Ladies and gentlemen, thank you for standing by. And welcome to the Prudential Second Quarter 2010 Earnings Call. [Operator Instructions] I would now like to turn the conference over to Mr. Eric Durant. Please go ahead.
Thank you very much, Cynthia. 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 second quarter of 2010, 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 recorded changes in asset values that are expected to ultimately accrue to contract holders and recorded changes in contract holder liabilities resulting from changes in related asset values.
The comparable GAAP presentation and the reconciliation between the two for the second 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.
Well, with that behind us, thank you very much for joining us. John Strangfeld, Rich Carbone and Mark Grier have some prepared comments. And then we will welcome your questions. John?
Thank you, Eric. Good morning, everyone. Thanks for joining us. I'll be brief.
Our earnings performance in the second quarter continued to be solid. Based on adjusted operating income, earnings per share were $1.51. This is down from last year's result, which reflected a greater benefit from items such as DAC and reserve unlockings that are largely market-driven. Taking these items out of both the current year and year-ago’s quarters, would produce an EPS increase of about 11%.
We achieved an ROE of 11% for both the second quarter and the first half, based on annualized after-tax adjusted operating income of the Financial Services businesses. Excluding the impact of market-driven and other discrete items, ROE would be roughly 10%.
Our all-in measures were also strong this quarter. Net income was $798 million or $1.70 per share. Our investment portfolio is performing well. And our general account fixed maturities are in a $5.8 billion net unrealized gain position at the end of the quarter.
Our GAAP book value per share reached nearly $60 at the end of the quarter, roughly 50% higher than a year ago. And excluding the impact of unrealized gains and losses on investments and pension and post-retirement benefits, book value increased by $4.3 billion or 19%.
Most importantly, our business momentum continues apace, as is demonstrated by strong flows and sales in many of our businesses. Sales in individual annuities remained exceptionally robust. Full Service Retirement recorded its 11th consecutive quarter of net additions. Our Asset Management business continues to enjoy extraordinary net flows in both institutional and retail AUM.
And finally, International Insurance sales again reached a new high based on constant dollars. This success reflects our high-quality products, expanding distribution, financial strength and strong leadership across our businesses.
We are focused on adding high-quality business that can contribute appropriate returns over the market cycles. We will also consider acquisitions, but will evaluate opportunities with our customary care.
To sum up, our financial results are solid. Sales and flows continue to be very strong. Our businesses are competitive in their markets, well led and well positioned for the future. We like our overall balance and mix of businesses. We would like to do acquisitions, but we don't need to do them to change our business mix or to address a problem. As we've said before, we view M&A as like to do, not have to do. Now Rich and Mark will take you through the second quarter. And then we welcome your questions. Rich?
Thanks, John, and good morning, everyone. As you've seen from yesterday’s release and as you’ve just heard from John, we reported common stock earnings per share of $1.51 for the second quarter, and that's, of course, based on adjusted operating income for the Financial Services businesses. This compares to $1.87 per share in the year-ago quarter. ROE was roughly 11% for both the second quarter and the first half of the year. And that is, of course, based on adjusted operating incomes.
Let me start with some high-level comments on the current quarter. We're benefiting from account value growth in our Annuity Retirement businesses, driven by strong sales and net flows as well as cumulative market value increases over the past year. In our Asset Management business, credit-related charges have declined, with commercial real estate value showing signs of improvement. And we are benefiting from higher Asset Management fees driven by strong growth in our assets under management. Lower results from our U.S. Protection business were driven by the equity market decline in the quarter and less favorable underwriting in Group Insurance. Our international businesses are continuing to perform well, and International Insurance sales are benefiting from our expanded distribution platform that Mark will discuss later on.
Operating results for some of our businesses were affected in the quarter by market-driven or discrete items, and I'll go through them now. In the Annuity business, mark-to-market of hedging positions earning better derivatives associated with our living benefit guarantees, together with the hedge we put on to help protect our capital from adverse swings in financial markets, had a favorable impact of $0.65 per share. The vast majority of this impact came from the market-based measure of our own non-performance risk that we are required to apply to the embedded derivative liability for all of these benefits.
Also in our Individual Annuity business and going the other way, we increased reserves to guaranteed minimum death and income benefits. And we increased amortization of deferred policy acquisition and other costs, resulting in charges of $0.30 and $0.14 per share, respectively, or a total of $0.44 per share. These charges were driven largely by the equity market downturn in the quarter.
Our Individual Life Insurance business recorded increased net amortization charges of $0.05 per share, also as a result of the equity market decline in the quarter.
In total, the items I just mentioned had a net favorable impact of about $0.16 on our earnings per share for the second quarter and about one percentage point benefit to our return on equity. Our results in the year-ago quarter benefited from favorable unlockings, largely driven by a 15% increase in the S&P 500 and other discrete items, with an estimated contribution of about $0.65 per share, that we identified last year in the second quarter.
Taking these items out of both the current year and the year-ago quarters, would produce an EPS increase of about 11% year-over-year or quarter-over-quarter, I should say.
Moving to the GAAP results of our Financial Services business. We reported net income of $798 million or $1.70 per share for the second quarter compared to $538 million or $1.25 per share a year ago. GAAP pretax results for this quarter include amounts characterized as net realized investment gains of $212 million. These gains reflect $349 million of market value increases on derivatives, mainly in our duration management programs driven essentially by changes in interest rates.
