All right, we're going to get started. Thanks very much for Prudential for attending the conference again this year. Up here with me is Mark Grier, Vice Chairman, and also Mark Finkelstein is in the front row from Investor Relations. Starting out, you had a June Investor Day. You talked a lot about strategies to drive growth in your U.S. markets. You also recently announced the realignment of your U.S. business. Do you see for the various U.S. markets?
Yeah, the answer is the realignment follows the development of strategy. We reorganized as part of implementing the strategic initiatives that we talked about on Investor Day. The broad themes there are around the basic point of optimizing the franchise that we have and every customer that we touch. The particular focus on Investor Day was on things that we do through our institutional channels, meaning primarily group insurance and retirement, where we have a very large number of clients that we serve through the employer platforms. The development of technology to facilitate accessing those clients and the development of a value proposition around individual financial wellness are sort of the cornerstones of optimizing that part of our franchise.
As you see in our reorganization, we're more segment driven by the type of clients, and we're structured in a way that will let us look through the distribution channels in a way that then facilitates that optimization of all of the people that we touch in our businesses.
I guess related to that, how are you thinking about synergies across businesses within these kind of different segments?
I think there's a broad synergy theme around the way in which we develop solutions in our product areas, and then the way in which those solutions are delivered through the distribution channels. I'd start with the broad synergy that's driven by having solutions to protection, retirement, and investment challenges, to use our marketing slogan. There's a broad synergy there in terms of the solutions that we develop and then the way in which those solutions can be applied to individuals, as I said, in these other more institutionally driven businesses. The second synergy is purely the access that we have. As I mentioned, we touch a lot of clients through retirement and group insurance that we're not optimizing. As we put the financial wellness value proposition in front of employers and through employers to the individuals, that's a very powerful source of synergy.
I think we've got a really attractive equation there that appeals to the employer base and it appeals to the individual clients. The theme of financial wellness, again, complemented and supported by the solution side of what we do, fits together really well.
In the last few years, you've guided to higher incremental expenses due to various strategic investments. Can you talk in more detail about what some of these strategic investments are that you're making at this point and have been making?
Let me talk about that three ways. One that we have discussed on a number of occasions relates to distribution initiatives and asset management. This includes extending our global marketing reach, it also includes developing, again, to use the word, more of a solutions-oriented capability for some of the mandates that we get. We see that paying off. One of the things that fortunately we can talk about quarter after quarter is the flow into our asset management business. Some of that reflects a payoff from recent, meaning last few years, recent initiatives around marketing and distribution. We're also investing in technology to support the financial wellness initiatives in the U.S., we're also investing in technology and marketing capabilities to support the cross-business initiatives that I mentioned a few minutes ago that span our institutional businesses and complement our retail businesses.
I would add that total initiative spending is actually less than we've incrementally identified. We have funded some of these expenses from other expense cuts. We don't tend to push through the company sort of macro lumpy expense initiatives. We're always managing expenses. We're always benchmarking. We're always focused on margins, returns, and productivity. As we go through finding opportunities on what I guess I'd almost call a routine basis, we have freed up expense money to dedicate to our initiatives. While we've talked about $0.15, $0.15, and then kind of flat as the incremental piece, there's actually been more initiative spending than that. It's been funded internally.
Are these expenses something you see ongoing for a long period of time, or is there a point in which you could see them drop off a little?
Well, I like the way you said it. I think there will be a point at which they drop off a little. I wouldn't oversell the notion of a cliff here where we spend a lot, then we stop spending. What will really happen as you see the bottom line is that the revenue side is going to catch up, as it has in asset management. We'll start to see the benefits because most of these expenses are directed at the end game of more business and supporting growth.
Yeah.
I wouldn't oversell, again, the notion of a cliff here that expenses will drop, but they'll come down a bit and we'll see the results of the investments showing up on the revenue side.
You said you mentioned most of them are more really around growth and revenue opportunities. We've also heard a lot of companies in the industry talk about updating their back office systems, moving more to cloud-based systems, using robotics. I guess, where does Prudential stand on kind of the back office side?
