Prudential Financial (PRU) John Robert Strangfeld on Q2 2016 Results - Earnings Call Transcript

| About: Prudential Financial, (PRU)

Prudential Financial, Inc. (NYSE:PRU)

Q2 2016 Earnings Call

August 04, 2016 11:00 am ET

Executives

Alan Mark Finkelstein - Senior Vice President & Head-Investor Relations

John Robert Strangfeld - Chairman & Chief Executive Officer

Mark B. Grier - Vice Chairman

Robert M. Falzon - Chief Financial Officer & Executive Vice President

Stephen P. Pelletier - Executive Vice President & COO-US Business Unit

Analysts

Ryan Krueger - Keefe, Bruyette & Woods, Inc.

Nigel P. Dally - Morgan Stanley & Co. LLC

Jamminder Singh Bhullar - JPMorgan Securities LLC

Mike Kovac - Goldman Sachs & Co.

Seth M. Weiss - Bank of America Merrill Lynch

Yaron J. Kinar - Deutsche Bank Securities, Inc.

Randy Binner - FBR Capital Markets & Co.

Eric Berg - RBC Capital Markets LLC

Suneet L. Kamath - UBS Securities LLC

Operator

Ladies and gentlemen, thank you for standing by, and welcome to the Prudential quarterly earnings call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. As a reminder, the conference is being recorded.

I would now like to turn the conference over to our host, Mr. Mark Finkelstein. Please go ahead.

Alan Mark Finkelstein - Senior Vice President & Head-Investor Relations

Thank you, Don. Good morning, and thank you for joining our call. Representing Prudential on today's call are John Strangfeld, CEO; Mark Grier, Vice Chairman; Charlie Lowrey, Head of International Businesses; Steve Pelletier, Head of Domestic Businesses; Rob Falzon, Chief Financial Officer and Rob Axel, Controller and Principal Accounting Officer.

We will start with prepared comments by John, Mark and Rob, and then we will answer your questions.

Today's presentation may include forward-looking statements. It is possible that actual results may differ materially from the predictions we make today.

In addition, this presentation may include references to non-GAAP measures. For a reconciliation of such measures to the comparable GAAP measures and a discussion of factors that could cause actual results to differ materially from those in the forward-looking statements. Please see the section titled forward-looking statements and non-GAAP measure of our earnings press release which can be found on our website at www.investor.prudential.com.

John, hand it over to you.

John Robert Strangfeld - Chairman & Chief Executive Officer

Thank you, Mark. Good morning, everyone, and thank you for joining us. I will provide some high-level observations on the quarter and the fundamental trends in our businesses. I will then briefly discuss actions we've taken to improve our capital flexibility and reduce volatility, which directly led to last evenings announcement of a $500 million increase in our share repurchase authorization for 2016.

In closing, I will comment on the regulatory environment and then hand it over to Mark and Rob.

We continue to successfully navigate a challenging environment. We benefit from a collection of businesses that fit well together and provide diverse sources of earnings and cash flows. We are therefore able to generate solid results despite market volatility and broader macro uncertainties.

At the same time, we're also generating considerable excess capital. We are reinvesting in our operations to capitalize on longer-term growth opportunities as well as returning substantial amounts of capital to shareholders through dividends and share repurchases. Notably, we returned about $1.4 billion to shareholders in the first half of 2016 alone.

Now, specific to the quarter, reported earnings were impacted by several significant items. This includes the outcome of our annual review of actuarial assumptions and other reserve refinements. Although this annual review had a positive impact on our overall results, it had an adverse effect on adjusted operating income.

This is largely due to a change we took in our Individual Life business related to a recent interpretation of accounting guidance. Mark will discuss this and other factors influencing reported earnings in more detail.

If you exclude the impact of our annual review and other market-driven and discrete items, adjusted operating earnings per share would have been $2.46, which is in line with our expectations for the quarter.

Annualized return on equity, on the same basis for the quarter, at just over 13%, was also consistent with our longer-term target.

In terms of growth drivers, we produced good sales and flows across our domestic and international businesses in the quarter. This is while continuing to take actions to adjust our product offering and pricing to reflect a lower and in some cases negative interest rate environment.

Turning to the fundamentals in our businesses, our international operations produced solid results. We reported solid core growth and underwriting margins in both our Life Planner and Gibraltar businesses.

While the level of interest rates in Japan is a real challenge, and has necessitated aggressive product and pricing actions, including the suspending the sales of certain yen-based products, we still produced 7% constant currency sales growth in our overall international operations in the quarter.

This was led by our U.S. dollar product sales in Japan, which increased 53% over the prior year. And for the first time in our history, our Japanese operations sold more U.S. dollar products than yen-based products. This shows the benefit of our broad suite of protection-based products and their distribution strength.

Our domestic businesses also produced solid results and generally good sales and net flow trends. PGIM, our Asset Management business, had strong results reporting very good earnings and robust net inflows of $3.6 billion. PGIM, again, exceeded $1 trillion in total AUM. And we're particularly pleased that third-party unaffiliated institutional and retail assets under management crossed the $500 billion threshold for the first time. We continue to be optimistic about PGIM's prospects and are investing in expanding capabilities and distribution.

Our Retirement and Individual Annuity businesses performed largely in line with our expectations. Retirement closed on two significant UK longevity pension risk transfer cases in the quarter and produced overall positive net flows. As we've mentioned in the past, the timing of PRT transactions can be lumpy but we continue to believe this is a good long-term growth business and expect to benefit from our best-in-class platform.

I would also highlight that Retirement earnings again reflected pension risk transfer case experience more favorable than our average expectations. While we may have quarters in the future in which this isn't the case, the underwriting experience of the PRT block has well exceeded our expectations.

Our U.S. protection trends are mixed. Group Insurance produced very good underwriting margins with a benefit ratio in the quarter modestly more favorable than our target range. Group Insurance is also showing improved top line growth, following a multiyear effort focused on improving underlying results. Conversely, while Individual Life Insurance produced good sales growth, we did experience adverse mortality that dampened earnings. Mortality results have clearly disappointed in the first half of 2016, though this will fluctuate on a quarterly basis. And the longer-term mortality trend has been very good.