The gains on the derivatives were partially offset by impairments and credit losses in the quarter amounting to $169 million. About $90 million of the impairments and credit losses came from holdings in our Japanese insurance operations, reflecting currency exchange rates as well as credit issues. The remainder was spread across various asset classes in our U.S. portfolio.
Turning to where we stand on capital. First I'll focus on our insurance companies. We began the year with an RBC of 577 for Prudential Insurance. During the second quarter, Prudential Insurance paid a $2.4 billion dividend to the parent company. While this dividend had no impact on our overall capital position, it did reduce the statutory capital of Prudential Insurance. If we were reporting RBC for Prudential Insurance as of June 30, we believe that it would be well above 400. Keep in mind that this is hypothetical since RBC is an annual calculation, and we do not have a bottoms-up calculation at this time. Our Japanese insurance companies, Prudential of Japan and Gibraltar Life, each reported solvency margins as of their fiscal year end, March 31, 2010, comfortably above their benchmarks for AA rating.
Looking at the overall capital position for the Financial Services business, as you have heard from me in the past, we measure our capital by starting with the capital we need to run the company, which we call required equity, and compare this amount to the capital we have on balance sheet, which includes actual equity and long-term debt that we classify as capital debt. Required equity assumes the amount of capital we need to maintain a 400 RBC ratio at Prudential Insurance and solvency margins at our international insurance companies that we believe are consistent with or above AA ratings targets. We estimated that all-in balance sheet capital capacity for our Financial Services business at year end 2009 was in the range of $3.5 billion to $4 billion.
Since many of the inputs into our capital capacity are based on annual calculations, I'm hesitant to provide a hard update for this range at this time. That said, and considering the capital generated by our businesses during the first half of the year, the capital needed to support business growth, the impact of the equity market decline and the credit migration and impairments, I would estimate no material change through June 30, a long way of saying, “No material change.”
We have historically maintained on-balance sheet capital capacity in the range of $2 billion to $3 billion for the anticipated business growth, market opportunities and as a buffer against potential stress conditions. We’d expect to hold a reasonable margin going forward.
We also have capacity for additional leverage we think of as off-balance sheet capital capacity. We measure this capacity by comparing our reported debt-to-capital ratio to 25% maximum. As you know, Moody's recently issued guidance that will reduce the equity credit that we give for hybrid securities, like we’ve issued from 75% to 25% -- it was the other way around in the past -- effective as of the end of this year. We used Moody's more stringent methodology to update our calculation of the debt-to-capital ratio this quarter. This change in the calculation drove most of the increase at our reported debt-to-capital ratio from 21.9% at March 31 to 24.3% at June 30.
Other rating agencies give greater equity credit to these securities and have not changed their views. In considering incremental issue of capital debt, we will consider the views of each of the rating agencies as part of our overall evaluation, as well as the deal-specific economics as they relate to our credit-worthiness and capacity to service the debt. We think this change impacts the use of proceeds from hybrids more than the amount we can issue. So from an acquisition capacity perspective, we don't think much has changed.
We continue to hold liquidity at the end of the second quarter in excess of our longer-term targets. Cash and short-term investments at the parent company, net of short-term inter-company borrowings and commercial paper, amounted to roughly $5 billion at June 30. This represents an increase of about $2.5 billion from March 31, driven mainly by the $2.4 billion dividend paid by Prudential Insurance I mentioned a few moments ago. We expect to utilize about $1.5 billion of our current cash position over the balance of the year to repay existing short-term debt at maturity and to fund tax payments and operating needs of our businesses as well as the holding company.
We also continue to target a $1 billion liquidity cushion at the parent company representing 18 months’ worth of fixed charges. We still expect to invest the majority of our remaining cash position in business growth and in longer-term investments as market opportunities arrive. Now Mark will comment on the investment portfolio for the Financial Services businesses and review our business results for the quarter. Mark?
Thank you, John and Rich. And thank you all for joining the call today. Credit market conditions were essentially benign in the quarter. As Rich mentioned, total general account credit losses and impairments this quarter were $169 million. This is the lowest quarterly level we have seen since 2007. U.S. interest rates have trended down during the quarter, driven by lower treasury rates, with a partial offset from some widening of credit spreads in most asset classes. While this has created downward pressure on some long-term re-investment rates, our domestic general account blended fixed income new money rate for the quarter has actually moved up about 30 basis points from the first quarter. While a prolonged period of low interest rates would be generally unfavorable for products with fixed rates and long guarantee periods, our exposure is mitigated by our business mix, duration matching strategies and hedging programs and risk management at the product level including low crediting rate floors and experience rating on our $38 billion of Full Service Retirement stable value balances.
In our general account fixed maturity portfolio, declines in base interest rates both in the U.S. and Japan have increased our net unrealized gain position to $5.8 billion at the end of the second quarter, up from $1 billion at year end. This compares to net unrealized losses of $4.4 billion a year ago. Gross unrealized losses on fixed maturities in our general account stood at $3.3 billion at the end of the quarter. This represents a recovery of $4.5 billion from $7.8 billion a year earlier. About 6.2% of our $138 billion general account fixed maturity portfolio ranks below high and highest quality, based on amortized costs and NAIC categories as of the end of the second quarter. This compares to roughly 7% as of the end of last year.
Our subprime holdings at amortized cost, which excludes FAS 115, were $3.8 billion as of the end of the quarter, down from $5 billion a year ago due largely to pay-downs. Our general account commercial mortgage and other loan holdings amounted to $22 billion as of the end of the quarter, based on unpaid principal balances. At June 30, the average loan-to-value ratio for our commercial mortgage holdings is 65%. And the average debt service coverage ratio is 1.74x. Delinquencies are still light, amounting to about 0.5% of the holdings.