If you had to make a statement at 40,000 feet, I'd say we're pretty good at this. We have a nice balance between centralized management of the technology infrastructure and the things that we do in the businesses that I think works very effectively for us. Through that structure, we are able to centrally manage things that have real consolidated central payoffs while we're also able to make sure we have effective technology supporting and serving our businesses. I guess, the cliche would be we're into everything. We're into the cloud, we're into artificial intelligence, we're into some of the individual wellness platform work that is ultimately going to pay off for us on the revenue side, but our infrastructure's in pretty good shape. Again, expense management for us is a continuous process. It's not a discrete $300 million-
Yeah
answer one day. It's a constant part of what we're always looking at. We do have specific initiatives, for example, that have looked across corporate functions and the particular theme there is where can we consolidate and where can we save money in the corporate side of what we do. We also have initiatives in our businesses looking at things like call centers and some of the technology platform where we also have opportunities to consolidate. There's a lot out there. Some of it's pure technology, as you described. Some of it's the physical infrastructure and the way in which we run. Again, I think it's a good, healthy, continuous process for us.
Thanks. Moving to the ROE on the December outlook call last year, you guided to an intermediate term ROE of 12%-13%, which came down a bit from the prior 13%-14% outlook that you had provided across cycles. Can you remind us what were the key factors that drove that revision? Do you see a path back up to the 13%-14% level over time?
Yeah. That was an update of our intermediate term and more strategically defined earnings power, the ROE that we think we can produce over time. The 13%-14% was a target that we set, actually coming out of the financial crisis in 2011, 2012. It was time to update thinking, and the main factor driving updating thinking was the realization of a substantial period of chronically low interest rates. The headline reason for that recalibration was the impact of interest rates. For us, that impact is kind of a macro compression of spreads. If you just think very broadly about Prudential, assets reprice faster than liabilities do over time. While there's not a sudden explosive thing that hits us, we do get squeezed.
As rates have stayed low and we've been reinvesting at lower rates, it was appropriate for us to recalibrate that ROE objective downward. We added at the time, though, by the way, the anticipation of some strategic expenses, and we're realizing that that's part of what our story has been in terms of particularly annual guidance in the way we've talked about the outlook for the future year. Part of that, in addition to low rates, was the anticipation of some of the initiative spending that we've already discussed. If you're thinking just big picture in kind of a linear way about the path back, we would need the 10-year Treasury to go somewhere above 3%, let's say into the low 3%, in order to get to the point where we're breaking even between runoff in the portfolio and reinvestment.
If there's a stylized way to think about the negative impact of low rates and then the possibility of neutralizing that negative impact, it's probably to think about what it takes to put an end to that decay in the overall portfolio yield. As I said, it's having the 10-year somewhere back above 3%.
Got it. If you look at your results over the past year and make adjustments for things you've called out as non-trendable, you've been more around that high end of the 12%-13% range, closer to 13% ROE. Is that a reasonable level for the company's earnings power at this point, or are there other negative factors we should think about that could put you down a little bit into that range?
There aren't other negative factors that should put us down into that range. It's been more that, the way I sometimes say it on the earnings call is that things that fluctuate have been fluctuating in a favorable direction. We have called out and talked about returns on non-coupon investments, we've talked about prepayment on fixed income and mortgage investments, and we've talked about some of our case experience, particularly in retirement. There have been some things that have shaded at higher. The absences of those things that shaded higher are not going to be things that will drive it for any sustainable period of time anyway below that target range as far as we discuss it.
You've taken a bunch of actions to reduce GAAP net income volatility in recent years. We did see some volatility return in the second quarter in terms of your actuarial review and the charge you took in individual life. I guess, can you help us think about how we should think about that charge and then your confidence level going forward that you've kind of taken the appropriate actions to minimize GAAP net income volatility?
We have done a lot, and I think the things that we focused on have made material contributions to reducing GAAP volatility. The big and ugly one was that FX revaluation process that we lived with for a number of years after our Gibraltar acquisition. Having solved that problem, we've turned our attention to some aspects of the variable annuity business, some aspects of the way in which we use derivatives versus cash. Other drivers of that below the line volatility. We can see that we've had, over time, a pretty significant convergence between operating income and net income. There are concrete results from the things that we've done.
Having said that, everybody forgot about all of that in the second quarter because we did have noise between net income and operating income, and actually some things in operating income that reflected broadly the results of actuarial updates. That's, again, a general characterization of some things that included systems enhancements and changes in methodology as well as changes in assumptions. The fact is that the nature of our business is such that we can't promise those things won't happen. Having said that, if you think about what I just went through, changes in methodology and systems enhancements over time will reduce volatility. That will make us better at the quarterly entries that we make and also at the annual assumption updates that we go through.
