Perfect. Okay. You'll also find in your materials an agenda for the day. I'll go through a couple of points. We will start with executive updates from John and Mark. They will present, but we will wait until the end for a Q&A with them. They will join Rob Falzon. Thematically, you're going to see or hear shorter presentations from Charlie and Steve than usual. What you'll see is some more thematic or topical areas that we're going to spend some more time on, including Prudential Retirement, covering pension risk transfer, Prudential Annuities, and John Hanrahan will give some updates on some financial metrics in Japan. Third, we will have three breaks over the day. One will be after the international session, the second will be between Prudential Retirement and Prudential Annuities, and we'll have one before the financial update. We'll have you out of here by 1:00.
With that, I will hand it over to our Chairman and CEO, John Strangfeld.
Thank you. Good morning, everyone. It's nice to be here. Nice to see you. Today, we'll provide both, as Mark said, both business and strategy overviews, as well as focus on some specific topics we believe are of particular importance. My role here this morning is to provide context for what follows. You're going to find a lot of consistency between my comments today, what you've heard from us before, what we've accomplished, and the expectations we have ourselves, whether it's in terms of our mission, our strategies to execute on that mission, financial expectations, and our culture of talent and collaboration. This consistency is highly intentional, and in fact, it's by design.
Now, on one specific financial topic, I would mention that in the same spirit of delivering consistency, it is our intention to create a direct line of sight as possible between our core business results and our bottom line net income. We've been working on an important aspect of this, meaning finding ways of tightening that linkage by reducing below the line noise while still focusing on the economics. I'm going to come back to that in a few minutes. Outside of that work in progress, to us, it's crystal clear and highly consistent in terms of where we've been, what we've built, and where we're going. It starts with our underlying mission, namely, to assume risks that are better borne by us than an individual or an employer. Through our products, make financial aspects of life less random and more predictable for our customers.
That fundamental mission never changes, though the way we deliver on the mission grows and evolves. We're continuing to innovate, to meet evolving customer needs, and in terms of products that can help achieve greater certainty of outcomes, and in terms of how we deliver on those products. Those things change, but the fundamental mission doesn't. This consistent focus on creating value for clients and business models where we both benefit from distinctive capabilities is a thematic driver of our value proposition. The clarity of our mission is reflected in our strategies and actions. Presented here is a portrayal of the last 15 years of actions and outcomes, which we view as the result of a very consistent playbook in building our value proposition. We've accomplished this while navigating times of challenging markets and changing regulatory circumstances.
As you can see, we've been continually focused on building and refining a distinctive mix of businesses that fulfill our mission and satisfy critical market needs, which in turn creates the ability to generate attractive returns. We've also built our businesses on a foundation of solid financial strength, never losing sight of the most fundamental aspect of what we offer our customers, namely the unquestioned ability to stand behind our promises. There are a few overriding themes related to this page I'd like to highlight. First, our focus on business mix. This includes defining what is core to us, life insurance, retirement, and asset management, both individually and in combination. All of the businesses we've acquired and divested are true to that framework, a framework that's been in place since our IPO.
What you see across the timeline is growth of businesses characterized by high entry barriers, allowing us to differentiate based on our unique combination of financial strength, expertise, talent, and collaboration. Our core strengths in risk management, innovation, and execution, as well as the attraction, retention, and development of talent, has produced an unusually high degree of success in organic business growth as well as M&A. This enables us to act with confidence and conviction when we see the right opportunity. Our market leadership in pension risk transfer is a prime example of our ability to successfully execute on new, complex, and challenging market opportunities, and our growth in life planner and asset management businesses are examples of strong execution over a long period of time, driving good organic growth.
Second thematic, we approach capital and risk management in a way that gives us the ability, as tested through the financial crisis, to be both conservative and opportunistic. Our approach supports both offense and defense in challenging times. Among the examples of our successful offense following market dislocations are the acquisitions of Star and Edison, and more recently, Hartford Life. This approach to capital and risk management supports our ability to balance our investment in our businesses with meaningful distributions to our shareholders. Looking forward, we will continue to stay true to our core businesses while evolving in order to continue to grow and generate attractive returns.
You can expect to see new products where we can innovate to meet evolving market needs in our core areas of focus, new forms of distribution as opportunities emerge to enhance the customer experience or access to our products, and new geography in selected markets where there are needs that we can meet in a differentiated manner. Thinking about 2015 and beyond, here are some of the key objectives and priorities. Our financial objectives include maintaining a 13%-14% ROE throughout the cycle. We believe this differentiates us and is achievable as a result of our mix of businesses and risks. We expect to generate strong cash flows, supporting a balance of capital deployment between investing in our business and also making distributions to our shareholders. These cash flows also provide enhanced visibility as to the earning power of our businesses.
We also seek to report solid earnings and book value growth with lower volatility. As I acknowledged earlier, we know that below-the-line volatility creates investor frustration. We don't like it either. For that reason, for the fact that it distracts from the consistency of our strategy, our execution, and operating results, and hence our value proposition. Part of the disconnect between our business operating results, which have been relatively consistent, and our net income pattern, which is not, relates to items we consider non-economic, such as foreign currency remeasurement. We've mitigated that particular issue, and we continue to work on other causes of volatility. The objective, as I said, is to tighten that linkage between the business results and net income while remaining focused on our economics.
Among our other priorities going forward are, number 1, enhancement of our capabilities in digital data and infrastructure areas, supporting our continued ability to innovate on the product front and enhance client experience and distribution. Number 2, pursue growth opportunities in terms of building our existing businesses, furthering product innovation, expanding into selected growth markets such as our international insurance business in Brazil, and executing complementary M&A, including the retirement joint venture in Chile that we expect to close later this year. Third, constructively navigating in the evolving regulatory environment, working with regulators and the industry to help assure a reasonable framework that's suited to our businesses. Finally, talent and culture, what we believe to be the most sustainable form of competitive differentiation. I'm talking about the quality of people and the way that they work together. Talking about a culture of no drama, low ego, high collaboration.
People who believe in the power and the wisdom of teamwork and diversity. People who see talent and culture as leader-led, not a periodic HR exercise, and recognize the value of blending internally developed talent with those from the outside. Some people think of this as the soft stuff, but to us, it's the soft stuff that makes the hard stuff possible. Proof points would be high customer satisfaction, innovation within and across businesses, near-flawless execution on M&A, and a strong and stable leadership team with smooth leadership transitions. Talent and culture are what make that happen. They're what provides sustainability and what gives me great confidence and optimism regarding our future. As context, there you have it.
Clear and consistent mission, very focused strategy, clarity on deliverables, an acknowledgment of a need to tighten the linkage between operating results and net income, and a leadership environment that expects a lot of itself and takes pride in our ability to deliver on it. These are the elements that provide the basis for quality, consistency, and sustainability of our investor proposition. Thank you. With that, I'd like to hand it over to Mark.
Thank you. I guess I usually say good morning, good afternoon, or good evening, I'll start off with that again. Thank you all for your interest in Prudential and for attending today. I'm going to fill in some things between John's comments about the company overall and some of the business presentations that you're going to hear. In the context of things that are important as you think about us as a federally regulated company, as you think about some of the changes that we're going through in supervision and the things that we have to deal with. In that context, an update on process or descriptions of what's going on wouldn't have much new information.
We continue to rely on constructive and thoughtful processes to work toward what we expect will be a useful and constructive outcome in terms of transparent and effective regulation and capital standards. I know everyone wants to know the date that all of this is going to be wrapped up with a ribbon and a bow, I don't have any idea what that date might look like. I'll just say again that processes are constructive and work's going on in a thoughtful way about how to get this right. John expressed our mission as taking risks that are best taken institutionally rather than by individuals. When you start to blow that out, the first thing that's right in front of you is that this is pretty complicated stuff. The kind of risks that we take are not very straightforward.
They're not like betting that the yen goes up or down, then checking the price of the yen in the paper every morning. The things that we do in mortality and longevity are done through complicated vehicles, business systems, and products that generate complexity in our operating and execution environment and also generate complexity as we try to summarize it and report on it, either from an earnings perspective, a balance sheet perspective, or a statutory or federally defined capital environment for financial reporting. All this complexity also facilitates our ability to assume high-value risks, that's good for you as shareholders. That's what we get paid for.
Our business system can, to use the more contemporary term maybe, can originate high-value risks, and our business system can manage those high-value risks and ultimately get to the point where we're paying you a dividend or we're buying back stock or we're reinvesting so that we can do more of that somewhere in the future. The complexities that arise then really become the core things that differentiate us from banks. We started a few years ago on this capital theme, kind of making the abstract assertion that we weren't a bank, everybody did. The whole industry was collectively screaming, "We're not banks." That sort of left the rest of that sentence hanging out there. Okay, if you're not a bank, what are you and what's it all about, and how should we think about it?
I want to extend that point a bit in the context of what we describe as our mission and how that turns into to what we do every day. What I want you to think about as I'm going through this is that these are the things that need to be in front of anyone who's considering capital standards or who's considering solvency or who's considering risk issues for companies like Prudential. These are the things that are really important for us to be reflected in the way we're viewed as a company that's supervised by the Fed at the group level or by the insurance departments at the statutory entity level. There's a lot in here in terms of the real messages about how to find financial strength in a company like Prudential and how to think about setting capital standards.
The takeaway that I'm hoping for is to reinforce your understanding of what this is all about at the level at which the business model comes together with the financial statements. Let's start off with the notion of what we do when we originate these high-value risks. The first thing we have to do is value and reserve for those risks. They have to be recognized somewhere, somehow. The main point to understand about that is that this is really where we're different from banks. We're going to value and reserve for liabilities, our business model will back those liabilities. We don't fund assets. We back liabilities. If you need a punchline for how the insurance industry is different from banking, that's it. Banks fund assets, insurance companies back liabilities.
In the course of backing liabilities, we start with the notion of what it is we're going to fund in order to make sure we have the money to meet those obligations when they come due. That's the reserve. The reserve is what we're going to fund. It's not the liability. The liability is the underlying policy. It's the contract that's going to create a claim someday, there's more in the reserve than just the liability. You think of a bank recognizing all over its balance sheet the present value of expected cash flows. We're generally not doing that. We're generally recognizing the present value of expected cash flows plus a lot of other stuff.
This builds up into the notion of what we've called margins and reserves, the difference between the best estimate, the present value of expected cash flows, and what's really on our books. What's really on our books, by the way, is funded with assets on the other side. Couple of examples that you would be familiar with. XXX and AXXX reserves. You hear terms like non-economic or redundant. A better way to think about that maybe is that's the really, really, really, really, really unlikely part of the tail. It's a very low risk portion of what we've reserved for. Sometimes that gets carved off and managed separately. That's part of margins and reserves. It's that part that's not very likely to happen.
Another thing you might be familiar with is the GAAP accounting rule that we can't recognize a gain at issue when we sell an insurance policy. When we do these big PRT deals we take in more money than we have to recognize in terms of the real core liability. That's the money that we've made. A derivatives trader would book that, by the way, and have a really big party that night. For us, that gain at issue goes into the reserve. Again, there's more in there than just the liability. It's not the present value of expected cash flows. It's the present value of expected cash flows, and in this case, plus the expected lifetime profit of that business, not in capital, but up in reserves.
You have these themes about reserving that you have to understand and you have to value in order to get to the right answers about solvency and financial strength and the overall framework in which to set capital standards. Think about all the stuff that's in there, interest rate assumptions, mortality assumptions, client behavior assumptions. You could argue that for an insurance company, the real cornerstone of financial strength isn't the capital number. It's how conservative those reserves are. What are the margins? What's the interest rate assumption that's supporting all of the balance sheet? What's the mortality assumption that's supporting all of the balance sheet? What are the client behavior assumptions?
You have all this going on in the reserve account, the line called reserves, not called capital, that relates to financial strength, that differentiates us from banks, and that also plays a very important role in understanding whether a company is conservative or aggressive without even having to go look at the capital line. The easy way out of this is to look at capital and say there's a lot of it or there's not much of it. Unless you understand what's somewhere else, you're not quite going to get there in terms of understanding real financial strength and conservative versus aggressive approaches to capital management and risk. Extending this a little bit further, there's some elements of product design that matter a lot. Separate accounts are very important to us.
They are on the consolidated GAAP balance sheet, but separate guarantees because we understand guarantees are real and need to be understood and managed. Separate accounts don't have a line of sight to our capital. They blow up the GAAP balance sheet, but that is only optics. That is not real in terms of where the risk of the asset performance lies. We have a commercial interest in the separate accounts, so they matter a lot to us economically because we have a commercial interest. We earn fees on those assets. The investment performance, as you think about risk, is a little bit different question. We have things like participating policies, where we have the dividend scale as a huge shock absorber against fluctuations in investment experience or fluctuations in mortality, for example.
As you piece together the balance sheet and think about conservative or aggressive, all of these things come into play, all of these things are important, all of these things need to be in front of asking the right questions and drawing the right conclusions about financial strength. You have heard me say on earnings call after earnings call that we are not hoarding capital. We are not changing what we are doing today because we think we do it right, and we expect that we will comfortably exceed any reasonable regulatory capital standards that are set.
The reason that I am comfortable and confident in saying that relates to all the things that I just talked about, which is if you get into this the right way and ask the right questions and understand it from the perspective of the way in which the business model flows in to the financial statements, you would be as confident and comfortable as I am. It takes an extension beyond looking at just the capital line. The update on the development of capital standards is centered on the pursuit of those themes as we look at how things work and what, again, relates our business model to financial statements in a meaningful way. The next level of this is to play out cash flows and understand how all of this works over time.
If you are thinking about capital standards, you might think that playing out the cash flows is putting the cart before the horse, meaning that you would start with the financial statements and tear those apart and then see where the real things are. It turns out it is a lot easier and better and more accurate to lay out the cash and then map it back to the financial statements. In fact, the cash can be mapped back to the financial statements. The financial statements cannot be extrapolated into the cash. The second piece of this picture is that the emphasis is on the kind of things that we do in our Asset Adequacy Testing and the way in which we map out the cash flows and stress those cash flows.
The GAAP equivalent would be the things that we do in loss recognition reserve testing, where again, it's very cash flow driven, and then you come back to a financial statement. The second piece of this is that once you understand what this real picture looks like, play it out in cash and map it back, and then see what your financial strength picture looks like in either GAAP or STAT or IFRS or JGAAP or whatever system it needs to fit. The last thing I want to talk about is a broader view of the picture, and this ties in a little bit to capital standards. It ties in a little bit to supervision, and it ties in a little bit to linking these issues to the value proposition for investors and relating it to shareholders.
That is that we kind of live in a world of four things from this perspective. One is risk awareness. That's the hypothetical what ifs, the extremes, the stress tests, the tail events. Maybe it's not so extreme, but it's the stuff that happens. The second thing in the middle is risk recognition. This one is critical. It's an extremely important differentiator versus banks again, that is that we book for some of the risks that we haven't yet realized. When we run our Asset Adequacy Test and we reserve for that low interest rate shock, we've basically funded that stress test. It's no longer a hypothetical what if. It's recognized. It's in our reserves, and it's supported by hard assets on the other side. If you know these cash flow test models, the assets have to really be hard assets. They're not thin air.
That's all over the place for us. There are places where risk has been recognized and booked that has not come true yet. This is one of the reasons, by the way, why sometimes you're so frustrated that there's not a linear connection between a what if this happens, what happens to your books? One reason there's not that linear connection is some of it's probably already in there. You've already recognized it. It's already supported and funded. You have awareness, recognition, then you have realization. A lot of realization of risk claims we're paying today were recognized a long time ago. That becomes sort of the final step that cleans up the whole system. If we've got all this right as we're going along, that's already been booked.
We're not surprised by the event of the claim when the life insurance policy is presented. Then the fourth thing is the realization then of the output of this system as capital. Then you get a dividend or you get shares bought back, or we reinvest in something else. That's how things flow through us and come true. This is happening all the time. You don't look out and see a discrete set of things. This is happening all over the place every day in all of our businesses. We go on looking more like a flow. The discrete events that take the fulfillment of the mission, put it on the books, manage the risk, and realize the outcome, is the real chain that then leads to the creation of value. We started with high-value risks that are priced right.
We managed them well as they went through this thing and as they moved through the books the way I described. At the end, we realized the capital that then is available for the benefit of our shareholders. That kind of links to a notion of supervision. You want to ask those questions about companies. It kind of links to a notion of solvency and capital because you want to spend a lot of time looking at that recognition category. It links to the shareholder value proposition because that's what stuff goes through before it winds up in your pocket as a dividend or as a share repurchase. I said at the beginning that a process update would say that we're continuing on a constructive path.