Now I'll cover our business results for the quarter. I'll start with our U.S. businesses. Our Annuity business reported adjusted operating income of $286 million for the second quarter compared to $432 million a year ago. Results for the current quarter reflect several discrete, largely market-driven items that Rich mentioned, with a net favorable impact of $133 million. Current quarter results include a net benefit of $417 million from mark-to-market of embedded derivatives and hedged positions. I'll talk about this in a moment.
Going the other way, current quarter results include a charge of $196 million to strengthen our reserves for guaranteed minimum death and income benefits, and a further charge of $88 million to increase amortization of deferred policy acquisition and other costs, driven in both cases mainly by the equity market decline.
Back to the $417 million benefit I mentioned from hedging and derivatives. This amount includes $362 million of favorable breakage between changes in the values of our living benefit guarantees and the related hedging instrument. Our hedging was highly effective in matching the change in our liability before giving effect to the adjustment for a market-based measure of our own non-performance risk or NPR. Excluding NPR, breakage after DAC amounted to a net charge of just $23 million on hedged account values of nearly $50 billion. However, the NPR adjustment is applied only to the liability, not the corresponding hedging derivatives. An expansion of the liability driven by financial market conditions drove an increase in this adjustment, producing a favorable impact of $385 million for the quarter. The net of the $385 million benefit from NPR and the $23 million charge for breakage, produces the $362 million net benefit.
The remaining $55 million of adjusted operating income from derivative activities in the Annuity business came from the hedges we put on in mid-2009 to help protect our capital from exposure to adverse financial market condition. We recently changed the focus of our capital hedge program from equity price risk associated with our Annuity business to a broader view of the equity market exposure of our statutory capital for the Financial Services businesses. We've also adapted the program to focus on tail risk rather than general equity market decline, in order to protect our capital in a more cost-effective manner under stress scenarios involving severe equity market decline.
Results for the year-ago quarter included a net benefit of $359 million from favorable unlockings, reserve releases and market-driven true-ups, partly offset by negative hedging breakage. Stripping these items out of the comparison, Annuity results were $153 million for the current quarter compared to $73 million a year ago. The $80 million of increase, in what I would consider underlying results, reflects higher fees due to a $19 billion increase in account values over the past year, driven mainly by $14 billion of net sales. Our gross variable annuity sales for the quarter amounted to $5.3 billion compared to $3.4 billion a year ago.
Our current quarter sales results are driven by our HD 6 Plus Living Benefit product feature which we introduced about a year ago. Like our earlier Highest Daily or HD products, HD 6 Plus includes an auto-rebalancing feature that shifts customer funds to fixed income investments to protect account values and support our guarantees in market downturns, reducing our risk profile and limiting our exposure to changing hedging costs.
As of June 30, almost 3/4 of our account values with Living Benefits and more than half of our overall variable annuity account values are subject to auto-rebalancing. Our HD products have proven highly attractive in each of our distribution channels, independent financial planners, wire houses, insurance agents and banks. And each channel registered a substantial sales increase in comparison to the year-ago quarter. The value proposition of our HD products has helped us to add significant new distribution relationships, especially in the bank channel and to increase penetration in major wire houses.
The Retirement segment reported adjusted operating income of $142 million for the current quarter compared to $99 million a year ago. The increase was driven mainly by higher investment spreads and by higher fees due to growth in full service account values. The higher spreads reflected more favorable investment portfolio results, including stronger performance from joint venture and similar investment, as well as crediting rate reductions in our full service stable value business in July of last year and January of this year.
Full service account values stood at $125 billion at June 30, up $14 billion from a year earlier. The increase was driven by market appreciation and $3.8 billion of positive net flows, including about $300 million of net addition in the current quarter. Current quarter full service gross sales and deposits were $4 billion, essentially unchanged from a year ago. Our full service persistency was a very strong 96% for the quarter. With the current focus of many plan sponsors on the implications of healthcare reform rather than retirement benefits, we are seeing a relatively slow pace of RFP activity in the marketplace. This tends to hold existing business in place while reducing new sales opportunities.
The Asset Management segment reported adjusted operating income of $124 million for the current quarter compared to $33 million a year ago. The increase came mainly from more favorable results from commercial mortgage and proprietary investing activities. Net charges on interim loans we hold in the Asset Management portfolio amounted to about $10 million in the current quarter. This compares to roughly $60 million a year ago. We are seeing evidence of improvements in commercial real estate valuations, in contrast to a year ago when values were declining and we were strengthening our reserves. Proprietary investing activities contributed income of about $5 million in the current quarter compared to losses of about $20 million a year ago, driven by changes in the value of our investments and institutional real estate funds that we manage. Current quarter results also benefited from growth in Asset Management fees. The segment’s assets under management increased by $75 billion or 18% from a year ago, driven by positive net flows in each of the last four quarters as well as cumulative market appreciation. Institutional net flows for the current quarter reached a record high $10 billion, mainly driven by strong fixed income inflows from a diverse group of U.S. and international clients including pension funds.
Adjusted operating income from our Individual Life Insurance business was $88 million for the current quarter compared to $138 million a year ago. The decrease was driven by the impact of market performance on amortization of DAC and other items together with related costs. Current quarter results include charges of about $30 million to accelerate amortization of DAC and other items, driven by unfavorable separate account performance linked to the 12% decline in the S&P 500. Conversely, results for the year-ago quarter benefited by about $30 million from reduced amortization and other costs linked to a 15% increase in the S&P 500 in that quarter.