There always will be places where lapse assumptions change or interest rate assumptions change or mortality assumptions change, and those things will drive some recalibration of reserves and possibly recalibration of earnings going forward. That will be a structural aspect of the nature of our business that we can't promise will go away. We can promise that we're working on the controllable parts of it. Again, we've done a lot here across a number of different areas, most recently, including some of the things in our life platform that include both methodology and better systems that should improve the volatility picture and also, I think, improve the transparency picture. It's part of the challenge of the businesses that we're in. We live with things that go on the books with a whole basket of assumptions and stay on the books for a long time.
The fact is things do change, and they do get reflected in our reserve entries and sometimes earnings.
It's where are you in the process of things like systems updates. I think you've done some for other businesses. Have you gotten most of those done at this point?
We've got most of them done, we have another generation or two to go in some of the product areas. It's not always negative, by the way.
Yeah.
We went through some of this in Japan and had positive consequences from installing new systems. It's not always negative, but at least in terms of absolute value, it's always noise as the market sees it. We're not quite finished. We've got some more to do on the platform side.
Moving to regulation and, I guess, specifically non-bank SIFI. Can you give us an update on the prospects and process to potentially become de-designated? If you were to remove that designation, would that materially change anything about how you're running the business or how we should think about expenses?
Let me start with the second half of that. There would be very little consequence for us of de-designation. I've said over and over again that I don't think capital requirements will be the problem. We don't have capital requirements from the Fed yet, but I still don't think that if we ever do and remain designated, they would be a challenge for us. Another reason to think about a less dramatic impact from de-designation is that the state of New Jersey is now playing a role of group supervisor as well. In terms of reporting and examination costs and kind of the operating side of supervision, a lot of what the Fed's doing would be replaced or is being replaced or complemented by what New Jersey's doing.
I think we've said repeatedly that we're not managing capital in anticipation of changes that would reflect what the Fed decides to do. We're managing capital the way in which we think is right and we still will. Again, on the operating side, I think whatever the Fed stops doing, New Jersey is likely to start doing. Some of those kind of infrastructure implementation costs around supervision are likely to remain in place. I think the outlook is pretty good for us not being designated at some point. The administration is working on, and in this case, the administration really means Treasury, responding to the president's mandate to review regulation, but also to review what goes on with FSOC. We've been part of that process as we play a role in the industry, but also as we're an individually designated company.
I think the outlook is reasonably good at some point that that landscape will change. Right now, it's not a particular burden for us.
In terms of New Jersey, I guess, do you actually expect capital requirements to be imposed kind of on the overall organization from New Jersey, or is it more about a just group-level supervisor?
Well, the state process by nature is heavily focused on the individual legal entities as opposed to a consolidated or group concept around capital. Most of what we do as it relates to the states is more bottoms-up driven.
Yeah.
Now, exactly where that goes is an open issue. The NAIC started a project a couple of years ago on what they were calling group capital guidelines. They weren't going to call it standards. They wanted to come up with a methodology that would allow for some benchmarking of company to company on a total group basis. There was an announcement recently that the NAIC will be working with the Fed on the whole broader question of capital standards. I think the good news about that is that if it's really true that they're going to work together, it's much more likely that this will be a very familiar capital arena for an insurance company, meaning that things will tilt toward what's been called the building block approach, which is roughly described as an indexed approach to consolidating individual statutory solvency margins or risk-based capital ratios.
That would be more bottoms-up driven, more statutory driven, and again, at the highest level, would look more like an indexed approach to sort of adding things up instead of consolidating real capital measures that are somehow defined. I think the NAIC has been reluctant to call it a standard. They're still calling it a guideline. The Fed has an obligation to have a standard. Whether they're supervising us or not, they've still got these thrift holding companies to worry about.
They've got to come up with something for them. I think it's a positive direction for all of us that we're moving into what looks like a better relationship between the statutory side and the Fed's mindset. Wherever that goes, I expect it will be both a framework and a calibration that'll be pretty comfortable for the industry.
Got it. Thanks. Maybe moving into the businesses a bit and starting with variable annuities. The ROA was 127 basis points in the second quarter. You gave guidance longer term for 110 to 115 basis points. Can you talk through some of the reasons that you expect the ROA to come down to that level over time? If that involves doing anything strategically different, and then how we should think about the timeframe.
