economics of what we are doing in the variable annuity business. We do understand that there are sensitivities to the volatility and the complexity and the lack of transparency and linear relationships in terms of the accounting results. And that is a source of frustration because the accounting is, I believe, quite a lot more volatile than the economics. But we are sensitive to that issue and we continue to focus on how that fits in to the bigger picture of Prudential overall. But again in terms of the fundamentals, the economics and cash outcomes we are very comfortable with where we are here and finally, we are not pricing to aggressively gain share.

We are pricing to meet targets that we think are appropriate for the business. We are not compromising. We are not buying share at the expense of future profitability. And I think our approach has been healthy. We have been the beneficiary of some turmoil in the markets combined with the value of our brand and the quality of our product but not necessarily reflecting aggressive pricing to gain share. So that is another overlay on our comfort level that puts this in context. We do have significant share gains but they don't result from an attempt to undercut everybody in terms of pricing.

Suneet Kamath – Sanford Bernstein

Okay. Thank you very much.

Operator

Thank you. Our next question comes from the line of Nigel Dally from Morgan Stanley. Please go ahead.

Nigel Dally – Morgan Stanley

Great. Thanks. Good morning. A couple of questions for Bernard on your commercial mortgage activities. Relatively sizable loss this quarter associated with the interim portfolio. Perhaps if you can provide us a little more detail as to what drove the loss. I guess the key issue I am trying to get to is did the actions this quarter effectively put to rest the risks surrounding those exposures or is there still the potential for similar meaningful losses now going forward? Also at your analyst day you were optimistic that we were seeing signs of stabilization in commercial real estate. I am assuming your views haven't changed but it's best if you can also provide an update as to your outlook for commercial real estate in 2010? Thanks.

Bernard Winograd

Happy to do both those things Nigel. The interim loan portfolio, I think what just to revisit what I said back on investor day was in anticipation of what you now see in terms of these reserve activity. We have gotten to the point where we believe we have reserves that are probably a good approximation of what the ultimate losses will be on this portfolio. Which is not to say that there won't be more reserves, because there is a tendency for the, in the way the accounting for these things work for the reserves ultimately to overshoot the actual losses and then result in gains as things work them through over time. But we certainly don't think that the run rate, if you will, of reserves that we took in the fourth quarter are in any way indicative of what the future experience will be because we have gotten to that point.

With regard to the stabilization of the market, just to be clear, what I was referring to which I think I would affirm is that we believe we have begun to see a turn in the valuation of commercial real estate which has begun to trend up beginning late in the fourth quarter and continuing. The fundamentals of real estate are not necessarily yet following the valuation. We do still have questions with regard to what the ultimate vacancy rate will be and so forth. But because the expectations are that we are close to that bottom values are beginning and because there is a lot of money looking to take advantage of the bottom, we are beginning to see a stabilization in values. Our conviction in that regard has gotten, if anything, stronger since investor day.

Nigel Dally – Morgan Stanley

That is great. Thank you.

Operator

Thank you and our next question come will come from the line of Tom Gallagher with Credit Suisse. Please go ahead.

Tom Gallagher – Credit Suisse

Hi. First just a follow-up on the M&A question. John, can you talk about what line of businesses you would be most interested in? I know you talked a bit about geographies. Are you still thinking more internationally traditional insurance businesses and domestically retirement and would you consider an acquisition that significantly increased the size of your variable annuity business? That is my first question. Second question is the $38 million macro hedge charge you took for variable annuities. Should we really consider that a one-timer since I assume if the market continues to go up that these would be recurring?

John Strangfeld

Okay. Tom, this is John. I will take the first part of that. I think you characterized it well that our primary interest would be on the international side would be in traditional insurance. But bear in mind what we are seeing happen with traditional insurance is it's increasingly migrating to have a retirement component to it. We are seeing this very evident in Japan and we think there will be more signs of this over time. So that distinction between traditional protection and traditional retirement is beginning to morph in some sense like our U.S. business mix did over time. Domestic retirement as well I think you characterized.

As for VA business the probability of us doing a pure-play acquisition in the VA space is highly unlikely because most other books don't look like the product design that we have that we feel so comfortable with. Having said that, you can't imagine circumstances were as part of a broader opportunity there may be a component of it that has a VA element to it. And we would simply have to evaluate that at that time.

Mark Grier

On the capital hedge the short answer is yes. That is an outright short and, all things being equal it will go down when the market goes up and vice versa. However, we have also said in the past that we are evaluating alternative approaches to hedging capital and we are always looking at market conditions and other ways to accomplish our objectives. So I won't necessarily commit to having that in place forever but the answer right now is yes. It's a direct outright short.