More favorable mortality experience in the current quarter partially offset the swing in results from market performance. Sales amounted to $61 million in the current quarter compared to a record high $98 million a year ago. Our focus in Individual Life is to grow business that can contribute appropriate returns. And we increased our prices on universal life and term products late last year in view of expected reserve financing costs, interest rates and other considerations. Not all companies reacted the same way to the changing environment. And some competitors offered these products at lower rates. The change in price positioning has held back our sales, especially in the third-party channels.
The Group Insurance business reported adjusted operating income of $32 million in the current quarter compared to $105 million a year ago. Less favorable group underwriting results had a negative impact of about $40 million in the comparison. We estimate that roughly half of this variance is a normal claims fluctuation in relation to favorable experience a year ago. The remainder of the variance reflects the lapsing of some business that had favorable claims experience in the year-ago quarter reflecting the competitive market.
Group Disability experience was also less favorable than in the year-ago quarter, when claims incidence was unusually low. In addition, expenses were higher than a year ago driven partly by a $7 million charge in the current quarter to true-up our estimate of premium taxes. Sales for the quarter were $42 million compared to $61 million a year ago. Most of our Group Insurance 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 $168 million in the current quarter compared to $150 million a year ago. Gibraltar's results for the current quarter benefited by $5 million in comparison to a year ago, from translation of yen earnings at a more favorable rate. And results for the year-ago quarter included net charges of $7 million from refinements resulting from implementation of a new policy valuation system. Stripping out currency translation and the year-ago refinements, Gibraltar's adjusted operating income was up $6 million, essentially representing the earnings contribution from the Yamato Life business we acquired in mid-2009.
Sales from Gibraltar Life, based on annualized premiums in constant dollars, reached a record high $212 million in the current quarter, up $63 million from $149 million a year ago. Bank channel sales were $76 million in the current quarter, up from $25 million a year ago. The increase was driven almost entirely by sales of life insurance protection products, which have grown sequentially in each of the last four quarters.
Sales from the Life Advisor channel were up $12 million or 10% from a year ago, driven entirely by sales of life insurance protection products. Our Life Planner business reported adjusted operating income of $291 million for the current quarter. This compares to $315 million a year ago, which included a $25 million benefit from true-ups resulting from implementation of the same policy valuation system that I mentioned for Gibraltar. Stripping that benefit out of the comparison, results are essentially unchanged from a year ago. Continued business growth, mainly in Japan, was offset by a less favorable level of benefits and expenses, which encompasses mortality, reserve true-ups and expenses including costs to modernize our field support technology. Sales from our Life Planner operations, based on annualized premiums in constant dollars, were $196 million in the current quarter, up by $10 million from a year ago.
International Insurance sales on an all-in basis including Life Planners, Life Advisors and the bank channel were $408 million for the second quarter, up 22% from a year ago and passing the $400 million milestone for the first time. The International Investment segment reported adjusted operating income of $19 million for the current quarter compared to $11 million a year ago. The increase reflected improved results from our Global Commodities operations.
Corporate and Other operations reported a loss of $184 million for the current quarter compared to $168 million loss a year ago. The loss we reported for Corporate and Other operations is primarily driven by interest expense net of investment income. These net financing costs increased from a year ago mainly due to higher capital debt. The increase in net financing costs was partly offset by a $7 million improvement in results from our Real Estate and Relocation business, which earned $10 million in the current quarter.
And briefly on the Closed Block business. The results of the Closed Block business are associated with our Class B stock. Closed Block business reported net income of $279 million for the current quarter compared to a net loss of $375 million a year ago. The current quarter results reflect $421 million of pretax realized investment gains mainly from mark-to-market on derivatives we use in duration management and hedging programs while the year-ago loss included $440 million of negative mark-to-market on derivatives. We measure results for the Closed Block business only based on GAAP.
Turning back to the Financial Services businesses. Our value proposition and enhanced competitive position have enabled us to achieve substantial account value growth in key businesses including annuities in retirement, contributing to run rate performance.
Our Asset Management business has benefited from strong net flows from institutional clients driving growth in Asset Management revenues, and pressure on results from adverse commercial real estate markets has abated. Results from our U.S. Protection businesses were negatively affected in the quarter by the equity market downturn and less favorable group underwriting results. And our international businesses continue to perform well with record sales in the quarter driven by expanding distribution.
Thank you for your interest in Prudential. Now we look forward to hearing your questions.
[Operator Instructions] The first question will be from Andrew Kligerman from UBS.
Andrew Kligerman - UBS Investment Bank
I'll ask a question on variable annuities. But $5.3 billion in variable annuity sales, that's a 57% year-over-year increase. And you mentioned all the different channels where you're getting that pickup. When do you think that kind of comes off a bit? Or when do you think the competition comes up with an HD competing product? It just seems kind of too strong to last for a long time. So maybe an outlook, where you see yourself going, I think that's like a 20% market share.
Andrew, why don’t we have Bernard Winograd take that.
Morning, Andrew. I think that it's hard for us to predict where the momentum stops for a couple of reasons. One is we do not see competition on the HD front. And while there may be people that work on products that would enable them to imitate or compete more directly with the HD format, as we've discussed many times before, there's both a time and a resources expenditure that's required in order to build the system's capability to do that. The second thing is that clearly we still are the position we have been in for some time now, where a lot of the growth is coming from the opening of new distribution relationships rather than the existing distribution relationships selling more. That was true again in this quarter, particularly noticeable in the bank channel. And so we haven't, so to speak, annualized fully the impact on the business system of all that new distribution. Having said that, it's hard to argue with the premise of your question. At some point, people will respond in ways that we will not choose to or be able to compete with and the market share will level off. Where that is, is very hard for us to estimate.
