Nov 5, 2009
Executives
Eric Durant - Senior Vice President John R. Strangfeld Jr.
- Chairman of the Board, President, Chief Executive Officer Bernard B. Winograd - Executive Vice President, U.S.
Businesses Richard J. Carbone - Chief Financial Officer, Executive Vice President Mark B.
Grier - Vice Chairman of the Board
Analysts
Suneet Kamath - Sanford Bernstein Nigel Dally – Morgan Stanley Thomas Gallagher - Credit Suisse Andrew Kligerman - UBS Edward Spehar - Banc of America Jimmy Bhullar - JP Morgan
Operator
Ladies and gentlemen, thank you for standing by and welcome to the Prudential third quarter 2009 earnings call. At this time all participants are in a listen only mode.
Later we will conduct a question and answer session. Instructions will be given to you at that time.
(Operator’s instructions) And as a reminder today’s conference call is being recorded. I would now like to turn the conference over to Mr.
Eric Durant. Please go ahead.
Eric Durant
Thank you, Cynthia. Good morning or I guess I should say, good morning, good afternoon, good evening depending upon where you are and where you’re listening to us.
Thank you for joining us. In order to help you to understand Prudential Financial we will make some forward-looking statements in the following presentation.
It is possible that actual results may differ materially from the predictions we make today. Additional information regarding factors that could cause such a difference appears in the section titled forward-looking statements and non-GAAP measure of our earning’s press release for the third quarter of 2009 which could be found on our website at www.investor.prudential.com.
In addition, in managing our businesses we use a non-GAAP measure we call adjusted operating income to measure the performance of our financial services businesses. Adjusted operating income excludes (inaudible) gains and losses, as adjusted and related charges and adjustments as well as results from divested businesses.
Adjusted operating income also excludes recorded changes in asset values that will ultimately accrue to contract holders and recorded changes in contract holder liabilities resulted from changes in related asset values. The comparable GAAP presentation and the reconciliation between the two for the third quarter are set out in our earnings press release on our website.
Additional historical information related to the company’s financial performance is also located on our website. Okay.
Our speakers today are John Strangfeld, CEO, Rich Carbone, Chief Financial Officer, and Mark Grier, Vice Chairman. After our formal remarks, we’ll welcome your questions and in the Q&A John and Rich and Mark will be joined by Bernard Winograd, the CEO of our Domestic Businesses, Ed Baird the CEO of our International Businesses and Peter Sayard (ph) our Controller.
John?
John R. Strangfeld Jr.
Thank you, Eric and good morning or afternoon everyone. Thank you for joining us.
As Eric mentioned I will kick things off with some high level comments and then Rich and Mark will walk you through the quarter in detail. Let me start, very macro.
Commence of the drama and mayhem of the financial crisis, the Prudential management team has kept two thematic top of mind. One is an expectation, the second is an aspiration.
The expectation is for ourselves to weather the storm better than most. And we believe we have.
The aspiration has been to gain ground. We have done that as well.
In fact, it is not an aspiration it’s a reality. As evidenced by quarterly results in each sequential quarter, but most visible in Q3.
Our ability to achieve both our expectation and our aspiration is a product of the quality of our businesses, the skill and cohesiveness of our management team and the confidence our customers place in our brands and our financial strength. We’re not declaring victory but we do think that with the benefit of hindsight we struck the right balance between taking short term actions to reduce risks while maintaining our long term strategic trajectory.
Furthermore we have not simply hunkered down. We have been focused on being well positioned to benefit from the flight to quality, both in new business and in talent.
As we pull through the other side of this crisis we look to make the most of it. I would characterize our mindset as confident but not cocky.
Now, moving more specifically to the third quarter, our results show solid underlying performance and also reflect better market conditions. Our businesses with relatively modest exposure to US financial markets, namely individual group insurance, retirement and international insurance, show few ill effects from recent dislocations in the environment.
These businesses are as strong and well positioned as they have ever been. In fact we believe they are benefiting from a strength and competitive position as we emerge from the recent environment.
At the same time those businesses that are more sensitive to market conditions, annuity and asset management, are fundamentally sounds and are positioned to benefit from improving market conditions. Meanwhile, each is demonstrating excellent commercial momentum.
Annuities are enjoying record variable annuity sales and flows. And asset management is recording strong flows from both institutional and retail investors.
Our businesses serve different markets and they are effected by different risks. And because of these differences they have not and will not perform equally well in all period.
But and this is the key point, they are all good businesses. That is they have quality businesses models.
They’ve served attractive markets. They are well led and they are highly competitive in their markets.
We believe our portfolio of businesses will produce superior returns over time. As well as superior consistence of results relative to those of our US like peers.
Our sales and our flows demonstrate that we are gaining ground in the marketplace. They are solid virtually across the board in the third quarter and year to date.
And reflect, we believe, the attractiveness of our products and our ability to stand behind them. We believe that the financial market volatility of the recent past has strengthened the appeal of our value proposition to clients.
As Rich will review for you we have significantly enhanced our financial flexibility this year through our management of capital and liquidity. We have made a strong company stronger and we view our financial strength as an enabler to pursue exceptional organic growth opportunities as you have seen.
And we have ample resources to continue to pursue these opportunities. And at the same time, we believe we have fortified ourselves against the risk of another adverse environment.
This brings me to earnings guidance for the full year. Considering current financial market conditions, including equity market levels, interest rates and credit spreads, as well as our results for the first nine months of the year we believe that Prudential Financial will achieve common stock earnings per share for 2009 in the range of $5.40-$5.60.
Based on after tax adjusted operating income of the financial services businesses, and to be clear, this expectation assumes stable equity market over the remainder of the year from today’s levels. To sum up, our businesses are solid and market conditions are improving.
Our sales and flows show that we are gaining ground. Our financial strength and flexibility allows us to pursue exceptional opportunities and our management team is confident.
Now, Rich and Mark will walk you through the details and then we will welcome your questions. Rich?
Richard J. Carbone
Thanks John and good morning everyone. As you’ve seen from yesterday’s release, we reported common stock earnings per share of $1.59 for the third quarter.