Tom Gallagher – Credit Suisse

Okay. Thanks.

Operator

Thank you. We’ll go to the line of Eric Berg with Barclays Capital. Please go ahead.

Eric Berg – Barclays Capital

Thanks very much. John, just a quick follow-up on the M&A question. Recently one of the leading consulting actuaries in the business in the M&A area said that he was more busy last year than ever in terms of receiving requests to do appraisals for properties for sale. But even though he got paid a lot because he was more busy than ever, he didn't complete a single transaction because of the big gap in pricing expectations between buyer and seller. Now that markets have improved and the distress on sellers is so much less than it had been is it reasonable to think that the environment to actually do transactions is better than it was at this time last year?

John Strangfeld

Eric. There is some very interesting different dynamics at work here. If you had asked us 15 months ago would there be opportunities arising from all of the turmoil in the marketplace, we would have said absolutely yes. And at that time our expectation would have been that over the ensuing 15 months or so we would have seen a lot more M&A than we have seen. So that was surprising to us not to see more take place. But what was equally surprising to us was just if you want to call it the flight to quality. And in our case the positioning to take advantage of it so that the organic side of this was far more pronounced than we would have thought. It is also a product of this turmoil. Now, as we get into a more stabilized environment you got competing forces. In some cases that means there is less need.

In other cases they have a commitment to divest. On the other hand, the availability of financing and capital is greater than it was at that time so there is a variety of forces at work here. I think it partly depends upon the time horizon you want to use. There is so many things that may eventually come on the market were being sold by parties that never actually anticipated the sale so they were necessarily prepared for it. So I think that the gestation period of this in a number of cases has taken longer and I think there was a period when there was a gap between perception of value by seller and buyer and the complexity of financing. So some of those things are normalizing and some of those forces will remain at work. So it's a little hard to judge but think of it also though as having an interplay as we have experienced between the M&A and the organic. There is a stronger balance of the two than we would have thought going into this.

Eric Berg – Barclays Capital

And would you say last and final question. Would you say that the pickup in market share that you are getting, obviously incredibly strong in the United States. Do you think that you have benefited from a flight to quality in Japan? Is the addition to your business, is the perception of U.S. companies in general and Pru in particular as strong relative to the peers there as it is here?

John Strangfeld

I would like to get Ed Baird, Eric, to respond to that.

Ed Baird

Yeah. Hi. Eric. The results obviously are very strong across the board in our biggest operations both in Japan and Korea. While you can never know for certain what the drivers are, it would strongly suggest that there is a growing recognition by the consumer to be able to differentiate between those foreign companies that are distressed, some to the point of actually withdrawing from the marketplace in Japan and those that are really committed and surviving well. So I think that is one of the reasons we suffered, along with some of the other foreign companies with relatively soft performance in the fourth quarter of '08. Whereas the fourth quarter of this year, as you can see, was a very strong sales quarter for us. So I do think that differentiation you are inquiring about is taking place in the market.

Mark Grier

I also think Eric, the other form of differentiation is not necessarily at the end consumer. It's also at the distributor or their intermediary if there is one. Meaning that they have it and we see this in the U.S. as well where they have a propensity, they may have it all on the shelf but they may have a greater propensity to be comfortable with our product rather than others. And there is less of a complicated story to tell.

Eric Berg – Barclays Capital

Thank you.

Operator

Thank you. And our next question comes from the line of John Nadel from Sterne, Agee. Please go ahead.

John Nadel – Sterne, Agee

Hey, Good morning. Most of mine have been asked and answered but just a question for you. Mortality in both the U.S. and Japan appeared to be actually very good this quarter. I am wondering if you can just give us a sense for relative to longer-term expectations for mortality under your pricing assumptions how much would you estimate mortality contributed above those longer-term expectations in the quarter? Just trying to think about where we would go if mortality was just in line.

Bernard Winograd

John, it's Bernard Winograd. In the U.S. the answer to that question would be $32 million.

John Nadel – Sterne, Agee

And in Japan, do you have a similar?

Ed Baird

Yeah. No. Actually on the international front the story is a little bit different. Gibraltar results were affected by a return more to normal mortality. Last year in this quarter was unusually favorable. In fact, we estimated probably about $12 million roughly. You never normalize these things exactly. So I think the number you are looking for on mortality in Gibraltar is a fairly indicative mortality rate. And I don't think there was anything extraordinary one way or the other on the POJ line.

John Nadel – Sterne, Agee

Perfect. Thank you.