Now I'll briefly cover the structural changes we made in managing the risks of our variable annuity business. But before doing so, I want to provide some perspective on how this project fits into our broader strategic focus as a company. Over the last couple of years, we have focused intently and intensely on simplifying our business, improving our transparency and reducing volatility. We believe that over time a clear line of sight to our business fundamentals should contribute to a more valuable franchise. In this regard, you've seen us take a number of actions.

As a result of the substantial completion of our variable annuity restructuring, we expect a meaningful reduction in our capital volatility in our Individual Annuities business and increased stability and certainty of cash flows generated from the business. We believe that Individual Annuities should become a significant source of free cash flow in the future.

And at the same time, we continue to manage the business to robust standards focused on the economics of the risk. And we're particularly pleased that the economic synergies achieved from this action has led to a release of capital and facilitated last evening's announced increase in our share repurchase authorization by the board. Rob Falzon will have more to say on this topic.

Finally, on the regulatory front, we are preparing a response to the Federal Reserve on the recently issued advance notice of proposed rulemaking or ANPR that addresses capital requirements for supervised insurance entities. And the NPR focused on corporate governance, risk management and liquidity standards. While these proposals still have a ways to go until they reach the finish line, we are encouraged by the dialogue and the focus by the Fed on seeking to appropriately reflect the unique characteristics of insurance companies into a properly designed set of standards.

With that, I'll hand it over to Mark.

Mark B. Grier - Vice Chairman

Thanks, John. Good morning, good afternoon or good evening. Thank you all for joining the call today. I'll take you through our results, and then I'll turn it over to Rob Falzon, who will cover liquidity, leverage and capital highlights.

Starting on slide 2, after-tax adjusted operating income amounted to $1.84 per share for the quarter compared to $2.91 a year ago. After adjusting for market-driven and discrete items, EPS of $2.46 was down $0.16 from year ago. Underlying business performance remained solid through the challenging macro environment.

The decrease reflected a number of moving parts, but I would highlight a greater loss from corporate and other operations driven by negative fluctuations in expenses and investment income and less favorable claims experience in comparison to the outperformance we called out in the year-ago quarter. We estimate that these two items, together with less favorable currency exchange rates, had a negative impact of roughly $0.25 per share on the comparison of results to a year ago.

Current quarter variances in comparison to our average expectations for mortality in Individual Life and International Insurance, pension risk transfer case experience and returns on non-coupon investments were largely offsetting. Favorable revenue seasonality in International Insurance contributed about $0.04 per share to earnings.

After adjusting for market-driven and discrete items, our EPS of $4.72 for the first half of 2016 implies an annualized ROE of just under 13%. This includes a modest net negative impact from variances compared to average expectations for the items I mentioned, together with favorable International Insurance revenue seasonality.

On a GAAP basis, including amounts categorized as realized investment gains or losses, and results from divested businesses, we reported net income of $921 million for the current quarter, about $90 million above our after-tax adjusted operating income. GAAP net income included a net favorable impact from our annual actuarial review for items we account for outside of AOI, which I will discuss further.

Turning to slide 3, this year's annual actuarial review including reserve updates and refinements for our ongoing businesses, resulted in a net favorable pre-tax impact of $590 million, including a benefit of about $1 billion outside of AOI, partly offset by net charges in AOI totaling $444 million. The non-AOI benefit to earnings was mainly driven by an update of our utilization assumptions related to the amount of income payouts taken under our annuities living benefit guarantees based on emerging experience.

While we reduced our long-term interest rate assumptions as part of the annual review, this did not have a meaningful impact on the outcome. The charge that was included in AOI came mainly from Individual Life, driven by a recent interpretation of accounting guidance relating to the expected pattern of earnings on the Universal Life block of business that we acquired from Hartford. Under this guidance, we are recording a reserve now to reflect the period of losses that we expect to emerge about 15 years in the future after our expected returns have been largely realized. It's worth noting that the majority of these losses were assumed in our original forecast at the time of the Hartford acquisition.

Turning to slide 4. The remainder of market-driven and discrete items for the quarter consists of a benefit from our quarterly market and experience unlocking in the annuities business driven mainly by performance of equities in our customer accounts and a charge in Corporate and Other for cost of our $500 million debt tender offer in June.

Moving on to slide 5. Our GAAP net income of $921 million for the current quarter includes amounts characterized as net realized investment gains of $360 million. And divested business results and other items outside of AOI amounting to net pre-tax losses of $68 million. Of note, product related embedded derivatives and hedging had a positive impact of $574 million. This includes the favorable impact of the annual actuarial review on annuities living benefits that I mentioned, partly offset by an increase in the gross GAAP liability balance for these living benefits which was driven by the decline in interest rates in the quarter.

The loss from other risk management activities was mainly driven by true-ups reflecting our annual review. Impairments and credit losses of $51 million were the lowest of the past four quarters and about half the level of the first quarter.

Moving to our business results and starting on slide 6, I'll discuss the comparative results excluding the market-driven and discrete items that I have mentioned. Annuities earnings were $375 million for the quarter, down $48 million from a year ago. The earnings decrease was mainly driven by a 7% decline in policy charges and fees reflecting a roughly similar decline in average account values. Higher expenses also contributed to the earnings decline and the decrease in return on assets or ROA. ROA was modestly below 100 basis point range of the past few quarters.

Slide 7 presents our annuity sales. Total sales are largely unchanged from a year ago. However, our mix of sales has changed dramatically over the past year reflecting our diversification strategy. Sales of our fixed income based PDI product reached a record high of over $1 billion in the quarter, reflecting market demand and the success of our product diversification efforts. In addition, we're externally re-ensuring about half of the living benefit guaranty on new business related to the Highest Daily or HD product under an agreement which extends through this year. As a result, less than one third of our sales for the current quarter come with retained exposure to equity market linked living benefit guarantees.