And that’s up 56% from the $1.02 that we reported in the year ago quarter. And that’s based, of course, on adjusted operating income for the financial services business.
Let me start with some high level comments on the current quarter. We’re benefiting from good performance in our major businesses both in adjusted operating income results and in sales and net flows.
Continued improvement in the financial markets are driving recovery of account values, which contribute to favorable and locking adjustments as well as base earnings for several of our businesses. But, please, keep in mind that most of our earnings are in businesses that are not market sensitive and they have turned in record to very strong results for the quarter.
On the other hand, the cost of holding excess liquidity which is showing up at the negative spread mostly incorporated another was a drag on our results for the quarter. In addition, we expanded the hedging program in our annuity business to help protect our capital from adverse swings in the financial markets.
We include the changes in market value of derivatives we use in this hedging program in adjusted operating income. This partially offset the benefit of rising equity markets.
Our earnings per share for the current quarter also reflected dilution of about $0.14 from the 37 million shares we issued in June. Operating results of some of our businesses are effective by discreet items, including the impact of our annual review of experience and actuarially assumptions that we typically complete for our insurance and retirement businesses in the third quarter.
And I’ll go through the major items now. In our annuity business, we had a benefit of about $0.30 per share from the release of a portion of our reserves for guaranteed minimum debt and income benefits.
And we had a benefit of about $0.04 per share on the positive unlocking of debt. This reduced amortization of deferred policy acquisition costs.
Going the other way, the capital program I just mentioned had a negative impact of about $0.23 per share on results for the annuity business. Now this is separate from our living benefit hedge.
The impact of hedging breakage from our variable annuity living benefits including the adjustment for our own non-performance risk was not significant during the current quarter. Our individual life insurance business benefited $0.17 from the reduction the net amortization of DAK and related costs due to the completion of the annual review of actuarial assumptions and the recovery of account values in the third quarter.
Individual life also benefited another $0.05 per share from compensation received based on the multi year profitability from sales of certain third party products. Our retirement business had a net charge of about $0.01 per share from completion of its annual review.
And in our international business, Gibraltar Life an income of about $0.02 per share from initial policy surrenders in the Amato Life business we acquired in May. In total, all the items I just mentioned had a net favorable impact of about $0.34 per share on our earnings per share for the third quarter.
Now let’s move on to the Cap results for the financial services business. We reported net income of $1.1 billion or $2.35 per share for the third quarter.
This compares to a net loss of $118 million or $0.25 per share in the third quarter of 2008. GAAP pre tax results for this quarter include amounts characterized as net realized investment losses of $235 million.
This loss reflects $360 million of impairments and credit losses including $292 million from impairments and credit losses on fixed maturities and $62 million from impairments on equity securities. The $292 million of impairments in credit losses from fixed maturities includes roughly $25 million from sales of credit impaired securities, $150 of fixed income credit losses on sub prime AVS, and $120 million spread across public and private corporate holding and other asset based securities.
The $62 million in equity impairments came mainly from declines in value reaching the 12 month mark. And identification of securities that we intend to sell primarily Japanese equities that we’re in unrealized loss impairments.
The impairments and credit losses in the quarter were partially offset by favorable mark-to-market on externally managed European securities. Now I’ll give you an update on where we stand in capital and liquidity.
We begin the year with a very strong capital position, which we significantly enhanced over the past nine months. During the third quarter we issued $600 million of three year notes at 3.6% and $900 of six year notes at 4.8%.
These rates were near five year loans. We saw this as an opportunity to replace some short term borrowings at very attractive levels.
In September, we issued at $500 million exchangeable surplus note at a Prudential insurance to Nippon Life. This note which counts as statutory surplus for Prudential Insurance has a 10 year maturity and an interest coupon of 5.4%.
And can be exchanged commencing five years after issue for Prudential Financial common stock at a conversion price of $98.78 per share. Together with the $1.4 billion of common stock and the $1 billion in public long term debt we issued in June we have raised more than $4 billion of long term debt and equity over the first nine months of 2009.
We are continuing to manage our insurance companies at levels consistent with what we believe to be AA standards. The 15% in increase in the S&P index for the third quarter following the 15% increase in the second quarter reversed a portion of the capital erosion that we experienced last year in the early part of 2009 and when equity markets fell in the first part of – excuse me, at the end of 2008 and the early part of 2009.
Credit migration and impairments have always been considered in our capital forecast. And remain consistent with our original expectations.
The surplus note issued during the third quarter has displaced other capital management options for Prudential Insurance that we might have considered under certain circumstances. If we were reporting RVC for Prudential Insurance at September 30, we believe it would be comfortably above 400.
Keep in mind, that this is hypothetical because RVC is an annual calculation and we have not done a bottoms-up analysis as of September 30th. Other than the surplus notes, none of the proceeds from the securities we issued this year were utilized at Prudential Insurance to bolster its RVC.
In addition, the estimate or RVC for the quarter includes no benefit for the gain we expect to realize on the sale of our investment in the Wachovia joint venture. We believe the benefit from the gain will add over 100 points to RVC including tax attributes.
Our Japanese insurance companies, Financial of Japan and Gibraltar Life each reported solvency for their most margins for the most recent fiscal year, March 31, 2009. I was comfortably above their benchmarks for an AA rating.
We had return businesses continued to generate capital and we’re confident that the solvency margins have been maintained or improved through the end of September. Our capital position provides for both business growth and a buffer to manage our insurance company’s capital under stress conditions in the equity and credit markets.
That said, with the economy and the financial markets continuing to face challenges and the level of impairments and credit migration over the remainder of the credits cycle still uncertain we continue to believe that it is ill advised to quantify a measure of excess or available capital. Now the liquidity, as noted earlier, we have retained a substantial portion of the proceeds of our debt and equity issuances at the parent company invested in cash equivalents.
This contributes to a strong liquidity position, but also creates a bit of a negative spread for now. At September 30th, we had $4.2 billion of cash and short term investments at the parent company, PFI.
