Prudential Financial, Inc.
Q2 2020 Earnings Call Transcript

Published: 5 Aug 2020

[Operator:]

Ladies and gentlemen, thank you for standing by. And welcome to the Prudential Quarterly Earnings Conference Call. At this point, all participants are in a listen-only mode. As a reminder, today's call is being recorded. I'll turn the call now to Mr. Darin Arita. Please go ahead, sir.

[Darin Arita:]

[,:]

[Charlie Lowrey:]

Thank you, Darin. Good morning, everyone, and thank you for joining us today. I’ll start by saying we hope that you, your families and colleagues remain safe and healthy during these extraordinary times. The events of the past several months have created unforeseen new difficulties for people around the world, while further exposing the deep-seated problem of an equity in our society. It's in times like these that we believe our company's purpose of solving the financial challenges of our changing world and standing by our employees, customers and communities is most important. After transitioning over 95% of our US employees and most of our international employees to remote work in March, we continue to seamlessly serve customers, while the vast majority of our employees around the world continue to work in that fashion. This allows us to exercise utmost caution as we evaluate how and when to return to the workplace. In the meantime, I am so proud of our people and how they've continued to focus on meeting the evolving needs of our customers, many of whom face new challenges related to the COVID-19 pandemic and its economic impact. We’ll continue to innovate the ways we serve our customers during and after the pandemic. During the second quarter, we maintained a clear focus on executing against our 2020 initiative, despite the challenging macroeconomic backdrop. By delivering on progress on our cost savings targets, aggressively repricing and pivoting products to mitigate the impact of low rates on our performance and rotating our international earnings mix. We’re also focused on identifying opportunities for further action, particularly as we look to continue to reduce our sensitivity to market. And we’re exploring the potential to generate additional cost savings on top our existing 2020 targets. Throughout this period, we benefited from the strength of our rock-solid balance sheet, which gives us the confidence and the flexibility to navigate changes to the economic environment. I’ll touch on each of these points in greater detail before turning it over to Rob and Ken for a look at our second quarter results.

[Rob Falzon:]

Thank you, Charlie. And I want to reemphasize your comment about our commitment as a management team to supporting racial equity. This is an issue that is aligned to our purpose, it's part of the fabric of our culture and critical to our success as an organization.

[Ken Tanji:]