Every time we get to talk to anybody, domestic or international, about capital standards, we get a chance to be in front of people that want to and need to hear the kind of things that I just talked about, the real guts of what we're all about and where and how to find it and where and how to think about it as you turn it into a regulatory regime. What you've heard is a lot of what we spend time fleshing out, diving deeper on details, refining, thinking, clarifying some of the aspects of transparency and complexity to try to be part of a constructive solution to questions about the right capital standards for us. I'll stop there. Thank you.
Thanks, Mark. Tom, Charlie, and John.
Unlike Mark Grier, I actually do have some slides. As Mark Finkelstein said, I'll give a very brief overview of the international businesses and then turn it over to John, who will speak in more depth about yen sensitivity and our capital management policies. I'd like to begin by emphasizing the dual attributes of the international business, which are low volatility and high returns. The high returns that this business has generated have been sustained over time due to our differentiated distribution strategy that enables us to focus on debt protection and our success in both acquiring and then, as importantly, integrating the companies. The emphasis on protection products, which you'll see in a couple of pages, is one of the characteristics of this business that results in low volatility.
We believe that there is the potential for continued growth in this business on a core basis, I will define what I mean by core in a moment. From continuing to grow the LifePlanner model, from focusing on new market needs, such as the inheritance market opportunity in LifePlanner and in Gibraltar, from expanding into selected new markets, from the evolution of our products to meet customer needs, and finally, from furthering the development of complementary distribution channels. I say core growth because obviously, we know that there are significant headwinds, such as the depreciation of the yen, which clearly affect reported top-line growth. As you can see from this slide, we continue to enjoy high returns and have experienced steady growth in the international business over time.
Despite these headwinds, we continue to see this as a high return business with expectations that ROEs will likely remain in the high 10s to low 20s historical range. As I mentioned in my introduction, this business was founded upon and continues to emphasize death protection, which we are able to do by virtue of our focus on proprietary distribution. As you can see by either the premiums in force on the left-hand side or new sales on the right, the majority of what we sell is in fact death protection, or in the case of retirement products, has a death protection element to it. This focus is perhaps best seen if we look at the bank channel in Japan, where historically it has been the hardest to sell recurring premium death protection products.
We have taken a very different approach in the banks than many of our competitors have done, including taking LPs and seconding them into the banks, thereby bringing a far more knowledgeable and sophisticated professional into the banks to promote death protection products. As you can see by the blue portion of the bars, the amount of death protection products that we have sold last year is about two-thirds of our total production. In fact, our 10 pay and longer whole life product represented by the dark blue portion of the bars now comprises about a third of the business that we sell in the banks today. With some of this due to our focus on the inheritance market. This slide shows the steady growth of our international business over the past 15 years. The vast majority of our earnings are derived from our Japanese businesses.
We have been able to sustain this steady growth through a variety of international factors, such as volatile financial markets, as well as substantial physical traumas such as earthquakes, tsunamis, and even more recently, volcanoes. This trend has come from organic growth as well as our successful integration of acquired companies. As you see, we made 5 substantial acquisitions in Japan and integrated each one successfully. Kyoei was the first, which we transformed into Gibraltar, followed by Aoba, Yamato, Star, and Edison. As mentioned, we have continued to grow throughout a variety of economic circumstances. Through essentially flat GDP growth in Japan, through a volatile FX market in which, interestingly, the yen has depreciated to over 120 four times in the last 15 years, through substantial volatility in the Japanese equity markets, and finally, over the past 8 years of declining interest rates in Japan. Sorry.
The key point is that these businesses have weathered a lot of challenging environments and have grown despite them. Some of these challenges have led to opportunities such as acquisitions, which we've highlighted. While a larger block makes it naturally harder to sustain consistent growth rates, and we do face headwinds, the quality of our distribution and the track record of our execution gives us confidence that we will be able to show core growth in our business in the future. As we look forward, we look to grow through four key pillars. The most important pillar of our strategy is to execute on our existing business model, which we focus on relentlessly. This includes maintaining the quality of our distribution force, particularly Life Planners, where recruiting standards are very high, which has enabled us to show industry-leading retention and productivity.
Product development and expansion of complementary distribution channels will also produce growth. As an example, our focus on death protection products sold through the banks and the agencies will produce growth over time. Finally, very selective M&A is also part of our strategy. This slide provides a little more color on the core growth fundamentals split between Life Planners and Gibraltar. I won't go into the details, as we've largely covered a lot of these topics, but we include this for your reference at a later date. As mentioned throughout the presentation, there are clearly challenges we face, both short-term and long-term. Short-term challenges such as low interest rates and currency risk have the effect of dampening AOI, but not necessarily the effect of dampening core growth.
Longer-term challenges, such as the aging Japanese population, can be turned into opportunities on which we can capitalize, such as the sale of insurance-based retirement products or our focus on inheritance needs. In short, we remain optimistic about our international business and its ability to produce core growth in the future. With that, I'll turn the podium over to John, who will now discuss some key topical financial matters. Thank you.
Good morning. As you just saw from Charlie's presentation, the international story remains very consistent. Despite all the market headwinds, all the different things that have happened, it really boils down to execution. If you have the right people, like we do in Japan, then you can meet any of those challenges and still continue to grow. Charlie asked me to cover three financial areas, including some of those challenges. The foreign exchange and interest rate, to give you some idea of what's our exposure, how sensitive our earnings are to changes in those. Also to talk a little bit about our capital management program, because these are areas that have been of interest to the group, and we want to make sure that it's as clear as possible to all of you. The first is to talk about our currency exposure.
This is something that may not have been as clear to everyone, the amount of our yen earnings, the percentage of our yen earnings, is actually a little less than half of our total Japan earnings. That's for a variety of reasons. One reason is that we're selling U.S. dollar and Australian dollar products. Compounding that, or the impact, is the fact that our expenses in Japan are in yen. Our fixed expenses, a lot of agency offices, fixed expense, home office and so on, those are in yen. In addition, we have U.S. dollar investments that are generating U.S. dollar investment income, some of those are reducing our net yen exposure. As you can see here, as of the first quarter, almost two-thirds of our earnings in Japan are non-yen driven. That's pretty close to a run rate for 2015.
That's the first point we want to make, is that our overall exposure to the yen fluctuations is not necessarily as significant as you might have thought. What this next slide shows is to give you some idea of the sensitivity. We did a full spectrum here. Even with an over 50% deterioration of the yen from this year's plan rate of 91, I'll talk a little bit more about how that 91 is derived. Even if we took our first quarter 2015 results and retranslated them using a rate of 140, a 54% depreciation, still the impact on our earnings is a little over $100 million or about 13%. It's significant, but it's not as significant as you might have expected, even despite that type of change in exchange rates.
Now, because we are a U.S.-based company, we still want to protect our value in multiple ways. We want to make sure from a U.S. dollar perspective, we protected our earnings, our AOI. We also want to protect the long-term value of the organization. Our Japanese operations represent a substantial part of our enterprise value, we want to make sure that that remains stable despite FX fluctuations. The final point is we want to make sure that our local solvency margins are adequate and more than adequate. We want to make sure that we make every commitment that we've made to our Japanese customers or any of our customers around the world. We want to make sure that we're adequately capitalized in every one of those operations on a local basis, because those commitments are long-term. They trust us. We have to be there.
All three things have to be satisfied. We protect the enterprise from fluctuations, we protect our value long term, we make sure that in every country we operate, we're adequately capitalized. Now, this slide is to give you an idea of our overall hedging program, how it's distributed. The first part of our hedging program is to protect our near-term earnings. This program has been in place for many, many years. Many of you have heard about it, how it operates. I'll do a quick update on that. We have about $2 billion worth of yen protection, representing about almost two years' worth of earnings, it's spread over the next three years. It's 100% of the 12-month forward earnings and then a declining percentage beyond that over the next two years. Those total income hedges represent about $1.9 billion in value.
On top of that, as part of the overall enterprise capital management, we have our equity hedge or our capital hedge that we talk about. In total, that represents about $13.5 billion of hedges that are in place. Those protect the company regardless of where the JPY moves, protects that amount of value from fluctuation in the JPY. One important point here to realize is that we always have more than enough JPY assets to protect our JPY liabilities. Here again, we have JPY customers. Mark Grier talked earlier about the reserves that we hold. We take a look at what our JPY liabilities are. We project those out. On a present value basis, we are more than adequately covered with JPY assets to match all those JPY liabilities. This represents a large portion of the remaining piece, which is essentially Prudential's value.
That's the total picture of our JPY in numbers. Now just a quick reminder about our JPY earnings hedge and the way this works. We enter into forward contracts over a three-year period to hedge our projected future JPY earnings. As we constantly update our projections of JPY earnings, we're constantly updating those hedges such that at any point in time, the next year, one year from now's earnings for that quarter are fully hedged. By the time we got to the end of 2014, 100% of our 2015 expected JPY earnings had been hedged. A portion of our 2016 JPY earnings have been hedged, and a smaller portion of our 2017 JPY earnings have been hedged. That does not eliminate the impact of JPY fluctuations. All it does is smooth it out.
As you can see from this chart, the red line, the red bars represent our actual plan rates. That's the rate on which our JPY forward contracts actually settle. We're receiving from external counterparties, JPY settlements, plus or minus, depending on where the JPY is versus what the rate we locked in. You can see the blue line is the actual spot rate as it fluctuated. The red line, which is a much smoother line, represents our plan rate. If you combine our actual earnings out of Japan, JPY earnings, and with our hedges, you end up using the plan rate. That's why we're using a rate of JPY 91 this year, because we actually have settlements on those JPY forward contracts offsetting the decline in value for this year in the earnings from Japan.
On the equity hedge, one of the things you heard in the first quarter, we talked about what was the current fair value of these JPY equity hedges. At the point, the JPY was about at 120, the fair value, the positive value from holding those U.S. dollar assets in Japan, the positive value of all those JPY equity hedges was about $2.4 billion. You can see what would have happened if the JPY were to strengthen by 10%, then the fair value would drop down about in half to about $1.2 billion. It's pretty symmetrical. If the JPY were to weaken by 10% from the 120, then it would go up by about $1.3 billion. You can get a feel for where the overall average equity value, what those rates were put in place at, is in the high 90s.
That's our sort of breakeven rate that our equity hedge applies. On the bottom of this slide, you can see how these hedges will settle, the period. Over the next two years, this year and next, a little over 40% of those hedges will settle. Actual cash transactions between operations. Almost 60% is for 2017 and beyond. That's through the structure of the way we have the hedges in place. Just to give you one illustration of how this would work. As these hedges settle, if the JPY has weakened from when we put them in place, that means that the U.S. dollar assets that our Japanese operations are holding on their local books have appreciated in JPY value. That's not important to them. They want to maintain a stable JPY value.
Those hedges mean they will then send cash to the U.S., so that their net JPY amount is the same. The U.S. dollar values are worth more JPY, they settle the hedges, and they're back to breakeven. On a local basis, they're holding JPY. As you can see on the left-hand side, the solvency margin remains above that 800%. No impact. Meanwhile, if they buy the U.S. dollar assets and there's no change in the value of the JPY, then the net settlements will be 0. No cash will exchange hands. No cash from either operation.
Finally, if the JPY were to strengthen from when we put those hedges in place, when we purchased those U.S. dollar assets, if the JPY strengthens at the time of the settlement, then Japan would have less JPY value because their U.S. dollar assets will be worth less, and the U.S. would then send cash to Japan, to bring their JPY value back in place. Throughout all that, the solvency margin in Japan is maintained stable. Meanwhile, as a U.S.-based company, our Japanese JPY asset change in value is being offset by the fact that they're holding U.S. dollar assets ultimately, because these internal hedges will eliminate. That's how we achieve the multiple objectives of maintaining long-term value for the company and maintaining stable solvency margin ratios in Japan. Next topic is to talk about our interest rate exposure.
This is something in the U.S., it's a relatively recent phenomenon to deal with such low interest rates and so on. This chart goes all the way back to 1997, which is about the time I became the CFO International. At the time, I thought the rates were low. Little did I know, they just haven't gotten higher. We've been dealing with this for a lot of years. The low interest rate environment is not new to Japan at all. The type of business we have, it's a long-term business. We have low portfolio turnover. We match those long-term liabilities with long-term assets. That asset liability manager has allowed us to maintain our profits throughout this period. Most importantly, it's the emphasis, it's the nature of our business, is first focused on protection products.
We make our earnings out of mortality and expense loading, providing service to our customers for that. The investment spread portion is a much, much smaller piece of our total operations. It is really about protection, mortality and expense loads. Meanwhile, during this cycle, even though those rates were low and as they got lower, we would reprice our products very frequently to make sure that we were maintaining the margin. We have raised our premiums over the years as a result of those declining interest rates, whether it was US dollar or Japanese yen or Australian dollar.
Finally, where we sell products that have a much higher savings component, in that case, the multicurrency fixed annuity products, single premium products, those products are repriced on a biweekly basis and have a market value adjustment so that the customer has the benefit of a drop in interest rate or pays the price of a rise in interest rate within their cash surrender value. The risk is now transferred there. Savings type product like that We have to be more careful on the interest rate sensitivity. That's how we've been dealing with this over time.
To give you some idea of the sensitivity, what the impact still would be of interest rate volatility, if we had a 25 basis point change in the entire yield curve, US dollar and Japanese yen rates across the board, the run rate is about $30 million per year. For the course of the first year, it would end up costing about $15 million, because you're losing for about half a year. Ultimately, it's about $30 million a year, it compounds, $15 million the first year, $45 million, $75 million, and so on. Again, remind you, on the base of over $3 billion that we're earning in our international businesses. You've seen some of the impact of this. These low rates have occurred. We have taken some reduction in our earnings.
Some of our growth rate has been hurt somewhat by these lower rates, but it's again, not as dramatic as you might have expected. The last topic that I was asked to cover was talking about a little bit update on our capital, how we generate capital, how we're able to utilize excess capital. Here we have, again, been very consistent. We've been able to redeploy about 60% of our after-tax AOI over this cycle, and it even goes back further. You can see year-to-year, there can be some fluctuation. Back in 2010, as we were preparing for the Star Edison acquisition, we held back some capital because we were using that, planning to use that for the acquisition itself, and then did so in 2011. You can see some year-to-year fluctuation.
In general, we've been able to redeploy about 60% of our after-tax AOI. Over time, as these operations are maturing, you would expect, and we would expect that a higher percentage of that AOI would be available for redeployment. On the far right, the pie chart shows what our distribution of sources of ways that we've been able to access that excess capital. There are regulatory restrictions that we have to abide, and we will abide by every one of those. Again, the important fundamental, we're going to keep a sufficient capital in Japan. One item that will change over time is debt repayment. When we funded the Star Edison acquisition, there was a fair amount of debt used from the U.S. to Japan, and that debt has been being repaid over the course of time.
That amount is now coming down and ultimately will be paid off. Where we will expect to make that up is ultimately dividends will increase out of our Japan operations. In fact, this year, for the first time, we're paying a shareholder dividend out of Gibraltar Life. This is something we expect to maintain this level, and over time, as these operations mature, actually increase the level of excess capital redeployment. The final slide is just to talk about our solvency margin ratios in Japan. We maintain very high solvency margin ratios. Again, it comes back to we are in Japan, we are Japanese legal entities, Japanese customers, commitments that we must keep. We maintain very strong capital solvency margin ratios. One of the things that's happened over the last couple of years is with Abenomics, you've seen the Nikkei index has risen quite a bit.
Interest rates still being low, so the value of fixed income assets is higher and so on. That has very minimal impact on us because we don't have a lot of equity investments, and a lot of our longer term fixed income assets are held for reserve, which means we get HTM type treatment, so we're not recognizing the change in value. We have a lot less sensitivity to those types of things. We have these high solvency margin ratios, and these high solvency margin ratios are very stable. Despite what can happen. You see the stress scenario we've identified, which is a kind of extreme scenarios that the equity market drops 55%, real estate drops. Everything, and each of these were designed to be which would have a negative impact on our solvency margin.
The combined effect of this has about 100% drop on POJ and about 140% drop in the solvency margin ratio at Gibraltar. Even in these very extreme case scenarios, our solvency margin ratios in Japan remain very strong. High ratios today and stable despite fluctuations in the markets. With that, I think we're ready for questions. Thank you.