If we remove outstanding commercial paper and short term inter company borrowings, we have net cash on hand at $3.4 billion. $3.4 billion net cash position is essentially unchanged from $3.5 billion at the end of the second quarter.
About $1.2 billion of the proceeds from our $1.5 billion parent company debt issuances during the third quarter we used to replace commercial paper financings in several of our businesses where we felt longer term debt was a more appropriate financing source. Commercial paper borrowing at the end of the third quarter was about $200 million at PFI and about $700 million at Prudential Funding, the financing arm of Prudential Insurance.
These borrowing are not material or essential for our business needs. This compares to $1.2 billion of commercial paper at PFI and $4.4 billion of commercial paper at Prudential Funding as of last year end.
We have no significant debt maturities at PFI until 2011. Lastly, given the continued market uncertainties our current intent is to maintain a current cash position at PFI representing 18-24 months of cash requirements, including maturities, or about $1.5 billion to (inaudible).
We will reassess this policy as the long term effects of the market downturn are better understood. Now Mark will comment on the investment portfolio for our financial services business and review our business results for the quarter.
Mark.
Mark B. Grier
Thanks, Rich and John. Hello everyone thanks for joining us today.
I’m going to start of comments on the investment portfolio. The narrowing of credit spreads that began earlier this year has continued through the third quarter driving substantial recovery of values in our investment portfolio.
While the market values the many classes of assets have fluctuated due to volatile financial market conditions, and we may not have seen the last of this volatility, we manage our investment portfolio primarily with a focus on its cash flow prospects since our general account investments are mainly supporting long term insurance liabilities. I’ll start with our fixed maturity portfolio.
The continuing narrowing of credit spreads coupled with the modest decrease in base interest rates during the quarter has returned our general account fixed maturity portfolio to a net unrealized gain position, roughly $1 billion for the first time since a year ago. Gross unrealized losses on fixed maturities in our general accounts stood at $4.8 billion at the end of the third quarter.
This represents a recovery of $3 billion from the second quarter and $6.5 billion from last year end. Roughly $1.5 billion of total gross unrealized losses at the end of the third quarter relate to subprime holdings.
This compares to $2.1 billion at the end of the second quarter. Total subprime holdings were roughly $4.5 billion at the end of the third quarter based on amortized costs.
This represents a decrease of over $400 million from the second quarter, reflecting just under $300 million of pay downs during the quarter and the $150 million of impairments that Rich mentioned. At September 30th, the general account fixed maturity portfolio included $7.8 billion of commercial mortgage backed securities at amortized costs, 93% of these holdings have AAA ratings.
Super senior AAA securities with 30% subordination represent roughly 80% of our holdings. Based on amortized costs, non investment grade securities comprised about 8% of the $131 billion fixed maturity portfolio at the end of the quarter.
This is up from about 7% at last year end, mainly as a result of rating agency downgrades on a portion of our subprime holdings earlier in the year. This is a high quality fixed maturity portfolio, as Rich mentioned, total impairments in credit losses for the quarter were under $300 million, including about $150 million for subprime ABS.
The reminder includes write downs to market values for securities we intend to sell. And we estimate that about half represents true credit losses.
One last comment on the investments portfolio, we had $22 billion of general account commercial mortgage in other loan holdings as of the end of the quarter. At September 30th, the average loan to value ratio for our commercial holdings is 65%.
And the average debt service coverage ratio is 1.8 times. Delinquencies are light amounting to less than 1% of holdings.
Now I’ll cover our business results for the quarter, starting with the US businesses. Our annuity business reported adjusts operating income of $166 (inaudible) for the third quarter compared to a loss of $307 million a year ago.
Results of the current quarter reflect several discreet items, including our annual unlocking of actuarial assumptions. We released a portion of our reserves for guaranteed minimum death and income benefits contributing $185 million to current quarter results.
This benefit to earnings is mainly driven by the equity market uptick in the quarter. And also reflects the annual update of our actuarial assumptions including mortality and lapses.
Together with a market driven release of these reserves in the second quarter we’ve recovered about three quarters of the GAAP reserve increases we recorded since a year ago. Largely for our older products that don’t contain the auto rebalancing feature we package with our current living benefits.
The improvement in the equity markets also resulted in a net release of over $800 million of statutory reserves for our annuity guarantees over the past two quarters, including about $350 million in the third quarter. With a corresponding restoration of the decrease of statutory capital that came from the earlier equity market decline.
Current quarter results also benefited from reduced amortization of deferred policy acquisition and other costs amounting to $26 million, reflecting market performance and the update of our actuarial assumptions. Under the reversion to mean to approach we used to evaluate DAK and reserves we set expected future returns for a look forward period, currently four years.
So that expected returns in combination with historical returns will average out to a long term assumption. However, we cap expected equity returns for the look forward period, meaning that we will not assume returns greater than a maximum level.
In connection with our annual review of assumptions, we reduced the assumed returns for overall account values from 10.5% to 9.7%. As Rich mentioned we recently expanded the hedging program in our annuity business to help protect our capital from adverse swings in the financial markets, primarily equity market exposure.
Mark-to-market on the derivatives we are using in this capital hedge program essentially driving by the uptick in the equity markets had a negative impact of $140 million on current quarter results. The items I mentioned sum up to a net favorable impact of $71 million on current quarter results.
The impact of breakage between changes in the value of our living benefit guaranteed and the related hedging instruments was not significant in the current quarter, amounting to a net charge of $9 million after related amortization of DAK. This compares to a net charge of $37 million a year ago.
Results of the year ago quarter also included a $418 million negative effect from unfavorable unlockings and market driven true-ups. Stripping out the unlockings and true-ups the mark-to-market from the capital hedge program and hedging breakage on our living benefit guarantees from the comparison, annuity results were down $44 million from a year ago.
Reflecting an increase in the portion of fees we’re reserving for guaranteed benefits and the non capitalized portion of commissions associated with the increase in sales. All of the variable annuity living benefit features we offer today come packaged with an auto rebalancing feature.
Where customer funds are reallocated to fixed income investments to support our guarantees in the event of market decline. Given the popularity of these features over the past several years, driven by our highest daily family of benefits, over 60% of our account values with living benefits at September 30th are now subject to auto rebalancing.