Thanks, Rob. I will begin on slide 12, which provides insight into earnings for the third quarter relative to our second quarter results. The key point is that our underlying earnings power increased slightly from last quarter, primarily reflecting higher equity markets. To help you see this, I’ll start with pretax adjusted operating income in the second quarter, which was $931 million and resulted in earnings per share of $1.85 on an after-tax basis. Then, we adjust for the following items. First, the annual review of assumptions and other refinements resulted in a net charge of $334 million in the second quarter, primarily driven by a reduction of our long-term interest rate assumption by 50 basis points in the US. Next, we adjusted variable income to a normalized level, which is worth $130 million. Please note that while we have not included an adjustment for variable investment income for the third quarter, the potential exists for continued revaluation of private equity and real estate investments due to the current adverse economic conditions. While returns of our alternative investment portfolio are currently lower than our target returns, and will vary period-to-period, over time, this portfolio has generated income above our target returns. Third, we adjusted underwriting experience by $155 million. This reflects $100 million of favorable experience in the second quarter, primarily driven by reserve gains in retirement. We estimate claims experience in the third quarter will include $55 million for COVID-19. Next, there are other items that combined may be $75 million more favorable in the third quarter, primarily related to expenses and markets. We expect expenses, including implementation costs to be $130 million lower in the third quarter, this is primarily due to legal expenses in the second quarter. In addition, due to favorable markets in the second quarter, other related revenues in PGIM benefited by $45 million. And in income in our Gibraltar segment also benefited by $25 million. We expect operating cost due to COVID-19 to be $25 million in the third quarter. And last, we anticipate net investment income will be reduced by $15 million, reflecting the difference between new money rates and disposition yields of our investment portfolio. These items combined get us to a baseline of $2.63 per share for the third quarter. Please note that this baseline includes items specific to the third quarter that reduced EPS by approximately $0.19 per share. While we have provided these items to consider, to meet the other factors that affect earnings per share in the third quarter. On Slide 13, we provided an update on the potential impact of the pandemic. We have included a sensitivity for operating income based on the US population experiencing 100,000 of incremental deaths due to the pandemic. We estimate that this may lower operating income by $70 million. And this is less than the sensitivity we provided on our last earnings call, as we have seen a lower fatality rate due to COVID-19 in our US insurance businesses than previously estimated. Our third quarter baseline includes a net impact for mortality due to COVID-19 of approximately $55 million. The actual impact will depend on a variety of factors, such as infection and fatality rates, geographic considerations and progress in testing and medical treatments. We have also reduced our estimate for incremental operating costs due to COVID-19 and have estimated the potential reduction in other operating costs, such as for travel and entertainment. In the second half of 2020, we expect to incur incremental operating costs of $60 million due to COVID-19, with $40 million in the third quarter and $20 million in the fourth quarter. The estimate of these costs is lower than what we provided on our last call, primarily due to lower health benefit costs of our US employees and lower cost to support our sales professionals in Japan, as their productivity is improving faster than previously estimated. We also expect to have $30 million of lower travel and entertainment expenses in the second half of 2020. Turning to Slide 14, we continue to maintain a robust capital position and adequate sources of funding. Our capital position exceeds our AA financial strength targets, and we maintain liquid assets at the parent company that are greater than 3 times annual fixed charges. We have substantial sources of funding. Our cash and liquid assets at the parent company were $4.5 billion at the end of the quarter. We expect to receive net proceeds of $1.7 billion from the sale of our Prudential of Korea business following the close of the transaction, which is expected in the second half of this year. And another source of funding is free cash flow from our businesses. In May, we added a new $1.5 billion contingent capital facility that combined with our previous facility, brings our total available contingent capital funding resources to $3 billion. Turning to Slide 15. And in summary, we remained on-track with our objectives for the year, as we accelerate the execution of our initiatives. We’re exploring the potential to increase our cost savings initiative and looking at additional ways to build upon our repricing and product shift to further mitigate market impacts. And we maintain a rock bound – rock-solid balance sheet with a robust capital liquidity position. Now, I’ll turn it over to the operator for your questions.

[Operator:]

First, with the line of Elyse Greenspan with Wells Fargo. Please go ahead.

[Elyse Greenspan:]

Hi, thanks. Good morning. My first question was just on the mortality assumption you laid out for the third quarter. So if I look at your disclosures, longevity did benefit your results in both the Q1 and the Q2 this year. So I’m just trying to understand why that would at least continue to some degree in the third quarter?

[Ken Tanji:]

Hi, Elyse. This is Ken. I’ll take your question about the COVID mortality into the third quarter. So we - in our second quarter, we benefited from our longevity business in the UK. Mortality in the UK came in a little bit higher than we had previously estimated, and that resulted in a gain from our UK longevity reinsurance business. While there was fatalities in the UK in the second, right now that seems to be more contained and we wouldn't expect that to continue given the current fatality rates. So we also, in our new estimate, have incorporated into to that sensitivity, what we learned from the second quarter, which is in our - also in our life insurance and group insurance businesses, the fatality rates were lower than we previously estimated. So we've incorporated that into our new estimate.

[Elyse Greenspan:]

Okay. Thanks. And then second, on the capital side, you guys said in your prepared remarks that you would continue to monitor credit markets and the economy in determining your strategy. I guess, as we have one additional quarter under your belt, how are you thinking about capital return? Is it dependent upon getting the capital, you know, the $1.7 billion from the Korea sales towards the end of this year? Or is it more just dependent upon kind of more time going on and seeing how credit loss developed?

[Charlie Lowrey:]

Elyse, it's Charlie. I’ll take that one. So as you know, we paused our share repurchases in the second quarter, in line with the risk framework that we had in place. And as you said, until we get better visibility into the depth and the duration of the pandemic, the possible recession and the credit cycle, we will maintain our financial flexibility and resiliency. When we get the clarity into those issues I just mentioned, we’ll then share the timing of our plan to resume share buybacks and by how much, and that would also include the proceeds from the sale or potential sale of the Korean business. So we're going to focus on maintaining our financial strength. But when we get clarity into the issues going forward, we will certainly let you know, and we’ll be transparent about it.

