Prudential Financial (PRU) Q2 2017 Results - Earnings Call Transcript

|
About: Prudential Financial, Inc. (PRU)
by: SA Transcripts

Prudential Financial, Inc. (NYSE:PRU) Q2 2017 Earnings Call August 3, 2017 11:00 AM ET

Executives

Alan Mark Finkelstein - Prudential Financial, Inc.

John Robert Strangfeld - Prudential Financial, Inc.

Mark B. Grier - Prudential Financial, Inc.

Robert Michael Falzon - Prudential Financial, Inc.

Stephen P. Pelletier - Prudential Financial, Inc.

Charlie F. Lowrey - Prudential Financial, Inc.

Analysts

Seth M. Weiss - Bank of America Merrill Lynch

Erik Bass - Autonomous Research

John M. Nadel - Credit Suisse Securities (NYSE:USA) LLC

Thomas Gallagher - Evercore ISI

Ryan Krueger - Keefe, Bruyette & Woods, Inc.

Suneet Kamath - Citigroup Global Markets, Inc.

Jamminder Singh Bhullar - JPMorgan Securities LLC

Operator

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

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

Alan Mark Finkelstein - Prudential Financial, Inc.

Thank you, Brad. Good morning, and thank you for joining our call. Representing Prudential on today's call are John Strangfeld, Chairman and 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, 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 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 Measures of our earnings press release, which can be found on our website at www.investor.prudential.com.

And with that, I will hand it over to John.

John Robert Strangfeld - Prudential Financial, Inc.

Thank you, Mark. Good morning, everyone, and thank you for joining us. I will provide higher-level observations on the quarter, the core fundamental trends in our businesses and capital deployment, and then hand it over to Mark and Rob to cover the specifics.

We had a few moving parts that impacted reported results in the quarter. Looking through those items, one can see that we reported strong results. Second quarter adjusted operating income, excluding market-driven and discrete items of $2.93 per share, was well above the prior year of $2.46 per share. The annualized ROE for the quarter on the same basis was over 14%, exceeding our near-to-intermediate term objective of 12% to 13%.

Results for the quarter reflect the benefits from positive net flows and favorable equity markets in our fee-based businesses, top line growth in our International businesses and overall strong margins. While results for the quarter were better than we would ordinarily expect partly due to items that were inherently variable, we are pleased with our overall operating earnings trends.

We did experience some volatility in our reported results in the quarter. Reported adjusted operating income of $2.09 per share and net income of $1.12 per share were adversely impacted by adjustments taken as a result of our annual review of actuarial assumptions and other reserve refinements. These adjustments primarily affected our Individual Life business.

To put this in context, over the last few years, we've undergone a process of upgrading our systems across our Domestic businesses. This has enabled us to model our data at a more granular level and create efficiencies in our businesses. As you migrate to enhanced systems, there can be impact to reserve balances due to calculation differences as well as revisions to estimates facilitated by these enhanced capabilities. And these items comprise the majority of the impact to the quarter. Updates to our underlying policyholder behavior and capital markets assumptions overall had a relatively modest impact on our results.

In addition to the annual review of actuarial assumptions, net income in the quarter was impacted by mark-to-market losses in our variable annuity businesses, due mainly to items we view as non-economic, and, therefore, don't hedge, as Mark will discuss.

Overall, you can look through these significant items and see that the earnings power, cash generation and capital position of our combined businesses all remain in a very strong position, largely unaffected by the volatility we experienced in the quarter.

I will now touch on key fundamental trends in our businesses, starting with our Domestic businesses. We reported very good earnings in our Individual Annuities business, driven by record account values and exceptionally strong margins. We continue to benefit from the actions we took in 2016 to more effectively and efficiently manage the product guarantees in our variable annuity business.

The particularly strong return on assets in the quarter of 127 basis points exceeds our run rate expectation for the business, which continues to generate very good core margins and earnings and represents a strong source of cash flow to the holding company.

Retirement core earnings were also strong benefiting from record account values, another quarter of favorable case experience in our pension risk transfer business and better than expected investment performance.

Results have continued to trend modestly above our internal expectations, even after adjusting for the favorable items we call out. Having said that, Retirement's earnings power is very good and we remain optimistic on the long-term growth and earnings characteristics of this business.

Net flows were negative in the quarter, largely reflecting the quarterly lumpiness that we observe in this business. Nevertheless, we are pleased with the $1.6 billion funded pension risk transfer case we closed in the quarter, and have onboarded a $5.7 billion defined contribution plan that we closed early in the third quarter.

Our Asset Management business, or PGIM, had another outstanding result, generating solid earnings and outstanding net flows of $7.7 billion for the quarter. Total assets under management of $1.1 trillion and unaffiliated third-party assets under management of $565 billion were both records. PGIM continues to benefit from strong investment performance, and the pipeline for new mandates remains robust.

Results from our U.S. protection businesses were mixed. It was clearly a challenging quarter for our Individual Life Insurance business. Notably, results reflect a lowered expectation of earnings due to the ongoing impact from the annual actuarial assumption review. However, our Group Insurance business delivered very strong earnings, driven by a benefit ratio that was the lowest in recent memory. It was a nice bounce-back quarter for Group Insurance after seasonally lighter first quarter results, and our underwriting trends continue to perform very well.

I will now turn to our International businesses, which had one of its strongest core earnings quarters on record and generated 14% growth in constant currency sales. The quarter benefited from stable growth, better-than-expected underwriting margins, and other areas of favorability. Life Planner constant currency sales increased 23% over the prior year, which reflects the continued impact from a sales surge related to the repricing of yen-based products in Japan.

Gibraltar sales increased 8% over the prior year on a constant currency basis, benefiting from the same sales dynamic. While the acceleration in sales produced strong growth in our yen products at both Life Planner and Gibraltar, I would highlight that growth in our U.S. dollar products in Japan increased 18% over the prior year and comprised over 50% of our Japan sales.