Reducing our risk profit and limiting our exposure to fluctuation in the cost of hedging. With about 85% of our current quarter variable annuity sales including the HD living benefits we are continuing to migrate our book of business toward auto rebalancing products.
With the improving financial markets, about $5.5 billion dollars of account values that had been rebalanced to fixed income investments during the market downturn returned to client selected investments over the past two quarters. Our gross variable annuity sales for the quarter reached a record high of $5.8 billion compared to $2.5 billion a year ago.
This marks our second consecutive quarter of record breaking sales. Our highest daily or HD living benefit guarantees coupled with our auto rebalancing features that protects account values and market downturns has provided us with a substantial competitive advantage in the variable annuity market.
In August we introduced the next generation of our living benefit product feature called HD 6 plus. As implied by the name, this feature offers a 6% annual roll up for protected value rather than the previous products 7%.
And a higher but still competitive B structure. Now, it’s reasonable to assume that a portion of our third quarter sales reflected purchases of the earlier product in anticipation of the introduction of the new one, HD 6 plus continues to offer the differentiated value proposition that has driven our success in the marketplace.
And initial indications are that it is being well received by clients and their advisors. Net variable annuity sales were also very strong in the quarter amounting to $4.4 billion.
The retirement segment reported adjusted operating income of $119 million for the current quarter compared to $133 million a year ago. Current quarter results reflected a charge of $8 million from updating of DAK and other amortization items based on our annual review.
While results for the year ago quarter benefited by $12 million from net refinements including the impact of a similar annual review. Stripping these items out of the comparison, results from the retirement business were up $6 million from a year ago, as higher investment spreads were partially offset by less favorable case experience on traditional pension business and offset partially by lower fees.
Current quarter full service gross sales and deposits were $4.8 billion, including a $1 billion major case win. Where we will provide record keeping and consulting servicers through the Mullen unit we acquired late last year.
Large case sales emerge after length bid processes and the pace of bid active in the market over the past few quarters has been considerably slower then typical reflecting the challenges in the general business environment. Our full service persistence was over 96% and this was our eighth consecutive quarter of positive net flows.
The asset management segment reported adjusted operating income of $29 million for the current quarter compared to a loss of $8 million a year ago. The improvement end results reflected a reduction in losses from investment results associated with proprietary investing activity amounting to about $20 million in the current quarter and about $100 million a year ago.
The year ago losses came mainly from investments and fixed income inequity funds we manage which we later redeemed. While the current year loss came mainly from real estate fund investments.
The reduction in proprietary investing losses was partially offset by unfavorable results from commercial mortgage operations, including declines the value of interim loans we hold in the asset management portfolio, and by lower performance based fees mainly related to institutional real estate funds. Adjusted operating income from our individual life insurance business was $243 million for the current quarter compared to $238 million a year ago.
Current quarter results benefited from three discreet items. The DAK unlocking which mainly came from refinements of our assumptions for interest spreads on general account business and updating our actuarial assumptions to give effect to mortality experience over a five year period, contributed $55 million.
In addition, third quarter results benefited from a reduction in net amortization of deferred policy acquisition costs and other items that was driven by favorable separate account performance. We estimate that this market driven benefit had a favorable impact of about $50 million in comparison to a year ago quarter.
And compensation we received based on multi year profitability of third party products distributed by our agents contributed another $30 million. Due to the renegotiation of the distribution arrangements, opportunities for similar compensation will be limited going forward.
Results for the year ago period, included a $79 million benefit from a favorable unlocking and $53 million from compensation related to our distribution of third party products. Stripping these items from the comparison, results for individual life were essentially unchanged from a year ago.
Sales amounted to $86 million dollars in the current quarter compared to $82 million a year ago. The increase was driven by strong performance in our universal and term life products, especially in our third party distribution channel.
Our sales benefited from market opportunities due to the retrenchment of some carriers and from competitive positioning following our repricing of universal life insurance products in August of 2008. We commenced implementing price increases for universal life interim insurance in April and May of 2009.
And we have announced further price increases for both lines effective this fall. We believe our products will remain competitive given the trends we’re seeing in the market.
The group insurance business reported adjusted operating income of $64 million in the current quarter compared to $101 million a year ago. Results of the year ago quarter benefited by $13 million from group disability reserve refinements based on an annual review.
The current year’s annual review had no significant impact on our results. Stripping the annual reviews out of the comparison, results were down $24 million from a year ago, reflecting less favorable group life and disability claims experience in the current quarter.
Excluding the reserve requirements and reserve refinements, benefit ratios for the first nine months are essentially consistent with the year ago period in both lines. Sales for the quarter were $110 million compared to $117 million a year ago.
Turning to our international businesses, within our international insurance segment Gibraltar Life’s adjusted operating income was $190 million in the current quarter compared to $167 million a year ago. Current quarter results include income of $25 million from the Yamato Life business we acquired in May of this year.
We were selected by the Japanese regulators to acquire and restructure Yamato following its bankruptcy. The significant surrender charges were imposed with regulatory approval as part of the restructuring.
Consistent with our overall expectations, surrenders were concentrated during the initial period following the restructuring. And we estimate that these early surrenders contributed about $15 million to current quarter results.
Sales from Gibraltar Life based on annualized premiums and constant dollars were $140 million in the current quarter, up 25% from $112 million a year ago. Bank channel sales were $38 million in the current quarter, up from $15 million a year ago.
The increase was driven almost entirely by sales of life insurance protection products that we began to distribute through banks last year. Sales from the life advisor channel, our proprietary channel were up $5 million or 5% from a year ago.
Our life planner business, the international insurance operations other than Gibraltar Life, reported adjusted operating income of $310 million for the current quarter, up $17 million from a year ago. The increase track continued business growth.
Sales from our life planner operations based on annualized premiums and constant dollars were $205 million in the current quarter, up $27 million from $178 million a year ago. The increase was driven primarily by strong sales of our variable life and retirement income products in Korea and Taiwan, reflecting improving economic conditions in those markets as well as sales in advance of a repricing.