Turning to slide 8, Retirement earnings were $230 million for the quarter, down $7 million from a year ago. The decrease reflects the lower contribution from case experience which was about $20 million more favorable than our average quarterly expectations, but below the level of the year-ago quarter. In addition, lower fees in our Full Service business were largely offset by a modestly greater contribution from net investment results. Returns from non-coupon investments were about $30 million below our average expectations in the quarter.

Turning to slide 9, total Retirement gross deposits and sales were $8.1 billion for the current quarter compared to $14.2 billion a year ago which included three significant pension risk transfer transactions totaling about $7 billion. Standalone institutional gross sales were $3.4 billion for the quarter including about $2 billion from two new longevity reinsurance cases. Net flows for the quarter were positive both in Full Service and Institutional Investment Products totaling about $500 million.

Turning to slide 10, Asset Management earnings were $207 million for the quarter compared to $196 million a year ago. While most of the segment's results come from asset management fees, the increase from a year ago was mainly driven by a $9 million greater contribution from other related revenues, reflecting more favorable strategic investment results and higher real estate transaction fees. Earnings driven by Asset Management fees were essentially unchanged from a year ago. Higher fees for management of fixed income assets were largely offset by lower fees tied to equities. The Asset Management business reported $3.6 billion of net positive, third-party flows in the quarter with contributions from institutional and retail businesses each driven by fixed income flows.

Turning to slide 11, Individual Life earnings were $130 million for the quarter, compared to $177 million a year ago. The decrease in earnings came mainly from a negative fluctuation in claims experience with the current quarter contribution to earnings about $20 million below our average expectations compared to a strong year ago quarter. While mortality experience can vary from one quarter to another, it has been more favorable than our average expectations for each of the full years 2013, 2014 and 2015. In addition, in Individual Insurance, expenses were slightly higher in the current quarter than a year ago.

Turning to slide 12, Individual Life sales based on annualized new business premiums were up $29 million or 22% from a year ago. Guaranteed Universal Life sales contributed just under half of the increase reflecting current-quarter sales resulting from an accelerated flow of policy applications in advance of recently implemented price increases. The remainder of the increase came mainly from variable life where sales tend to be driven by large cases and are lumpy.

Turning to slide 13, Group Insurance earnings were $48 million for the quarter, essentially unchanged from a year ago. The current quarter total benefits ratio was consistent with the year-ago quarter and modestly more favorable than our targeted range of 87% to 91% with current-quarter disability underwriting results at the strongest level of the past four quarters.

Moving to International Insurance and turning to slide 14, earnings for our Life Planner business were $381 million for the quarter compared to $392 million a year ago. Excluding a $22 million negative impact of foreign currency exchange rates, earnings increased by $11 million from a year ago. The benefit to earnings from continued business growth was partly offset by higher expenses including costs supporting business growth and a lower contribution from investment results driven by declining fixed income returns.

Mortality experience in the current quarter was essentially unchanged from a year ago and about $10 million more favorable than our average expectations. The concentration of annual mode premium revenues in our Life Planner business that results in an earnings pattern favoring the first quarter drove the sequential quarter earnings decline.

Turning to slide 15, Gibraltar Life earnings were $494 million for the quarter compared to $471 million a year ago. Excluding a negative impact of $36 million on the comparison from foreign currency exchange rates, earnings increased by $59 million from a year ago. Current quarter results include a benefit of about $40 million from the sale of a home office property that came to us with the acquisition of Star and Edison. This sale substantially completes the realization of synergies from integration of the business infrastructure.

The remainder of the earnings increase was driven by business growth, largely reflecting the first full quarter contribution of our investment in AFP Habitat in Chile which was essentially in line with our expectations and also reflecting a greater contribution from net investment results. Net investment results for the quarter included returns on non-coupon investments, about $35 million more favorable than our average expectations driven by real estate sale within an investment fund. A concentration of annual mode premium revenues favors second-quarter results for Gibraltar Life. We would estimate that the benefit to current-quarter earnings in relation to a quarterly average was about $30 million.

Turning to slide 16, International Insurance sales on a constant-dollar basis were $747 million for the current quarter, up by $50 million or 7% from a year ago. The sales growth was driven by a 53% increase in our sales of U.S. dollar products in Japan which more than offset lower Yen-based sales. U.S. dollar products comprised more than half of our current-quarter sales in Japan compared to roughly one third of sales a year ago. Our exposure to declining interest rates in Japan is mitigated by our emphasis on protection products with the returns largely driven by mortality and expense margins and by strong asset liability management for our in-force business.

We've taken significant actions to maintain appropriate expected returns for new business in the current environment in Japan, including reductions in crediting rates and commissions and in some cases sales suspensions for yen products that are most affected by interest rates. These are generally those with the greatest cash value accumulation features including certain single premium products.

Our success in continuing to grow sales in Japan while adapting the product portfolio reflects the skills of our life planners and life consultants and matching our products with client needs and the enhanced attractiveness of our U.S. dollar products to Japanese consumers in the current environment. Life Planner sales in Japan were up 19% from a year ago reflecting an 8% increase in agent count together with higher productivity and higher average premium size.

Gibraltar sales were up by 6% from a year ago including a 15% increase from our life consultants. Bank channel sales were consistent with a year ago, reflecting a $27 million increase in U.S. dollar sales, essentially offsetting a decrease in yen-based sales.

Turning to slide 17, the Corporate and Other loss was $376 million for the current quarter compared to a $305 million loss a year ago. The main drivers of the increased loss are; lower investment income reflecting a charge of about $40 million from the declining value of a tax-advantaged investment that we account for under the equity method. Higher expenses including items such as fixed asset disposals, legal costs and employee benefit costs all of which can fluctuate. And lower income from our pension plan following our assumption update at year-end.

Now I'll turn it over to Rob.