Yeah. We've said on our last couple of calls that we've done a little better on earnings with respect to variable annuities than we anticipate doing over time. We also, on the last call, talked about the fact that in the variable annuity business, aside from whatever goes on in products and all the sort of hardware around the way that works, broadly speaking, we're focused on capital volatility and cash flow, and we're focused on the way in which we manage those things together to get a good outcome for our shareholders. You've heard us say that we're capitalized or protected in that business to a CTE 97, but to a CTE 97 with a little room to maneuver, so that in a moderate stress environment, we would maintain a CTE 97 in that business.
We will use the opportunity to have done a little better to lock up a comfort level around earnings and cash flow in a little more volatile environment. One of the reasons that we anticipate that ROA to go down is that we're going to protect ourselves so that there's a better outcome and a wider range of scenarios. That will be emerging over the next few quarters, that part of it, as it relates to, again, mixing and matching cash flow, capital, and volatility. Looking a little further out, there will be some pressure on fees in this business as the products mature. That's a more gradual impact over time. Looking past the next couple of years, we would also anticipate that there'll be some reduction in earnings power as the fees pass some of these thresholds that result in changes.
We're comfortable with the discussion that we've had around a higher ROE there than it was a year ago, two years ago. We're happy to have the opportunity to protect ourselves in a wider range of outcomes. It's also refreshing, by the way, on the calls to have to talk about variable annuities having done better. It's a good story. It's a very good story for us. You know we've taken a lot of capital out of the business, and we've got it structured in a way that it's very cash flow friendly and an important part of our business initiatives on the ground, back into this wellness thing, but also an important part of what we look like in terms of ROE and cash flow.
One change you've made is you've moved the hedging strategy to include a combination of more fixed assets with derivatives. Can you talk about why you did that and, I guess, how that improved the economics?
Yeah. The bottom line is it improves the economics by putting earning assets in place as part of the hedging picture. The answer to why is back in that story about the right balance between cash, capital, and volatility. We had extensive conversations with a lot of complicated stuff in front of us around how these products and cash flows and accounting results behave in different scenarios. We have landed in a place that, as we've described before, we're very comfortable with. It reflected really focusing on the interaction of those three things, cash, volatility, and capital, and the earnings results and the way we can get comfortable with where we are.
On cash flow, you've talked about a material improvement in the cash flow generation in your VA business. When we think about Prudential overall, do you still feel like 60% free cash flow conversion is the right range for the company given the improvement in VA, or is there potential upside?
I guess I'd tilt it a little bit more favorably and say that, again, this is an over time concept. Things vary quarter-to-quarter and year-to-year. Over time, I guess I'd say that 60 is probably more like the bottom of the range.
Okay
As opposed to the ongoing target. There's probably some upside in that. We would now say we expect to have at least 60%.
Got it. Moving to retirement, you've had pretty favorable case experience for a while now, it's even been favorable to expectations that you've raised. I guess, are you seeing something inherently different about the mortality experience in some of these retired populations, or do you think it reflects more conservative pricing from your end?
Let me talk a little bit about the starting point for some of these deals. We're in the large end. When we talk about favorable case experience, this is coming from really, really big cases. You ought to think about us doing those transactions more like an M&A environment than a product on the shelf that someone buys. There's very extensive due diligence. One of the things that we like about the jumbo market is that we tend to get very good information about the base that we're insuring. The underwriting process is more like deal due diligence than it is like product pricing. We've used that information to, I think, do a very thorough and careful, and then importantly, conservative job of underwriting the longevity risk in this business.
I would say the most general answer to your question is that it reflects being careful, doing a thorough job, and being conservative. I'm not totally surprised to find out that we're doing a little better than we priced for, because in a way, we should have.
Yeah.
There was an intrinsic conservatism in the way in which we reserved for these and priced these transactions. I don't think there's a structural answer to it. I think it's in the micro story around how we do these deals and our conservative approach to pricing. I would add, though, that one of the things we talked about on Investor Day a couple of years ago, and we've updated conceptually since then, is the notion of being roughly structurally balanced between mortality and longevity. That's still true. We're roughly structurally balanced between mortality and longevity. For us, at least from one perspective, this starts to look a little more like a nice spread business and a little less like a risk business on one side of it or the other.