Sales in Japan were up $4 million from a year ago. International insurance sales on an all in basis including life planners, life advisers and the bank channel amounted to $345 million for the third quarter, up 19% from a year ago.
Benefiting from expanding distribution and our strong value propositions that meet protection needs. Foreign currency translation was not a major factor in the comparison of our international insurance results due to our currency hedging programs.
The international investment segment reported adjusted operating income of $13 million for the current quarter compared to $37 million a year ago. Results for the current quarter include a mark-to-market income of $14 million on securities related to trading exchange memberships.
The remainder of the decline came from less favorable results from our global commodities operations. Corporate and other operations reported a loss of $201 million for the current quarter, compared to a $38 million loss a year ago.
Our results are bearing the cost of our management of liquidity and capital as we face continued uncertainties in the economy and financial markets. These costs primarily take the form of negative spread and higher interest expense on capital debt within corporate and other results.
As a result, interest expense net of investment income produced about half of the negative swing in corporate and other results compared to a year ago. Higher expenses including mark-to-market on deferred compensation liabilities drove most of the remaining increase in the loss.
And briefly on the closed block business. The results of the closed block business are associated with our Class B stock.
The closed block business reported a net loss of $8 million for the current quarter, compared to a net loss of $58 million a year ago. The reduced loss reflects a lower charge in the current quarter for dividends paid or accrued to policy holders including the impact of a reduction in the dividend scale that we had implemented for 2009.
We measure results for the closed block business only based on GAAP. To sum up, our businesses are performing very well.
Improving financial market conditions are contributing to our results and recovery of account values is strengthening our earnings power going forward. Our value propositions have become more compelling as clients are more aware of their financial risks and more motivated to look to a strong partner to help manage these risks.
We’ve enhanced our competitive position coming out of the recent market downturn and are continuing to register solid sales and good product flows virtually across the board. We remain comfortable with the risk profile of our investment portfolio.
We have excellent liquidity and a strong capital position and we’ve bolstered our financial strength and flexibility, enhancing our buffer against further market dislocation and increasing our resources to pursue business growth opportunities. Thank you for your interest in Prudential.
Now we look forward to hearing your questions.
Operator
(Operator's Instructions) Our first question goes to Suneet Kamath with Sanford Bernstein. Please go ahead.
Suneet Kamath - Sanford Bernstein
Thanks and good morning. I had a question about the variable annuity business and the changes in the product that you talked about.
What I'm wondering is how have the changes that you've made changed the return profile for that product, particularly given different market scenarios as you run them through in terms of the new versus the old, thanks.
John R. Strangfeld Jr.
I think Bernard Winograd will take that.
Bernard B. Winograd
Good morning. I think the overall scene here is that we are watching the evolution of this market with the benefit of being the low-cost provider of living-benefit guarantees at the moment.
And the reason for that is embedded in the auto rebalancing design which by definition gives us less to hedge than the people we are competing with and because hedging has become in the past year the most expensive newly expensive part of the product offering, we find ourselves in the enviable position of having a cost advantage. And the way we've chosen to take advantage of that gets to the answer to your question which is we are taking market share, but also raising prices to remain competitive and what we've done in the design or in the changes between HD7 and HD6 is, as we indicated before, taking down the rollup rate from seven to six, raising the C from 75 to 85 basis points, and making some other changes that all have the effect of giving us more revenue for what we sell and leaving us with a benefit that is still highly competitive in the marketplace.
So what we've also observed overall is that because of the cost advantage we've been able to do all that and see the expected return of all upwards as the marketplace evolves which means that currently our expectation for the margins or the return on equity involved in supporting HD6 are in the high teens which is up a bit form the mid teens kind of expectation we had for HD7 before.
Suneet Kamath - Sanford Bernstein
That's helpful. And I'm assuming that the high and mid teen numbers sort of assume a stable equity market environment.
I guess my question was really around what happens if we go back to something that we saw over the past 18 months or so. How low could those returns go or what would be the ROE differential between the new product and the old product?
John R. Strangfeld Jr.
I think it's safe to say that returns will compress, but less than the returns will compress from competitive products in the marketplace. Again, became of the auto-rebalancing we'll have lesser drops in asset values in that kind of scenario going forward.
We are, at this point, at 41% of total book and over 65% of the living benefit book now in the auto-rebalance format as a result of the sales that we've driven. And as a consequence the portfolio as a whole would be more resistant to a downturn than the old one was.
We are roughly at 95% of what our peak AUM was back in the third quarter of '07 in the annuity business, but with a very different risk profile. Probably the best way to think about that is that the auto-rebalancing products, despite their increasing share of the portfolio, still now represent only about 9% of the net of the at risk on the death benefit, for example.
And so there’s a very different profile we'd expect going forward.
Suneet Kamath - Sanford Bernstein
Thanks. Just one quick followup on the auto rebalance, when things are in the fixed income portion I'm assuming that's bond funds, and you run your market stresses, I mean, I'm going to go ahead and assume that you’re stressing the bond piece also because clearly bond funds can lose money just like equity funds, is that correct?
John R. Strangfeld Jr.
We are and we're doing a stochastic model of that that reflects the distribution of the risks, if you will, of correlation changes in a tail event as well.
Suneet Kamath - Sanford Bernstein
Great. Thank you very much.
Operator
Thank you. Our next question comes from the line of Nigel Dally of Morgan Stanley.
Nigel Dally – Morgan Stanley
Great. Thanks and good morning everyone.
First, can we get an update on the outlook for asset management? You continue to have a loss of some proprietary investments and commercial mortgage lines which continue to dampen the result; from your perspective where are we in this cycle?
Is it reasonably to believe that offers will dissipate from here or do you continue to see challenges in commercial real estate remaining a headwind as we look to 2010? Then the second question I had was on acquisition opportunity.
Recently we got news that AIG is no longer planning on disposing certain assets that I think many of us thought would be a good strategic bet for you. So I would just be interested in your views, are you still seeing an attractive pipeline or potential consolidation opportunity or has it become more difficult to find opportunities that will be a strong strategic fit at this point?