Operator

Thank you. Our next question comes from the line of Ed Spehar from Bank of America/Merrill Lynch. Please go ahead.

Ed Spehar – Bank of America/Merrill Lynch

Thank you. I wanted to ask some capital questions. Rich, just to make sure I understand at the investor day I think you said capital capacity of 4 billion. Is that the comparable number to the 3.5 to 4 you just gave us?

Rich Carbone

No. On Investor Day I said net on balance sheet capital capacity was 2 billion. And then at the bottom of the slide, I said but if we settle the Wachovia foot at the full proceeds we would add another 2 billion.

Ed Spehar – Bank of America/Merrill Lynch

Right. So that's 4.

Rich Carbone

That's 4. So the 3.5 to 4, I am talking about today of course, includes the recognition realization of the Wachovia proceeds and that compares to the 2 billion of Investor Day without the Wachovia proceeds.

Ed Spehar – Bank of America/Merrill Lynch

Right. Okay. So okay. I got it. Is that in terms of the holding company? This 1.5 billion that you said on the call today, should we subtract off the 1 billion for 1.5 times coverage to say that sort of the excess is 500 million?

Rich Carbone

No. You are mixing cash and capital. The 1.5 billion at the holding company is cash. Now some of that -- it's hard to separate it at times from capital. But just think about that 1.5 billion as cash. $500 million is extra cash held at the holding company and $1 billion is the cushion that we will use to pay our debt service costs throughout 2010. You have to keep in mind that's a bit of an evergreen number because we are expecting dividends from the subs to replace that during the year, which is why technically we don't count that against our capital.

Ed Spehar – Bank of America/Merrill Lynch

Okay. I guess the real question is, if you do some math here it looks to me like with a mid 500 RBC ratio that if we assumed 400 was the right level, which is 50 points higher than what you used to assume I think, that would say that there is about 3.5 to 4 billion, I am sorry, about 3 to 3.5 billion I think at PICA above a 400 RBC? That is pretty close isn't it?

Rich Carbone

Yeah. That's the majority of the 3.5 to 4 billion is represented by the difference between the 400 and the mid 550 RBC in PICA.

Ed Spehar – Bank of America/Merrill Lynch

Okay. So you have got 3 to 3.5 at PICA. It seems like you probably 500 million at the holding company isn't probably that far off.

Rich Carbone

No.

Ed Spehar – Bank of America/Merrill Lynch

I guess the question is this, why -- a 400 RBC is four times regulatory minimum capital. I would think that most of us believe that that is factoring in a cushion. When you refer to this 2 to 3 billion that you have historically held, are you telling us that the cushion you need to have for the real cushion is essentially it's a 500% RBC ratio? I mean it just seems like, I don't quite understand why 3.5 to 4 billion of capital capacity isn't 3.5 to 4 billion of capital capacity.

Rich Carbone

It is a 3.5 to 4 billion of capital capacity, but its capacity needed to sustain a 400 RBC. I thought I said this. Its capital needed to sustain a 400 RBC in a stress scenario so that is capital for the two purposes, right? If there is another stress scenario and we want to keep PICA at 400 we have got to take some of it out and dump it down. I think it's as simple as that. If we let it -- if we allow PICA to drop lower then that is -- but that's a different construct to calculate capital capacity. So the 3.5 to 4, I am repeating myself, is there for dislocations in the marketplace, fund organic growth, et cetera.

Ed Spehar – Bank of America/Merrill Lynch

Okay. Thanks.

Operator

Thank you. And we have one final question will be from the line of Colin Devine with Citigroup. Please, go ahead.

Colin Devine – Citigroup

I have two questions. I guess first for Bernard, I know we have watched the yield on the fixed income investments come steadily down. And how much of a drag on the earnings is this starting to be? And then secondly for Rich, when I hear the questions about capital and how much you have raised it just seems there is a pattern now that Prudential is almost in the market every quarter raising capital. Now, if we look back to what the JV ultimately added to PICA, I guess that is over 5 billion you had to raise the surplus note. Why do you need all of this capital? You are issuing debt here in January. I would have thought at this point that you had more than enough.

Rich Carbone

Colin, that is a fair question but we are mixing up capital debt refinancing with operating debt refinancing. All of the refinancings that were done in January fulfilled virtually all of our operating debt needs, refinancing needs, pardon me, for 2010. So none of the debt issuances that took place in January were capital debt, it was all replacement of operating debt that matured or pardon me or that will mature throughout 2010.

Colin Devine – Citigroup

Do you think you are done at this point for the year?

Rich Carbone

Yeah. We are pretty much done.