Thanks, John. We're ready to start taking questions. Before we do so, just some protocols. We are being webcast. After being called on, wait for the mic, please state your name and firm, and please ask one question and a follow-up. Also, it is very challenging to see up here, so I'll try to call you by name, but I may point out colors of shirts and ties. I see Jay Gelb is who I can see clearly. Thanks, Margo.
Thank you.
Jay Gelb from Barclays. I just wanted to circle back first on page 24, where you talked about the rate sensitivity. Could you walk us through that again? There seemed to be a cumulative factor to that in the out years.
Sure. Can you hear me okay?
Yep. Think so.
Yeah, the cumulative impact is that for each year, if the rate curve stays down, the combination of new investments that are being reinvested at that lower yield has an impact on us. The first year's new investments are costing us the $15 million on average. That same set of investments in the following year is going to cost us about $30 million per year. If there's another set of new investments, either renewal premiums coming in and so on, more assets maturing, that new basket will cost another $15 million. That's why it's $45 million in the second year. It compounds at a rate of about $30 million per year.
All right, thank you. Then you mentioned the Japan dividend should increase. To what extent are you looking for that? If you want to tie that into the Gibraltar Life initial dividend, that would be helpful too.
Well, we won't make an actual projection of what the actual dividend amounts are, but I guess the point is, up until this year, we had not paid a regular dividend from Gibraltar. This year, we're paying a dividend in the $100 million range. That's our initial dividend. That dividend ultimately will be tied to JGAAP earnings, and those earnings will be growing and have grown significantly. I won't put out a number for the future.
On the overall, though, for the increase in the overall Japan dividends, can you give order of magnitude?
No.
I don't think so. Sorry, Jay.
I was going to but I
I think the important thing is that we've started dividends from Gibraltar this year.
Okay. Who's next? Seth.
Hi, thank you. Seth Weiss, Bank of America Merrill Lynch. Question on the currency exposure. This is page 16 of the presentation. I was a little surprised to see that only a third now is basically yen exposed. Could you talk about what's caused this shift from half of earnings to fall to a third of earnings in only a couple of years?
Sure. A couple of things that are happening. One is that the amount of our U.S. dollar and Australian dollar business has been growing. The second is that as we've done more U.S. dollar investing, the investment income from the U.S. dollar investments are raising our U.S. dollar portion, and conversely, the yen investment income has gone down. What's happening is that those are sort of serving almost as offsets to our yen income already. You're seeing sort of a compounded effect over that period. There can be the consumption tax increase, so more yen expenses. Those types of things are all combining to the level we are now. Again, I think the 2015 number is more of a run rate type number for this year and nearer term.
If I could follow up, one, just a technical question on the SMR. The current level, when we think about the internal hedges that you have, does that include, I suppose, the liability on the yen side of dollar payments that will come up? Or as those settlements happen in the next two to three years, will we see a negative impact to the SMR?
No, actually, the impact of that, they're holding a U.S. dollar investment, and then they have it hedged back to yen, so on. The ultimate impact on their solvency margin ratio is neutral. The mark-to-market of both is offsetting. We will not have a solvency margin impact from those.
Yeah, it's on an MTM basis. It's not on a settlement basis.
Great. Thank you.
Colin.
Colin Devine, Jefferies. I'd like to dig into this issue a little bit more too, about the percentage of the earnings that are coming from yen. Perhaps you could expand on what percentage of the investments in Japan are in U.S. dollars, and what percentage are in yen? Let's compare that to the liabilities. What percentage of those are in dollars, and what percentage are in yen to start?
If you don't have those numbers, we can take that offline.
Yeah. I wouldn't have the exact numbers, but I guess the one point I would want to reiterate is that the yen assets that we have are significantly larger than the yen liabilities on a present value or economic cash flow-based measure. We have our U.S. dollar assets backing U.S. dollar liabilities, and then on top of that, we have essentially a portion of the excess of what would have been yen assets over yen liabilities. I don't have the exact numbers, but if I had to guess, I think our total is somewhere around a third is U.S. dollar assets and another maybe 10% is Australian dollar. I don't have the numbers.
I'm sorry, how would that compare to the liabilities?
It would be higher because, again, on a hedged basis, if you eliminate those, all the surplus, especially on a GAAP basis, is in U.S. dollars.
Okay. Then let's go a little bit further. When we're thinking of the investment portfolio, let's say we'll compare it to Aflac. Okay. Where I believe 6% of their investments, Japanese investments backing Aflac Japan are in U.S. dollars that are unhedged. There's another portion that's hedged. Is Prudential running that same strategy where a portion of the investments that support Japanese liabilities are invested in U.S. dollars on an unhedged basis, and if so, how much?
Again, the answer is no. All of our yen liabilities are fully backed by yen assets on a present value cash flow basis, and more than backed by yen assets. That answer is no. I can't comment on what Aflac is doing.
I just want to be able to compare. Okay. One other follow-up. Changing the amount of capital that you're taking back to the U.S., does that do anything to change your effective tax rate?
No. We have an assumption in terms of what amount of our Japanese earnings will be repatriated, and what we've been doing has been consistent with those assumptions all along. We have been reflecting the ultimate U.S. tax rate on repatriated earnings.
Yeah, let me just clarify. Historically, we've used a U.S. tax rate. In 2014 and 2015, we have made the decision not to repatriate 2014 and 2015 sourced earnings, and therefore, we're able to capitalize on the lower tax rates in Japan and the changes that have occurred.
Okay.
Eric Berg.
Oh, thanks. Eric Berg from the Royal Bank of Canada. Charlie, you referenced growth opportunities in Japan. John went on to reference a maturing Japan business. I'm sure you can have both, and I'm hoping we can expand on how you could have both of those things happening at the same time. More importantly, I'm hoping, John, you can build on your statement as to why you expect the ratio of distributable earnings to your total earnings in Japan to grow with time. What's going to happen? I think the second bullet on your next to last slide says that you expect capital return to shareholders relative to earnings to increase that ratio. What's going to cause that to increase? Thank you.
Let me start and just say that we don't think lower growth in Japan or what's happening to the demographics of Japan is mutually exclusive from being able to grow a business in Japan. If you look at our strategy, we believe we have a very defined and differentiated strategy in Life Planners, and you've all heard that before of how we hire, how we recruit, who we go after, and the strategy behind the Life Planner business. That has proven to be successful, and we think will still continue to be successful. Last year at this point, we identified a new idea, which was the inheritance market, and we pursued that and capitalized on that. There will be other ideas going forward.
If you look at the presentation we gave last year, you saw the different demographic charts that we showed from Japan going from about 128 million people in 2010 to in 2060, probably going down to about 100 million people. The population is decreasing. However, if you look at our target market, which is from 20-year-olds up, that population is actually, for us, increasing because it becomes a larger percentage of the population. For the next 30 or 40 years, we think that the population that represents our target market is actually increasing. Compounding, I think the opportunity is the fact that many of the local players are now looking overseas. Their proprietary distribution systems are actually decreasing. They do not have as many brokers.
As we look to increase the number of Life Planners and Life Plan consultants and go after those markets, which we think are our target markets, we believe that there continues to be growth opportunities in Japan.
Okay, thanks. I think when we talk about the maturing versus growth, we're just so large that that growth will represent a smaller and smaller percentage of the base with all the acquisitions. To answer your question about why do we see the distributable earnings, the dividend-based earnings, why would we expect that to grow? It comes back to some of the comments that Mark Grier made earlier about the nature of reserves for insurance business. In Japan, it's even another step further. U.S. GAAP reserves have some conservatism built into them, a delay of future profits until the whole contract is settled. Japanese reserves, JGAAP reserves, are even another level of conservative. You have to hold full net level reserves, meaning you're immediately expensing all of your front-end acquisition expenses on Japanese GAAP reserve basis.
When you issue the policy and you pay that commission, the override, the underwriting, instead of spreading that out the way U.S. GAAP would, you expense it immediately. That makes your overall reserve level and capital level very, very high relative to your expected future earnings. What happens over time, though, is those reserves ultimately are just a timing difference between whether it's a U.S. GAAP or a JGAAP and so on. As a business matures, those higher reserves that you set up in those earlier years are ultimately being released into earnings or to pay claims and so on, whereas the smaller U.S. GAAP reserves have to continue to grow.
There is a transition as you go from a growing business with lots of new business where reserves strain is higher to a mature business where the reserves strain is much lower, and that's why the JGAAP earnings, which drive the dividend capacity, are expected to increase and are increasing now.
I think we have time. A couple more questions. I think that's Tom Gallagher. Just behind you, Josh.
Thanks. Thomas Gallagher, Credit Suisse. John, I just wanted to come back to the cash flow discussion. I think if I look back over the last three or four years, most of the cash flows were coming from debt repayment. You mentioned that the internal debt structure that you've been using, I think you said you expected that to largely get repaid. I just want to make sure that that's right. Is that no longer going to be used as a tool for taking cash flows out of Japan?
Yes. We still have about $1.3 billion as of the first quarter remaining of debt repayment capacity. Once that is exhausted, that tool will go away until the next acquisition. In addition to that, there are other options and other methods we have used to deploy excess capital. The debt repayment, once that $1.3 billion is paid off, that's finished.
Moving on to the next phase of how you get capital out of Japan. You mentioned that FSA-based earnings were expected to get stronger. If I look back a couple of years ago, I recall all in FSA-based earnings in Japan were only $200 million or $300 million. The ratio relative to GAAP earnings was incredibly low. Has that changed markedly? If you just give us a sense of where that is now, and I am not asking you to project, but I just want to get a sense for whether that has changed meaningfully, and now we could expect the cash flow figures coming out of Japan to not fall off here.
Sure. They let me go back in time. I just cannot go forward. The JGAAP earnings in the past, there is a couple of factors that may have influenced it in any given year, those sound low. One of the things is as they lowered the standard interest rate, the rate that you use for the JGAAP reserve, as they lowered that rate prior to our repricing of certain products, that ends up creating deficiency reserves on a JGAAP basis. That meant on top of an already conservative reserve, you are now tacking on the present value premium deficiency, very large deficiency reserves. That plus contingency, price fluctuation, and other reserves were all driving down JGAAP earnings over that period. The JGAAP earnings now are substantially higher than the number you quoted for the 2014 fiscal year.
What were they for 2014 approximately?
Combined, I think it was in the $700 million range. I am not exactly sure, but I know it was way higher than that. We had dipped down to a low in that one year because of those deficiency reserves. I think it is in the $700 range.
Sorry, Mark, my last follow-up. If it's only $700 million and now that's the go forward main source of dividends, isn't that going to mean less cash flows coming out of Japan for some period of time? Or is that $700 million figure going to get meaningfully higher for some reason?
Now you're going by projections, but I did explain the difference between U.S. GAAP and JGAAP.
Well.
It will get bigger.
If you could address the question of will we have some period of time where you'll have less cash flows coming out of Japan, or is that not the case?
Don't forget, we have many arrows in our quiver, including affiliate lending. I think in affiliate lending, we have $2.4 billion, somewhere of that nature left as well. All told right now, we have upwards of $4 billion in affiliate lending and affiliate debt. We still have plenty of room to repatriate capital to the U.S. for some period of time.
Thanks.
Take one more question. I can't see who that is.
Hi, it's Jimmy Bhullar, J.P. Morgan.
Hi, Jimmy.
Can you discuss a little bit just on what you're seeing in terms of trends in the business, specifically at Prudential of Japan in terms of sales? I think four of the last five quarters have been negative on sales. Each of the last two years have been negative. Also maybe talk a little bit about the international business outside of Japan, Brazil, Korea. What's going on there?
Sure. Let me start with POJ, and John, you may want to add some. I'll take the last quarter as an example. It's very difficult to look just by a specific quarter because in the last quarter, for instance, the last couple of quarters, there was a very tough comparison to a year ago. Sales were down slightly in Japan, and that was due to we stopped selling a Japanese retirement income product. We're constantly looking at the profitability of products, the business mix we have, and making changes accordingly, which can affect sales in any particular quarter. We look at the profitability of products. We look at the business mix itself, and that's what governs how much of any product we want to sell.
We're constantly looking at sort of an accelerator and a brake to look at particular products and how we want to enter the market or remain in the market. Last quarter, there was a very specific product, and that affected last quarter, and I believe the quarter before as well, in terms of POJ. The underlying fundamentals, I think, of POJ have been very good. If you look at the Life Planner count, if you look at productivity or premium, the Life Planner count has now in the last quarter went up 4%. Previously to that, it was actually down because we were transferring Life Planners to become sales managers. There are a lot of different things that go on in any particular quarter. We think that the fundamentals of the Life Planner business are very good. Now, you had a second.
Would you add anything to that?
No, I think that's it.
Okay.
The Life Planner growth will drive.
The second question was?
Just trends in the business outside of Japan, so Korea, Brazil.
Sure. Trends in Brazil continue to remain very good. We almost have 1,000 Life Planners now. At the end of last quarter, we had 972 to be precise. Not that anyone actually counts the Life Planners. The trends are very good. If you look at productivity, if you look at premium, if you look at Life Planner count, if you look at sales, those are all going in absolutely the right direction. We're selling the right product. We're selling death protection product in Brazil. We're getting a lot of good M&E margin. You're beginning to see that come through the bottom line. If you looked at last year, we actually had a positive net income growth, and passed the line of breaking even.
We're very pleased with the progress we're making in Brazil, and the fundamentals are really good and will continue to be.
Korea?
Korea? Korea is a tough market. It's a very competitive market. We have a very small market share. We have 2.5%-3%. On a profitability basis, we're within the top 10 in terms of profitability on an overall basis, not on a percentage basis, but on an absolute basis, because we don't believe in competing for market share. In Korea, we are looking at steady growth to the extent we can, but profitability trumps growth. We want to remain profitable. Our products are profitable, and we continue to get very high marks for service. We were just meeting with the Korean insurance industry the other day, and they actually commended us because for five years in a row, we've gotten the top service award in Korea.
We concentrate there on the quality of the individuals, again, the Life Planners, as well as the profitability of our product. Will you see significant growth in Korea? Probably not. You'll hopefully see some growth, but it will be profitable growth. That's what we're going to concentrate on.
Just lastly, on the foreign exchange remeasurement had gone more and more negative as the yen had actually weakened. Obviously, you changed the accounting for that, so it shouldn't get any bigger going forward. How should we think about those losses reversing? Should it be as the policies mature, and if that's the case, over how many years should that actually accrue back into book value at AOCI?
Jimmy, it's a very long timeframe. I want to say half should go over the next 10 years. We'll confirm that for you, but it's over the life of the policies. It's a long time.
With that, we'll take a 10-minute break.
If we could please find our seats, we're ready to get started. All right. I think we're now going to start our U.S. businesses section. I'd like to introduce Stephen Pelletier, who runs our U.S. businesses.
Thanks, Mark. Good morning, everyone. I appreciate this opportunity to share with you some perspectives on our U.S. business portfolio, both the progress we've made and the prospects before us. It's no accident at all that the themes I'm going to speak to are identical to the ones you heard about from John Strangfeld in his opening comments. It's my job to illustrate for you how those themes come to life within the U.S. businesses. What drives both our progress and our prospects is our business mix. It's by virtue of that mix that we're able to generate sustainable, profitable growth. Our mix has been purposefully designed to present a diversified and complementary set of risks. This provides strength in times of market stress by all weatherizing our business portfolio. Our business mix also positions us ideally to capitalize on long-term trends and growth opportunities in the marketplace.
As the risks that individuals and institutions bear become more pronounced, we're able to help them address those risks by putting our distinctive capabilities in investments, insurance, and retirement to work in integrated, collaborative ways across our businesses. We continue to invest in our businesses, both within them and across them, so that we can continue to capitalize on these long-term opportunities. Over the last several years, our U.S. businesses have experienced very meaningful earnings growth. That's been a combination of strong net positive flows, outsized organic growth through pension risk transfer, The Hartford acquisition, and market appreciation. In particular, the step function change that you see from 2012 to 2013 shows the impact of PRT and The Hartford.
Even without The Hartford acquisition, as you can perhaps see in the call-out box in the upper right-hand corner, our earnings growth rate over this four-year period was very, very strong. This reflects solid business performance, including the impact of underwriting results more favorable than our average expectations. To be sure, it also reflects the benefit of some tailwinds, equity market appreciation, and outsized gains from alternative investments. We have four businesses producing annual earnings north of $500 million. Three of those businesses well north of that threshold. Group Insurance is making solid progress in its turnaround. Two key points. The sustainability of these earnings is rooted in our mix of businesses and risks. The quality of these earnings is rooted in the sources of our revenue streams. Let me expand on each of those points. This slide shows our diverse and complementary set of risks.