Thanks.
John R. Strangfeld Jr.
So, Nigel, Bernard will take part A and I'll take part B, and this is John.
Bernard B. Winograd
Let me try to separate the market and the losses questions that you asked with regards to commercial real estate. We've been expecting for some time now that the market would be down 45% or so from peak to trough and we're down about 35 as of the end of the third quarter.
So we clearly have some distance to go yet, but there's a limit as to how much further down we think it can go and we clearly have also the lion's share of that behind us at this point. From the market's point of view 2010 should be a better year in terms of the marketplace in general than 2009.
The way that manifests itself in our reported results is a little bit mediated by the accounting principles that don't allow us to recognize losses until they actually appear in a debt portfolio and we're marking to market in the equity portfolio. The equity portfolio mark to market means that it's done on an appraisal basis so there's a little bit of a wag but we would expect that the equity environment would be better in 2010 than in 2009, which is not to say good, but better.
And with regard to the mortgage market, the more equity like mortgages that we have, that is the inter-loan portfolio, for example, we hope to have — we do not yet know whether this will happen because it's constrained by the actual events that are beyond our control, but we hope to have ourselves in a position by the end of 2009 where the reserves that remain to be taken will be less in 2010 than 2009. And finally with regard to the high quality mortgages that are staple of the general account, there's still very little indication that our portfolio is going to face any substantial losses, but whatever we have will probably materialize late in the cycle.
John R. Strangfeld Jr.
Now taking the second part of your question about M&A pipeline outlook, let me hit that in a broader sense and then a little more specific to pipeline without obviously returning to any specific set of circumstances. Our historical characterization of M&A being like to do versus have to do still holds and there are really two reasons for that.
One is the one we've always used in the past and the second or most recently have used in the past and the second is one new observation. And that is, for now, the last three years or so we've found ourselves not being in a position of having subscale businesses that needed M&A to make them upscale.
In fact these businesses are now each individually performing very well. The second is that some of the market share progress that we're seeing in several lines of our business is of a scale and nature that you would normally associate with M&A without all the execution risk.
So as a consequence of that, the opportunity cost in a sense of doing something is higher than it would be in more normal times. Obviously there's a prospect for things in motion and it's hard to define the specifics.
If you do look at the supply side of divestitures over the next 36 months, both what is visible and what is likely, it's very extensive and some of it may be potentially attractive and we think we're better positioned than most as a counterparty if there is a trade sale because of our size, our scope, our scale, our management depth, and our financial strength and having said that, activities and specific outcomes are very hard to predict. So, our view on this is there could be some interesting opportunities there yet we're going to be patient, careful, thoughtful, and disciplined, in recognizing that there's a long-term pipeline involved here in terms of activity levels not just of current events.
So that's how I would characterize M&A.
Nigel Dally – Morgan Stanley
That's great. Thank you.
Operator
Thank you. Our next question comes from the line of Thomas Gallagher with Credit Suisse.
Thomas Gallagher - Credit Suisse
Good morning, a few questions. First for Rich, can you talk a bit about the excess liquidity drag?
So if I understand correctly, you essentially termed your short term into longer-term debt. If you have that much excess liquidity, why bother doing that?
Why not just repurchase it instead of taking the negative spread? That's question number one.
The second question is related to the comment about credit and statutory surplus and the comment that you didn’t' inject anything into the sub. Wasn't the $500 million surplus note that you issued to Nippon sort of a backdoor capital injection, or am I not reading that correctly?
Thanks.
Richard J. Carbone
Paul, let me take the second question first. I think in my remarks I said other than the $500 million Nippon note, none of the proceeds, that were raised by PFI were injected into PICA.
So I thought I was clear that indeed the surplus note is issued at PICA's level so that PICA did benefit I guess about 25 RBC points from the Nippon note. But to be fair and make sure everybody knows this, earlier in the year when we brought up some retail notes out of PICA, PICA did book a gain of $300 million on those retail notes that were paid back to PFI.
So to complete the picture, PICA benefited from the $500 million in surplus notes that it issued to Nippon, and then it benefited from a gain of 300 as we extracted the retail notes, but no proceeds have been downstream to PICA from any of our issuances.
Thomas Gallagher - Credit Suisse
Got it, okay.
Richard J. Carbone
Okay. Now on your first question that I reversed the order of let me talk about liquidity from the holding company's perspective.
It is our intent to maintain, and I said this in my opening remarks, to maintain a liquidity cushion. And I'm differentiating between a cushion and excess.
So a cushion is something that we're going to hold onto for the foreseeable future and that's about 18-24 months of cash at the holding company that the holding company needs in the next 18-24 months including maturities. We've got more than that on the balance sheet today.
We will deploy that piece over time into our assets that will eliminate a piece of that negative spread. So the capital that was available, the debt was available out there in the markets at very attractive rates, we brought them on the balance sheet, some is going to be maintained in the liquidity cushion and some will be invested over the course of 2010 at rates that will eliminate a portion of the negative spread.
Thomas Gallagher - Credit Suisse
Okay, thanks. And then just one follow up, on the variable annuity side in hedging, can you just comment on, I believe you're hedging some of your capital now, can you comment on what the structure of it is and how large it is?
And then are you still making on the GMDB or should we think about at least part of that being hedged now?
Mark B. Grier
Well, to answer the second part of it first, the hedge that we have discussed today should be considered to cover exposures to capital in the annuity business and some of those exposures may arise from fluctuations in GMDB reserves. So you can think of that relationship, but you ought to think of it on a fairly general level, but the short economic answer to your question is probably yes.
With respect to what we've done it's a derivative based short and the impact of this on earnings in this quarter was $140 million so I think you can probably do some work and scale it if you want to think about how much the market moved relative to the $140 million that we printed.
Thomas Gallagher - Credit Suisse
Okay fair enough, thanks.
Operator
Thank you. Our next question comes from the line of Andrew Kligerman from UBS.
Andrew Kligerman - UBS
Great, good morning. Just Rich, on that excess liquidity or just liquidity in general, can you clarify what it is that 18-24 month cushion you want to have there?