Colin Devine – Citigroup

Okay. And net-net how much since the end of the fourth quarter of '08 has the capital position of PICA been strengthened? And then on to Bernard for investments and I had a follow-up question VA.

Rich Carbone

Okay. So let's go through it. We know we had the gain on Wachovia that strengthen the capital position in PICA. We know we issued $500 million in notes to Nippon Life.

Colin Devine – Citigroup

Rich, just to clarify, it would be the whole contribution of the JV wouldn't it? Not just the gain?

Rich Carbone

No. Let's go back. No, let’s go back. We contributed the book value in 2008.

Colin Devine – Citigroup

Well, that's what I asked from fourth quarter of '08. I want to pick up the end of '08, if you like December 31, '08, to December 31, '09, how much you have strengthened PICA on that 12-month period.

Rich Carbone

All right, Colin. I read that to be what we put in 2009.

Colin Devine – Citigroup

Yeah.

Rich Carbone

So you want to start in 2008?

Colin Devine – Citigroup

Well, we might as well pick up the JV.

Rich Carbone

We have contributed the book value in 2008. We picked up the gain in 2009. So in total that's going to be $3.7 billion after tax. We did the $500 million in Nippon and we added about and now you are testing my memory. In the first quarter of 2009, we added or converted about $500 million of retail notes brought the cash up to the holding company and then contributed that down to PICA. And that was about it.

Colin Devine – Citigroup

Okay.

Rich Carbone

The last one maybe Neil or Eric and get back to you on to verify that, but that's it.

Colin Devine – Citigroup

Okay.

Rich Carbone

The lion's share was the Wachovia gain, the Wachovia original book value and the $500 million Nippon surplus note.

Colin Devine – Citigroup

Thank you.

Operator

Thank you. And with that, ladies and gentlemen, that does…

Colin Devine – Citigroup

Wait a minute. Question on investment yield.

Operator

(Operator Instructions) And please go ahead.

Colin Devine – Citigroup

Okay. And then Bernard also made a comment about the VA products that you used to sell. And I was wondering what's different since one of the ones you used to sell was the HD 5 and I assumed he was referring to that being -- not reaching its target profitability.

Bernard Winograd

Colin, I think that it's a -- yes, absolutely. Let me clarify that. I think the point, I am making is with regard to the level of risk relative to any given market level. So certainly, even if you sell an auto rebalancing product, you are in market falls 40%, you are going to have some incremental capital and you are going to be disappointed in the behavior of that cohort. But the point from our perspective is that over a cycle which is an investment cycle, which is how you have to think about the pricing you are going to average in to what you sell. And the things that you sell at the bottom of the investment cycle are going to way outperform your expected results and the things you sell at the top of the investment cycle are going to underperform. The point about the HD product set is just that it narrows the variation along the way. It doesn't -- it's not a complete immunization from the kind of extreme market movements we have seen.

Colin Devine – Citigroup

Okay. Perhaps we can follow-up on that one later with Eric just so I am clear on the differences between the 5 to the 7 back to the 6 and why the 5 is not a problem. And then just on the bond yields coming down, how maybe for you or for Rich, they continue to drop fairly significantly. How much of an earnings drag is this starting to be or is that really what you brought down the ROE guidance long-term at the investor meeting?

Mark Grier

It's not why we brought down the ROE guidance. That reflects basically a whole bunch of market influences on some of the things like you were just talking about in annuities as well as the capital structure issues and excess or holding higher levels of liquidity. And there are a bunch of influences in that ROE picture. With respect to the level of interest rates, the impact on us is very gradual. We have maintained or in some cases even improved the spreads on our books where we have market sensitive liabilities, so we are not seeing much of a squeeze there. We do have the influence to use the insurance concept investing surplus and over time, as the yield on the portfolio goes down, we will see some impact from that. But the effect on us is very gradual and with respect to the core businesses we have held up extremely well.

Colin Devine – Citigroup

Okay. So I shouldn't be that concerned about the 36 basis point year-over-year drop in fixed maturity yields in '09?

Mark Grier

No. You don't see that moving through the elements of profitability that we have talked about.

Colin Devine – Citigroup

Great. Okay. Thank you.

Operator

Thank you. And ladies and gentlemen, today's conference will be available or replay after 1.30 p.m. Eastern today until midnight February 18. You may access the AT&T teleconference replay system by dialing 800-475-6701 and entering the access code of 138440. International participants dial 320-365-3844. And those numbers once again 1-800-475-6701 or 320-365-3844 and enter the access code of 138440. That concludes your conference call for today. Thank you for your participation and for using AT&T executive teleconference service. You may now disconnect.

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