[Elyse Greenspan:]

Thank you. I appreciate the color.

[Operator:]

Our next question is from the line of Ryan Krueger with KBW. Please go ahead.

[Ryan Krueger:]

Hi, good morning. Could you elaborate on, I guess, the things you're considering that would cause a reduction in your market in interest rate sensitivity? And I guess, in particular, I guess, I would assume to meaningfully change that you - that would require some sort of in-force reinsurance transaction. But if you could elaborate some on what you're thinking about?

[Rob Falzon:]

Ryan, it's Rob. I'll take a shot at that. First, let me just bring it up a level and say, as we sort of think about our strategy on a go-forward basis, we think about the elements of that is, in the first instance, simplifying and derisking the business as we articulated in our opening remarks, The other components of that are about improving near-term earnings through the efficiency initiatives that we've talked about and which we think has some expansion opportunity associated with them And then obviously, continue to expand our addressable market in order to support longer-term growth. Specifically with regard to the derisking, I would characterize the repricing and product shifts that we've done as sort of the first steps transitioning to lower volatility, less interest rate and general market sensitivity across our businesses. For those products that we've either stepped back from or actually explicitly discontinued. So think about that as being HDI in the variable annuities business and guaranteed universal life in the life business. We'll look actively at opportunities to optimize the economics of the legacy blocks that are associated with those products. And those options range anywhere from simply sort of just running off the blocks to reinsuring indoor – looking at selling the blocks. A couple of other things outside of that across our products, we're actually looking actively at product design, as well as individual and aggregate limits that could reduce the amount of potential volatility that we get from any individual products or grouping of products. So you saw us significantly reduced the retention limits that we have within our individual life business, by way of example. Charlie hit on financial flexibility and resiliency, so we're going to retain our capital in order to make sure that we that in place. And we think that, that's an element of the derisking, at least in the near term. We're also looking at the investment portfolio, and looking at strategic asset allocation, re-optimizing sort of the risk return and volatility trade-offs that are associated with our equity, our credit and our interest rate exposures, in light of where we are in the cycle and the opportunities that are in front of us. And I guess the last thing I'd mention is that as we look at the growth of the business, on a go-forward basis, our strategic emphasis is really on growing the elements of our business that are less rate-sensitive and more predictable and more capital like, for instance, peach of our asset management business. So those would be the primary things that we're thinking about from a derisking standpoint. Charlie, I don't know if there's any further color you'd want to add on to that?

[Charlie Lowrey:]

Yes. Thanks, Rob. So, Ryan let me just try and connect some dots. Because over the past 18 months, as Rob said, we’ve taken actions to begin to accomplish many of the objectives that Rob articulated, namely, lower market sensitivity, lower capital intensity of our business mix becoming more competitive in terms of serving our customers with processes, better processes and lower costs. And then finally, as Rob said, increasing growth, right? And so let me just tick through a number of things that we've done in order to achieve those objectives. We're sold or selling out of lower growth businesses, Italy, Poland, Korea and exploring options for Taiwan. We acquired assurance around which we have high conviction about growth in a business that isn't as market sensitive, so lower risk. We've significantly reduced or stopped selling certainly highly interest rate-sensitive products and annuities and IOI . We introduced less market-sensitive products such as the buffered annuity. We repriced almost our entire product line. We announced and are executing on our future work initiative, which will produce $500 million in cost savings with the potential to do more. And as Rob said, we're currently exploring other options on book to business that are market sensitive. So we're executing on a series of incremental changes that we believe will lead to fundamental change in our business mix and ultimately, the trajectory of the firm as we go forward. So that's a foundation off of which we are going to grow going forward.

[Ryan Krueger:]

Thank you. Appreciate it.

[Operator:]

And next from the line of Humphrey Lee with Dowling & Partners. Please go ahead.

[Humphrey Lee:]

Good morning and thank you for taking my questions. Regarding the kind of potential – hello?

[Charlie Lowrey:]

Yes, Humphrey we can hear you.