Shifting to capital deployment, we returned approximately $640 million of capital to shareholders in the quarter, about equally split between dividends and buybacks. We have a robust capital position and generate considerable free cash flow, which enable us to return healthy amounts of capital to shareholders while continuing to invest in our businesses for long-term growth.

On that note, we recently announced a realignment of our U.S. businesses that will better position us to leverage our business mix to capture long-term growth opportunities within and across our Domestic businesses. As we communicated at our June Investor Day, we believe that our unique capabilities, customer base, and culture of innovation and collaboration put us in an enviable position to deliver needed products to customers at attractive returns to our shareholders.

And with that, I'll hand it over to Mark.

Mark B. Grier - Prudential Financial, Inc.

Thank you, John. Good morning, good afternoon or good evening. Thank you for joining our 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.

I'll start on slide 2. After-tax adjusted operating income amounted to $2.09 per share for the quarter compared to $1.84 a year ago. After adjusting for $0.84 per share of market-driven and discrete items, which I will discuss momentarily, EPS amounted to $2.93 for the quarter, up from $2.46 a year ago, as the core performance of our businesses overall was strong in the quarter.

Looking across our businesses, I'll mention a few highlights of results compared to a year ago. First, fees from our Individual Annuities and Asset Management businesses increased by about $160 million, reflecting market appreciation and positive flows. We also benefited from refinements to our annuities risk management strategy, which was implemented last year. Second, continued business growth in our International Insurance business on a constant currency basis. Third, a lower loss from Corporate & Other operations, driven by favorable fluctuations in expenses and investment income.

These benefits were partially offset by higher expenses in several of our businesses. In addition, current quarter results also included a few inherently variable items. We experienced $80 million of favorable net underwriting results as compared to our average expectations. Non-coupon investment returns and prepayment income were about $55 million above our average expectations. And we incurred higher-than-typical expenses in our Life Planner business of about $25 million. These variable items had a net positive impact on current quarter results of about $0.16 per share. After adjusting for market-driven and discrete items, our EPS of $5.69 for the first half of 2017 implies an ROE of 14.4% on an annualized basis.

On a GAAP basis, including amounts categorized as realized investment gains or losses and results from divested businesses, we reported net income of $491 million for the current quarter, or $1.12 per share, about $400 million below our after-tax adjusted operating income. This difference was mainly driven by a negative impact from product derivatives, which I will discuss shortly.

Moving to slide 3. This year's actuarial review, including reserve updates and refinements for our ongoing businesses, resulted in a net unfavorable pre-tax impact of $492 million, including a net charge of $622 million to AOI, partially offset by a net benefit of $130 million outside of AOI. The annual updates to insurance assumptions were generally modest across our businesses with the exception of Individual Life, where the updates aggregated to a net charge of $560 million.

This charge is driven by the following items. During the quarter, we completed an upgrade of an Individual Life valuation system. This resulted in an increase in reserves from a refinement in the calculation of estimated mortality claims. In addition, our Individual Life systems upgrades provided enhanced cash flow estimates that enabled us to revise our reinsurance accounting methodology, which accelerated the recognition of reinsurance expense. These two items accounted for most of the Individual Life charge in the quarter, with the remainder due to other factors including modestly lower lapse experience in our Guaranteed Universal Life block.

The overall impact of the changes in policyholder behavior and capital market assumption was largely offsetting across our businesses. I would highlight that this year's review of economic assumptions included a reduction in expected long-term fixed income returns. While returns vary by duration, we reduced our long-term expectation of the 10-year U.S. Treasury rate by 25 basis points, and now grade to 3.75% over 10 years.

In Japan, we reduced the long-term expected return by 40 basis points on Japanese government bonds and now grade to 1.5% over 10 years. Our expected long-term U.S. equity returns remain largely unchanged. As John mentioned, the annual actual update had a largely inconsequential impact on future earnings as the favorable effects on our Annuities and Retirement businesses mostly offset the unfavorable effect on our Individual Life business. And our view of capital capacity was also largely unaffected.

Turning to slide 4. Aside from the annual review of actuarial assumptions, the additional market-driven and discrete item for the current quarter consists of our quarterly market and experience unlockings in the annuity business. These favorable unlockings were mainly driven by performance of equities in our customer accounts and resulted in a net benefit of $0.08 per share.

Moving to slide 5. Our GAAP net income of $491 million in the current quarter includes amounts characterized as pre-tax net realized investment losses of $679 million and divested business results and other items outside of adjusted operating income, amounting to a net pre-tax gain of $73 million. Of note, product-related derivatives and hedging had a negative impact of $961 million, largely due to the impact of applying our tighter credit spread to the gross GAAP liability balance for variable annuity living benefits. The gain from the general investment portfolio and related activities are driven by pre-tax gains in our International Insurance investment portfolios.

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 mentioned earlier. Annuities earnings were $512 million for the quarter, up by $137 million from a year ago. The increase was driven by a greater contribution from policy charges and fee income, primarily a result of a 6% increase in our variable annuity average separate account values. They were driven by the benefit from our retirement and risk management strategy for product guarantees implemented in 2016, and by the favorable impacts of the annual actuarial review.

Also contributing to the growth in earnings were more favorable net investment results from higher invested asset balances and current quarter earnings from non-coupon investments and prepayment fees about $5 million above our average expectations compared to results modestly below expectations a year ago.

The return on assets, or ROA, of 127 basis points reflects the items I just mentioned and is well above recent trends. While we believe that some of the ROA improvement is sustainable, including the impact of the annual actuarial review, we do not expect to be able to maintain this elevated level as a baseline in the future.

Slide 7 presents our annuity sales. Total gross sales of $1.5 billion in the quarter are down by $800 million from a year ago and up by $100 million from the prior quarter. This trend in gross sales reflects the actions we have taken to reprice our PDI product as well as broader industry sales pressure we believe partly in response to the DOL Fiduciary rule, which was partially effective in June and is expected to be fully implemented in January of 2018.