Andrew, it’s Mark. One other comment, which is there’s a micro dynamic here around our access to channels and success with new distributors. There’s also the issue of product attributes and value proposition. But remember the broad context of a really big shakeup in the market. And business is moving around, players have exited or significantly reduced their level of aggressiveness in the market, new players are entering. So part of this is there's just a big shakeup. And to reiterate Bernard's point, I'm not sure how long it’s going to continue, but there's a macro force that kind of says the business is going to go somewhere, and I think you have to separate that notion from some of the micro points about how we execute. But this market’s being going through a big shakeup.
Andrew Kligerman - UBS Investment Bank
Interesting stuff. And then just to follow up on the Group Disability benefit ratio picking up to 93% in the quarter versus 89% last year, I think, Mark, you mentioned a termination being partly responsible for that. But maybe a little color around incidence and what you're seeing there. And whether you need to take any pricing up in the long term disability area.
Andrew, it's Bernard. Let me try to address that. The disability ratio did go up. Incidence and severity were both in play here. And I think first of all, we’d have to say, acknowledge that we're watching this closely. But I think everybody would say that the volatility around disability on a quarterly basis is pretty high, and we are not inclined to overreact to any one quarter’s views. In general, for some period of time now the disability business has held up much better than I think we would have anticipated in a recession scenario and there were some one-off features in the numbers this quarter that don’t give us any real reason to believe that the spike here is the new normal, to borrow a phrase that's currently over-used in another context. The comment you made about the one-off item that Mark alluded to, however, was in the life business, not in the disability.
Andrew Kligerman - UBS Investment Bank
Okay, got it. And so then it doesn't sound like you’re going to rush to take any pricing then?
No. These businesses are very competitive on a pricing basis. And that hasn't changed. But we don't have big initiatives in mind in that regard, no.
Our next question comes from the line of Suneet Kamath from Sanford Bernstein.
Suneet Kamath - Bernstein Research
Two questions. First I was just wondering what the rationale was for taking the, I think it was $2.4 billion dividend out of PICA to the holding company. If I just kind of go through what Rich was talking about in terms of cash at the holding company, I think he said $5 billion sort of net of CP. Even if you back out a billion and a half dollars of maturities and another $1 billion for the liquidity cushion, you still have $2.5 billion of cash up there. Just wondering what the rationale was for that.
Yes, Suneet, it’s Mark. I'm going to make a brief comment and then hand it over to Rich. We have a routine annually of assessing where the capital sits and a general theme around the insurance companies to appropriate RBC levels and trying to maintain financial flexibility at the parent level. And so I would consider this very much to be the ordinary course of business and consistent with our past practice. And I’ll ask Rich to comment on cash holdings and other holding company issues.
I don't think I can add much to that, Suneet. It's our practice. And we'd rather have financial flexibility at the mother ship, so that it can use it to fund capital needs of all of the subs rather than have to have it buried in one of the subsidiaries.
Suneet Kamath - Bernstein Research
I understand the flexibility point. But I mean are any of your subsidiaries in need of capital right now, International, et cetera? I mean, I would imagine that most of the subs are pretty much self-funding at this point.
All of the subs are well capitalized. And, Suneet, you said self-funding, that may be a bit of an overstatement because we’re funding DAC and we’re funding XXX with operating debt that's coming down from the holding company.
The answer is this is not in response to a pretty specific need in any particular sub. Everything’s well capitalized and producing good earnings and all of our balance sheets are very strong from a credit perspective, but it’s good housekeeping to manage the financial flexibility at the holding company level as opposed to in the regulated entities. And again, business as usual for us and consistent with past practice.
Suneet Kamath - Bernstein Research
So given that comment, I guess is it fair just to think that, that cash that you pulled out could be used for something like an acquisition at some point, if you find something?
Well that cash tracks, right? The cash in the holding company tracks the holding company's component of capital capacity. So the holding company’s got $2.5 billion of unencumbered cash, $5 billion in total, and you reconciled down to the $2.5 billion a moment ago when you talked about the cushion and the remaining year’s cash needs. So the holding company’s capital capacity is about 2.5, its cash is about 2.5. The rest of the capital capacity of 3.5 to 4 sits in the operating subs because their regulatory capital exceeds our targeted levels.
Suneet Kamath - Bernstein Research
Okay, I think I got it. And then the second question is just on the return on equity. I mean, if I look over the past six quarters and I go through the typical exercise of normalizing for some of the noise, it just seems like the ROE has been sort of in this 9% to 10% range. Obviously, growth in the business has been pretty strong pretty much across the board. So I guess I’m wondering at what point do we start to see that growth sort of translate into some ROE improvement. And do we need to see some capital redeployment in terms of buybacks in order for the company to hit its, I guess, 2012 target of 12% to 13% ROE?