[Humphrey Lee:]

I know it's still probably in the early stage of planning. But is there any way to help us think line of about the potential size and scope of that impact? Should it be kind of comparable to what you've been targeting so far? Or just more of an incremental to what you – just a modest incremental to what you've been targeting?

[Rob Falzon:]

Humphrey, it's Rob. I'll take a shot at that. You cut out a little bit, but I think I understood your question. So as we have been in the course of executing on the efficiency initiatives that we had articulated earlier in the year - earlier last year. We've actually accelerated those actions. And in the course of doing so, we've actually institutionalized continuous transformation capability. And as a result of that, we're generating new ideas and strategies for further efficiencies that enhance customer experiences. Remember, that's sort of the first priority of that is they enable our businesses, putting us in more competitive positions, and it increases our operating profits, particularly in light of the – which is needed in particular in light of the impact of earnings of a low rate environment. The levers we're using Humphrey are pretty much the things that we've done to date. So increased use of technology and automation, process improvements, sourcing, org design, all the things that are classic. We just think there's - as a result of this continuous process, much further that we can go from – than what we've articulated to date. We're also contemplating learnings from the crisis and some of the implications of the pandemic and our experience in that on things like remote work, changes in communications and travel and use of technology on a go-forward basis. So all of that leads us to be optimistic that we can expand materially from where we are today. But we're not ready to quantify that. We'll provide more guidance on that when we get further into year. And once we finished our work, we'll – as Charlie indicated, will be transparent.

[Humphrey Lee:]

Appreciate the color. Shifting gear, looking at PGIM, as you mentioned, flows were very good in the quarter, especially on the retail side. But on the institutional side, even after that $4.5 billion of passive equity mandate redemption, flows were still connective So I was just wondering, can you comment on what you saw in the quarter? And then also, how is your pipeline looking out for - especially on the institutional side?

[Andy Sullivan:]

Sure, Humphrey. It's Andy. I'll take your question. And you were cutting in a little bit. I'm not sure if it was you or me. So retail flows are really a result of three things, very strong investment management performance, a broad and wide product portfolio and strong distribution. And we're performing well on all of those fronts. Our investment performance in the second quarter was very strong. All of our PGIM fixed income strategies outperformed benchmark. 96% of our equity - Genesis equities outperformed benchmark, so very, very strong fundamental performance. As you know, we've been building out our global distribution over time. So we were actually quite pleased with our flows in the quarter. We were the number one mutual fund family year-to-date, and had $9.5 billion in positive retail flows. We did have the $4.5 billion index passive flow related to QMA. That was a very low mandate. So think in the neighborhood of 1 to 2 bps. So literally, it was less than $1 million in fees. It also was the last of our - what I would call As you look forward, quarter-to-quarter, there will be variability. But over the long run, our fundamental investment performance, the strength of our distribution, we have had strong organic flows over the last five years, and we expect that to continue as we look forward over the next several years.

[Charlie Lowrey:]

Andy, you cut out for one sec. Do you want to repeat the point you were making about? I don't know that it was well heard on the number of passive large mandate passive funds.

[Andy Sullivan:]

Sorry about that. All I mentioned was the $4.5 billion outflow was the last large passive mandate that we have in our portfolio.

[Humphrey Lee:]

Got it. Appreciate the color.

[Operator:]

And next we’ll go to the line of Tom Gallagher with Evercore. Please go ahead.

[Tom Gallagher:]

Good morning. Charlie, just a follow up on Ryan's question on the - I guess, the range of things you're considering with risk transfer. I hear what you guys are saying on limiting new sales considering some reinsurance back books, it sounds like maybe on life insurance. Have you considered anything more transformational? And the reason I ask that is kind of a more moderate, we'll say, limited approach to the strategy probably from a shareholder standpoint is going to result in very limited growth as you have some of these businesses that you still own that are shrinking every year. So it becomes kind of a challenge from an annual earnings growth standpoint. Have you considered that? And would you consider something more extreme like an IPO of some of your capital market-sensitive businesses or a bigger reinsurance transaction? Or are you thinking in a more limited scale?