The bar on the left illustrates our businesses and their earnings kind of in proportion to each other. On the right, we've listed the principal risks that we consider when we think and talk about each of our businesses. Businesses with higher exposure to equity markets, such as our annuities and asset management business, are counterbalanced by businesses with minimal exposure in that regard, our insurance businesses. Businesses with exposure to longevity risk, such as our annuities business and within Retirement, pension risk transfer, are counterbalanced by businesses with exposure to mortality risk, again, our insurance businesses. It may look somewhat unbalanced on this slide with more earnings exposed to longevity risk than to mortality risk. Remember that this slide excludes our international businesses, which as you heard just a few minutes ago from Charles and John Hanrahan, are primarily grounded in mortality risk.
The benefit of this mortality longevity balance will be demonstrated quite clearly in a slide that Rob Falzon will show a bit later. That shows how the impact of a longevity shock is effectively neutralized by our complementary exposure to longevity and mortality risks. I want to emphasize something, and that's that while Prudential's risk profile benefits significantly from this mortality longevity balance, we price our products and transactions within our businesses such as PRT based on the risks that we assume in those particular opportunities. We have businesses with varying degrees of exposure to investment portfolio risk, especially credit risk, such as in the assets that support our pension risk transfer liabilities. We consider the management of credit risk to be a core competency of our asset management business.
We put that skill to work for the benefit of the clients of that business, we're also able to put it to work throughout our business mix. As for interest rate risk, we manage that at a product level, at a business unit level, and as you'll hear again more about later from Rob, at a corporate level. This balance of risks is a critical contributor to the sustainability of our earnings performance. The quality of our earnings is based on diverse and continuously improving revenue streams, and we've experienced growth in each category of earnings over the last four years. Underwriting is the primary source of earnings in our individual life and Group Insurance businesses. Growth in individual life, reflecting the acquisition of The Hartford, drove higher net underwriting margins in that business over this time period.
Underwriting margins in our Group Insurance business actually contracted somewhat in the initial years of the period shown here, have begun to expand towards the end of this period over the last couple of years due to our focus on repricing and effective claims management. Spread income is the primary source of earnings for Retirement. Over the last four years, we've booked large funded PRT transactions. We've seen continual growth in client account values, and we've effectively managed discretionary crediting rates. All of that has helped counterbalance the impact of lower reinvestment rates due to a declining rate environment. As I mentioned before, we benefited from stronger than expected gains in alternative investments, particularly over the past two years. Fee income is the primary source of earnings in our annuities and asset management businesses.
Our fee streams have experienced very solid growth since 2010 based on strong positive net flows and equity market appreciation. Our fees are also very well diversified in terms of the asset categories from which they're derived. About 50% from equities, 40% from fixed income, and most of the remainder from real estate. Up to this point, I've talked about how our business mix generates sustainable and high-quality earnings. It certainly does that, but it also supports very attractive return prospects. Our insurance businesses collectively have long-term return prospects in the low double digits, and we're focused on restoring our returns in Group Insurance to those longer-term expectations. Our asset management, retirement, and annuities businesses collectively have return expectations in the mid to high teens, significantly higher on a standalone basis for asset management, which, as you know, is not a capital-intensive business, relatively.
Our higher return businesses are also our higher growth businesses, as you see illustrated here. We carefully manage our business mix to achieve appropriate returns as we maintain a diversified risk profile. We do this across our businesses. We also do it within businesses. In annuities, for example, we've implemented a product diversification strategy that enables us to meet a wider range of client needs while also supporting our ability to achieve targeted returns and diversify our risk profile. The ROE potential of our U.S. businesses when combined with that of our international businesses, helps support an overall corporate objective of an ROE of 13%-14% across the cycle. Long-term trends are creating the need, in fact, the demand for more certain outcomes.
Both institutions and individuals can benefit from transferring risks that, as John mentioned at the start, they may not be well equipped to manage on their own. Let's talk about this from the standpoint of both corporations, corporate employers, and individuals. Employers have an increasing appetite to transfer defined benefit pension risk, a need to help employees save adequately so they can retire as planned, and a need to balance rising healthcare costs while offering benefit packages that help them attract and retain a high-quality workforce, and that help individuals in that workforce achieve financial wellness. Individuals need help managing investment and longevity risks, especially as they're shouldering more responsibility for their financial future. They need to protect their accumulated savings, including protection against costs associated with medical events. They need education and advice.
Our distinctive capabilities position us very well to respond to these needs through a full suite of defined benefit risk transfer solutions, redesigned defined contribution plans that include automatic features in such key areas as enrollment and contribution escalation, and that offer guaranteed income options on the platform. Expanded retail investment and annuity offerings to help individuals manage risks up to and through retirement. Enhanced life insurance policy features and voluntary benefit offerings that help protect assets and income against the unexpected. We're expanding the reach of our own agency force, Prudential Advisors, beyond its traditional bounds by enabling those advisors to offer financial planning and financial education seminars to employees of our Group Insurance clients. This creates a new client acquisition model for Prudential Advisors and a differentiated and distinctive service offering for Group Insurance.
At the same time, we're investing in resources to expand the ways in which we access customers and the ways in which we communicate the value of our solutions in fulfillment of their financial security needs. To ensure our ability to capitalize on growth opportunities, both today and well into the future, we're investing within and across our businesses in key areas. Cost savings and efficiencies in some areas are helping to fund investments in capabilities that will allow us to enhance the customer experience and capitalize on new growth opportunities. Two such investments are in our digital platform and data analytics. Digital is an important element of the overall customer experience. It includes our web presence, but it's certainly not limited to it. Broadly speaking, it's about the ways digital can simplify and enhance the client experience in all its dimensions.
Online, yes, also in our call centers and through our distribution partners, throughout the distribution landscape. In data analytics, our efforts right now are focusing on generating keen insights on customer behavior that will help inform our efforts in product design, product pricing, and underwriting. Over the long term, data analytics and digital will work hand in glove to help us better understand our customers and to have deeper, richer, more personalized, and ultimately, more profitable relationships with them. We're also making investments in technology and talent. In 2014, the net cost of these investments was about $100 million. We expect to continue to invest at approximately that same level over the next few years. Let me wrap up by recalling that a year ago, I outlined for you very specific objectives and strategies for our businesses. Every one of them is achieving those objectives.
In annuities, as I mentioned, we're successfully implementing our product diversification strategy. More on that in a bit from Bob O'Donnell and Yanela Frias. In Retirement, we're building on our market leadership position in pension risk transfer. More on that right after my remarks from Chris Marcks and Phil Waldeck. Also in Retirement, in our full-service business, our investments are paying off in terms of continued strong client persistency, improved sales, and improved cost structure, unit cost structure. As a top 10 global asset manager with a multi-manager model, our asset management business works every day with the world's most demanding and sophisticated institutional clients. We have strong and consistent investment performance, which powers strong and consistent positive net flows, and an earnings stream that is driven primarily and increasingly by asset management fees.
We've invested in new asset management talent, we're expanding our product offerings, international presence, and distribution footprint. Within Individual Life, we're generating sales that represent a more diversified set of risks and a less capital-intensive requirement. Last year, I outlined to you a targeted sales mix in this business of one-third guaranteed universal life, one-third other universal and variable life, and one-third term. Today, we are in very close alignment with that target mix. We've also completed the final steps in the integration of The Hartford acquisition, we expect to realize the full run rate cost savings associated with that integration during the third quarter. In Group Insurance, we've refined our product portfolio and sharpened our focus on the markets that we serve. We're completing the turnaround in disability based on improvements in pricing, underwriting, and claims management.
We're poised to resume controlled and disciplined growth in the Group Insurance business. All of this adds up to our continued ability to offer compelling solutions to our clients through our distinctive capabilities across our businesses and to generate sustainable, profitable growth. With that, I'll turn it over to Chris Marcks. She and Phil Waldeck will speak about our Retirement business, and I'll be happy to take your questions later in the program. Thanks.
Thank you, Steve. Good morning. Over the last few years, Prudential has grown pension risk transfer or PRT as an important part of our retirement strategy. Pension de-risking is a secular global trend that we believe provides a very attractive and profitable market opportunity for us. Today, after I give you a brief overview of the Retirement business, Phil Waldeck will do a deeper dive into the pension risk transfer business that he leads. In our review, we will cover the following points. First, explain the thoughtful approach that Prudential has taken to this pension de-risking market and how we see future growth opportunities. How Prudential's unique value proposition translates into sustainable competitive advantage and creates value for our clients. How we assess and manage the risks in this business and our comfort level with the business that we've written and its expected returns.
Finally, financial drivers and the value created for stakeholders. Prudential Retirement is one of the leading providers of retirement plans and services products, primarily in the United States. Our mission is to meet the retirement security needs of both institutions and individuals. This is a mission that serves as a rallying point for developing high-value, high-quality products and services, including a fully integrated set of defined contribution, defined benefit, non-qualified retirement plan services primarily focused on mid and large-size employers. Institutional investments, where we package and manufacture investment and guaranteed products like Stable Value for our own record-keeping platform as well as for third-party intermediaries. Structured settlements, where we convert court-ordered personal injury settlements into annuities. Of course, pension risk transfer, where we have established the leading market franchise in helping plan sponsors reduce and transfer their pension risk.
We've delivered strong and consistent business growth over the last few years, as you can see from the growth in account values. Account values have grown about 19% every year since 2010. The growth was primarily driven by innovation and market leadership in pension risk transfer and investment-only Stable Value. Also contributing to the growth was our full-service business, reflecting strong sales, excellent persistency, and market appreciation. Our strong market position results from the success of specific investments we've made in all three of these business lines, with the focus on expanding our market presence as well as improving both client and participant experience. As we all recognize, account value growth translates into earnings growth. In fact, we have set new high water marks for adjusted operating income in each year since 2010, the majority driven by our PRT business.
In each of the last two years, we've called out in our earnings reports income that exceeded our expected run rate results due to exceptionally strong investment performance and significant mortality gains. Both of these factors largely related to the PRT business we have put on the books since 2012. AOI growth has been strong even after adjusting for these factors. To some, pension risk transfer might appear as a new market, but it is not for Prudential. We have been writing PRT business since 1928 when we acquired our first customer, the Cleveland Public Library. Prudential is well-versed and expert in pension risk transfer with almost 90 years of experience. We're also one of the largest asset managers in the defined benefit pension market, ranking as the second largest active manager of domestic fixed income. Most of the assets are pension assets.
In fact, Prudential Investment Management, through its subsidiaries, manages pension assets on a fee basis for 23 of the 25 largest corporate pension plans. This provides us access to clients, credibility, and unique insights into how plan sponsors are thinking about dealing with their pension challenges and considering de-risking solutions. By putting all of this experience and expertise together, Prudential has established a leading market position both in the U.S. pension buyout market as well as a reinsurer of longevity risk in the U.K. With that, I'm going to turn this over to Phil Waldeck, who will take a deeper dive into pension risk transfer.
Thank you, Chris. We've thoughtfully built out our PRT capabilities and expertise over the past decade. While the PRT headlines emerged at the end of 2012 with the announcements of the landmark General Motors and Verizon cases, we substantially expanded our capabilities over the years leading up to those announcements. We identified the opportunity early. In 2006, we identified the market forces that suggested a potential PRT opportunity. We formed a team to evaluate how secular changes in the economy and in pension funding and accounting rules would impact plan sponsors and how various segments of sponsors would react. In 2007, we dedicated a core PRT team to research, incubate, and evaluate and assemble the right set of expert resources and control functions to properly build this business and to bring it to scale.
We intensely focused on U.K. longevity best practices, both to evaluate U.K. longevity reinsurance transactions, but also to determine how the U.K. longevity underwriting and pricing best practices could be applied to the U.S. market. We meaningfully built our capabilities and expertise over the next few years, and this included further examination of U.K. longevity underwriting. We learned from negotiating with large U.S. plan sponsors and their advisors on potential transactions that didn't come to fruition. As a result, in 2011, Prudential wrote our first U.K. longevity reinsurance agreement, and in that same year, we also executed the first modern era U.S. PRT transaction, which was a strategy that we'd adapted from the U.K. to the U.S. market. In 2012, Prudential closed on the landmark $25 billion and $8 billion General Motors and Verizon cases, respectively.
Significant in their unprecedented scale, complexity, and innovation, these cases transformed current-day PRT techniques, which we subsequently leveraged in a series of other PRT buyout cases. In 2014, Prudential completed the largest-ever longevity reinsurance case in the industry with the BT Pension Scheme. We've now completed a total of 9 U.K. longevity reinsurance cases. The global corporate pension market for PRT is large and growing. In the U.S. and the U.K., about three-quarters of corporate plan sponsors have closed or frozen their pension plans. Pension de-risking for most sponsors has become a question of when and how, rather than if. The U.K. market has been the leader for pension de-risking, with almost $200 billion of transactions that have been completed, including 33 separate transactions of $1 billion or more, including PRT buyouts, buy-ins, and longevity insurance.
The U.S. market has developed more recently with 5 transactions of $1 billion or larger since the end of 2012. There's real potential for PRT with Canadian corporate pension liabilities. In fact, earlier this year, Bell Canada announced the first Canadian jumbo PRT transaction of $4 billion longevity insurance transaction. Overall, the PRT markets are just getting started. As a percentage of pension liabilities that have transacted to date in the U.K., the U.S., and Canada, it's relatively small. We believe that PRT may emerge over time in other markets, such as the Netherlands. Prudential is well-positioned in the PRT markets. We've built the best expert teams, scale capabilities, and risk management disciplines, We focused early and meaningfully on the PRT opportunity. The unique combination of our key attributes cannot be easily or quickly replicated by others.
We have decades of experience successfully managing PRT liabilities and a well-respected position as a leading pension asset manager. We bring financial strength and a balance sheet capacity to take on large, long-dated pension obligations. We've got deep expertise and collaboration across complex disciplines to evaluate, close, and execute PRT well. This includes actuarial, asset liability management, capital management, law, and more. We've got proven structuring skills, external focus, and an understanding of client needs, leading to win-win solutions to meet client challenges. We've got a track record of execution excellence across all of our PRT transactions. No one else has tackled the issues that we have, closed such complex cases, and onboarded 100,000 or more retirees at a time. We've done so flawlessly.
Prudential's built our sizable PRT business over the last few years by transacting directly with leading U.S. plan sponsors and their independent fiduciaries, and by reinsuring U.K. pension longevity risks taken on by U.K. insurers. Our PRT business has grown by $75 billion in liabilities, covering over a half a million retirees for more than 130 plans in the U.K. and the U.S. Our creative solutions and strong execution were essential to this growth and have been recognized by industry observers. For example, in 2014, Insurance Risk Magazine recognized Prudential as the Reinsurer of the Year, Chief Investment Officer Magazine has awarded us the PRT Innovation Award four years running. Our jumbo transactions have been attractive individually. They're particularly attractive in an aggregate because how they form such a well-diversified block of liabilities.
Each pension sponsor faces unique challenges and circumstances, we're recognized for our ability to understand each client's unique requirements, craft customized solutions, while appropriately accounting for and managing risk. Let me highlight four examples of PRT industry firsts that Prudential's introduced. These are just a few of many examples where we led the market and provided unique, valuable solutions for our clients, and why we remain the provider of choice in the jumbo PRT market. The first is delivering execution confidence in spite of uncertainties. Providing execution confidence was absolutely critical to the PRT transactions with General Motors, Verizon, Bristol-Myers, Motorola, Kimberly-Clark. We created an advanced purchase agreement structure that can be entered into months prior to the actual annuity contract closing.
This gave clients the time and ability to publicly announce the transaction to various stakeholders, including investors and retirees, to prepare their portfolio for in-kind asset transfer, and to take other actions such as lump sum offers to some retirees. We developed and repeatedly delivered rigorous legal documentation and procedures to move transactions from agreement to closing with execution confidence. On at least one occasion, we were the only insurer that was able to close within the client's accelerated timeframe. The most visible aspect of our execution success, and arguably the most important, is the retirees experience. By virtue of our decades-long expertise in pension administration, we consistently deliver seamless transitions, including best-in-class personalized communications, and ultimately, we deliver millions of pension annuity payments each year to retirees. The second innovation example is new transaction structure.