Robert M. Falzon - Chief Financial Officer & Executive Vice President

Thanks, Mark. I'm going to cover an update on key balance sheet items, financial measures and other related areas of interest starting on slide 18. You'll notice a change in how we present the comparison of RBC to our target. As of April 1, we recaptured the living benefit risk from our reinsurance captive. Most of the economics and risks of our variable annuity contracts now reside in a single statutory entity we call PALAC, which was the direct writer of a substantial portion of our in-force annuity business.

As a result, a meaningful portion of our statutory capital has migrated to PALAC and is no longer rolling up to the RBC of Prudential Insurance under statutory accounting. We now view composite RBC, which includes our U.S. insurance entities on a comprehensive basis, as a more meaningful measure of our statutory financial strength in relation to our benchmark. On this basis, composite RBC at year-end 2015 was 486%, and we estimate that it is well above our 400% target at the end of the second quarter.

In Japan, Prudential Japan and Gibraltar reported strong solvency margins of 801% and 928%, respectively, as of March 31 their fiscal year-end. These solvency margins are comfortably above our targets.

Let me provide a few additional points on the variable annuity recapture. As of August 1, all of the risks of our annuities contracts are managed within the annuities business. As a result, the historic management of a portion of the interest rate risk of our annuities guarantees at the holding company has been closed out. We are now managing all of the product risks by holding derivatives and other financial assets in our statutory entities. In addition, we will continue to manage the product risks of our annuities businesses as we have done historically on an economic basis. This includes the ability to maintain a CTE 97 threshold in moderate stress scenarios, consistent with how we manage risks across our businesses, standards that we believe are consistent with AA financial strength.

Further, due to synergies that occur when all the product risks are managed together, we're able to release about $1 billion of capital from our annuities business. The outcome of this restructuring substantially simplifies our annuities operation, reduces our capital volatility and increases the certainty around cash flows from the annuities business.

Looking at the liquidity, leverage and capital deployment highlights on slide 19, our cash and liquid assets at the parent company amounted to $4 billion at the end of the quarter, essentially unchanged from March 31. This reflects the impact of cash inflows including the $1 billion related to the annuities restructuring that I mentioned, in addition to a dividend from PICA. It is net of the return of about $700 million to shareholders including $370 million of share repurchases and the repayment of about $1 billion of debt including $500 million under our tender offer in June.

Our financial leverage and total leverage ratios as of June 30 remained within our targets. Consistent with our balanced approach to capital management and deployment, the capital released as a result of our annuities actions supported a $500 million increase in our share repurchase authorization for the second half of this year, bringing the authorization for 2016 to $2 billion, of which $750 million has been executed through June 30. Those of you who have followed our historical dividend pattern are accustomed to seeing a review of our dividend level in the fourth quarter. While we evaluate shareholder distributions with the board in every quarter, we expect to move the routine dividend evaluation process to the first quarter in order to better align with our capital planning cycle.

Now I'll turn it back over to John.

John Robert Strangfeld - Chairman & Chief Executive Officer

Thank you, Rob. Thank you, Mark. And let's open it up to questions.

Question-and-Answer Session

Operator

And first we're going to the line of Ryan Krueger, KBW. Please go ahead.

Ryan Krueger - Keefe, Bruyette & Woods, Inc.

Hey. Thanks. Good morning. I had a question about the annuity ROA; it dipped down a bit to 98 bps in the quarter from kind of 105 basis point range it's been running at. Can you give an update on how we should think about that going forward?

Stephen P. Pelletier - Executive Vice President & COO-US Business Unit

Ryan, this is Steve. We've long encouraged people to think in terms of 100 basis points as being the longer-term run rate of ROA for the annuities business. The recent change in this quarter reflected a couple of things. First of all, it reflected some one-time expenses, and it also reflected something of a shift in our product mix gradually over time towards the PDI product, which is lower risk but also on a marginal basis lower fees as well. So given all of that, we'd still encourage people to think very much in terms of 100 bps as the ROA for the annuities business.

Ryan Krueger - Keefe, Bruyette & Woods, Inc.

Okay. Great, thanks. And then do you just have an update on the fair value of the yen capital hedge?

Robert M. Falzon - Chief Financial Officer & Executive Vice President

Ryan, it's Rob. Yeah, so we've – the hedge at the end of the first quarter was a negative $520 million.

Ryan Krueger - Keefe, Bruyette & Woods, Inc.

Okay. And then does that – would you expect that to have an impact on – I guess if things stay unchanged, should we think of that as having any impact on free cash flow generation over time as it gets realized?

Robert M. Falzon - Chief Financial Officer & Executive Vice President

Well, let me sort of step back. First, if you sort of bring it up a level, Ryan, the hedge was actually doing exactly what it was designed to do. It's protecting our ROE regardless of the direction of the yen. Our (30:34) settlements in the program have actually been sufficient to complete the offset any depreciation that's occurred in the yen to its current level. And recall that we actually started this program back when the yen was at 77.

Specifically, to your question, we have had periods in the past where the hedges worked in the other direction and cash would be flowing back to the international businesses as those settled. They are staged over time, and so they settle over periods of time. They've been orchestrated in a way such that the improved earnings on a yen basis – or the yen earnings that we have in Japan on a dollar basis are going up as a result of that appreciation in the yen, and therefore, the dividends that we're getting out of that business will offset over time the cash that goes on the settlement of the hedges.

So we sort of think of it as, there could be on a year-to-year or quarter-to-quarter basis a little bit of cash mismatch, but overall, these things will settle out.

Ryan Krueger - Keefe, Bruyette & Woods, Inc.

Okay. That's helpful. Thank you.

Operator

Thank you. And next we're going to the line of Nigel Dally. Please go ahead. Morgan Stanley.

Nigel P. Dally - Morgan Stanley & Co. LLC

Great. Thank you. Good morning. So, Mark, you mentioned that you've reduced the interest rate assumptions as part of the actuarial review. Could you elaborate on that? How much was it changed and what was it changed to? And also, did you recalibrate the separate account return assumptions?