[Charlie Lowrey:]

So Tom, thanks for the question. I appreciate it. Let me just take a step back and then I'll answer your question directly, but - and make a comment about how we think about capital allocation and particular optimization. Because when we look across our businesses, what we’re trying to both domestically and internationally is ensure we're optimizing that capital deployment. So we've mentioned in the past that we're looking at or continue to look at businesses such as IOI annuities and some of our international operations as well as LTC. You've seen us take some bold action in terms of Italy, Poland, Korea, potentially, Taiwan, et cetera. So what we're going to do is - and what we can assure you is that we will continue to look to ways to optimize capital and capital deployment to maximize outcomes for shareholders, right? Be that through significant dispositions, whatever flavor that may take, through potential share repurchases or through acquisitions. And right now, we have acknowledged - we'll continue to acknowledge that there's a high hurdle for any major acquisition given where our stock price is trading. We get that. But we're looking, as you've seen in the actions we've taken to date over the last 18 months. And I think what you'll see us do going forward is look at all our businesses in order to optimize the capital we deploy and how we do that. And that's our commitment to shareholders, and that's what we're doing.

[Tom Gallagher:]

Got you. Appreciate it. I guess, my follow-up is just, it looks like you've reduced pretty substantially the expense drag for the subsidies you were planning on or you've been paying to the Life Planners in Japan. Is that because you see greater visibility on a sales recovery emerging? Or have you guys lowered the level of subsidy?

[Scott Sleyster:]

Why don't I go ahead and take that, Tom? This is Scott. I think the answer is multifaceted, but maybe I'll speak first to the question on have we seen a sales recovery. We actually started to see a pretty good bounce back June, to the point where we were starting to get close to even to 2019 sales in both Japan and in Brazil. And that has continued and actually modestly strengthened in the month of July. So we are seeing a pretty good sales recovery, and we're encouraged. But of course, that is -- that has to be that has to be tempered by any kind of resurgence that could occur. In the case of the Life Planner, we were actually able to take what was an initial subsidy that was sort of an uncharacteristic payment that we have, and we were able to roll it into their bonusable plan. So a portion of the amount that we have for POJ is actually being deferred into their sales comp. So you're not seeing it as directly, but it's still there.

[Tom Gallagher:]

Okay. Thanks.

[Operator:]

And next we'll go to Jimmy Bhullar with JPMorgan. Please go ahead.

[Jimmy Bhullar:]

Hi. Good morning. First, just on your annual assumption review and the interest rate assumption. Obviously, it's more conservative than it was before. But still fairly optimistic versus market levels. So just if you could talk about what went into your thoughts on how much to reduce the rate assumption by? And why did you not like make a bigger adjustment given where market rates are?

[Ken Tanji:]

Jimmy, it's Ken. In terms of our long-term rate assumption, we followed a very established process that we've had for a number of years, and it considers multiple perspectives. So we look at, again, long-term interest rate forecast of economists, banks and managers. And we look to be at the median of all those. And for this year, when we looked at that, that meant a 10-year U.S. treasury rate in the long-term of 3.25% and 1% for the JGB in Japan. So we followed the same process we've had for a number of years. It's also important to know how we grade into that long-term assumption. We do that over 10 years, and the first two years follows the forward curve. And as a result, it's not just the long-term assumption, but the path of which we get there. And so over the next five years, our average rate would be 1.25%. In 10 years, it's about 1.9%. And so again, we have a pretty established process. We look at third-party inputs, and look to be at the median, and that was and that was the result for this year.

[Jimmy Bhullar:]

Okay. And then any color on how your long-term care block has held up recently? And whether you've seen any benefit on your claims or reserves from the pandemic?

[Ken Tanji:]

We saw a little bit elevated mortality in our policies that are already on claim, policies that are already on claim, but it was but it was fairly modest, and I wouldn't call significant.

[Jimmy Bhullar:]

Okay, thanks.

[Operator:]

And next, we'll go to John Barnidge with Piper Sandler. Please go ahead.

[John Barnidge:]

Great. Thanks. Most of my questions have been answered. But can you talk about commercial mortgage loan forbearance in the quarter, directionality of that as well? Thank you.