And then in general what is that liquidity level at the holding company? I believe you mentioned some numbers earlier, but I want to make sure I have them right.
Richard J. Carbone
Sure. What we're covering is fixed-charge coverages, monthly interest —
Andrew Kligerman - UBS
No, no, I got that. I just want to know the exact numbers.
Richard J. Carbone
Oh, its $1.5 billion which is where we're targeting today as the amount that we are holding at the holding company.
Andrew Kligerman - UBS
Do you have that amount and you're targeting that amount?
Richard J. Carbone
We have more than that amount and the amount above that amount is the piece that we will release and invest longer term, over time.
Andrew Kligerman - UBS
Right. And what is above that right now?
John R. Strangfeld Jr.
We're at $3.4 billion now as we measure and that excludes our commercial paper outstanding as well as the intercompany liquidity facility that Rich mentioned. So the difference between 3.4 and 1.5 is the number that you're looking for.
Andrew Kligerman - UBS
Got it, perfect; and then just one more clarification, Mark, derivative based short, can you just give me a little clarity around that one? What is it exactly that caused the $140 million loss?
This is a new program. This is something different than what you've done in the past, what exactly is this derivative based short?
Mark B. Grier
The answer is yes this is new; it' something that was done during the quarter reflective of you on our part that we wanted more protection for statutory capital in market fluctuations. What I mean by derivative short is that it's a total return swap and we would be paying the return on the market.
So when the market goes up we pay more money and when the market goes down we pay less money and that's how we benefit inversely from the market moves.
Andrew Kligerman - UBS
Got it. Okay, and then the really important question that I have is I took a look at the — I was very upbeat about this quarter, I took a look at the 540-560 guidance last night, that's part one, and I got a number of $1 as the midpoint of your guidance for next year.
Now, if you took all the unusuals out — Rich had mentioned, I think $0.34 of unusuals, you get $1.25 normalized and it's that $1.25 with some growth factors meshed in that would get you to something north of an 11% ROE. But if you're looking at $1 of earnings next year based on this new guidance, it's very concerning because then you're looking at an ROE maybe of 9%, maybe less.
And in talking with Neil Stern last night and trying to get a little color about what might be in that guidance, I would still sense that $1.25 is a more normal number so that gets me to the question what is your ROE goal looking into '10 and beyond? And the second part of it is, is that dollar the run rate that we should be thinking about as we look to '10?
John R. Strangfeld Jr.
Okay, Andrew. This is John.
Let me start with that and ask Mark to speak to it as well. While you may think the guidance is a little light as it relates to the fourth quarter, I would say it is, maybe only a little.
You should not infer that we see or anticipate any weakness in our fundamental momentum. The earnings do fluctuate quarter to quarter and we are giving you a reasonable view of the impact of some season-ability and some other known items that will show up in the fourth quarter, none of which is individually very large nor problematic.
So the message on our burins remains very, very positive.
Mark B. Grier
Yeah. Let me extend some of your points a little bit, but first of all, you should not be extrapolating this fourth quarter expectation into 2010.
You ought to be thinking about it in the context of exactly what John just said. And if you're thinking about the emerging ROE of the company you should be thinking about the performance of our businesses that are not sensitive to the markets and how well they’re doing and where they might be.
You should be thinking about the market sensitive businesses and how they are recovering as the market improves. You should be thinking about the excess liquidity that Rich talked about and the capital cushion and you should be thinking about the redeployment of proceeds from the settlement of Wells Fargo.
Those will be the drivers of the ROE of the company going forward. We'll go into this in more detail on investor day, but I want to steer you away from extrapolating the inference of fourth quarter numbers into 2010 or beyond.
In this guidance we're essentially giving guidance for one quarter just because of where we are in the calendar and that means of necessity, we're going to include seasonal influences and we're going to include the consideration of things that we know. We also in this guidance have made a more conservative assumption about the market, namely that it's flat, then we would make as we look out over longer periods of time.
So again I would caution you about extrapolating the fourth quarter number that you have inferred from our guidance and again as I said we're sort of in a box here giving one quarter guidance, but we are by no means giving 2010 guidance and we'll talk about that more in detail on investor day.
Andrew Kligerman - UBS
Yeah. And just quickly to followup on that comment you just made, Mark, about flat market; usually I think you're assuming something close to 3% equity appreciation per quarter, right?
And if I am right then what kind of a negative DAC impact might that have on the quarter? That's an interesting data point.
Mark B. Grier
Andrew, the 3% is the DAC assumption. The market assumption that we typically make is 8% a year.
Andrew Kligerman - UBS
So maybe 3% a quarter, but that could have maybe — I mean, would that have a negative impact in the fourth quarter if the market did end flat with where it was as of yesterday when you reported?
Mark B. Grier
Yes. It would.
If we don't have market anticipation that keeps up with what we've anticipated then we would have adapt from that.
Andrew Kligerman - UBS
That's what you're assuming based on what you just said before you're assuming some drag, right?
Mark B. Grier
Yeah. So again, the very short-term nature of this number makes it different from the emerging outlook for ROE that I think you're trying to focus on and that would be one element of that equation.
Andrew Kligerman - UBS
Yeah. Rich, this is very help and I think too many people are just extrapolating that number in what was just what I think was a phenomenal quarter, so thanks very much into that insight.
Richard J. Carbone
Well, we should share your view that we had a very good quarter and we would caution you about extrapolating that inferred number for the fourth quarter. That's not what's going on around here.
Operator
Thank you. Our next question comes from the line of Edward Spehar with Banc of America.
Edward Spehar - Banc of America
Thank you. Just two questions; I guess the first Mark, when you suggest the drag from excess liquidity being about half of the negative variance year over year in corporate and other, I think that's about $80 million negative in the quarter or about $320 million on an annual basis.
So that would suggest, I guess, we could do some math, that maybe you'll look at $6 billion plus as the number of potential redeployment. So I guess what I'm wondering, if my math is even close, that forgetting about the holding company, it seems like there's a few billion dollars that you could invest at the subs and I'm wondering how quickly do you think you'll do than, and then I have one followup.