Robert M. Falzon - Chief Financial Officer & Executive Vice President

So, Nigel, it's Rob. Actually, I'll jump in on this. The – we took the benchmark U.S. Treasury 10-year down from 4.25% to 4%. In Japan, we took the similar 10-year benchmark down from 2% down to 1.9%. The impact of that, if you think about the returns expected from the variable annuity accounts, which I think is what you're asking, is that the return over the what we call the near- to intermediate term, so call it the next 0 to 10 years, averages about 4.8%. And then after 10 years, as a result of migrating up to those reversion rates that I mentioned, it's about 6.5%

Nigel P. Dally - Morgan Stanley & Co. LLC

Okay. That's helpful. Then just on the buybacks, are the higher plans purely a reflection of the capital release from this VA restructuring that you completed, or does the restructure also improve the free cash flow which could possibly impact the pace of future buybacks?

Robert M. Falzon - Chief Financial Officer & Executive Vice President

So the immediate increase in the buyback is tied to the $1 billion that came up as a result of the recapture initiative that we have underway in our variable annuities business. But to the point that you've made, I would emphasize that while we'll continue to evaluate our buybacks and are not forecasting anything in the way of an increase at this point. We are encouraged by the increased cash flow profile that comes out of our annuities business.

It's really driven by two things, Nigel. First is the fact that as this block matures, the sales relative to the existing block lead it to throw off more cash. The second is this construct that we've put in place. It is a more stable long-term contract, subject to less volatility, and therefore gives us more degrees of freedom in terms of how we think about taking the cash out of the annuities business as earnings are generated annually.

Nigel P. Dally - Morgan Stanley & Co. LLC

Very helpful. Thank you.

Operator

Thank you. And next we're going to the line of Jimmy Bhullar. Please go ahead.

Jamminder Singh Bhullar - JPMorgan Securities LLC

Hi. The first question is just on your – just following-up on the rate assumption. I just wanted to make sure I got the numbers right. So you took the rate assumption down to 4%, or was it down to 2% from 4%?

Robert M. Falzon - Chief Financial Officer & Executive Vice President

So the U.S. rate 10-year benchmark, Jimmy, was brought from 4.25% down to 4%. The JGB 10-year benchmark was brought from 2% down to 1.9%.

Jamminder Singh Bhullar - JPMorgan Securities LLC

But considering current rates, those still seem relatively high level, so just wondering what the justification was for not reducing them further? And maybe if you could give us any sort of sensitivity to what the impact would have been to your results had you brought it down by another 50 basis points or 100 basis points in each market? Or is it 50 basis points in Japan, 100 basis points in the U.S.?

Robert M. Falzon - Chief Financial Officer & Executive Vice President

Okay. So a couple of thoughts. First, Jimmy, with respect to the process that we go through, understand it is a well-established and well-controlled actuarial review process that we undertake and come up with these rates. We look at historical rates, we look at forward rates, we survey both internal and external experts to get their views of rates on a go-forward basis. And we use a central estimate that's derived from looking at all of those data points. So that's consistent with what we've done in the past, and we continue to apply on a go-forward basis.

With respect to the interest rate sensitivity, if you look at our assumption updates, what I would tell you is that they were not materially affected by the decline in that long-term reversion rate. We had some interest rate impact; not particularly material. Most of it was driven by the current level of interest rates as opposed to a change in that long-term assumption.

Mark B. Grier - Vice Chairman

Yeah, that's important. Remember that we grade up to the long-term assumption but current rates are in the books.

Robert M. Falzon - Chief Financial Officer & Executive Vice President

And it takes about a 10-year period of time for that grade up, so we start at current levels and then follow the forward curve for a couple of years and then do a linear grade up to that long-term reversion rate by year 10.

Jamminder Singh Bhullar - JPMorgan Securities LLC

Okay.

Mark B. Grier - Vice Chairman

Yeah, so today's very low rates are in our balance sheet.

Jamminder Singh Bhullar - JPMorgan Securities LLC

Yeah. Basically, you're following the forward curve for maybe the next year, two years but then you're assuming a relatively steep increase to get to that 4%, right?

Robert M. Falzon - Chief Financial Officer & Executive Vice President

You can do the math; it's a linear extrapolation from third year on to year 10.

Jamminder Singh Bhullar - JPMorgan Securities LLC

Okay. And secondly just in Japan, what's your view of the bank channel in Japan? It's about I think close to 20% of your sales. Several companies have been pulling back from the channel, especially with the further drop in rates? So maybe if you could talk about your long-term view of that channel and profitability of the business that you're selling through the channel?

Stephen P. Pelletier - Executive Vice President & COO-US Business Unit

Sure. Let me take a little bit of a step back and talk about our position with regard to the bank channel. So we believe that we have a differentiated strategy within the bank channel. When we first acquired Star/Edison there were about 100 bank partners in total. And consistent with what we've done both in both independent agency and the LC channels, we reduced the number of relationships focusing on the quality of products, the service and the fit with the bank partners that we've chose to do business with. So we reduced that to about 60 bank partners that currently offer our products and we sell through about 80% of those bank partners in any given quarter.

But there are three points of differentiation that really affect our profitability in the bank channel. The first is that we provide exceptional service to our banking partners. We have about 240 secondees. Those are life planners that we've seconded to the banks and they provide exceptional service to the bank clients. So we don't have to be the lowest price. We compete on service; we don't compete via spreadsheets.

The second is that we focus on death protection. The majority of our sales include mortality and expense margins, obviously. And the other point here is that we have a very high proportion of recurring premium in current products as opposed to just savings products.

So over 80% of our sales in banks are recurring premiums and that's something we've been working really hard on and have changed the banks mentality, at least our partners' mentality, toward the kind of products that are sold.

And the third is that the relatively little single premium fixed annuity products that we do sell through the channel are re-priced twice a month for new business and they all have market value adjustment or MVA features. And now we really sell only U.S. dollar products, because we've been making that shift that John and Mark talked about.