Over time, and when I say structurally, I really mean with respect to the trend influences on mortality and longevity. Over time, we're kind of in the middle of this, and so while we don't see it quarter to quarter, although I think we did have one quarter where things went just the way you'd like them to, we don't always see it quarter to quarter. Directionally, we're not so sensitive to the structural influences on either longevity or mortality because we're in the middle. We've got good opportunities to originate both kinds of risk.
Got it. In your U.S. Life business, given the changes you made to actuarial assumptions, you did reduce your earnings outlook there. Can you give us an update on that and just how you're viewing that business overall post that change to guidance for earnings there?
Yes. I think two sort of short, simple answers. Strategically, U.S. Life is important. It fits into this wellness platform. It's an important product for us. It's been an attractive earner. It adds stability. It complements longevity risk. There's a nice strategic basket around this. The second answer is that even with the pressures that we've felt, the return is still attractive in this business. Stephen Pelletier, who runs the U.S. business, has said that we're still earning more than our cost of capital, we believe that this business is still a source of value for us. Not as attractive as it was, still above the cost of capital.
Going to Japan, can you talk about how you're dealing with low interest rates, both in terms of in-force profitability and also how it's changed how you're approaching new products and sales?
Yeah. Strategically, the big picture for us in Japan is driven by mortality profits anyway. While you can't say we're not sensitive to interest rates, the core competency that we have in Japan through our distribution channels is selling pure protection insurance and earning very attractive mortality margins. At least thinking about it that way, we start in a pretty good place with respect to what we can do and how we do it and what it means for both what's on the books, the in-force is very profitable in terms of mortality, and also the new business that we book, which is also very profitable in terms of mortality. Having said that, more tactically, we've been very aggressive in repricing. We've been very aggressive in eliminating products that were not suitable, in our view, from a return or risk perspective in the low rate environment.
We've been very actively managing the product portfolio, both in terms of what's out there and also in terms of how it's out there, meaning price and channel. We've done a good job, I think, of staying ahead of the issue in terms of new business, and we have the luxury in terms of the in-force of a very substantial embedded mortality profit stream. Having said that, we are vulnerable to interest rates, and Charlie Lowrey, who runs International, has said that there's likely to be some reduction in the ROE in Japan from, let's say, the low 20s down to the mid or high teens. Still an extremely attractive return. I would add that when we talk about our macro target of 12%-13%, all of that's in there. That includes what's happening to the interest rate impact in our Japanese business.
I think it's a good value story because of the nature of our business, meaning mortality-driven, and the fact that we've been very active in managing the incremental aspects of it, both from a pricing and other product dimension standpoint.
Given some of the pressures from low interest rates in Japan, do you see any potential mitigating factors such as Brazil becoming a more profitable business or expense actions and things like that that you could take to mitigate some of the impact?
When my son, who's 16, is running the company, we'll have a story about Brazil relative to Japan. I think until then, Japan is so big that that's going to be the main story. Having said that and joking a little bit about it, we're doing very well in Brazil, and it's going to be a good story, but the financial difference is still huge.
Got it. I guess on M&A, we haven't really seen much consolidation within the U.S. life insurance industry. Curious what you think is preventing that, and how are you thinking about M&A and potential opportunities for Prudential?
Well, M&A in terms of company deals and maybe even transformational type company deals is part of the landscape. We've seen a lot going on. We've seen corporate actions. We've seen some big strategic corporate actions, and we've also seen a fairly active market for blocks of insurance. Below that sort of total company deal level, there are things happening. I think the impediments are kind of as they've always been in good markets. There's not a lot of pressure on companies to sell, so it's not really a buyer's market. Things are going pretty well. The equity markets are doing well. Interest rates are not killing companies like everybody might have thought 5 years ago. If I told you this was going to come true, you probably would have been a lot more nervous. Interest rates aren't killing companies.
Regulators aren't generally very friendly to big consolidating type transactions anyway. If they're not feeling heat, they don't necessarily want to see jobs lost in their markets. The pressures that would drive consolidation, I think, are on the back burner relative to the things that make people comfortable with where they are.
Got it.
Again, there has been action. It just hasn't been company type action. We've said for a long time that M&A is nice to do, not have to do. If we see a nice complementary capability or a compelling financial opportunity, we would take advantage of it. We're not thinking that a transformational acquisition is out there for us right now.
Got it. Are there any questions in the audience? All right, I think we'll wrap it up there. Thanks a lot, Mark.
Yes.
Appreciate it.
Thank you very much.