Turning to slide 8. Retirement earnings were $328 million for the quarter, up by $98 million from a year ago. The increase was driven by a greater contribution from net investment results and by more favorable case experience. The contribution from net investment results was up $72 million from a year ago. Current quarter earnings from non-coupon investments and prepayment fees were about $25 million above our average expectations, compared to a contribution about $30 million below expectations a year ago.

A 5% increase in average spread-based account values also contributed to stronger net investment results. Current quarter case experience was about $30 million more favorable than our average expectations primarily from our pension risk transfer business, which continues to perform very well. This compares to about $20 million more favorable experience a year ago.

Turning to slide 9. Total Retirement gross deposits and sales were $7.8 billion for the current quarter compared to $8.1 billion a year ago. The decrease was driven by lower institutional investment product sales in the current quarter, as prior year sales included two longevity reinsurance cases totaling about $2 billion, while the current quarter included a $1.6 billion funded pension risk transfer case.

Total Retirement account values were a record at $401.3 billion, up by 7% from a year earlier. This includes the benefit from market appreciation as well as about $2 billion of positive net flows over the past year. The net outflows in the quarter reflect the episodic nature of the large case business, inherent in both full-service and Institutional Investment products, as well as the impact of the normal runoff of group annuity and longevity reinsurance cases. In particular, we experienced an elevated level of net outflows in our investment-only stable value business this quarter.

Turning to slide 10. Asset Management earnings were $218 million for the quarter compared to $207 million a year ago. The increase was driven by higher Asset Management fees, partially offset by higher expenses. The increase in Asset Management fees is driven by the 7% growth in assets under management and from the benefit of a fee rate restructuring in real estate in the third quarter of last year. Asset Management reported $7.7 billion of net unaffiliated third-party flows in the quarter, excluding money market activity, with contributions from the Institutional and Retail businesses, each driven by strong fixed income flows.

Turning to slide 11. Individual Life earnings were $96 million for the quarter, compared to $130 million a year ago. The decrease was driven by lower underwriting results and higher expenses, partially offset by a greater contribution from net investment results. The lower net contribution from underwriting was driven by the impact of the annual actuarial review and other refinements on current quarter results, partially offset by more favorable claims experience.

Earnings for the current quarter reflected claims experience that was about $10 million below our average expectations, compared to claims experience about $20 million below our average expectations a year ago. The higher contribution from net investment results included income from non-coupon investments and prepayment fees, essentially consistent with our average expectations and compared to returns about $5 million below our average expectations a year ago.

Turning to slide 12. Individual Life sales, based on annualized new business premiums, were down $6 million or 4% from a year ago. Guaranteed Universal Life sales were down 34% from a year ago, reflecting the impact of price increases and face amount limits in the second half of last year and the migration to our principles-based reserve compliant version of this product launched in March of this year. Partially offsetting that were other Universal Life sales, which increased by $10 million from the prior year, driven by large case estate planning sales and term product sales, which increased due to pricing actions.

Turning to slide 13. Group Insurance earnings were $81 million for the quarter, up by $33 million from a year ago. The increase came mainly from more favorable underwriting results and a greater contribution from net investment results. Group Insurance benefits ratio of 84.5% was well below the low end of our targeted range of 87% to 91%, driven by favorable Group Life incidents, which produced about $30 million of favorable earnings as compared to our expected range.

Moving to International Insurance and turning to slide 14. Earnings for our Life Planner business were $396 million for the quarter, compared to $381 million a year ago. Excluding a $9 million negative impact of foreign currency exchange rates, earnings increased by $24 million from a year ago. The increase was driven by continued business growth with constant dollar insurance revenues up 7% from a year ago, more favorable policy benefits experience and a greater contribution from investment results, partially offset by higher net expenses.

The more favorable policy benefit experience included current quarter claims experience which was about $20 million more favorable than our average expectations, compared to about $10 million more favorable a year ago. The higher contribution from net investment results included current quarter returns on non-coupon investments and prepayment fees, about $10 million above our average expectations and compared to returns, only slightly above our average expectations a year ago. In addition, the current quarter also included about $25 million of higher than typical net expenses, including true-ups to legal reserves and deferred acquisition costs.

Turning to slide 15. Gibraltar Life earnings were $473 million for the quarter, compared to $494 million a year ago. Excluding an $8 million negative impact from foreign currency exchange rates, earnings decreased by $13 million from a year ago. The decrease reflects higher net expenses and a lower contribution from net investment results, partially offset by more favorable policy benefits experience and business growth. The higher net expenses in the current quarter are driven by the absence of about $40 million of income recognized from a sale of a home office property that was part of the acquisition of Star and Edison in the year ago quarter.

The lower contribution from net investment results includes current quarter returns on non-coupon investments and prepayment fees, about $15 million above our average expectations, compared to returns about $35 million above expectations a year ago. The more favorable policy benefit experience includes claims experience, which was about $10 million more favorable than our average expectations in the current quarter. Benefit experience was essentially consistent with our expectations a year ago. In addition, a concentration of annual mode revenues favors second quarter results. We would estimate that the benefit to current quarter earnings was about $25 million.

Turning to slide 16. International Insurance sales on a constant dollar basis were $835 million for the current quarter, up by $101 million, or 14%, from a year ago, driven by higher sales in Japan. Life Planner sales in Japan were up by 35% from a year ago, reflecting primarily an elevated level of sales associated with rate increases due to the standard discount rate change on yen-based products effective April 1. Also contributing to the sales increase was a 6% increase in the Life Planner count in Japan.

Gibraltar sales were up by 8% from a year ago, also driven by a sales surge ahead of premium increases on yen-based products, as well as the introduction of a low cash value U.S. dollar whole life product with nursing care benefits, partially offset by a modest decline in bank channel sales. A little over half of our sales in Japan in the quarter were from U.S. dollar products despite higher yen-based sales.