Going in reverse order with respect to the emerging influence on ROE. The headline answer is, “Yes, we will need to deploy capital in order to have further accretion in ROE.” Right now we have both excess capital and excess liquidity, and each of those has a negative influence on ROE so that will play out over time as we deploy capital either in acquisitions or longer-term investments or otherwise deploy to our shareholders. So capital is a big issue. You hear big numbers here and don't forget that there's a lot of liquidity earning a very, very low rate of return. The second emerging influence, and I guess I’m saying emerging just looking forward because these are ben [ph 44:52] influences, is the recovery in the asset-sensitive businesses. And the markets were down in the second quarter, and so while we had some improvement in asset management, we had some other drags on earnings from those market influences on things like Annuities and Individual Life. So the market-sensitive components of the income statement, while broadly will be improving as markets improve, fluctuate quarter-to-quarter. And then the third piece of it is the contribution that our very solid businesses make that produce attractive returns and growth. And you hear some noise in the quarter with respect to some of the elements of those earnings’ pictures, but again over time, things like International will grow and will be very, very strong contributors to accretion and ROE. So I think the ROE framework is made up of those components: capital and liquidity, market-sensitive businesses and strong solid businesses. And that's what's going to play out to determine how fast it moves up.
Suneet, it’s Rich again. I also don't want to lose sight of the fact that in our types of businesses, first-year sales don't deliver the average ROE. So first-year sales because not all expenses are DAC-able. In Annuities and in Retirement, et cetera, we are going to have a dearth in ROE in the first year of the sale, and the true ROE will not emerge ’til the first full year of that sale is on the books. That's weighing us down this year as well.
Suneet Kamath - Bernstein Research
Okay. So we should probably see some of that improvement as we get into next year. I got it.
Our next question comes from the line of Nigel Dally from Morgan Stanley.
Nigel Dally - Morgan Stanley
First question is where is interest rates? I know we should probably expect some spare compression in Retirement in the back half of the year. Hoping you can also discuss how the low interest rates is going to be impacting your other operations as well, both the near-term and looking out longer-term. Second with the new Financial Services regulations, not a lot yet to be determined, but if you can provide your initial assessment as to what type of impact that could potentially have on your businesses, especially interested in hedging costs and variable annuities. And whether that has the potential to change your gross profitability assumptions for that business going forward.
Well, Nigel, it's Bernard Winograd. Let me try to address the interest rate question. And then I'll let Mark comment on it as well and the other question you’ve asked about the environment. All other things being equal, a low interest rate environment is never good news. But our business mix and our business practices do, as we indicated in the commentary, give us a lot of cushion and comfort around that. We don't have a lot in some of the products where the existing book is adversely affected by a low interest rate environment. And we've got a good deal of cushion in the places where we do between where rates are now and what minimum return rates would be. So there's some risk in the long-term, certainly. We don't see a lot of risk in the short-term. However, I think we're saying that it’s something we will have to address in pricing. And we'll have to be thinking about that in pricing because while the effects on the existing book is a manageable thing, the impact of a low-interest rate environment on the way in which we estimate our returns over the long haul is a factor that we need to take into account as we do our pricing discussion.
Nigel, it’s Mark. On the derivatives question. While the passage and signing of the bill represented a pretty discrete climax to the whole process of fixing everything, there's a lot of work to do in terms of interpretation and writing rules and implementation. And there are a lot of uncertainties for us around how we’re affected overall by the broad landscape of regulatory reform. On the specific issue that you mentioned, which is derivatives and hedging costs, I would anticipate that the providers of the long-term long-dated equity-linked derivatives that we use in our Annuity business may be required to hold more capital, and we may, as a result of that, see a more expensive environment in which to use those derivative products. However, on the other side of it, there's the combination of clearing and possibly exchange rating with respect to a lot of the other kinds of derivatives we use particularly the more plain vanilla interest-rate derivatives may drive the cost of those derivatives down somewhat. So I think we’re going to have things going two different directions. Some may be more transparent and less expensive, others may carry higher capital requirements on providers and, as a result of that, more expensive. And I think it's too early to tell which way it's going to go.
Our next question comes from the line of Thomas Gallagher with Crédit Suisse.
Thomas Gallagher - Crédit Suisse AG
First one for Rich. So you have $4 billion of on-balance sheet capital capacity. I'm sorry I missed the comment earlier. What's your debt capacity?
I didn't give you a debt capacity. What I feed off was that right now, with the change coming from Moody's, the debt capacity is going to be deal-specific. So depending upon the acquisition, we'll lever the deal appropriate to the creditworthiness of the deal and the deal’s ability to finance the leverage.
Thomas Gallagher - Crédit Suisse AG
So is it fair to say, Rich, you're about where you need to be from a leverage standpoint as it stands for Pru itself today without a deal?
Yes, we’re just below our 25% limit measured on a Moody's basis, the 24-point-something.
Thomas Gallagher - Crédit Suisse AG
Got it. Then the other question I had was really just a follow-up on the Variable Annuity business. So I believe you switched from an HD 7 to an HD 6 August of '09. Interest rates have come down a bunch since then. Any thoughts to re-designing that product? Should we think about HD 5 in response to low interest rates? And maybe you could just comment more broadly on how you feel about your variable annuity guarantees in lieu of the low rate environment?
Tom, it's Bernard again. I can't say much more than what I've said, so let me just repeat it in this context. You're correct in your timing about when we introduced HD 6. And we made changes to it in both design and pricing earlier this year. Every time we do that, we make an estimate of the market environment and conditions and that all feeds into the assumption and that gets us to our -- against our pricing objective of a mid-teens kind of return. What immediately happens thereafter is markets move, and sometimes they move in our favor and sometimes they move against us and more than interest rates change. Everything else being equal, a change in interest rates is not helpful. A lowering of interest rates is not helpful for the product we’ve just sold, but it’s not the only thing that's changed. And all I can say to you about it is that our process of looking at the pricing of HD 6 or the features of the current product offering is a continuous one, and with a limit to the number of times that can be adjusted every year in the marketplace. And we have been, as you note, changing things in response to market conditions. And we'll keep on doing so. But I don't think it would be right to single out the low-interest rate environment and say, “That's the thing that's going to drive us next.”