We've constructed several versions of price roll forward structures based on the specific circumstances of large plan sponsors. These structures hedge interest rate and credit spread changes from the transaction signing until the closing, which can be months later, enabling plan sponsors to achieve price certainty while preserving our economics and risk profile. For BT, we adapted our longevity reinsurance structure, which had previously been used to write reinsurance with traditional U.K. insurers, to transact instead with a wholly owned insurance subsidiary of the BT pension scheme. This brought scale and capacity to a pension plan that would not have been otherwise able to transact due to a lack of direct writer capacity in the U.K. This structure will likely be replicated over time for U.K. liabilities and for sponsors in other jurisdictions. The third example relates to liability changes and protections.
Liability changes are a significant issue for plan sponsors, we developed simple and transparent solutions to adjust for data changes in the underlying covered population from our initial pricing through closing and post-closing. We also structured our premium to increase based on lump sum election rates for retirees that enable the plan sponsor to achieve price certainty while protecting us against anti-selection risk based on the profile and volume of the lump sum elections. The last example relates to in-kind asset transfers. We've applied the expertise and sophistication of Prudential's third-party asset management resources as a top 10 asset manager as a unique competitive advantage in the PRT market.
We developed the first in-kind transfer for a U.S. PRT transaction. This allowed the plan sponsor to pay a substantial part of the transaction premium with investment assets rather than cash, thereby reducing both the cost and the risk to both parties. In-kind asset transfers have been and will continue to be critical success factors in the U.S. jumbo PRT market, as was the case beginning with GM and Verizon. We also negotiated limited allocations of private equity as part of the in-kind asset transfers. This contributed to jumbo PRT wins and was consistent with our enterprise appetite for exposure to that asset class. Overall, in each of our jumbo PRT transactions, we successfully developed and executed creative win-win solutions that differentiated Prudential from other insurers. They were key to independent fiduciaries and plan sponsors' selection of Prudential.
Our PRT franchise is built on a keen understanding of critical success factors and managing key risks. Successful execution in the PRT business can be defined at a very high level simply. Well-defined annuity payments for which we manage longevity risk, investment risk primarily in the form of credit risk and interest rate risk. Let's start with PRT pricing. We prudently establish our best estimates for the key drivers of risk in each transaction, such as longevity, investment, and interest rate risk. This is done with a rigorous review and governance process, including substantial corporate level reviews. We establish stress scenarios under regulatory capital and economic capital frameworks. We do so with loss absorption capacity to withstand shocks consistent with our AA ratings objectives.
Our starting point for pricing is based on extensive analysis of a plan sponsor's census data, plan specific mortality history, industry experience, and experience of our proprietary client base. We recognized early that the standard industry mortality tables neither adequately reflected lengthening life expectancies nor differentiated between plan sponsors. We developed and we continuously refine proprietary customized mortality assumptions. Plan sponsors in the industry overall have moved closer to our mortality views as these trends are being recognized more broadly, as reflected in the recently updated Society of Actuaries pension mortality tables. Additionally, we negotiate price triggers to adjust and increase our required premium for numerous factors, including changes between signing and closing. Finally, note, as Steve referenced earlier, that we price our PRT transactions independent from the benefits of corporate level risk diversification and corporate level longevity mortality netting. Next, investments.
I'll review a representative PRT asset portfolio in a few slides. Overall, it's worth summarizing that we manage our investment risk by structuring our assets primarily with a high quality corporate bond portfolio. This portfolio is very well diversified by issuer, industry, and geography. We place limits on the types and quality of securities that we'll accept that are in-kind asset transfers, generally calling from 90% investment-grade bonds and treasuries. In certain circumstances, we'll allow for a portion of assets outside of our requirements in exchange for additional premium charges. We set prudent best estimates of expected defaults and defaults under stress scenarios. We actively manage the portfolio within Prudential's global portfolio management group, consistent with our other investment portfolios that back insurance liabilities. Liquidity.
Our obligations are long-dated, illiquid liabilities, annuity benefit obligations predominantly to retirees for whom there's essentially zero lapse or policyholder behavior risk or exposure to accelerated payments. These predictable payments are well suited for disciplined cash flow management, and we're able to match the expected cash flows closely. This also leverages a key advantage, the private placement and commercial mortgage origination capabilities of Prudential Investment Management, as we can invest with lower liquidity needs for PRT portfolios than for other portfolios that back liabilities that require greater liquidity. Insurance. We receive significant and very credible plan specific mortality experience that enables us to create tailored mortality tables. This is quite different from the small case market where underwriting is done without the benefit of plan specific mortality experience.
This extensive, credible mortality experience is one of the reasons why we find the jumbo market to be the most attractive segment of the PRT market. In addition, the initial average age of annuitants in our jumbo PRT cases is approximately 72 years, and this limits the risk of significant longevity extension. Asset liability management. The nature of our liabilities and of our asset strategies enables us to manage the assets within tight duration corridors to closely track our liabilities. We do so with rigorous ongoing monitoring to maintain this controlled asset liability profile. Concentration. We've been thoughtfully building our well-diversified book of PRT liabilities. The extensive and credible mortality experience data on jumbo plans have made jumbo plans essential building blocks for our well-diversified growth. While insurer pricing is always neck and neck on jumbo plans, we've high conviction on these PRT opportunities.
This is because we obtained many years of credible mortality experience data on their specific populations that we can evaluate in combination with our own mortality data to create high conviction, customized mortality tables. For example, in a case like GM or BT, this can mean over 1 million life years, retirees times the number of years of data in which we can assess mortality rates. This sort of high conviction experience data is simply not available on smaller plans. We believe jumbo plans are the most attractive segment in the U.S. and the U.K. because jumbo plans are where we possess the greatest ability to differentiate our capabilities relative to other insurers, where we face meaningfully fewer competitors, and where our complex execution skills are most valued. Next, let's look at more detail on the well-diversified composition of our liabilities of our growing PRT business.
Well-diversified business mix. We built and will continue to maintain a well-diversified business by design, including geography, age, gender, industry, benefit size, and occupation, blue versus white collar. For example, on BT, that longevity reinsurance transaction broadly covered a well-diversified mix of retirees that was well-distributed across the entire U.K. with a good representation of blue and white-collar workers. In fact, the retiree population covers 2% of all the corporate retirees in the U.K., effectively like a U.K. longevity index. Overall, the average duration of the liabilities that we've assumed is 9 to 10 years for our buyout cases and 8 to 12 years for longevity reinsurance. Additionally, the annual runoff of liabilities from benefit payments and mortality in our U.S. PRT buyouts, net of portfolio earnings, is about $2.5 billion-$3 billion a year. Strong investment risk management.
Our investment portfolio is well-diversified and specifically constructed to back pension liabilities while managing risk. Over 90% of the portfolio is invested in high-quality fixed income securities, and the remainder is in small allocations to below investment-grade bonds and alternatives to enhance yields without assuming disproportionate risk. The portfolio is well-aligned for interest rate sensitivity with tight duration corridors. The weighted average duration of the portfolio closely tracks the duration of the liabilities. Transactions are structured initially closing with in-kind assets that limit our need to invest large amounts of cash or rotate out of undesired assets. This reduces our tax and transaction costs, but it also minimizes the risk of rate or spread changes that could otherwise be present when migrating to our ongoing portfolio. Complementary profit emergence patterns. We've built and will continue to develop portfolio solutions for client needs that vary by market.
The benefit of this approach is that we'll benefit from diversified market opportunities that emerge at different times. Additionally, we benefit from combining the different earning patterns of funded PRT with that of longevity reinsurance. These earnings patterns are complementary, though quite different in magnitude due to their nature. Specifically, PRT buyout earnings decline steadily from a case's closing, but longevity reinsurance earnings rise from closing and then peak years later. The expected earnings patterns shown on this slide are based on actual cases completed by Prudential. The expected earnings of buyouts begin to decline right away because of the payment of benefits and the impact of mortality on the block.
On the other hand, the expected earnings on longevity reinsurance cases increase somewhat over the early years of the transaction because we initially build reserves against adverse experience as premiums received and can release them into earnings later as experience emerges over time. The difference in magnitude in earnings reflects the fact that the longevity reinsurance transactions are essentially insurance risk only because longevity reinsurance lacks the credit risk associated with PRT buyout transactions. We price pension risk transfer cases to reflect the underlying risks we're undertaking. The governance with respect to pricing assumptions is significant. Larger cases subject to much broader oversight and approval criteria are more like M&A than traditional insurance transactions. We set our best estimate, view of returns using stressed assumptions, then stress or shock these assumptions further to set capital.
As part of the underwriting and approval process, we examine how the expected case returns may vary in different economic scenarios. In setting capital, we examine statutory and economic capital, and we price using the greater of regulatory capital using the National Association of Insurance Commissioners' risk-based capital and our view of economic capital required to support the risk. Generally, over time, the economic capital is the higher of the two metrics. Capital for longevity cases is held consistent with this framework, although the risks are significantly less for longevity reinsurance than for buyout cases, which have greater asset risk. We're intensely focused on identifying and mitigating the underlying transaction risks through transaction structure, pricing actions, hedging, and other mitigants. Some of the key risk parameters that we evaluate and price for are base mortality improvement, interest rates, and credit defaults.
As you can see, the biggest sensitivity is to mortality trend improvement, or the chance that people live longer than expected. Their benefit payments total more than expected. We price for an assumed level of mortality improvement. We further stress mortality improvement for the risk that the life expectancies improve more than what we priced for. We hold capital for this possibility. As a life insurer, we have decades of expertise doing this successfully. Another key risk that presents significant return sensitivities is credit risk, with which we're very comfortable. We're confident that these risks are well understood, well-priced, and adequately provided for in our capital framework, with sensitivities identified and properly reflected in our return targets. PRT is an attractive growth opportunity. We've built a premier franchise in a market that we see as very attractive.
PRT truly leverages the best of Prudential, with powerful and effective collaboration and a foundation of more than a century of relevant experience. We identified PRT in 2006 as a significant growth opportunity. We invested meaningfully to build our expertise and a scalable business system with rock-solid risk management. We're comfortable with the business we've written. Based on what we know now, we expect returns to be at or above our targets. Looking forward, we see an ongoing growth opportunity with solid return expectations and sustainable competitive advantages. We like PRT because it leverages our strengths. Because there are significant barriers to entry, particularly in the jumbo case market, based on the complexity of PRT and the regulatory requirements. Simply put, no other company approaches the PRT market with our combined strengths.
We're confident in how we'll enjoy sustainable growth in a controlled environment and how PRT will continue to produce long-term attractive risk-adjusted returns in a business that's core to our retirement security mission.
Thank you, Phil. We're going to take a 5 to 7-minute short break here.
Okay. If we could please find our seats. Okay. Our next speakers are Robert O'Donnell and Yanela Frias to cover the annuity segment. Bob is actually going to stay seated. He was recently in a skiing accident, so he's going to stay seated.
Thank you, Mark. I apologize for my logistical constraints. Today, we'll demonstrate a thoughtful and deeply informed approach to the annuities business. I'll review our diversification strategy, including the expansion of our product mix and the execution of reinsurance transaction. Next, we'll discuss policyholder behavior and our use of data analytics to better understand the factors that influence policyholder behavior. We'll also highlight how that work informed our 2014 assumption updates, as well as revisions to our dynamic lapse function. Next, we'll review the economics of our in-force book, and to do this, we'll employ a cash flow lens. These cash flows show continued strength and resilience across various stress scenarios and are the best and most transparent method to analyze the economics of the annuity business. Finally, we'll take a look at the strength of our balance sheet, and we'll review our captive reinsurance structure.
While we remain committed to our HDI product, over the past two years, we've embarked upon a strategy to diversify our risk profile and expand our product mix. This slide contains an overview of our current product offering. Focus first in the middle of this slide on the x-axis, where we've captured both policyholder behavior and capital markets risk. Furthest to the right, we're showing our HDI product. This is a withdrawal-based lifetime income guarantee that provides access to diverse equity-based investment options. Reflected here in light blue is our Prudential Defined Income annuity. It too is a withdrawal-based lifetime income guarantee, but rather provides access to a single bond investment option, creating, as you might expect, a very different capital markets experience than HDI. Shown here in light gray and the furthest to the left is the Prudential Premier Investment Variable Annuity.
This is our investment-only VA, and as an investment-only VA, offers no access to optional living benefit guarantees, creating, as you might expect, a very different capital markets and a very different behavioral risk profile than either PDI or HDI. Shown here in yellow is our single premium immediate annuity. Think of this pretty much as a table stakes product and not so much a strategic driver of growth. With the launch of our PDI product in February of 2014, we also introduced our monthly rate-setting capability. This is a capability that allows us to set both the withdrawal rate and the roll-up rate for new business on our optional living benefit guarantees as frequently as monthly. Prior to building this capability, such a task would have taken anywhere from six to eight months, which remains an industry standard. This slide demonstrates our successful execution of the diversification strategy.
In 2012, largely as a single solution provider, 90% of our sales came through our HDI product. In 2014, 30% of our sales came through products other than our HDI product. You'll also note a meaningful reduction in growth sales over this time period. We view this reduction as an expected and natural outcome of our deliberate action to manage the profitability of our business in the face of low interest rates. In addition to the success we've made in the execution of our diversification as measured through the change in new business mix, we recently entered into a reinsurance transaction whereby we will reinsure 50% of our HDI 3.0 optional living benefit sales in 2015 and 2016. These reinsured sales essentially turn 50% of our HDI sales into non-HDI sales, meaningfully changing the complexion of this image even further.
This slide contains the highlights of that transaction with Union Hamilton. Again, 50% of all HDI sales in 2015 and 2016. We are ceding the entire optional living benefit to Union Hamilton and retaining 100% of the economics and cash flows associated with base underlying annuity contract. This transaction affirms our commitment to and accelerates the execution of our diversification strategy. Yanela Frias, the annuity CFO, will now begin our discussion on policy holder behavior. Thank you.
Thank you, Bob, and good morning. As Bob mentioned, I will start with a discussion about policy holder behavior, and specifically, I will provide more details about the changes that we made to our assumptions during our 2014 annual assumption update process. In order to deepen our understanding of the factors that drive policy holder behavior, during 2014, we partnered with industry experts to enhance our data analytics capabilities and to analyze our emerging experience at a more granular level. In addition, we expanded our historical data to include industry experience. This was particularly helpful as we are very limited as to the data that we have due to the vintage of our products. It should be noted that our lapse experience continues to emerge as we have a very limited number of shares outside of the surrender charge period, and this is limited to the L share product.
This is a share class that has a four-year surrender charge period and a trail commission structure that is designed to encourage persistency. The insights of this project were used to aid, not replace the use of judgment in setting our assumptions, and the initial focus was on lapses and benefit utilization, with the goal of refining our assumptions, improving our valuations, and improving our risk management. Now, although we partnered with industry experts for the initial project, we are in the process of bringing this work in-house, and we expect it to continue to evolve. Next, I'd like to dive deeper into the changes that we made to our dynamic lapse function, which were by far the most significant. Now, historically, our lapse function dynamically reflected the level of in-the-moneyness in the policies. We believe this is a key driver of lapse behavior.
However, we also believe that lapse behavior will be influenced by the availability and the attractiveness of products in the marketplace, which is a function of interest rates. As a result of the changes that we made during the 2014 update process, we now have a dynamic lapse function that reflects both the level of in-the-moneyness as well as the impact of interest rates on lapses, which changes with the different interest rate assumptions. What does this mean? While the current macroeconomic environment has led to a de-risking of products compared to the historically available products, we believe that as interest rates rise, more attractive products will become available. By reflecting the level of interest rates in our dynamic lapse function, we can compare the value of a policyholder's living benefit guarantee to that which is available in the marketplace at any given interest rate environment.
Let me walk through that change by using the graph on the slide in front of you. Our prior dynamic lapse function is depicted by the dotted lines on the slide. The blue dotted lines represent the policy that was previously at the money, and the red dotted lines represent a policy that was previously 20% in the money. The gap between those two lines represents the difference in the lapse assumption resulting from the different level of in-the-moneyness of the policies. As you look along the x-axis and move from left to right and interest rates change, there is no change in the assumed lapse rate. Our new dynamic lapse function is depicted by the solid lines on the graph. The blue solid line represents a policy that is at the money, and the red solid line represents a policy that is 20% in the money.