Turning to slide 17. The Corporate & Other loss was $308 million for the current quarter, compared to a $376 million loss a year ago. The main drivers of the variants are lower expenses, including such items as fixed asset disposals, legal costs, and other expenses which can fluctuate, and higher investment income, including the absence of a $40 million charge in the prior year from a decline in value of a tax-advantaged investment that we account for under the equity method. We also recognized higher income from our pension plan, following our assumption update at year-end, and lower interest expense from our paydowns of debt last year.

Now, I'll turn it over to Rob Falzon.

Robert Michael Falzon - Prudential Financial, Inc.

Thanks, Mark. I'm going to provide an update on key balance sheet items and financial measures and I'll be brief. Following the recapture of our living benefit risks and the refinements we made to our risk management strategies in 2016, we view the RBC ratios at Prudential Insurance, or PICA, and PALAC, as well as the composite RBC shown here to be important measures of our financial strength.

Having said that, as we have highlighted previously, we manage our annuity risks using an economic framework that includes holding capital, holding total assets to a CTE 97 level, with the ability to maintain that level through moderate stresses. As a consequence, over time, we may see some variability in the excess of PALAC's RBC over our targeted ratio. At December 31, 2016, the PICA, PALAC, and composite ratios were well above our target, and we estimate that they continue to be so at the end of the second quarter.

In Japan, Prudential of Japan and Gibraltar Life reported strong solvency margin ratios of 879% and 893%, respectively, as of March 31, their fiscal year-end. The solvency margin ratios are comfortably above our targets, and we estimate that they continue to be so at the end of the second quarter.

Looking at the liquidity, leverage, and capital deployment highlights on slide 19. Highly liquid assets at the parent company amounted to $3.7 billion at the end of the quarter. While this represents a decline of about $300 million sequentially, cash balances at the parent company will fluctuate on a quarterly basis due to the timing of subsidiary dividends and holding company commitments.

During the second quarter, we returned about $640 million to shareholders, including $320 million of dividends and $313 million of share repurchases, under the $1.25 billion authorization for the year. And finally, our financial leverage and total leverage ratios were within our targets as of the end of the second quarter.

Now I'll turn it back over to John.

John Robert Strangfeld - Prudential Financial, Inc.

Thank you, Rob. Thank you, Mark. Now we'd like to open it up for questions.

Question-and-Answer Session

Operator

Our first question today comes from the line of Seth Weiss with Bank of America. Please go ahead.

Seth M. Weiss - Bank of America Merrill Lynch

Hi, good morning. If I could start with a question on annuities, you commented that the 127 basis point ROA is exceeding your run rate expectations. Could you classify what do you think is a more sustainable level and then help us map the difference between that level and the 105 basis point run rate we've seen the last couple of years?

Stephen P. Pelletier - Prudential Financial, Inc.

Seth, it's Steve Pelletier. I'll start by offering some comments on that score and I think Rob can follow up. The elevated ROA level reflects a number of factors. In particular, as Mark touched upon, favorable market conditions and the ongoing impact of our annual assumption updates and how that interacts with our risk management strategy. Those factors were significant drivers. And that contributed about 13 basis points of ROA compared to the first quarter.

Some of this list is sustainable, but we aren't necessarily expecting to maintain the full increase going forward. There was some favorability in the quarter on our hedging costs and other factors, and we're always assessing ways of managing the risk to create the best possible economic outcomes across multiple scenarios.

With that said, we think the block is very well-capitalized, well-managed, and generates very considerable free cash flow. So we would kind of update our thoughts about long-term sustainable ROA to the 110 to 115 basis points range over the long run, with meaningful upside to that in the near term. Rob?

Robert Michael Falzon - Prudential Financial, Inc.

Thanks, Steve. Maybe just pick up where Steve left off, which is just to reiterate that our annuities book is performing really strongly and we're quite happy with it. Earnings are up significantly, as is free cash flow. It's well-capitalized and our capitalization strengthened further during the course of the quarter. And volatility remains quite low.

So, the ROA that you saw in the current quarter is about – call it 125 basis points on kind of a run rate basis. It's about 15 basis points above the guidance that Steve has provided before, which was 105 to 110 in terms of what we thought was sustainable. We believe the sustainable rate in the long term is probably, as Steve mentioned, in that 110 to 115 range, though recognize that it's likely it will trend higher than that in the more immediate and intermediate term.

There are three things to keep in mind. First, we're benefiting from some positive hedge breakage and that's factored into that 125 basis points. And in the long term, we don't believe that's sustainable, we think that sort of nets out to zero, and so there will probably be some reversion on that over the course of time.

Secondly, recall that fee levels in our annuities business are likely to compress for two reasons. One, we've undertaken a product diversification strategy and the fees relevant to AUM and some of the newer products are lower than they were in our HD product. And secondly, as the book matures, we have step-downs in our scheduled fees, and so we'll see some impact from that over the course of time as well.

And the third is the item that Steve alluded to, which is with respect to our hedge strategy. We are likely to look at hedging tactics as we go forward. Recall that we manage, as I mentioned in my opening remarks, this block to a CTE 97 level, with the ability to withstand that level through cyclical or moderate stresses. But as we've previously said, we continually reevaluate our hedging strategy in order to optimize the balance between cash instruments we use and derivative instruments to manage the risk balancing between earnings, liquidity, capital flexibility, and volatility.

Given the recent run-up in the markets and some of the benefits that we're seeing from our assumption updates, this is a good opportunity for us to revisit that strategy, evaluating the tradeoffs between our increased ROAs and the ability to further decrease volatility and increase our flexibility with respect to distributable earnings and capital.

I'll reiterate, it's fair to say that we will likely trend above our view of that sustainable level in the near term, but we think that's how we would guide you to think about this business in the long-term.

