Prudential Financial (NYSE:PRU) reported a 77% year-on-year increase in pre-tax adjusted operating income for the second quarter of 2013, driven primarily by the blockbuster pension risk agreements with General Motors (NYSE:GM) and Verizon (NYSE:VZ) last year. Last June, Prudential issued a group annuity contract worth approximately $29 billion to General Motors, and followed it up with another agreement with Verizon covering approximately 41,000 members of Verizon’s pension plan and about $7.5 billion in pension liabilities.  Due to the income from these deals, the pre-tax operating income for the company’s retirement solutions division went up from $306 million in the second quarter of 2012 to $847 million this year. Retirement account values increased 23% over the prior year, breaching the $300 billion barrier.
Despite the increase in pre-tax income, Prudential reported a net loss of $524 million. This was primarily due to pre-tax charges of $1.6 billion due to foreign currency fluctuations mainly the weaker Yen. More than 30% of the company’s premiums outside the U.S. come from Japan where it accounts for products in Yen. Prudential also incurred pre-tax charges of $953 million due to changes in market value of derivatives that the company was using to hedge against fluctuations in interest rates.
Around 75% of Prudential’s assets are invested in fixed-maturity securities like government and corporate bonds, the returns from which are linked to interest rates. The 10 year Treasury bond yield has climbed from 1.66% in May to around 2.63%, primarily due to speculations that the Federal Reserve’s Quantitative Easing program might be winding down in the near future.  However, in the long term, higher bond yields will generate greater returns for Prudential. Prudential’s fixed-maturities yield fell from 5.3% in 2008 to 3% in 2012, but will increase as interest rates climb back to per-recession levels. The 10-year Treasury bond yield was around 5.5% in 2007, more than double the current yield. Investment income accounts for 10% of Prudential’s revenue but is very important for the insurer’s margins.
The Fed has indicated a threshold of 6.5% unemployment rate as a target for the economic recovery before it might start increasing interest rates.  The Fed has been keeping rates low by purchasing assets like long term treasuries and mortgage-backed securities from commercial banks and other financial institutions, thereby increasing liquidity and reducing long term interest rates.The unemployment rate in the U.S. has recovered from 10.1% observed during the financial crisis in 2009 and reached a four-year low of 7.5% in April, staying around 7.6% through May and June.  As the economy continues to improve, speculation regarding the impending end of the Quantitative Easing program will lead to higher bond yields. Based on recent trends, we have updated our forecast for Prudential’s yield from fixed maturity investments. We expect the yield to reach per-recession levels of around 5.5% within the next two years. Our price estimate of $80 for Prudential’s stock is in-line with the current market price.
Leading Life Insurer
The U.S. individual life and group insurance division reported a $69 million increase in earnings, as new business premiums doubled over the prior year. The increase was largely due to increased distribution capabilities from last year’s acquisition of The Hartford Financial Services Group’s (NYSE:HIG) individual life insurance business, which contributed $58 million to second quarter sales. Individual life premiums for the second quarter of 2013 were up 11% from the prior year.
Prudential is the third largest life insurer in the U.S., behind MetLife and Aflac Group, with a market share of 6.14%.  In the individual life insurance market, the company has a market share of 3.1%, with around 7 million policies in force.  We expect the market to grow in the coming years, with Prudential in a strong position to capitalize. For more, please read: A Look At Prudential’s U.S. Life Insurance Business
International Operations Look Strong
Prudential’s international division continued to grow through the three months ending June. Net premiums from international operations were up 2% from the prior year, on a constant exchange rate basis. Premiums were up 7% in Japan. The number of individual policies outside the U.S. increased from 11.8 million at the end of the second quarter of 2012 to 11.9 million at the end of June, 2013. In Japan, the number of policies has increased from 2.7 million to 2.9 million.
We expect Prudential to continue to grow its international operations in the coming years. The company is looking to expand in emerging markets, particularly in Asia and Latin America and has established operations in Japan, Taiwan, Italy, Korea, Brazil, Argentina, Poland and Mexico. For more information on the Japanese market, please read: An Overview Of The Japanese Life Insurance MarketNotes:
- Prudential Financial Inc : Prudential completes pension risk transfer transaction with Verizon, 4 traders, 10th December, 2012 [↩]
- Daily Treasury Yield Curve Rates, U.S. Department Of The Treasury [↩]
- Bernanke Offers Possible Timetable for Tapering [↩]
- U.S. Department of Labor, Labor Force Statistics from the Current Population Survey [↩]
- NATIONAL ASSOCIATION OF INSURANCE COMMISSIONERS LIFE AND FRATERNAL INSURANCE INDUSTRY 2012 TOP 25 GROUPS AND COMPANIES BY COUNTRYWIDE PREMIUM [↩]
- Life Insurers Fact Book by American Council of Life Insurers [↩]