Mark B. Grier
I'm going to let Rich answer that.
Richard J. Carbone
I'm not tracking all of your numbers, particularly the $6 billion. Eric spoke before about how we're going to hold the cushion at $1.5 billion and we have $3.4 billion now.
Some of that 3.4 is going to be used to pay fixed charges between now and the end of the year. So we're going to have about $1 billion coming out of the corporate account to reinvest at long-term rates and that will eliminate a part of the negative spread.
Mark mentioned that Wachovia proceeds. They will come in early next year and that will be additional monies that we can invest.
So I might have a number if you use $5 billion for Wachovia and $1 billion to be squeezed out of the corporate account of $5 billion. There may be some excess liquidity in PICA, but I'd rather talk about that on investor day when we have a clearer view of the future.
Edward Spehar - Banc of America
Okay. And then the followup, Rich, is on RBC.
At the end of the second quarter you said the same thing that you said at the end of this quarter and I guess if I combine the benefit from the Nippon notes plus the VA reserver lease, I think you had just those two items are probably 40-45 RBC points, plus I'm assuming you got some capital benefit from — I'm assuming that the equity portfolio and the closed block was up in the quarter. So when we talk about comfortably above 400, are we comfortable this quarter versus comfortable last quarter?
Richard J. Carbone
We're comfortably above 400 this quarter. Eric doesn't want me to do a very simple walk (laughter) —
Mark B. Grier
Our RBC ratios are very strong.
Edward Spehar - Banc of America
Are we going to get anything more specific, do you think, on investor day?
Mark B. Grier
No. Not in terms of parsing details of where we are today.
We will continue to talk about managing our RBC to the levels that we believe are consistent with our ratings aspiration and that's factored into our capital planning and stress-test picture, but we’re in very good shape.
John R. Strangfeld Jr.
And then just one point I want to make sure everybody understands on the Wachovia money. We’re earning zero on that investment today so it's the entire $5 billion that gets redeployed at an earnings rate.
There's some friction there for taxes and we'll pay a little tax in there, but that's about it.
Edward Spehar - Banc of America
Got it, thanks.
Operator
Thank you. Our next question comes from the line of Jimmy Bhullar with JP Morgan.
Jimmy Bhullar - JP Morgan
Hi, thank you. I have a couple of questions.
They're both on your international business. The first one's just on Gibraltar.
Your sales were up 25% and I think a huge portion of that was just the pick up in the bank channel. Just wanted you to talk about the opportunity you see in the bank channel and to the extent you can quantify any numbers in terms of distribution agreements you have already and how much you think you can potentially ad?
The second question is on the Korean business; your other life planner business outside of Japan had pretty good sales so I'm assuming that was primarily by Prudential of Korea. But in the past you have suffered because of aggressive competition in terms of agent retention, just if you can comment on trends in that market?
John R. Strangfeld Jr.
Sure, Jimmy. Let me start with the bank channel.
And what we're seeing there is the emergence of what could become a very substantial third distribution for us in addition to POJ in Gibraltar. The bank channel opened up as a result of deregulation.
It was limited to the annuity business at first, but starting last year they were allowed to sell insurance products and in the first quarter in which we sold which I was about five quarters ago, we sold just $1 million. But the big driver of the increase in this quarter was the growth in the sale of pure debt protection insurance.
So that grew from virtually $1 million to $23 million in this most recent quarter. And what's particularly unusual and valuable about it is it's not what you might assume with the single premium insurance, but rather its recurring premium, both for retirement income and for whole life.
As far as where that's going to go it's hard to say because this is still a very young distribution system. But your point about the distribution, we have continued to grow that quarter by quarter.
So, for example at the beginning of this year we had 10 banks within our distribution. We're now up to 19 banks.
So that alone should contribute to the growth in the channel beyond what we're already getting from our in-force relationships. As far as Korea, you're right, it appears, at least in the last few quarters, most noticeably in this quarter, that we may have turned a corner in what headband a multiyear cycle of very aggressive poaching by the competitors.
As a result we've seen an increase in the number of life plans almost to a new historic level and an increase of over 30% in the sales in Korea. It's also been more in the death protection area rather than in the variable annuity area, so across the board a number of positives.
We would attribute this to three or four different things. One is the economy as a whole is starting to bounce back in Korea.
Secondly there's been a marked weakening of the competition. The very competitors who were poaching and limiting our growth in the last few years were really damaged by the down cycle because they were selling a lot of hot products.
The market has returned more to traditional death protection products and that of course is our core competency and so we have benefited from that. And the final in fairness is that there's some anticipation of rate increase here as well as somewhat in Taiwan which also had very substantial growth, even a higher percentage than in Korea.
So we're getting a little bit of that phenomenon as well. But across the board a very positive cycle.
We'll want to wait another quarter or two to see whether this is indeed and enduring center of improvement or to some extent some cyclical benefit coming from the weakening of the completion coinciding with the strengthening of the economy.
Jimmy Bhullar - JP Morgan
Okay. And could you also address just your outlook for growth in life planners for Prudential of Japan?
You've aspired, I think in the past, to a high single digit rate. You haven’t had for several quarters, and maybe a few years, and it doesn't seem reasonable anymore given the size of the agency force, but what's your view on what a more realistic growth target would be for the life planner account at POJ?
John R. Strangfeld Jr.
Yeah. Let me give you some numbers for life planner in general and then we can focus on POJ.
Life plans in general I think have been growing this cycle if you adjust for the 4% in total by putting back the transfers out of POJ that have gone into the bank channel and help fuel that growth, that numbers get up to a little over 6%. I think it's 6.2%.
Now that's probably a more realistic number. Now, in POJ even with the adjustment for the transfers it's somewhat less than that, and I think it has to do with a couple of factors.
One you've mentioned which is the difficulty in continuing the thigh level of growth in a more mature large-scale organization, but I think somewhere in that range is a realistic number for us to be targeting for POJ.
Jimmy Bhullar - JP Morgan
Thank you.
Operator
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