[Rob Falzon:]

John, it's Rob. Yes, to date, our - we've received forbearance requests that are about 8% or so of the portfolio. We provided forbearance and 6% of those instances and the remaining 2% are under review, and that excludes a little bit that we've gotten requests on that were declined. but in that, only about 1% of the requests resulted in a deferral of interest. In all other instances, we remain current on interest and they've been deferrals of principal. Recall that across our portfolio, our loan to values are actually quite low. And so as a result of that, when we defer principal, we're actually not particularly concerned about that because we know that the principal amount is actually quite safe. The average loan-to-value across our entire portfolio, based on our internal appraisals is 56-ish percent, using external appraisals, it will be about 10 points lower than that, so less than 50%. And so given that low LTV, accommodations on amortization of principal or repayment or principal, we believe there's a prudent thing to be doing, and if we can remain card on interest, that keeps the loans performing, and that's been sort of our experience to date.

[John Barnidge:]

Great. Thanks for the answer.

[Operator:]

And next we'll go to Suneet Kamath with Citi. Please go ahead.

[Suneet Kamath:]

Thanks. Just a question, first off, on variable annuities. One of the things that folks are talking about now is that the AIC is reviewing the mean to reversion assumption that they include in VA capital reform. So just curious if that – what if that was changed would you expect to see either a big impact on your hedging program or your capital requirements for VA?

[Ken Tanji:]

Hi. This is Ken. We've - I just a little bit of backdrop on this for us. We've managed our VA business with a very robust economic view and active hedging for many years. We're very supportive of a statutory framework that also is based on robust economic scenarios, both in terms of the long-term assumptions, but also the dispersion around those assumptions. Our internal scenarios that we use to manage the business are actually more conservative than those being considered by the NAIC. So we continue to advocate for appropriate economic scenarios within the VM-21 framework and we believe that it will be well positioned due to our - the internal framework that we've used to manage the business for many years.

[Suneet Kamath:]

Got it. Okay. And then just to shift over to international, if I could. Obviously, a lot of moving parts in terms of COVID, face-to-face sales, low interest rates, expenses. But as you think about the longer-term outlook for the Japan businesses, when do you see those businesses sort of back to earnings growth, as opposed to earnings declines or flattish earnings, again, just conceptually, how are you thinking about the outlook for that business?

[Scott Sleyster:]

Hi, Suneet. This is Scott again, I'll go ahead and take that. I guess I’d talk a little bit about capital rotation mixed in with that question. We were seeing low growth in the developed markets in Korea, Taiwan and Japan. And you saw that we took out actions in Korea and we're considering those in Taiwan. And the reason that you see a difference between those businesses in Japan is that we have really strong market share in Japan, and we have a really high-performing LP model there. The business generates attractive returns over our cost of capital and it generates a lot of free cash flow to the parent. So we really like our Japan operation, and we continue to invest in it. That being said, overall premium growth in Japan is been negative for the last several years and the country continues to face demographic challenges. So the fact that we've been able to continue to grow in POJ has been a significant outperformance in the country. So I guess what I would say is, we expect kind of low single-digit growth in Japan. And if we're achieving that, that's actually very strong relative performance. And then in the context of a business system that's creating a lot of value and cash to the parent. In the meantime, we'll look for redeployment in higher-growth markets, but those are going to have to be opportunistic.

[Suneet Kamath:]

Okay. Thanks, Scott.

[Operator:]

And seeing no further questions coming in, Mr. Lowrey, I'll turn it over to you.

[Charlie Lowrey:]

Okay. Thanks very much. So as we come to the end of the call today, I'd just like to thank you for listening and for your continued interest in Prudential. I also want to take a moment to thank all our employees for the steps they continue to take to support our business, our customers and our community, including our collective efforts to address racial equity at Prudential and in society at large. We continue to make progress on executing our initiatives for the year, and frankly, are working to do more even as the global health pandemic continues. Backed by our financial strength and guided by our purpose, we'll continue to focus on delivering meaningful outcomes and value to all our stakeholders. Thanks again for joining us today. We appreciate it.

[Operator:]

Ladies and gentlemen, that does conclude your conference for today. Thank you for your participation. You may now disconnect.