So we feel very good about the differentiated strategy we employ, the mix of products we sell and the resultant profitability of the business.

Jamminder Singh Bhullar - JPMorgan Securities LLC

Thank you.

Operator

Thank you. Next we'll go to the line of Mike Kovac, Goldman Sachs. Please go ahead.

Mike Kovac - Goldman Sachs & Co.

Great. Thanks for taking the question. We've seen a couple of other life companies in the U.S. provide some increased disclosure on a lower for longer scenario in terms of the impact on both the life and annuity blocks. I'm wondering if you can give us an update in terms of how you see it impacting the balance sheet if we were in say, 1% for a prolonged of time?

Robert M. Falzon - Chief Financial Officer & Executive Vice President

So, Mike, it's Rob. Let me try to take a crack at that. First, it's important to point out that we've had a significant reduction in our interest rate sensitivity, post the completion of the VA captive initiative. You've seen that in both the first quarter and the second quarter, driven by the fact that, as I indicated earlier, we've migrated over to a more stable statutory framework and it reflects the long-term nature of the risks.

Importantly we eliminated the internal corporate hedge, under hedge, excuse me, as I indicated in my opening comments. And we're managing all of the VA risks within those same legal entities.

I'd also note that we manage our balance sheet so that we can maintain our AA targets through cyclical stress scenarios. So that includes 100 basis point further decline in interest rates from where we are today. So from a balance sheet standpoint, we would not expect to have any degradation in our credit quality as a result of a sustained low rate of a significant quantum from where we are today.

Mike Kovac - Goldman Sachs & Co.

So do you have a sense or can you provide us a sense of – I know this was part of an answer to an earlier question – in terms of taking the long-term interest rate assumption down by 25 basis points. I believe you mentioned it wasn't that material. But can you give us a sense of the scale of what that sort of immaterial means?

Robert M. Falzon - Chief Financial Officer & Executive Vice President

Well, in terms of the first 25 down, it was not material so I don't have the numbers to put around it because it wasn't something that rises to a level where we thought it was important to provide a disclosure.

With regard to an additional 25 basis points, we have not done the calculation in terms of what the – if you run that through all the assumption updates with another 25 basis points down, I'd go back to the comment that I made about a capital position which is that we've run stress scenarios significantly more severe than that and are comfortable that we're holding capital on a basis that would allow us to continue to maintain our AA rating and write business.

Mike Kovac - Goldman Sachs & Co.

Great. Thanks. And then maybe one for John here on regulation. Appreciate the comments and the statement that the rules still have a ways to go until they get to the finish line. Any sort of early thoughts in terms of strategy, either an impact on the overall bond portfolio shifts now to Closed Block will be managed given the commentary we saw come out from that side earlier in the year?

Mark B. Grier - Vice Chairman

No. This is Mark. That's very much still work in process and we're not ready to talk about or take any actions in anticipation of what comes out. I think the main message around the work on capital standards is that all of the signals are clearly consistent with the right approach to insurance.

Mike Kovac - Goldman Sachs & Co.

Thanks for the answers.

Operator

Thank you. And next we're going to the line of Seth Weiss, Bank of America. Please go ahead.

Seth M. Weiss - Bank of America Merrill Lynch

Yeah, hi. Good morning. Just a question on the VA recapture. Last quarter I think you mentioned that there were still some steps around ALM that needed to be completed throughout the remainder of the year. Is what you announced today basically finish those steps and put to bed any other remaining actions on the VA recapture?

Robert M. Falzon - Chief Financial Officer & Executive Vice President

So it's Rob, Seth. As of August 1, the recapture initiative was substantially completed. There is obviously fine tuning of both accounting and ALM as we proceed forward in order to optimize the structure that we have in place. But yes, we are completed as of August 1.

Seth M. Weiss - Bank of America Merrill Lynch

Okay. Great. Thanks a lot. And all around it seems like the recapture was a homerun; it reduces the volatility and increased the capacity by about $1 billion. I think if we go back to the fourth quarter last year, you commented that you were really able to make this change because of the updated regulatory environment allowing this discussion with the regulator. Was that the only thing that prevented you from doing this in the past, or are there any cost consequences that we should consider about? I guess I'm just wondering why it wasn't done in the past and want to make sure we're thinking about any kind of knock-on effects going forward.

Robert M. Falzon - Chief Financial Officer & Executive Vice President

The reason we set up the captive to begin with wasn't driven by a desire to manage capital down or otherwise optimize the way we're managing capital but rather in order to optimize the way in which we were managing the risk. And the way in which the statutory construct worked in the past was such that – the primary shortcoming of it was such that the use of derivatives which we thought was important to manage this risk was not fully incorporated or adequately incorporated into that construct. And where the statutory construct is migrating toward is one which gives a much fuller and robust recognition of derivatives, both their use, their mission, modeling of the derivatives and the accounting for the derivatives.

And that was really the primary reason why we went to captive and the motivation for being able to recapture from the captive. There are economic benefits in the recapture that I've described before that led to, as you know, to the reduced volatility and the free up of capital. So all things being equal, we'd rather manage this thing holistically. It was the shortcomings of the construct before that prevented us from doing so.

Mark B. Grier - Vice Chairman

Yeah, I think maybe just to emphasize part of what you might be asking. Because we never used the captive to arbitrage either reserves or admitted assets or capital, we didn't go into the recapture in a hole. We actually, as you see, went into the recapture from a position of strength. So there are things out there that would have been an advantage in the captive structure that we're going to lose as a result of the recapture.

Seth M. Weiss - Bank of America Merrill Lynch

Great. Thank you very much.

Operator

Thank you. And next we're going to the line of Yaron Kinar from Deutsche Bank. Please go ahead.

Yaron J. Kinar - Deutsche Bank Securities, Inc.

Good morning. I actually have a follow-up on Seth's line of questions. I just want to make sure that I understand the impact or the mechanics of the recapture here. So ultimately, does it mean that you have added to the hedging this variable annuity hedging, or is it just that the accounting for the same hedges is now different?