Again, the gap between the two lines represents the difference in the lapse rate driven by the different in-the-moneyness level. Now these two lines have a slope, and that slope represents the sensitivity of the lapse rate to interest rates. If you move to the right and interest rates rise, we would expect more attractive products to be available in the marketplace, leading to higher lapses. As you move to the left and interest rates decline, we would expect less attractive products to be available in the marketplace, leading to lower lapses. This change resulted in a lower lapse assumption for our richer benefit products, especially those sold pre-crisis.
However, the application of the entire new dynamic lapse function to our in-force resulted in a strengthening of the living benefit reserve, as we assume a significantly higher level of sophistication on the part of the policyholder, both in low interest rate environments and in high interest rate environments. Both extremes actually can be quite punitive. Again, as you move to the right and interest rates rise, more attractive products will become available, leading to higher lapses, and in that scenario, we would receive lower fees. As you move to the left, you would have less attractive products in the market, lower lapses, and therefore, we would pay higher claims. Next, I'd like to shift gears into a discussion of the in-force economics through a cash flow lens. This is the same framework we introduced during our 2013 Investor Day.
As Bob mentioned, we believe it is the best and most transparent way to analyze the economics of our annuities business. We'll start with the baseline cash flows as of December 2014, and then we will share a number of sensitivities. Independently, we will look at capital markets and policyholder behavior sensitivities, and then we will bring those sensitivities together into one set of cash flows. We will show a number of negative scenarios with punitive outcomes. However, we believe it is important to demonstrate the resilience and the strength of the cash flows. You will see that although our GAAP results can be volatile, the in-force continues to generate strong and resilient cash flows. These cash flows have been further bolstered by the strength in the equity markets over the past two years. Now let's walk through the cash flows.
We'll start with reviewing our baseline assumptions, which are consistent with our best estimate assumptions as of December 2014. For capital markets, we assume an annual equity market return of 3.5% grading to our long-term assumption of 8% by year six. We have an annual fixed income assumption of 1.8% grading to our long-term assumption of 5.5% by year 10. These result in an annual blended return of 2.9% grading to our 6.6% by year 10. The cash flows assume the living benefit is fully hedged, and we reflect the cost of hedging in every scenario. In addition, the cash flows exclude the benefit of any release of capital or excess reserves. You will see later in the presentation that we have $12 billion of loss absorbing resources in our VA captive.
For policyholder behavior, the base lapse assumption is the result of applying our dynamic lapse function in the base case, which as I mentioned, reflects both the level of in-the-moneyness and the impact of interest rates. We assume 95% of policyholders take lifetime withdrawals and that they take 86% of their guaranteed income amount. These assumptions track our experience. Those baseline assumptions result in the cash flows we show on slide 13. Let me walk through these in detail. We start with base contract and notional rider fees net of administrative expenses of $32.2 billion. Next, we show the cost of purchasing hedge assets to manage our living benefit risks, which is $13.1 billion in this scenario. Benefits net of recoveries in this scenario are $1.9 billion, and they're generally death benefits that we do not hedge.
Lastly, we have some modest spread income on our general account products of $700 million. When you put that together, the total expected present value of cash flows over the lifetime of the in-force is $17.9 billion. Next, we'd like to compare the cash flows to the cash flows we shared during 2013, which were as of December 2012. On the left-hand side of your slide, we show the change in cash flows from December 2012 to December 2014. You could see that they have increased by over $1 billion net of fees collected and claims paid during 2013 and 2014. However, when you look at the right-hand side and you see the change in the GAAP liability over that same time period, there has been a significant increase in the liability. Now, as a reminder, our GAAP liability is valued using FAS 133-157.
What this means is that in valuation, we apply no risk premium to the assets backing the liability, and that we discount the liability using a risk neutral rate. Both of these assumptions lead to a liability that is significantly larger and more sensitive to interest rates than a liability valued using real-world assumptions. While the increase in our GAAP liability will be generally offset by the hedge assets that we hold on our balance sheet, we think this is a good comparison to demonstrate the disconnect between the economics of the in-force and the GAAP valuation. While the cash flows on the left using real-world assumptions show an increase in economic value over the past two years, the GAAP liability using risk neutral assumptions and demonstrating the current interest rate environment has increased significantly over those two years.
Let's look at the cash flow sensitivities. The next slide shows the impact of changing capital market scenarios on the expected cash flows. Here we hold the policyholder behavior assumptions flat at baseline. However, keep in mind that with our dynamic lapse function, the base assumptions will change with the change in capital market assumptions. In the middle of the slide, we have the baseline cash flows of $17.9 billion. To the left, we show a positive market scenario. What we have assumed here is an immediate equity market increase of 30%, followed by our baseline annual assumption, and an increase to our long-term interest rate assumption of 100 basis points. These assumptions generate lifetime cash flows of $23.1 billion as we would experience higher fees and lower claims in this scenario. To the immediate right, we show a negative market scenario.
Here we have assumed an equity market decline of 30%, followed by our annual baseline growth assumption. In addition to that, we have applied 100 basis point decline to our assumed fixed income return and held that flat for the lifetime of the projection. This implies a 10-year treasury of 117 for the lifetime of the projection. This scenario demonstrates the resilience of the cash flows at $5.2 billion after both stress events have been applied. To the far right, we provide a break-even scenario. What we've done here is we've applied the same interest rate sensitivity, 100 basis point decline to our fixed income assumption, held flat. That's a 10-year treasury of 117 for the lifetime of the projection. We solve for the annual equity market return that would be required for the cash flows to break even, and that equity market return is a negative 13%.
This means that the in-force can withstand a 10-year treasury of 117 for the lifetime, and an annual equity market return of negative 13% and still break even. Let me highlight that in both the negative market scenario and the break-even scenario, we benefit from the impact of the contract level rebalancing formula that is embedded in 87% of our contracts with living benefit guarantees. As we experience a negative market path and account values drop, the auto rebalancing mechanism will move assets from equities into fixed income, protecting both the policyholder as well as Prudential. The next slide provides the policyholder behavior sensitivities. Here we have returned the capital market assumptions to baseline, and we will sensitize both lapses and benefit utilization. Again, in the middle, we have the baseline cash flows at $17.9 billion. To the left, we show a lapse sensitivity.
What we've done here is we've reduced lapses by 20% from the baseline scenario, you could see the impact is an increase in cash flows to $18.5 billion, as the higher fees that we collect would more than offset the higher claims that we would pay. To the right, we have a benefit utilization sensitivity. As a reminder, in the baseline, we assume 95% of policyholders take lifetime withdrawals and that they take 86% of their guaranteed income. For this sensitivity, we assume 95% of policyholders take lifetime withdrawals and that they take 95% of their guaranteed income amount. This is near perfect utilization. While the results here are a decrease in cash flows, cash flows remain strong at $12.6 billion. Let's put the sensitivities together into one set of cash flows. On this slide, we show the impact of combining the shocks.
Again, in the middle, we have the baseline cash flows of 17. On the left, we combine the lapse sensitivity with the negative market sensitivity. Let me summarize all the assumptions. We have a 100 basis point decline in the fixed income return held flat. That's a 10-year treasury of 117 for the lifetime of the projection, a 30% equity market decline, a 20% reduction in lapses from the negative market scenario. Let me explain what that means. That means that the lapses that result from applying our dynamic lapse function in the negative market scenario, which will already be lower than the baseline, are further reduced by 20%. Even when combining these severe shocks, the in-force continues to generate positive cash flows at $3.1 billion. I would highlight that the impact of the combined shocks is greater than the sum of the independent shocks.
That's because path matters for our liability. Where the impact of lower lapses in the baseline scenario led to higher cash flows, the impact of those lower lapses in the negative market scenario leads to lower cash flows as we would pay higher claims. To the right, we combine the negative market scenario with the higher utilization scenario. The same market assumptions, 10-year treasury of 117 for the lifetime, 30% equity market decline, is combined with the assumption that policyholders take 95% of their guaranteed income amount. In this scenario, the cash flows remain slightly positive at $400 million. Our last cash flow slide is a little bit different than the ones I just walked through. The prior cash flow slides were looking at deterministic scenarios based on the assumptions that I laid out.
In this cash flow slide, we show the distribution of potential cash flows over 1,000 stochastically generated market paths around the baseline assumptions. What we've done here is we have sorted the present value of cash flows from low to high. While there's a large variance in cash flows with a high of $41.8 billion and a low of $3.3 billion, cash flows remain positive in all scenarios with a mean of $17.1 billion For the minimum scenario, we've provided additional details to demonstrate the severity of this market path. This is a scenario where we experienced an equity market decline of 45%.
We have a cumulative equity market return over the first five years of negative 38%, and this is coupled with a sustained low interest rate environment, which includes a 10-year Treasury rate of 193 for the first 10 years, with the 10-year hitting a low of 0.97%. Even in this very severe market scenario, the in-force produces positive cash flows. Before moving on, let me summarize the cash flow discussion. As you've seen in a variety of scenarios, both deterministic and stochastic, both capital market sensitivities, policyholder behavior sensitivities, and the combined shocks, the cash flows demonstrate strength and resilience. Next, I'd like to walk through the GAAP balance sheet. On slide 20, we have the consolidated annuities GAAP balance sheet. This includes both our issuing entities and our VA captive.
The key headline here is that we have $24 billion of liquid assets supporting $22 billion of long-term liabilities. Our obligations are supported by high-quality assets, as we do not use letters of credit or other off-balance sheet funding arrangements in our variable annuity captive. In addition, we have $8.7 billion of GAAP equity supporting the variable annuity business. This translates to 5.5% of account value. Our last slide looks at the financial strength of our variable annuity captive. It's important to note, we do not use our variable annuity captive to achieve an overall reduction in reserves or capital. We capitalize the captive at levels that we believe are consistent with double A standards, and our captive is domiciled in Arizona. This is the same regulator that oversees the issuing entities for the majority of our business.
This results in increased transparency for our regulator as they see both sides of the transaction. We use our captive to aggregate our living benefit risk and to align our accounting with our hedging strategy, which follows our economics. In this slide, we show a comparison of the statutory reserve for the living benefit guarantee. You could think about that as the reserve credit that we take in the issuing entity to the total assets that we hold in our VA captive, which is the sum of the capital and reserves. Historically, we have held assets in the captive that are at least equal to the reserve credit that we take in the ceding entity, and this slide shows that relationship for the past three years. In the past three years, the assets in the captive have been more than twice that which would be required in the statutory entity.
This relationship was still the case in the first quarter of 2015. To summarize our presentation, we remain very comfortable with our in-force while diversifying our risk profile. We have demonstrated success with our product diversification strategy, and we believe that will be further enhanced by the reinsurance transaction with Union Hamilton. We further believe that our policyholder assumptions are supported by a best-in-class approach that is based on enhanced and sophisticated data analytics to predict policyholder behavior. We have provided very severe cash flow scenarios, sensitizing each key variable, as well as providing the impact of combined shocks. The key there is that the cash flows remain strong and resilient and remain positive in all these scenarios. This excludes any release of excess reserves or capital.
Our balance sheet is strong with assets in the captive that are more than twice that which would be required in the statutory entity and supported by hard assets. In conclusion, we believe we have a high-quality block of business with well-managed risks, an improving risk profile, and the prospects for significant net cash flows to the enterprise under a wide variety of scenarios. Thank you, and now we will take questions.
Thank you, Yanela. Dr. Bob, Chris, and Phil, if you want to come back up on stage. If I can ask for those people that have not asked a question yet to follow the precedent of my predecessor. Erik.
Thank you. Erik Bass with Citigroup. I had a couple of questions on pension risk transfer. I guess first, can you talk about how you think holistically for Pru about kind of the balance between longevity risk and mortality risk across the enterprise? In particular, where some of the markets where you're doing the longevity risk, such as the U.K., you may not have direct mortality exposure in those same markets. I guess, how do you think about the balance of those two and how it relates to capacity for PRT?
We're going to address that in the final section, Erik.
Okay.
Is that?
Maybe a second on somewhat related. I guess, I think you made the comment that when you're allocating capital to these transactions, you're not assuming any benefit from kind of the corporate level diversification. Is it right to think about kind of the IRRs that you outlined, that's how you're pricing the business in the entity, but for Prudential overall, the returns could be modestly higher and the total capital allocated could be less?
Well, it's correct that we don't take into account corporate level, either diversification or longevity mortality netting. Then I'd say in terms of how to think about the returns, we think about the returns on an IRR basis Where there potentially is further benefit that's not at the transaction level, but overall, the internal rate of returns, you'll see that there's a range from 11%-15%, as previously depicted on the slide.
Thanks.
Let's go back to John Nadel.
Thank you, Mark. John Nadel from Piper Jaffray. Just a question on the annuity reinsurance deal that you have entered into. Is there any limitation on the total dollar amount of sales on the HDI product over the next two years that would be applicable to that reinsurance program?
There is. Yeah. The deal is capped at $5 billion. It's also representing 50% of our HDI sales. It fits nicely within our expectations.
In other words, you could do $10 billion of HDI sales, $5 billion goes to the Wells Fargo subsidiary?
That's right.
Thank you.
Go to Steven Schwartz. Sorry.
Thank you. Steven Schwartz, Raymond James. A couple first for Yanela. On the GAAP balance sheet, the annuity footprint, there is a $3 billion difference between the hedged asset and the hedged liability. Does that represent the short Rho position?
In total, we have hedged assets of $7.7 billion. There is a portion in the invested assets which represents the receivable from corporate related to the portion of interest rates we hedged between annuities and corporate.
Okay, that's someplace else. The cash flows that you showed, my assumption would be, this is assuming that the short Rho position is still on, that those would be exacerbated either which way. I think your assumption was that you were fully hedged, that wasn't accurate, at least as of your end.
Yes, the assumption is that we're fully hedged. From an annuities perspective, we assume that we're hedged for all our capital markets risks. There's a portion of that interest rate risk that is hedged with corporate.
Okay. For Phil, there was a statement that you made that when you look at pricing, you look at how many people take immediate benefits, take a lump sum benefit. You seem to indicate that there was some actuarial value to looking at that indicated something, but it wasn't clear what. Maybe you can fill that out.
Sure. What I was describing is, in limited situations, there are plan sponsors that offer lump sums to retirees prior to the closing of the transaction. This was the case with General Motors. The concern or the risk that we're focused on in that circumstance, that we negotiate intensely in terms of the terms of the transaction, but also the economics of the transaction are what are the range of outcomes that we could have for lump sum elections, what percentage of the people that are available, and the profile of the people that accept the lump sums. Based on that, we negotiate price triggers where our premium changes. It increases based on the outcome of that lump sum election. The benefit for the sponsor is they get certainty in terms of the potential outcomes.
The benefit for us is we're protecting against anti-selection risk based on the volumes and profile of the lump sum elections.
John Hall.
Thanks very much, Mark. John Hall with Wells Fargo, and this is for Phil. I was wondering if you could just talk a little bit about the pipeline in the PRT market, how that might have changed with interest rates and some of the drivers there, and just a way for us to size it.
Well, it's an unpredictable pipeline. I'd say the dynamics in terms of what drives PRT activity, of course, is the dynamic of the plan sponsors, their awareness of the risk, and their willingness to transfer that risk. I think the desire for a PRT transaction is very high. In the low rate environment, the economics associated with it creates a trade-off from a plan sponsor's perspective. I'd say there's a high level of inquiry, the sort of pluses and minuses on the drivers. Higher PBGC premiums, increased measure of longevity, which will soon be reflected in both funding and accounting measures for sponsors in terms of upping their liability. Headwinds, though, are the funding status driven by low rates and driven by a prioritization to proceed with lump sum transactions outside of pension risk transfer. Previously, I answered a question about retiree lump sums connected with annuitization.
Many plan sponsors are putting their first project to be issuing lump sums, particularly to vested, terminated, deferred participants, and doing so with the interest rate and mortality environment they currently face. That's a priority for sponsors. Punchline is both the U.S. and U.K., very high level of activity, but very difficult to predict the timing that activity will transact because it is lumpy. If you lengthen the time horizon, my conviction goes way up, but in the short term, it's unpredictable.
I guess could you say if that activity level is higher from a year ago?
It's been consistently intense in terms of inquired interest, but each plan sponsor has a trade-off, as you know, between their desire to de-risk and not wanting to be exposed to the volatility that they have versus the hope that rates will go up. There's some portion of sponsors that decide to take interest rate agnostic stances, and that's what was interesting about the jumbo transactions of GM, Verizon, and BT. In each case, they transferred only a quarter of their liabilities where they're effectively dollar cost averaging out. The activities remain consistent, but I've been a very poor predictor of volumes. In fact, with Prudential management, my batting average saying, "Well, gee, if rates decline, people won't transact." I said that about a year prior to GM and Verizon, so I would discount my predictive skills in terms of
Fair enough. Just as a quick follow-up.