Seth M. Weiss - Bank of America Merrill Lynch

That's incredibly helpful. Thank you very much. And then just a quick one on the actuarial review. The system updates that you refer to have not an inconsequential impact on book value. Are there any more system updates coming forward that we should be aware of? Or have you mostly made your way through all these conversions?

Robert Michael Falzon - Prudential Financial, Inc.

So, let me, if you don't mind, Seth, answer that perhaps a little more broadly and then come back and answer your very specific question. We are highly sensitive to the non-economic outcomes that have been created by virtue of the systems enhancements and the disconnect that that creates between our operating income and our reported GAAP income. And while we would portray those things as not really reflective of any change in the underlying economics, we recognize that to the extent that we have that disconnect, that creates noise in the marketplace, can have an impact on our share price. And if it has an impact on our share price, it is, by definition, economics, and so we care about it.

We've taken a lot of actions and we've been investing in systems in order to address that disconnect that we've seen in the past by reducing complexity and reducing earnings volatility. You've seen the payoffs from this in a number of places already. So, we did the Closed Block restructuring a number of years ago, we did our division restructuring in Japan which mitigated the FX remeasurement volatility we had been seeing in the past. We've significantly reduced our duration management swaps by some 60% or so, and implemented derivative hedge accounting wherever it was permissible. And then most recently, we did the VA captive recapture and the restructuring, and along with that, we eliminated the corporate interest rate under-hedge. All of those things took a substantial amount of volatility out of our financial statements.

We've also been going through this multi-year series of significant actuarial systems enhancements to sort of get back to your very specific question. They have facilitated, as John indicated in opening remarks, a more sophisticated and granular capability for modeling. Over time, this enhanced capability leads to better modeling and less reliance on estimates and approximations, and that we expect will then produce less volatility prospectively. However, the initial process of implementing the systems can generate greater interim volatility as we migrate from old platforms and models to the newer ones. And that's what you've seen in Life this quarter.

Now, the good news is that we have substantially completed the upgrades to our most significant actuarial valuation systems. Evidence of this, you can see in the results from our Annuities business, where volatility has declined significantly as it was one of the earlier businesses to go through the systems and model enhancements that we've been undertaking. Life is now at the tail-end of that, as well, and our other businesses have that largely behind them.

So, while we will still be subject to changes in experience, which can give rise to actuarial assumption updates, we would expect the refinements components of our 2Q updates that are driven by model updates and enhancements to be more muted on a go-forward basis. We expect these and other actions that we've taken over time will result in a more clear and consistent representation of economics of our business model in our reported financial results. I apologize for the tangent, Seth, but I thought it was important that you and others understand that we continue to be sensitive to this and we wanted to address it and let you know that we're still very engaged and focused on this.

Seth M. Weiss - Bank of America Merrill Lynch

Very helpful. Thanks a lot.

Operator

And we do have a question from the line of Erik Bass with Autonomous Research. Please go ahead.

Erik Bass - Autonomous Research

Hi, thank you. I was hoping you could provide more detail on the implications of the Individual Life assumption changes for the overall profitability of the block and the go-forward operating earnings. And then, assuming there is a reduction in earnings, and is that more a function of timing in terms of recognizing reinsurance expense or lower assumed future profitability?

Robert Michael Falzon - Prudential Financial, Inc.

So, Erik, let me take a stab at that and then Steve may want to jump in as well. So, if you – you should think about the updates that we've made during the course of the second quarter, on an after-tax AOI basis, it aggregates, call it around $420 million. It had three principal components to it. As John mentioned in his opening remarks, the first two relate to refinements in modeling and changes in accounting methods for the mortality on the Hartford block and for reinsurance on all of our GUL and VUL.

Together, those two components account for about 75% of the charge. The result is a change in a pattern of future earnings, which will result in a level of lower – a level of earnings in the near-term, low level of earnings in the near-term that will be offset by a higher level of earnings further out. What I would emphasize is that there is no statutory impact, no capital impact, or no cash impact from this. Neither reflects a change in our view of the underlying economics, either.

So, and then generally, those updates, as I described to my answer to Seth, were really enabled by the system enhancements, which allowed much more refined modeling. And also important to note, with respect to the Hartford component of this, recall that a year ago we adopted this PFL, profits followed by losses accounting, and that tends to very much magnify small changes. So, you have relatively small changes on a large block, then magnified by PFL accounting, resulting in some of the larger change that you've seen.

The remaining piece of the $420 million after-tax, so, is about 25%. It does reflect a change in actuarial assumptions, primarily lapse rates. This is a change in underlying economics, and it affected both GAAP and stat. The statutory impact was offset by other positive things that happened in stat during the course of the quarter.

So, to directly answer your question, on a combined basis, if you take all of this and you look at both the updates and the refinements and how it manifested itself in the period run rate of AOI for Life, it's about $40 million lower than what we've seen in previous quarters, on a pre-tax basis. Now, that's largely offset by the run rates that we've seen in our other businesses, the increases there. But we would suggest that that's the appropriate way to think about the earnings run rate for the business going forward and we think, as a result of these changes, those earnings now bear a much closer relationship to the economics that underlie that business as well.

Erik Bass - Autonomous Research

Got it. Thank you.

Stephen P. Pelletier - Prudential Financial, Inc.

Erik, it's Steve. Just to amplify one note on what Rob said, we don't usually talk about business unit returns, but I think for purposes of this quarter and your question, it's useful to do so. Even as we absorb the impact that Rob mentioned in terms of our run rate earnings in the Individual Life business, we still see returns in the range of 10% on an unlevered basis, which we consider to be quite respectable in the current environment.

Erik Bass - Autonomous Research

Thank you. That's very helpful. And I guess, thinking about it, based on that sort of expected run rate, it looks like Individual Life earnings are kind of back to the level where they were sort of prior to the Hartford acquisition, and obviously, there have been moving parts in terms of interest rates and other factors that affect earnings. I guess, how should we think about the contributions of that acquisition?