Robert M. Falzon - Chief Financial Officer & Executive Vice President

Yaron, the GAAP accounting has not changed, just to be clear on that. What has changed is we've taken business that resided in five different legal entities and consolidated it down to two and substantially just in one. We have a New York and non-New York set of entities. All of the risks of the business are now being managed within those two statutory entities and we're managing them through a combination of derivatives and on-balance-sheet financial assets.

Yaron J. Kinar - Deutsche Bank Securities, Inc.

And why would that new construct ultimately lead to a meaningful reduction in capital volatility and to the increased stability and cash flow uncertainty?

Robert M. Falzon - Chief Financial Officer & Executive Vice President

So, think about it this way, as I had mentioned before, we hold to CTE 97, and we do so including under modeled stress scenarios. When you're doing that calculation in five different entities, now imagine doing that consolidated across a single entity largely or the two entities. You get efficiencies, as you might expect, both in the reduction in risks that result in the offsetting of risks that go in different directions from the writer than they do the host contract. And you get efficiencies associated with the capital management because you don't have the friction of having to move capital and hedges between the different legal entities. So both from a capital standpoint in terms of how the calculation works and then from our ability to then manage the risk and then you lay on top of that the statutory construct being one that is more stable, less volatile, all three of those combine to the reduced volatility that you're seeing and will see going forward and the free-up of the capital.

Mark B. Grier - Vice Chairman

Yeah, maybe a big-picture way to think about it is that the profitability of the host contract mitigates the risk of the living benefit standalone, and when the living benefit guarantee was in a standalone entity we had to manage all the volatility that went with it. But when it's combined with the host, there are substantial positive cash flows and very stable cash flows from the host contract

Yaron J. Kinar - Deutsche Bank Securities, Inc.

Got it. That's very helpful. I appreciate the color.

Operator

Thank you. And next we're going to the line of Randy Binner from FBR. Please go ahead.

Randy Binner - FBR Capital Markets & Co.

Yeah, I also have a question on the recapture, sorry to belabor this. But my impression at one point was that while everything you've said about the recapture is true and I think, as Seth and Yaron said, it was a home run. But doesn't it create a reporting or an accounting potential for volatility in tail scenarios now that you've moved from that modified GAAP to the statutory accounting now? If I'm wrong, please explain why. I thought the catch in this was that it might not report as well under tail scenarios under this construct versus the old one?

Robert M. Falzon - Chief Financial Officer & Executive Vice President

So, Randy, very clearly there can be noneconomic volatility in GAAP outcomes. We've seen that in the past and we expect we'll continue to see that. If you look at our results, however, a large portion of this was due to the, quote, "corporate under-hedge" of the interest rate risk, which has now been eliminated. There is a residual misalignment between statutory and economic view of the liability and how it gets expressed in GAAP. You saw that in what we called the risk margin, which was the delta between the GAAP liability and the hedge target before. And you will continue to see that volatility between the full GAAP liability and our economic target of that liability, so that has not gone away for us. Having said that, we expect to manage the outcome in a way that helps to mitigate that reported volatility going forward.

The other thing I think is important to highlight is that, as I mentioned earlier, the annuities business going forward we think in addition to the stability coming out of it is going to be a source of strong cash flow for the two reasons that I highlighted. And so the wins associated with this construct far outweigh what we view to be the potential for GAAP volatility, which frankly, we've been dealing with for our historical period already.

Randy Binner - FBR Capital Markets & Co.

So basically, for all intents and purposes, you're saying that whatever that GAAP volatility is that's non-economic, really, it won't change that much in the structure versus what you had before?

Robert M. Falzon - Chief Financial Officer & Executive Vice President

I think that's fair to say. Our expectation is, relative to interest rates we'll have less GAAP volatility than we had before, and our volatility in response to equity market movements will be roughly what it was before.

Randy Binner - FBR Capital Markets & Co.

All right. Thank you.

Operator

Thank you. And next we're going to the line of Eric Berg, RBC Capital. Please go ahead.

Eric Berg - RBC Capital Markets LLC

Thanks very much. With respect to the interest rate that you have now lowered – your long-term interest rate assumptions that you've lowered. Are we referencing here the rates for the appreciation in the separate accounts or are we talking about discount rates that is used to discount the cash flows underlying the liability calculation?

Robert M. Falzon - Chief Financial Officer & Executive Vice President

So this is the – Randy, it's Rob. This is the -

Alan Mark Finkelstein - Senior Vice President & Head-Investor Relations

Eric.

Robert M. Falzon - Chief Financial Officer & Executive Vice President

Oh I'm sorry. Eric.

Eric Berg - RBC Capital Markets LLC

No problem. No problem at all. Go right ahead.

Robert M. Falzon - Chief Financial Officer & Executive Vice President

Eric, it's Rob. I'm on the last question. That is the long-term rate that's used in our actuarial assumptions as they affect the different liabilities that we have on our balance sheet, so that includes the account values and the rate at which they grow, but it also includes the host of other liabilities that we have for which we have to do actuarial computations.

Mark B. Grier - Vice Chairman

It's not just the variable annuity piece.

Robert M. Falzon - Chief Financial Officer & Executive Vice President

Right.

Eric Berg - RBC Capital Markets LLC

Right. And maybe, John, you could address it – and my second and final question relates to the Asset Management business in general. As is widely known, it has proven to be a historic year in a negative sense for the asset management industry. It looks like we're on track to have a record amount of equity outflows from equity funds in North America. What is Prudential's strategy? You've talked now for two quarters about outflows in equities. What is your strategy for Asset Management given this very challenging context?