Yeah.
You did a transaction with Kimberly-Clark earlier in the year, and it was somewhat unique for what you've done in the jumbo market, in that it was a party transaction where you shared it with another company. Is that something that sort of limits your opportunity, or does it expand your opportunity in the PRT market party transactions?
I think what was interesting about Kimberly-Clark is that you had a dynamic, which was obviously a split insurer transaction, John. I think that's going to be part of the solution toolbox. Each year in the PRT market, it's been growing. On my comments about the market growth, you take GM and Verizon out of the picture, the remaining market's gone from $2 billion to $4 billion to $8 billion in the U.S. I think part of what will create opportunity is not only funded status rising, but more sponsors observing other sponsors transacting, getting more comfortable with the concept, and more solutions coming to the market. In Kimberly-Clark case, you had both the independent fiduciary and the plan sponsor who wanted our execution skills but saw value in a multi-insurer structure.
While the pie could get split amongst multiple insurers, I think the pie is going to get bigger each year, especially as funded status increases. I'd add that what was attractive about Kimberly-Clark from our perspective is not only designing a solution that the real-world values, so that that'll create more transactions. That split insurance arrangement was one where we can say confidently that the premium that we received was as high as any other insurer for the liability taken on, and that we received additional premium for being the lead administrator. Our execution skills, that'll be continued to be valued in the market. We're confident that that's the credibility that plan sponsors are going to value. If it means that they're split transactions, we're fine with that.
Suneet. Margo. Further up. Right down the aisle.
Thanks, Mark. Suneet Kamath from UBS. I was hoping you could update us on your thoughts on the Department of Labor's fiduciary standards as it relates to both annuities and retirement. In particular, in annuities, we're going to see an impact on growth for the industry, as well as the propensity for companies to use living benefit riders, versus kind of what we've been hearing of late, which is companies have been dialing back risk. In retirement, I think you had mentioned at one point, Chris, service capabilities and Prudential Advisors. I guess my concern is, are those individuals going to get wrapped up into this fiduciary standard issue as well, which might limit their ability or willingness or liability for providing advice to plan participants?
Suneet, I'll start off by addressing that question that kind of on an overall basis, and then I'll invite Chris and Bob to follow up. We certainly support the development of regulations that provide transparency to our clients and that give them increased confidence that they're doing business in a framework that safeguards their interests. At the same time, we and many others in the industry feel it's important that steps taken in that direction not produce unintended consequences. In the case of this regulation, some of the unintended consequences that could be at risk would be the restriction of the access on the part of clients to advice and to solutions that are important elements in addressing their financial security, including very much retirement income solutions and including the very specific guaranteed lifetime income that are pretty distinctive to variable annuities.
We've been a thoughtful and constructive participant in this dialogue, both in our own right and through industry associations. We know the dialogue's an open one. We hope it will ultimately be a productive one. We'll see how it unfolds. At the same time, we do feel very confident that whatever changes are produced in this framework, we have the business mix, the strength of franchise, and the specific business models that will enable us to cope effectively with changes. What do I mean by that in terms of business models? Just to go into a few specifics. Number one, while we do some IRA rollovers that we actually transact with clients, that's a relatively limited portion of our overall business mix, those ones that we transact.
Number two, in the retirement business and in DC record keeping, virtually all of our business is done with plan sponsors over 100 participants. Number three, in the annuities business- Even as we pursue our product diversification strategy very successfully, the bulk of our business, over 85%, is done with living benefits, HDI and PDI. The value to the policyholder in VAs with living benefits is there, whether it's sourced from non-qualified money or from qualified money. Chris and Bob, other points?
I'll just address the question about advisors. As Steve said, virtually all of what we're selling is in the mid to large market, so it's larger plans. There, the advisors, the vast majority of them, already are taking fiduciary. They've got what's called 3(38) fiduciary status. They are making the recommendations to the plan sponsors. While a few of them may have practices that involve IRA rollovers, most of what we're working with are, I'll say, true plan specialist kinds of firms. They don't really see this as anything different than a standard that they've had to live by for the past several years.
I'd first disclose that my predictive capabilities are almost as good as Phil's. With that said, I think that there may be a kind of a 2-stage impact on the marketplace. I think, look, the job has gotten a little bit harder because of the administrative burden with the regulation, right? I think we should acknowledge that. Increased transparency and better understanding should translate into greater market confidence, and in the long run, I think bodes well for the industry. Again, we're aligned with the regulators in the best interest standard. I think it's hard to argue that that's not a good thing for everyone. There is a bigger administrative burden that could create some short-term headwinds. Long term, though, I like our chances.
Okay, thanks. I guess relatedly, the other regulatory issue out there is some inquiries around non-cash compensation in the annuity market, referring specifically to Senator Elizabeth Warren's inquiry on this matter. Can you just talk about your approach, whether you use non-cash compensation, and if you do, maybe what % of the business that you're right is that associated with?
I think the Warren letter highlighted kind of a separation in the annuities industry. We're already subject to all the FINRA regulations around non-cash compensation, consistent with mutual funds and other securities. To that extent, that inquiry really doesn't affect the business that we're engaged in.
Okay. Is there a way that it does affect your business, or you're saying that you're not expecting any impact at all from this?
The extent to which I think there's better understanding and greater transparency across the business or the industry, I think it will bode well for all of us. Many of the questions that Senator Warren raised have nothing to do with the business that Prudential is engaged in.
Okay. Thank you.
Let's go to Nigel.
Thanks. Nigel Dally from Morgan Stanley. Just looking at the retirement business between 2013 and 2014, we had very good growth in assets under management, up over 10%. Yet, when we look at the earnings, they were flat excluding the notable items. Just hoping you can explain why the return on assets is coming down in that division.
I didn't quite get the question to be honest.
Can you repeat the question, Nigel?
The return on assets, in the retirement division, why has that been coming down? Excluding notable items.
Return on assets coming down.
He wants to know why they come down.
Pardon me?
He wants to know why their ROI comes down.
We've had a growth. It probably ties to our business mix in some respects here. We have had a shift in business mix between 2010 and 2014, where in the earlier stages, we were more full service oriented. We have grown in investment only Stable Value. We've grown in PRT. There has been price pressure in the full service business, I don't think we're unique in experiencing that across the industry. There is some spread compression as a result of interest rates coming down. I think those are the factors contributing to it.
Yeah, Nigel, the other point is that you have a lot of longevity transactions that have been added, and those are going to come in at a very different ROA than you would expect on a PRT. When you do a BT deal of $27 billion, that's a pretty meaningful increase in the account values, and that obviously doesn't have the same ROA.
Second question, just on the annuity transaction, on the annuity reinsurance. Can you discuss the cost of that? How is that impacting your new business return on equity from what it was previously?
We're ceding 100% of the rider fee for 100% of the risks on the living benefit. We do expect it to be a positive impact on pricing of the new business.
Thank you.
Let's go right up the line there to Ryan.
Thanks. Ryan Krueger with KBW. I had a question on the VA cash flow scenario. I think you mentioned that maybe at least in the baseline, you assumed that you were fully hedged. I think you're under-hedged interest rates. How does that under-hedge on interest rates come through the projections, I guess, in both the base and the stress scenarios?
Again, for the cash flows, we are assuming we're fully hedged. Whether rates move up or down related to the underhedge, those cash flows would not change from an annuities perspective.
We do have a portion of the interest rate that is reinsured to corporate. That risk is managed holistically at the enterprise level. Obviously, depending on where rates go, the total cash flows would change either up or down.
I guess in the stress scenario where you stress lower interest rates, is that not fully capturing the potential impact given the underhedge?
The stress scenario assumes that we're fully hedged. We do assume a 20% level of breakage in the hedging on the negative scenarios. Again, in that negative scenario, the impact on the underhedge would be offset and managed at the enterprise level.
Ryan, let's let Rob address that in the final section. He can talk about that more broadly.
I guess could also be for that. Just on the captive, there's a $4.5 billion difference between the reserves that you're holding and the statutory reserve credit. If you consolidated the captive today, would your statutory capital effectively go up by that difference, or are there other offsets we should think about?
There is a significant difference. That's because the reserve in our captive is based on a modified GAAP, which is more risk neutral, and the statutory reserve is more like a real-world scenario. That difference is substantial today. It does depend on level of interest rates. Now if we were to recapture, that difference would be monetized, there's other moving parts as well. There's also RBC and other portions that would come into place, not just the reserve difference. The reason that we hedge within the captive, as I mentioned, is that we are better able to align the hedging and the accounting, which is not easily doable in a statutory entity, given the STAT rules today.
We'll take one last question in this section. Yaron?
Thank you. Yaron Kinar with Deutsche Bank. I have a question on the lapse rate assumptions. If I turn to slide 10 of the annuities presentation. One thing that was somewhat counterintuitive to me was as I look at a low interest rate environment, kind of the left side of that figure, I would've thought that the spread between at-the-money and in-the-money lapse rates would actually close, where at-the-money lapse rates would actually come down much more. I don't see that as the case in this illustration. Is that just illustrative purposes or that I've missed that, or am I not thinking of this spread or the behavior correctly?
This is a stylized view, it's not plotted perfectly. Again, the gap between the two is driven by the level of in-the-moneyness. The interest rate sensitivity is reflected by the slope of the lines. Now, the gap will move around depending on the level of interest rates because the in-the-moneyness level will change. We're assuming that this is always a policy that is 20% in the money.
Right. In a low interest rate environment where you have fewer alternatives, I would just think that as an at-the-money account holder, I would necessarily not look at alternatives or they're just not out there.
That's exactly the slope of the line. Right?
It doesn't close. I mean, the gap between the at-the-money and the in-the-money customer does not close in that or shrink, let's say, in that scenario.
No. That gap is looking at different options.
Okay.
That's just always 20% of the money. It's not-
Yeah. Okay.
It's illustrative. It's purely illustrative.
Okay. Then one question on the PRT business. Is there an economies of scale benefit? As clearly Pru's been very active in the jumbo space. Does that necessarily give you some advantages over time that maybe accumulate?
Well, I'd say in terms of economies of scale, there's not an economies of scale when it comes to the risk, meaning we're going to evaluate each longevity exposure and mortality improvement trends individually. There is an economies of scale in terms of operations and asset liability management being done efficiently. I'd probably say the most important economy of scale is the talent economy of scale. There is a learning curve, and an assembly of talent across various disciplines that each time we transact in the market, we're challenged with a new component that we have to decide and structure so that there can be a win-win outcome or decide that it's a risk that we don't want to embrace. I think the economy of scale comes around really from the learning curve as opposed to volume and economics.
Sure, incrementally paying another 100,000 pension checks each month, there's a small incremental economy of scale. The real issue is the learning curve.
Thank you.
Okay, I think we're going to take our third and final break ahead of the financial management section. If we could take a 10-minute break and be back promptly, that would be great.
This is a good way to start off.
If we could please take our seats, we'll get started momentarily. Okay, I'd like to introduce Robert Falzon, our CFO, to talk about financial management in our final session.
Thank you, Mark. Good afternoon or good morning still, or just past afternoon, everyone. We're bringing down the home stretch. You've heard from John, Mark, and our business leads today about our success and how it comes from talent and the way in which we collaborate, innovate, and execute to provide a superior client experience. That formula is what defines culture at Prudential, and it's what drives commercial success and shareholder value. Our success is manifested in a business focus which produces a diversified and balanced mix of insurance and markets risks. Financial strength as evidenced by our capital leverage and liquidity metrics as well as by our robust risk management framework. By a balanced and sustainable sources of earnings resulting in a targeted 13%-14% ROE through a market cycle, growth in earnings and in book value per share.
Importantly, in the consistency and transparency of our earnings. We expect that an increasing percentage of our earnings will translate into free cash flow, which can be redeployed to enhance growth and to grow our distributions to shareholders. We provided guidance that the expected free cash flow would increase to around 60% of earnings over a period of time. We are focused on the sources of volatility in our reported earnings, including both AOI and GAAP net income. Our focus on protection, retirement, and asset management allows us to construct a diversified and balanced mix of insurance and market risks that can provide both stability and a superior return, as could be seen on this graphic, which shows our more insurance sensitive businesses on the right-hand side in green and our more market sensitive businesses in blue on the left-hand side.
We are going to come back to this when I address our risk management framework. Turning to our financial strength and starting first with our capital capacity. We generally measure available capital by looking at the capital we have in our businesses in excess of that which is required for our AA standards. At the end of the first quarter, that amount exceeded $4.5 billion. We reduced this by an amount that is necessary to bring our financial leverage ratio down to our target of equal to or less than 25%. This was about $2 billion as of the end of the first quarter, including $1.4 billion that was going to be funded from the closed block restructuring and as part of the dividend that we received from PICA in the second quarter.
The result is that greater than $2.5 billion of balance sheet capital capacity that we identified during our earnings call. We generate a substantial amount of capital from our businesses each year. We have some sensitivity to markets, and in particular to interest rates, and that sensitivity has resulted in both some upward and downward adjustments to our capital capacity in any given quarter. We expect this within ranges that we have determined to be acceptable. I am going to come back to this topic in just a few slides. If you look at the composition of our capital, we target a financial leverage ratio of less than or equal to 25% with equity at 70%-75% of total capital. We also target hybrids to be at or below 15%.
For purposes of calculating our financial leverage ratio, we give hybrids a weighting of 25% equity and 75% debt. The remainder of our capital stack is senior debt. As of the first quarter, we were near our targeted ratios, though our financial leverage was above our target. This is before the adjustment that we make to our capital capacity to bring that leverage back down. All else being equal, we expect to be within our targeted range within the near term. Moving from our financial leverage ratio to look at our total leverage. Total leverage includes operating debt. Operating debt is financing where the proceeds have been used to invest in financial assets or cash and includes all of our AXXX and XXX excess reserve financing. Total debts declined by $2.5 billion since 2011, despite the growth in our business over that period of time.
Our total leverage ratio has declined from about 50%-44%, which is within our targeted ratio of less than or equal to 45%. For purposes of calculating our total and financial leverage ratios, we exclude from equity all of AOCI as well as NPR, net of DAC, and the cumulative impact from FX remeasurement. At March 31st, end of the first quarter, we had $3.7 billion in net cash. Net cash excludes our intercompany liquidity account and any proceeds that we have from commercial paper. We have substantial sources of additional holding company liquidity, including a $1.5 billion innovative 10-year funded contingent capital facility and $3.8 billion from our bank credit facility. That facility was recently replaced with a new 21-bank, $4 billion five-year credit facility. It has a net worth maintenance covenant, it has no MAC clause.
We also have about $2 billion of capacity through our commercial paper program and our intercompany liquidity account. Our risk management framework starts with an economic assessment of our risks. However, risks emerge differently in different regimes, including GAAP, STAT, and tax. While our economic framework is directionally aligned with the different accounting regimes, there is a level of volatility or noise that occurs between those. We're increasingly looking to reduce or eliminate unnecessary volatility where we can. Creating the divisional structure in Japan helps significantly in this effort by substantially eliminating the non-economic FX remeasurement breakage that we had in US GAAP. We think of our risks generally in 3 categories: insurance risk, market risk, and operational risk. We manage these risks individually at the business unit level and also aggregated across the businesses at the enterprise level.
We have a set of tools for doing this, including product design. By way of example, you saw in the earlier annuities presentation, introduction of new product, including the innovation of our PDI product, which has allowed us to sell guaranteed annuity products without adding to our equity market sensitivity. Our tools also include diversification and pooling, disciplined asset liability matching, hedging, and internal controls, including risk appetites and limits, and contingency planning. We look to have a balance of risks which optimize our enterprise-wide risk and capital positions and the returns that we generate from these positions.
Returning to our insurance risk management framework and perhaps to address some of the questions that came up earlier on this topic, this slide addresses how we calibrate our risks of life expectancy changes between our mortality businesses, primarily our U.S. individual life business and the international insurance business, and our longevity businesses, which are primarily in the retirement and annuities businesses. We calibrate that such that, as shown here, we're substantially equally weighted between them and therefore have significant correlation benefits. These correlations are not perfect. This graphic assumes the same level of longevity stress across all populations and geographies. We actually insure very different populations within and between our businesses. There are correlation benefits, but mortality and longevity risks are not entirely offsetting, and we don't account for them as such.