Thomas Gallagher - Crédit Suisse AG
Fair enough, Bernard. But is it fair to say that the product cycle last August -- is this August also a normal product cycle? Or is that not necessarily the case?
No, it's not necessarily the case. We will evaluate it continuously. And we will react when we think the combination of our market activity and the financial environment makes it necessary for us to tweak things.
Thomas Gallagher - Crédit Suisse AG
Okay. Mark, you had referenced, I think, changing your hedge strategy a little bit, moving to more of a tail focus. Can you just comment practically what that means?
Yes. We had, as we’ve mentioned in previous calls, a pretty plain vanilla short on with respect to what we call the capital hedge. And we said repeatedly that we would be assessing that and looking for opportunities to change it. And so we took that opportunity. We closed that hedge out during the quarter. We’ve talked about the $55 million gain that we took when we closed that out at a level of the market somewhat below where it is today. And we added a hedge that's got more structural complexity and will pay off in a greater amount at lower levels of the market. We can talk about it more off-line. It's a little more complicated but it's designed to produce higher returns as the market goes down and help us in the stressed and extreme environments, but have much less of an influence around the current level of the market and as markets fluctuate within normal ranges.
Our next question comes from the line of John Nadel from Sterne Agee.
John Nadel - Sterne Agee & Leach Inc.
I have a question on the dividend as well. And it's more of a math one. Rich, you said that you took the $2.4 billion dividend. If I assume the denominator of your RBC ratio was relatively static, and that may be a faulty assumption, but if I did that, the $2.4 billion dividend would reduce RBC by about 100 points, by my math. And you're saying that RBC, which was 577 at year-end '09 is comfortably above 400%. I know you don't want to give us an exact number, but does comfortably above, does that comfortably above mean really comfortably above? Or has something else changed in the math?
John, to use your terminology, it means really comfortably above. But remember there are some market-sensitive components in that. The mark-to-market on derivatives, for example. But when Rich said, “Comfortably above” the answer is, “Yes, really comfortably above.”
John Nadel - Sterne Agee & Leach Inc.
Okay, that’s helpful. And then just going back to an overall question on just the M&A environment, maybe for John. Can you give us a sense for -- obviously markets have recovered a lot. We've seen a couple of things take place recently. We've seen a couple of European companies maybe put up a business here or a business there for sale. I mean can you characterize what the discussions and what the -- how much is going on? How much are you seeing in terms of opportunities today relative to maybe two or three quarters ago?
Okay, John. So let me take that in a broad context and then answer more specifically as to the M&A fees [ph 57:15]. Because I think that one needs to think about the terms of the organic aspect of this as well as how it relates to M&A. We very much continue to believe, and in fact our experience reinforces, that these are times where there's a lot of upside associated with our brand, strong capital and a very clear commitment to the businesses in which we're in. It clearly expands the existing opportunities, whether it’s the bank channels then or it creates new opportunities as well. And converting these opportunities into reality is the charge of our individual business leaders. And they're doing a great job at it, as you can see, in the U.S. and outside the U.S. And we feel very, very good about that. The manifestation of that has been market share gains in many of our businesses. And in many cases, market share gains you would have normally associated with M&A without the intrusion and disruption and costs of M&A. So we're feeling very comfortable with what we're achieving in that regard. But now transitioning to your question more about M&A, there’s obviously a number of well-publicized franchises that remain in flux with uncertain time lines. There’s others that are less visible, but are likely to arrive. Whether we buy them or whether we compete with them will be a function of our overriding considerations in market dynamics. It is an interesting time in terms of supply and demand dynamics in the sense that there’s a limited number of counterparties that have the scale, scope, management and international capacity that we do and that makes us, at least in our eyes, an attractive and qualified trade-buyer. And furthermore some people who did have the capacity have already now made choices as to how they’re committing their capital and they've chosen to commit their capital on things that would not have been of interest to us. It's not a critical comment about what they've done; it’s rather just an observation about our own opportunities there. So we can't really at this point predict the likelihood or timing of our role in M&A. It's naturally unpredictable. We also have a situation where a number of these businesses were never envisioned to be divested so they’re going through long and painful processes in terms of preparing them for marketplace. We’re at the same time very protective of our organic momentum as well. So there's a lot of things to be encouraged about, both organically and also on the market dynamic front. At the end of the day, I think I have to summarize it by saying that we shall see.
And our next question comes from the line of Ed Spehar from Bank of America-Merrill Lynch.
Edward Spehar - BofA Merrill Lynch
Just following up on John's questions. Could you give us some sense for what the equity market hit was to statutory capital in the second quarter? And how much of that maybe has been recovered already, if we just look at what the market’s done in July?
Ed, it's Rich. We really don't track these things at that granular level. It hasn't had a material impact on RBC in either direction. So that's about all I can say.
Edward Spehar - BofA Merrill Lynch
Okay. And then the follow-up is on the GAAP side, Mark, related to all the noise in the Individual Annuity line. I think everybody, probably almost everyone on this call, can agree that the $385 million NPR item is kind of a silly item. So I guess if we just looked at the rest of this, and we said, “You had a $133 million benefit when we net all this stuff together. If we took out the $385 million from the NPR, it's a $250 million roughly hurt all the other items.” Can you give us any feel for what portion, if any, of that $250 million you consider to be an economic event?