Stephen P. Pelletier - Prudential Financial, Inc.

I think, Erik, again, we'd see the Hartford acquisition as still a very attractive step forward for the business. It generated meaningful scale economies and expense synergies. It very considerably strengthened our return, our distribution footprint, and our ability to cover really all the relevant distribution channels in the business.

And again, we would characterize returns, unlevered IRRs in the 10% range on the acquisition. Modestly lower than we might have expressed a couple of years ago or a few years ago, due largely to interest rate environment – movements in the interest rate environment since the acquisition, and to certain experiences around lapsation in certain products, but still an acquisition that we're glad we made.

Erik Bass - Autonomous Research

Great. Thank you for the comment.

Operator

And we do have a question from the line of John Nadel with Credit Suisse. Please go ahead.

John M. Nadel - Credit Suisse Securities (USA) LLC

Hey, good morning, everybody. I was hoping maybe, Rob, you could elaborate a little bit more. A couple of times here, I guess on this call, you've really talked about or expressed very favorable free cash flow dynamics associated with the annuity block. And I was just wondering, at least relative to your overall free cash flow expectations for the corporation, how does the annuity block look today? And I assume it looks better than it did even a couple of quarters ago, given some of the increase in earnings here.

Robert Michael Falzon - Prudential Financial, Inc.

So, John, I think that's sort of appropriate conclusion for you to reach. So, one, the level of earnings is up significantly. Two, as a result of both assumption updates and the sales environment that we find ourselves in, the business is throwing off a tremendous amount of cash. And so, at this point in time, the cash coming from the annuities business would be very accretive to the overall target that we have of 60% of free cash flow relative to our adjusted operating income.

John M. Nadel - Credit Suisse Securities (USA) LLC

Got it. That's very helpful. Thank you. That's all I have.

Robert Michael Falzon - Prudential Financial, Inc.

The sales reference, by the way, is to the fact that lower sales means higher cash flow.

John M. Nadel - Credit Suisse Securities (USA) LLC

Yes, I understand.

Operator

And we do have a question from the line of Tom Gallagher with Evercore ISI. Please go ahead.

Thomas Gallagher - Evercore ISI

Good morning. Just another question on the review, Rob. You mentioned a 40 basis point reduction in assumed JGB yields, I guess that's a large percentage change. Just curious if that had any impact. It doesn't appear to have any impacts on the balance sheet or future earnings associated with that, but I'm guessing, if you bake that into EGPs that would – that could be meaningful from a future earnings standpoint. So, just trying to reconcile how to think about that.

Robert Michael Falzon - Prudential Financial, Inc.

Yeah, Tom. So, in the International businesses on a combined basis, as a result of taking that long-term reversion rate down, you saw a pre-tax charge of about $50 million between the businesses. Now, what I will say is that it was more prevalent in POJ than it was in Gibraltar. Gibraltar had – one, it's a shorter duration book than POJ is, but two, Gibraltar also had some offsets in other areas. So, when you actually look through the numbers, you won't see the Gibraltar charge, you'll see it a little bit more clearly in POJ. So, yeah, on a percentage basis, a relatively large charge, but not a particularly large charge given the size of those books.

Thomas Gallagher - Evercore ISI

I guess I'm more curious about future earnings and the way to think about profitability of the block. If you're taking that future yield on new money assumption down by that much, I would imagine it would have a negative impact. Is the reason that you wouldn't have a change in DAC amortization because you have more FAS 60 business where it's not an EGP construct or I just want to – if you could help me think through that?

Robert Michael Falzon - Prudential Financial, Inc.

Yeah. So, let me hit that in two parts, Tom. First, yes, the Japan block is largely a FAS 60 block, so you're not going to see the types of K-factor resetting that you see in the FAS 97 and related products. So, that's correct.

Having said that, and I guess the second point I was going to make is that, when we look at pricing, and so having adjusted down our long-term reversion rate, and Charlie may want to elaborate on this, but within the business or within all of our businesses, when we look at pricing, we don't look at pricing under any single scenario, we look at pricing across a range of scenarios. And I always like to describe the bookends of those scenarios. At one end of the book is the actuarial assumptions, and we would have taken that down from the 1.9% down to the 1.4%. At the other end of the spectrum would be a flat forever scenario where we assume that the current interest rate is sustained and we want to ensure that we're comfortable with the profitability of the book under that scenario. And in between there, we follow the forward curve and see what that looks like, as well.

And so, any point in time we're pricing, we want to ensure that we're going to get adequate return relative to all of the scenarios in which we look at it. And we define that at – we do adjust the hurdle rate to reflect those different scenarios. So, if interest rates are likely to rise to our long-term reversion rate, we have a higher hurdle rate than we might have if we're in a sustained low interest rate environment forever. We would adjust for that.

The diminution in our Japan books, in the latest quarter, if you looked at the delta between the pricing on those two bookends, it'd be a couple hundred basis points. That's for a series of products that do double-digit returns from a pricing standpoint. So, while it's a not-insignificant decline, what we wind up with is a book of business that's still producing a very attractive return on the capital that we have to hold against it. Charlie, I didn't know if you wanted to add anything to elaborate on that.

Charlie F. Lowrey - Prudential Financial, Inc.

Yeah, and I'd just add a couple of things. One, Rob's absolutely right. We look at both bookends, and we make a determination on the pricing we want to have based on those two bookends. And it's usually somewhere in between, but we absolutely take into account low rates forever and look at that scenario.

The other thing I would just say, which is kind of an obvious comment, but is the amount of U.S. dollar product we sell and foreign currency product we sell. So, while we are affected by the diminution in interest rates, we also – over 50% of our book that we sold this quarter was U.S. dollar product.