John Robert Strangfeld - Chairman & Chief Executive Officer

Okay. Eric, so let me take a couple of minutes on how we think about Asset Management because I think our view on this reflects both the uniqueness of our approach and our circumstances. So for us, Asset Management is a hybrid business model, one that we're very proud of, one that works well for our clients and ourselves. By that what I mean is, it's not a holding in which we have a passive ownership stake as some do and nor is it a department that's serving one client. What it is is a business and has a capability with critical interconnectivity to Prudential and its strategies. And its market-facing strength enables us to attract and retain topflight investment talent which in turn produces consistent investment results that are very favorable.

At this point it's got over $1 trillion in AUM and as we commented today, it's over $0.5 trillion of third-party unaffiliated assets. And actually in terms of Asset Management fees, roughly 80% of them are derived from managing third-party assets. So it's a very significant third-party asset manager and business but it does exceedingly well. I think last year's flows were around $20 billion. Keep in mind we have more fixed income assets than we have equities, so we sort of benefit from that pace of the cycle. But it's also a major contributor as well as beneficiary of its interrelationship with other parts of PRU.

And you see that manifest within a lot of ways which in turn enables us to be more competitive and gives us an edge in various areas whether it's PRT and the role asset management plays there or whether it's the role it plays in investing assets on behalf of our activities in Japan or the role the private placements and mortgages play to our various activities in our spread-related activities. So to us it's very distinctive in relation to others. It's not a holding in which we have a passive stake. It's not a department. It's a hybrid and it's doing very, very well. It's doing very well in part because of the consistency of our investment performance and the consistency and the stability and the quality of our investment professionals as well.

Stephen P. Pelletier - Executive Vice President & COO-US Business Unit

Eric, it's Steve. Let me take the strategic points that John mentioned and make them a bit more granular. You referenced equity outflows in the industry and we've seen that as well. In our case it's very much the shift from active to passive that is driving that. That's particularly visible in our traditional U.S. style box strategies. I want to point out however that those strategies only represent about 10% to 15% of the total PGIM to AUM. Nonetheless we're addressing that on two levels. First within the equities business itself. We're continuing to invest in growth in areas that have shown relatively greater resilience in the active to passive trend.

Among those I would count global, international, income-oriented and the factor-based enhanced indexing that we do in our quantitative management business. So we're maintaining that commitment to alpha generation but diversifying our approach to how we make that happen.

Second, and perhaps even more significant, the basic nature of our multi-manager structure provides sustainability and strength. We've seen equity outflows, as you mentioned, but we've also seen robust inflows in fixed income and real estate and strong origination levels in privates and mortgages.

That multi-manager structure has been one of the principal drivers of 13 straight years of positive third-party institutional net flows and it continues to give us confidence in our prospects going forward.

Eric Berg - RBC Capital Markets LLC

Great. Thanks both of you.

Alan Mark Finkelstein - Senior Vice President & Head-Investor Relations

Don, we'll take one more question, please.

Operator

Thank you. Next we'll go to the line of Suneet Kamath, UBS. Please go ahead.

Suneet L. Kamath - UBS Securities LLC

Thanks. Good morning. I just wanted to start with the annuities business. I guess we've kind of been in breakeven flows now for several quarters. And given its one of your largest earnings contributors, I'm trying to get a sense of, do you have some initiatives in place around product innovation, et cetera, that can start to turn the flows positive at some point over the next several quarters?

Stephen P. Pelletier - Executive Vice President & COO-US Business Unit

Suneet, this is Steve. First of all, we very much want to make sure at all times in the annuities business, that we're operating it on a sustainable basis.

So while obviously we seek to be competitive, we also want to make sure that we're maintaining a pricing discipline. In PDI for example, we recently announced a 25 basis point decrease in both the rollup rate and the payout rate and we think that's appropriate under the circumstance.

But I'd say that we look at this, Suneet, on both a tactical and a strategic level. First of all, on a tactical level, we'll continue to make the adjustments necessary, as I say, to make sure we're tailoring our product design and pricing it on a sustainable basis. But on a more strategic basis, I think it's going to be very much a story of product diversification, including getting more and more into areas of streamlined and simplified product design.

I think our recent track record on how we've managed product in the annuities business and how we've managed our diversification strategy gives us a lot of confidence in our ability to continue this. We've taken PDI from a standing start basically from launch two years ago, only two years ago, to now representing over half of our sales in this quarter; half of our sales even before you account for HDI reinsurance. So that type of success and diversification up to this point gives us, as I say, a lot of confidence in believing that we can take that further in product design along the lines that I mentioned.

Suneet L. Kamath - UBS Securities LLC

Got it. And then just a little while ago, Lincoln talked about on its call, moving to more passive options within the VA, presumably to lower cost to the consumer. Is that something that you guys are looking at as well?

Stephen P. Pelletier - Executive Vice President & COO-US Business Unit

I think there will be a lot of different elements where we're looking to, as I say to have a streamlined and simplified product design and some that may be lower cost as well. In a sense, PDI represents already a step in that regard but we'll continue that path.

Suneet L. Kamath - UBS Securities LLC

Got it. And then just one quick one for Rob. You may have covered this before, so I apologize, but on the Life Insurance charge and the change in accounting interpretation that was referenced earlier, is there any ongoing impact to earnings that we should expect from that change, or is it purely a one-time phenomenon?

Stephen P. Pelletier - Executive Vice President & COO-US Business Unit

It is a one-time charge, however, recall that the way it works in any business, the present value of a number that we have to accrete to over time, some 15 plus years out. And so therefore, there is an ongoing impact as you establish a number that on a PV basis now needs to grow to that future value. So our belief is net of all our assumption updates that'll get washed out. But on an isolated basis it has a small, modest drag going forward.

Suneet L. Kamath - UBS Securities LLC

All right. Thanks.

Operator

Thank you. Ladies and gentlemen, this conference will be available for replay after 1:30 p.m. today through 11:59 p.m. August 11, 2016. You may access the AT&T TeleConference replay system at any time by dialing 1-800-475-6701 and entering the access code 383124. Those numbers again are 1-800-475-6701 and access code 383124. That does conclude your conference for today. Thank you for your participation and for using AT&T Executive TeleConference Service. You may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!