I don't have it parsed in the detail that you might be thinking of. But you've all heard me say before, that the real economics of the Annuity business are not as volatile as the accounting for the Annuity business. And I’ve really got a couple of things in mind there. One is that there are some mismatches between the way some of the components of embedded derivatives, for example, are valued relative to what really happens to policy holders. So there's some things there where I believe we overstate the liabilities and particularly overstate the impact of changes in the financial markets on the liability. And secondly, another point that I've made is that there is, with respect to DAC accounting, a fairly substantial mark-to-market component. And so, it's not necessarily a portrayal of current period earnings as most of us would like to think about, and a simple way to say what I mean by that is that if you apply a PE to the DAC number, you're double capitalizing a huge bunch of stuff because DAC reflects valuation influences as opposed to just current period earning influences. So again I don't have it parsed to the detail that you might be asking for. But there are substantial components of this that are either not consistent with the real underlying economics or represent something that's more like a mark-to-market as opposed to a current period earnings influence. So that would be my comment on the general picture there.
Our next question comes from the line of Mark Finkelstein with Macquarie.
A. Mark Finkelstein - Macquarie Research
The capital margin, I think, was $3.5 billion to $4 billion, roughly in line with where we were at year end. I know these are approximates. Historically, you've used a 60% operating earnings-to-capital-generation ratio. I think with the growth earlier this year I feel like maybe that was taken down to 40% range. What I'm asking is what is the current thinking about capital generation from here for the back half of the year? And should we be thinking about that 40% of operating earnings as a good metric?
I don't think so. I think it's probably closer to 50%, but we've got some more work to do on that.
A. Mark Finkelstein - Macquarie Research
Okay. So we can think about capital growth from the $3.5 billion to $4 billion using 50% and offsetting kind of the normal capital deployment and realized loss-type numbers?
Right. But it’s also highly dependent upon sales and where the sales are, right?
A. Mark Finkelstein - Macquarie Research
Okay. And then just secondly, can you just give a little color on the flows in the Asset Management business? I mean this is, obviously, a huge quarter. I think it was $13 billion between Institutional and Retail. And can you just talk about, I mean, mainly on the Institutional side, how should we think about the margin on those flows? And what is really driving those flows? And how should we think about that going forward?
This is Bernard. I think the margin varies widely just because the basis points of revenue per dollar of AUM is quite different, depending upon which asset class you're talking about. But all of that, I think you can discern from our disclosures. I think what's driving the outcome is a combination of things: it’s first of all, good investment performance, which is true for us, has been true for us for quite some time, but is unusually distinctive at this point in the cycle. And secondly, we do have very substantial fixed income flows, and fixed income as an asset class is getting the lion's share of the flows in the institutional world at the moment. So to the extent that continues, that works to our advantage.
Next we'll go to the line of Jimmy Bhullar from JP Morgan.
Jamminder Bhullar - JP Morgan Chase & Co
I had a question first on your 401(k) business. Your deposits and the flows were weaker than they’ve been in the past few quarters. So just your views on the 401(k) market given the environment that we’re in. And then second, just if you were to do a deal, what would your preference be in terms of how to finance it? You do have some balance sheet flexibility; there’s some room in the RBC as well. So and assuming it's a $3 billion to $5 billion deal, is it reasonable to assume that in the environment we’re in you’d actually consider a modest-sized equity raise? Or could you do that type of a deal without having to raise new equity?
Jimmy, let me go first. It’s Bernard again and answer the question about the 401(k) business, and then I will let John address the other question you have. I think the right way to answer that is to say that we are cautiously optimistic, with emphasis on the "cautiously", with regard to the RFP pipeline and the Retirement business. And I say it that way because things have improved in many ways. People are reinstating matches and so forth in the business. And there’s not the same sort of heightened anxiety about the benefit. But it's also fair to say that the passage of the Healthcare Reform Bill has sort of taken up a lot of the bandwidth, if you will, for discussions of this benefit with the executives in corporate America who are responsible for administering both the healthcare benefits for their employees as well as the retirement benefits. And so I don't think that we have seen yet a robust pipeline of RFPs of the kind you might have assumed would happen here just because so much of the energy of the clients at the moment is focused on thinking through how to adjust to the healthcare business. So it's getting better, but it's not growing dramatically at this point.
Jamminder Bhullar - JP Morgan Chase & Co
And do you expect this to -- the thoughts on healthcare and the taking time on the part of benefit managers, do you think this is going to go through next year, given that there are a lot of changes that have happened with the healthcare reform?
I think that depends on the pace of events in Washington. The grandfathering rules on existing healthcare plans need to become a lot clearer before anybody's going to know what they want to do. And until they know what they want to do, it's going to be hard for them to focus on other issues.
And, Jimmy, I'm going to turn over to Rich the other piece about the financing. I mean, clearly we talked earlier about some of our mathematical capacity, but how we think about this is going to be a function of how we view individual attributes of any potential acquisition. Rich?
It will be deal-specific, Jimmy, but I'm going to address your question around the equity issuance specifically. At the upper end of your range, the $5 billion end, that would likely require some equity issuance. At the lower end of your range, the $3 billion, it would be very deal-specific and might not require an equity issuance.
Thank you. And that's all the time we have for today's conference call. But it will be available for replay after 1:30 p.m. today until midnight, August 12. You may access the AT&T replay system by dialing 1 (800) 475-6701 and entering the access code of 144584. International participants, dial (320) 365-3844.
That does conclude 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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