Thomas Gallagher - Evercore ISI

Got you. And then just, Rob, just one final follow-up on that point, just to make sure I understand it. So your point was that maybe it's a couple of hundred basis points of deterioration on the ROE, but you'd still have double-digit returns, even after the reset. And because it's FAS 60, as long as you don't have no profit on the block, that would determine DAC amortization and whether DAC is recoverable. So you're not even remotely close to having any kind of impairment impact on DAC. Is that more or less the right way to think about it?

Robert Michael Falzon - Prudential Financial, Inc.

Yeah, that's all correct, Tom.

Thomas Gallagher - Evercore ISI

Okay, thanks.

Operator

And we do have a question from the line of Ryan Krueger with KBW. Please go ahead.

Ryan Krueger - Keefe, Bruyette & Woods, Inc.

Hey, thanks, good morning. I was just hoping you could provide some more color on the drivers of the $7.7 billion of Asset Management flows and how the pipeline looks going forward?

Stephen P. Pelletier - Prudential Financial, Inc.

Ryan, it's Steve. I will address that. The $7.7 billion reflects strength in multiple asset classes – particularly, however, fixed income. And the strength in fixed income is really across the board. It reflects positive flows, both institutional and retail, both from existing clients and from new mandates. It also reflects positive flows from both public and private sectors of the fixed income asset class. We're seeing the payoffs from our investments in our businesses – in our Asset Management business payoff. We really see that materializing, particularly in the distribution arena.

A lot of our investments have been to be sure in our investment capabilities, but also in our distribution capabilities and strengthening our global Institutional client management framework. And we see that paying off. So, we still see the basis – high demand for what we do and the basis for strong flows. Obviously, we'll see what level they prove out to be, but we're confident that we have a very strong value proposition, and that that's being reflected in our flows.

The other item I would mention is that outflows in our equity business continued, but at a mitigated level, due largely to our improved performance in those businesses. So, while we continue to see outflows in the equity business, they've been mitigated by that factor.

Ryan Krueger - Keefe, Bruyette & Woods, Inc.

Thanks. And then on Retirement, you've fairly consistently had, I guess, what you've been characterizing as favorable case experience for a while now. I guess at what point – or are you getting closer to the point where you just feel like the profitability of the block is perhaps better than you originally priced it for?

Stephen P. Pelletier - Prudential Financial, Inc.

Ryan, I just mentioned that we have, over the years, made several refinements and improvements of our expected case experience in pension risk transfer. So, it's not as if we haven't been raising the bar. At the same time, we've continued to see very strong case experience, even above those expectations that we have raised over time, including, by the way, this quarter where we raised expectations with a quarterly impact of about $5 million.

We think that this type of case experience really serves to validate the very strong basis on which we have underwritten and priced this business. We continue to write this business in full achievement of our targeted returns in PRT, and we think that this type of case experience really bears that out. At the same time, we will continue to review our experience going forward. We have made some adjustments. We'll make further if our experience and analysis dictates that that's appropriate.

Ryan Krueger - Keefe, Bruyette & Woods, Inc.

Thank you.

Operator

And we do have a question from the line of Suneet Kamath with Citi. Please go ahead.

Suneet Kamath - Citigroup Global Markets, Inc.

Hi, there, thanks. Just wanted a clarification on the CTE 97 at moderate stress, assuming moderate stress. Can you just help us understand the – how you define moderate stress scenario, both in terms of equity markets and interest rates, and then over what sort of duration you're thinking?

Robert Michael Falzon - Prudential Financial, Inc.

Suneet, yeah, it's Rob. So, a combination of things that go through there. So, we look at a 20% decline in equity markets. I'm going to get the interest rate assumption wrong on that, and look to see if someone knows that. I want to say it's 50 basis points, but we'll have to verify that for you after the fact. And then, we have a – more importantly than that, we also have a credit deterioration that you would typically see in a recessionary-type scenario, so you have an expansion in credit spreads and some incurrence of credit losses. That extends out for a multi-year period of time and then is assumed to recover thereafter.

So, the point, the duration of it is less important than when it actually happens because you have to actually survive the point of that downturn. And then, after that point in time, the stress becomes less. So, the duration of it is frankly less important than the actual quantums that we hit within a one to two-year period of time.

Suneet Kamath - Citigroup Global Markets, Inc.

Okay. Just on like the equity markets, what sort of recovery after that initial 20% do you assume?

Robert Michael Falzon - Prudential Financial, Inc.

It's a normal, 8%, our long-term reversion rate, so it's an assumption that the total return on equities thereafter goes up by 8% per year; a combination of 2% dividend, 6% appreciation.

Suneet Kamath - Citigroup Global Markets, Inc.

Okay. Got it. And then just, I guess, a question for Mark, maybe on the ROE. I think at the Investor Day, you talked about the International ROE coming down 50 basis points a year, I think largely due to interest rates. But given that that division, I think, it uses almost half, maybe 40% of your overall equity, what are the businesses that you have that can generate ROE expansion to help offset that ROE decline? Or are we just looking at consolidated ROEs just continuing to face some pressure going forward? Thanks.

Mark B. Grier - Prudential Financial, Inc.

This is Mark. On Investor Day, I talked about regulation and supervision. So, I'm going to hand that one over to Rob, unless you want to come back to regulation and supervision.

Robert Michael Falzon - Prudential Financial, Inc.

Yeah, actually, and we're going to pass this right along. I think Charlie is probably in the best position to answer that. So, go ahead, Charlie.

Charlie F. Lowrey - Prudential Financial, Inc.

So what I would say is I think what we talked about was in Japan, the interest rates are coming down, and therefore, there would be some potential diminution over time of ROEs. On the other hand, we have some other countries like Brazil, which are small at this point, but which are increasing. And so, I think what you'll see is as we are successful in terms of expanding in other countries, that that diminution may be mitigated some – the diminution in Japan may be mitigated to a certain extent by the growth in the other countries.

