Prudential Financial (NYSE:PRU) is one of the leading provider of retirement solutions in the U.S. The company earns more than 40% of its revenues from the division. While pension risk agreements with General Motors (NYSE:GM) and Verizon (NYSE:VZ) grabbed most of the headlines last year, the insurer also expanded its individual annuities business. According to sales data from LIMRA, Prudential was the highest seller of variable annuities in 2012, with a market share of 14%. The company took over the pole position from MetLife (NYSE:MET) which was the highest seller in 2011 but decided to cut back on the equity linked product to reduce risk in 2012. In terms of total annuity sales, Prudential is second in sales behind the U.S. subsidiary of its British namesake, Jackson National Life.
Our price estimate of $58 for Prudential’s stock is in-line with the current market price.
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Prudential primarily targets the mass affluent market in the U.S., which includes households with investable assets or annual income in excess of $100,000. The company uses a distribution network of independent financial planners, wirehouses, banks, and insurance agents including Allstate’s agency distribution force with over 300 wholesalers across the country. Variable annuities offered by the company allow policyholders to invest in propriety and non-propriety mutual funds represented as separate account interests that provide returns based on the underlying investment portfolio.
Apart from premium revenues, Prudential also earns asset management fees as a percentage of the average assets of the mutual funds in its variable annuity products. At the end of 2012, the company had separate account assets of $253 million, up from $218 million at the end of 2011. Prudential also earns other administration fees like mortality and expense fees.
The pricing of the insurance products takes into account assumptions on equity market returns that the company can generate, interest rates, longevity or life expectancy of the insured party, timing of withdrawals as well as hedging costs. Due to differences between assumptions and the real world experience, the returns Prudential can generate from variable annuities are always at risk. To minimize this risk, the company adopts a mathematical model to transfer assets automatically between investments selected by the policyholder and more stable investments like bonds.
Under the present economic uncertainty, variable annuities remain a popular investment for Americans. With MetLife pulling out of the market, we expect Prudential to gain market share in the coming years. However, the profitability of the product depends largely on the company’s ability to maintain underwriting discipline enabling it to earn a margin over the costs involved with providing benefits and managing assets. Expenses involved include policyholder benefits, interest credited to account balances, interest expense, amortization of deferred policy acquisition costs and other expenses related to policy acquisition.
The operating margin for the individual annuities business has been around 30% for the last few years. However, since the income statement includes values derived from actuarial assumptions as well as actual payments made by the company, the long term operating margins can be difficult to predict. We expect the company to maintain margins as it continues its practice of maintaining underwriting discipline.