John Robert Strangfeld - Prudential Financial, Inc.

I guess the other thing I'd add is that when we think about ROEs, obviously, they're not – we're not immune to the market environment, but what we're focusing on is relative performance of ROEs. And what we believe, Suneet, is by virtue of our business mix, by virtue of our fundamentals and the quality with which we're operating these businesses, that we would aspire to be very near the top of the pack in terms of relative comparison to anyone in the space. Absolute numbers may move a little because of absolute levels of interest rate, but in terms of relative performance, our aspiration is absolutely unchanged from what it's been in terms of our overall outcome.

Robert Michael Falzon - Prudential Financial, Inc.

And just adding to that, so it's fully understood the 12% to 13% guidance that we provided last year fully incorporated the anticipation of the diminution in the ROE in Japan over time. So, there was – that's not something above and beyond the guidance that we gave that went from the 13% to 14% to 12% to 13% ROEs.

Suneet Kamath - Citigroup Global Markets, Inc.

I got that part, it's just once we get past the near-term, which I think is your target, 12% to 13% is sort of over the near term, I'm trying to think of, is the next phase higher than 12% to 13% or is it actually potentially lower than that, just given the International business coming down?

Robert Michael Falzon - Prudential Financial, Inc.

I'm not 100% sure how to answer that question, Suneet. What I would say is that when we look at the long-term sustainable rate, we look at it against the interest rate environment. And so, if interest rates in Japan remain low for a long period of time, but rates rise within the U.S., then, yeah, the Japanese component of our business would continue to have a more modest ROE. And therefore, we might go back to the lower end of the 13% to 14% range that we gave before, as opposed to a mid or higher point of it. So, you'd have to think about. If what you're asking is if rates go up in the U.S. but don't go up in Japan, how do we think about that? Japan is 40%, 45% of the earnings, and therefore, the return there would be – the lower return there would be sustained and we'd have a more muted bounce back, but nonetheless, a bounce back.

Suneet Kamath - Citigroup Global Markets, Inc.

Got it. Okay. Thanks.

Operator

And we do have a question from the line of Jimmy Bhullar with JPMorgan. Please go ahead.

Jamminder Singh Bhullar - JPMorgan Securities LLC

Hi, I had a couple of questions. First, you've discussed in the past just disruption in the annuity market from the DOL rule. So, wondering if that's continued through this quarter or has that eased a bit? And besides annuities, how do you think about the impact of the rule on other businesses in the U.S., specifically the DC business? And then, could you just discuss the driver of the drop in the Life consultant count at Gibraltar?

Stephen P. Pelletier - Prudential Financial, Inc.

Jimmy, this is Steve. I will address your question. In regard to annuity sales, we do think what we've seen over the last couple of quarters, not just us, but the industry, is meaningfully driven by continued ambiguity around final outcomes in the DOL Fiduciary rule. As you know, a review period is underway and we, along with many others in the industry, are making our voice heard in that review and about the importance of ensuring that middle class Americans are still able to access financial advice and financial solutions, including retirement income solutions.

But, as that review is still pending and still underway, I think continued ambiguity regarding final outcome of the rule may still continue to have an impact on sales. For us, while we saw a decline from year ago quarter in sales, we did see a modest sequential quarter pick-up, and that was due to some repricing of our PDI product that we did towards the end of the first quarter.

In regard to other businesses, we do think that on an industry basis there could be some impact from the rule to the DC business. However, we think that impact would be largely felt at the smaller end of the market, where, for example, high proprietary ratios of Asset Management products in DC plans are the norm. We generally participate in the upper range of the market and we would expect the impact on us from that phenomenon to be minimum.

Charlie F. Lowrey - Prudential Financial, Inc.

And Jimmy, this is Charlie. On the second – your second question, I'll be short and sweet. We raised the bar. So, we have a more stringent recruiting process, we have slightly higher terminations because we raised the standards. We've been doing that around the world in various countries, so you saw us do it in Korea and Taiwan last year and we continually raise the bar.

Jamminder Singh Bhullar - JPMorgan Securities LLC

Okay. And just one more on International, did you see a benefit on your sales from front-ending, just related to the pricing changes with the lower discount rate? And if you did, then would you expect to drop off in the second half? Not have been looking for guidance as much as just what you're seeing in the market of second quarter versus second half.

Charlie F. Lowrey - Prudential Financial, Inc.

Yeah. I mean, intuitively, I think your comment is correct. We certainly saw an acceleration or a surge, if you will, from yen products in the first half of the year. Interestingly, we also saw a commensurate increase in the sales of U.S. dollar products. So, it wasn't just yen products, but U.S. dollar products, which weren't affected by the discount rate. I think that shows the power of our distribution franchise.

But, given the fact that we had accelerated sales in the first half, I think it is intuitive to say that in the second half we may see sort of a slight decrease, but hard to tell how much, in part because Life Planner count did increase by 6% and Gibraltar usually has, or always has a seasonal surge in the second quarter to a certain extent. So, hard to tell how much, but intuitively and directionally, I think your comment is correct.

Jamminder Singh Bhullar - JPMorgan Securities LLC

Thank you.

John Robert Strangfeld - Prudential Financial, Inc.

Brad, we have time for one more question.

Operator

And there currently are no more questions in queue at this time, sir.

John Robert Strangfeld - Prudential Financial, Inc.

Good. Thank you very much, everyone. Have a good day.

Operator

And ladies and gentlemen, this conference will be available for replay after 1:30 today through August 10. You may access the AT&T Teleconference Replay System at any time by dialing 1-800-475-6701 and entering the access code 407283. International participants may dial 320-365-3844. And those numbers again are 1-800-475-6701 and 320-365-3844, again entering the access code 407283.

That does conclude your conference for today. Thank you for your participation and for using the AT&T Executive Teleconference Service. You may now disconnect.