To be very clear, we do not price on the basis of these correlation benefits, but we do manage risk at the enterprise level, factoring in those correlation benefits. Moving to market risk management. Our businesses and the capital supporting them are sensitive to markets. We think about market risks along a spectrum that we tried to show here graphically that ranges from tail risks to less severe scenarios in what we call the body of the distribution. Our objective is to take off the table solvency risk associated with the tail events, and we do this through our capital protection framework. For less extreme market conditions, those that are in the, quote, "body of the distribution," we hedge the vast majority of our equity and interest rate risk through product and portfolio hedges. We think about these risks across the businesses netted at the enterprise level.
For instance, interest rates. Our annuities business has exposure to declining rates. Other parts of our businesses have exposure to rising rates, particularly spikes. That includes businesses like our retirement Stable Value and our international bank channel products. Even with hedging, we accept some level of volatility in our excess capital capacity in any given period. The economics may offset, but accounting may not reflect that. In addition, other factors include the fact that those risks are nonlinear in nature. They change as the markets move, and the available hedging instruments sometimes don't track these movements well. In addition, there are variances between business where we may not be able to move the capital between those in any given period. We constantly recalibrate our hedging to address risks as markets move and as our capital capacity and leverage change.
We have multiple tools for effecting this and ensuring that we remain within our risk tolerances. When we think about those risk tolerances for cyclical stresses, we generally seek to ensure that we remain above our 400% RBC target at Prudential. We maintain a level of positive excess capital capacity. We maintain a financial leverage ratio in line with our targeted 25%, and that we keep cash to the parent company above our targeted minimum of $1.3 billion. The types of cyclical stresses we anticipate include interest rates, equities, and credit events, both individually and in combination.
By way of example, we would consider as benchmark individual cyclical stresses as a decline in interest rates to below 1.5% on the 10-year treasury, a 30%-plus decline in the equity markets, and the impact of a moderately severe credit scenario comparable to what we experienced in the financial crisis and equal to about five times our expected annual credit losses. In each stress scenario, we include the impact of AAT reserves and of the reserve and capital requirements in all of our entities that sit outside of PICA, including Pruco Re, which is the annuities captive. In each stress scenario, we meet our capital leverage and liquidity objectives. In a combination of severe cyclical stresses or more severe individual stress scenarios, in other words, moving along that arrow further out toward the tail, we would still target to maintain a strong capital position and ample liquidity.
In such scenarios, RBC could temporarily fall below 400%, and/or we would allow leverage to rise above our target. This is very consistent with the way we manage the body of the distribution, and we would target maintaining competitive ratios calibrated to the severity of the shocks. For extreme or the tail market risk, we expect to maintain an adequate and competitive regulatory capital position. We would allow our financial leverage ratio to rise, but we would maintain an adequate cash position at the holding company. By tail stress, what do we mean? We mean a 50%-60% decline in the equity markets, a significant movement up or down in interest rates, depending on which is binding in the geography in which we're operating.
A credit event equivalent to the three worst years of the Great Depression compressed into a single year, and an appreciation in the yen to JPY 80 to the dollar. Understand that that's actually good for our business. In the short term, it creates a temporary capital strain as a result of our hedging that John discussed earlier. The tools we have to ensure that we meet these objectives include our existing balance sheet capital capacity. It would include allowing our RBC ratio to decline to below our targeted 400% level, if the severity of the stress called for that. We have derivatives, including our macro equity and interest rate hedges, contingent capital, including the $1.5 billion contingent capital facility that I mentioned earlier.
We have the $4 billion credit facility, along with Federal Home Loan Bank borrowing program that we're a member of at our U.S. insurance subsidiaries. Our disciplined capital and risk management and strong business results have produced attractive financial results as shown. EPS has grown by a highly competitive 18% compound annual rate since 2010. Similarly, our return on equity has expanded by 560 basis points over this period and is currently above what we call our long-term sustainable target of 13%-14%. Our book value per share growth has been less robust. This is driven in part by the noise that we've discussed that's occurred between our reported AOI and GAAP net income. As John mentioned, we're very focused on reducing this volatility in our reported results.
That financial performance has also allowed us to redeploy a substantial amount of capital in acquisitions and to our shareholders. Since 2010, we have redeployed $10 billion of capital. Going forward, we expect that our free cash flow will be about 60% of our after-tax AOI over time, allowing us to consistently return capital to shareholders and to deploy toward other accretive uses. To summarize, our focus on protection, retirement, and asset management produces a diversified and complementary mix of businesses and risks. We're financially strong, as demonstrated by our capital position and our balance sheet ratios, and we're able to withstand meaningful shocks in our market and insurance risk exposures. We've demonstrated growth in earnings and a superior sustainable ROE. We're focused on the consistency and transparency of our earnings going forward.
We have been good stewards of capital, balancing risk management and capital preservation with capital redeployment to enhance growth and to grow our distributions to shareholders. Thank you.
Thank you, Rob. If Mark and John would like to come to the stage, we'll start our final Q&A. While Mark and John are sitting situated, Rob, do you want to address Ryan's question?
On the assumption, is this on? Yep.
The underhedge, the question.
The topic that came up with respect to the underhedge during the annuities discussion. To be clear, as I mentioned during the course of the presentation, we're looking at our interest rate exposure across the enterprise. From an annuity standpoint, they've done their analysis appropriately, which is on the assumption that they are fully hedged because of the intercompany hedging that we've done and taken that underhedge out of annuities and into corporate. That underhedge is offset by exposure we have in interest rates going in other directions in other products.
Having said that, specifically with request to the question of what happens in the stress scenario where interest rates go very low, understand that in our risk management program, while we have a tolerance for capital volatility within the body of the distribution, should interest rates decline to the levels that were described by Yanela in the presentation, at that point in time, our hedging strategies kick in such that the underhedge effectively is gone well before we hit those levels of stress. In fact, the cash flows that Yanela showed would be both the corporate cash flows and the annuities cash flows because we have closed out that underhedge position well before we've gotten to that level of interest rate stress.
Did we, Ryan, address your other question regarding the longevity mortality appropriately? Or sorry, Eric, go ahead.
Do you mind if I make an ask? Is it too far?
I guess looking at the longevity bar and the mortality bar, they look relatively balanced now. As you think about the business mix going forward, the past few years, you've been growing the longevity businesses faster than the mortality businesses. Is how much more capacity do you have to grow longevity?
A couple thoughts with regard to that. First, recognize that while the longevity business is growing more rapidly, it also decays significantly more rapidly as well. When we bring on a pension risk transfer transaction and book that day one, the payouts begin on it immediately. We need to generate $3 billion-$4 billion just to stand still with regard to that longevity exposure. We have lots of capacity that's freed up each year as the existing book of business runs off, and we need to replace that existing book of business. Our mortality businesses continue to grow.
We're constantly looking at our reinsurance positions with regard to those businesses, we look to calibrate the level of reinsurance we're doing in order to make sure that we keep a mortality exposure on the books that's appropriate in light of the longevity opportunities that we have, that's a tool that we can actively manage.
Okay. Right next to you.
Humphrey Lee from Dowling & Partners. Just a question for Mark. Over the past couple of years, you've talked about comparing the insurance business model versus banks' business model and how you've been working with the regulators in terms of getting that point across. Maybe can you comment about how receptive the regulators have been? Have they changed in terms of seeing your point of view from the kind of business model differences between the banks and the insurance companies?
Yeah, let me make two comments on that. One is that when the Collins Amendment passed, that was very constructive in terms of the opportunities that we have now to be clearer about how different the insurance world looks relative to the banking world. The second comment is that I won't speak for the Fed in any regard, but I would say that we've had very constructive opportunities to talk about the kinds of things that Rob has talked about, the kind of things that I talked about. The process is thoughtful and deliberate and, I believe, very much focused on trying to get it right.
I think that one of the biggest question with regard to non-bank SIFI is what the eventual higher loss absorption would be, and I guess maybe can you share some of your comments on, in your perspective, what would that be? What we are looking at, and how should we think about in terms of that loss absorption buffer?
Your question is about the international framework that calls for so-called HLA on top of basic capital standards. Is that what you're at?
Yeah, part of it, I think eventually when you look at non-bank SIFI, just the loss absorption would be probably part of the capital adequacy calculation as well. Maybe you can share some of your thoughts on this topic.
Yeah. My first thought is that we need to make sure that we're having the scaling discussion, which is really sort of behind that question, in the right framework. We've been very focused on understanding what loss absorption capacity really means. Loss absorption capacity is on the asset side, not in the capital account. The notion of the assets that are available to absorb losses and the way in which those losses play out are realized and then funded by the available assets is kind of the theme there. I talked about this last year in the discussion of margins and reserves. Beyond that, I don't think we have a very specific thought at this point on scaling beyond the kinds of things that Robert Falzon talked about.
You've heard how severe the stresses are that we put ourselves through and how we make our capital protection plans to ensure that we're meeting our business objectives and corporate objectives in those very extreme scenarios. Some of this will depend on how the cash flow environment shapes up relative to the financial statement environment, and then we'll have the scaling conversation. I'm not ready to put a number out around a loss absorption scaling, meaning, is it 6% or 9% or 3% or 1% until we have the framework pulled together the right way. You've heard elements of it here in my conversations about how we manage the products and how they flow through the financial statements and from Robert Falzon in terms of the stresses that we subject ourselves to in our own planning. As you see from that, they're very extreme.
Thank you.
Is there anybody that has wanted to ask a question but not had an opportunity? Randy, I think that is.
Yeah. Thanks, Mark. It's Randy Binner with FBR Capital Markets. Looking at just page 14, I guess this is the second to last year, M&A has been less represented in the last three years. Steve mentioned that the turnaround was complete in Group, for instance. Maybe there's growth opportunity there with a better economy. Is there areas of the business that could benefit from scale, and can you talk high level about M&A as potentially used to excess capital?
Well, I'll take a go at that. The way we would look at M&A is it's like to do, not have to do. We feel very good about the businesses we have. We feel very good about the market positions and the quality of the businesses and the like. If it's an opportunistic opportunity within a line of business, we're certainly open to consider it. We're not dependent upon it to achieve our goals and the objectives that you see. Also, it's fair to say that we're in a phase of the market cycle that's less naturally suited to our inclinations in M&A, meaning we tend to be more active in the less favorable parts of the cycle than we are during more buoyant times like this.
Finally, our focus is less on relying on episodic instances like that and more focused on not only the health and vitality of our existing lines of business, but finding increasing ways to span across businesses in ways that historically we haven't. Meaning back 10 years ago or so, where we weren't where we wanted to be performance-wise, we were very stovepipe oriented by intention and by design. In today's market environment, we're at a very different place in the quality and maturation of our businesses, and we're seeing increasing opportunities to span across lines of businesses, Steve made some references to this, in ways that, competitively speaking, will both enhance the value proposition to our customers and ultimately, over time, enhance the financial outcomes for Prudential as well.
Those are the areas that tend to get more time and attention in our interest today, rather than the reliance upon M&A to strengthen or shore up a business because we don't feel we need it.
Yeah. Suffice to say, the things you're looking at now, they're pricier? They're not as attractive as they would've been a few years ago?
Well, suffice it to say that there are more buyers who are able to participate in today's marketplace than there would've been in years gone by, that tends to get reflected in the overall dynamics. Most of the things we've done historically have not been in a classic auction environment. They tend to be more private, off-market type of arrangements, whether it was with AIG and Star and Edison or other examples. Those examples are less prevalent in today's environment than they are in other phases of the cycle. Life's not linear. There are more cycles out there, we like to navigate those in an appropriate way. That's why it's important to us to have the capacity not only in buoyant times but in adverse phases of the cycle to be able to be opportunistic and move and be offensive, not just defensive.
Let's go to the far back. David Small in the blue shirt.
Hi, David Small, J.P. Morgan. Could we just follow up on the question of the VA captive, I think that was asked earlier, in terms of the RBC impact if you were going to consolidate the captive? I guess I'm just still a little unclear on that.
I think the way Yanela described it was accurate, which is that yes, if you look at the credit we're getting for ceding the insurance to the captive, that number is less than half the reserves that we're holding at the captive today. I think Yanela's caveat on what happens as a result of if you just recaptured it is that today, under existing statutory accounting requirements, the derivatives that we use as assets to back that liability would actually not be admitted.
We have other similar dynamics or nuances to what we do in Pruco Re that we would need to have accommodated back at the ceding company in order to be able to conduct the activity the way in which we're currently doing it, which is, remember, we've done this in order to be able to aggregate the risks in an appropriate way, hedge them efficiently by virtue of the aggregation and also by virtue of the accounting that we get that hedging matches up with both the statutory and the GAAP accounting.
Those are things that if you ceded it back in, you would want to make sure that the assets that are currently qualified would continue to get qualified and that some of the manifestations of the efficiency of the hedging also translated into that host company such that while you might get a day one capital pickup, you would find that that might dissipate on you as a result of a lot of breakage that would occur between a statutory capital construct and the economic capital construct that we're currently using. Yes, the simple math is there's a substantial difference between the reserves that we carry and that would be required at the host company, and that provides some running room, frankly, for being able to figure things like that out, should we elect to do so.
Just a quick follow-up. You file a consolidated financial statement on a New York basis that shows a considerable difference between your home state and New York. How do you think investors should think about that difference, which I think was a little over $7 billion of capital?
Okay.
Thanks.
Recognize first that this is an unmanaged outcome for us, that all of PICA is filed under that New York statutory blank. Let me make sure you understand what that includes, therefore. That's virtually 100% of the mortality risk that we have within the U.S. enterprise, including the use of captives. The captives reinsure the mortality risk back up to PICA. All of the enterprise U.S. mortality is captured in that entity. It also captures the Hartford acquisition that we did. Therefore, most of our GUL exposure, which came along with Hartford, is captured in that as well. Our long-term care business continues to sit in PICA, and we have not reinsured that back out.
When you're looking at the impact to our organization, to PICA under the New York statutory requirements, you have to recognize if you understand their reserving methodologies, if you name the three areas where they are most conservative, I just named them for you, okay, where you'll be most hit both on mortality, on the GUL assumptions, and on long-term care assumptions as well. This has not been a constraint for us. We have plenty of excess surplus to have absorbed that increase in reserves. We haven't felt compelled to manage an outcome with respect to those New York reserves. If for some reason that became a constraint for us, there are a number of levers that we could pull in order to change that outcome.
At this point in time, it is not an economic consideration for us, my specific answer to your question would be is I don't think investors should think about that as being a factor in how you would think about our solvency and the adequacy of our capitalization.
Go back to Thomas Gallagher.
Thanks. Thomas Gallagher, Credit Suisse. Hey, Rob, just to follow up on David's question, if you were to recapture the VA captive into the opco, would your consolidated RBC go up?
I have a hard time answering that question, Tom, because it would require a change in accounting. I think the answer to that is, just given the absolute quantums, the answer is obviously yes. Again, that's with a discussion we'd have to have with Arizona as to how that rider would be accounted for back at the host company.
Okay. Just a broader question, do you believe the VA captive structure is durable? Is this something, just looking at the environment, federal regulation that's coming, does it make sense to continue to operate in that manner, or is that something that you're contemplating changing?
Let me remind you of why we set that captive up in the first place. As I mentioned, it aggregates risk, then we're able to hedge all of that risk in one place. It creates, and I think this was unique and important to us, it created an alignment between the way in which we're reporting on a statutory basis, on a GAAP basis. We have something called modified GAAP that's used within that entity, and that's our statutory accounting. As a result of using that accounting, it allows us to use readily available market instruments in order to hedge the liability and have those hedges track the accounting outcome. Importantly, as I mentioned, those hedges are admitted assets within that.
If we were to think about doing something different with regard to that captive, we would want to look at, obviously, what capital gets freed up today. There's a pretty obvious answer to that, as has been implied earlier. We'd also want to look at the GAAP accounting. We'd want to look at the statutory accounting. We'd want to look at the hedge efficiencies or hedging efficiency that would occur under that. We'd also want to make sure that we understand liquidity and capital trade-offs. You want to look at all of those things under a variety of market circumstances. The answer is, we're constantly looking at that. Would we consider it? If we had good answers to all of those questions, we would absolutely consider it.
Okay. Just one follow-up on the information you gave out on total leverage of 45%. I guess I've never seen that presented in that way before, and I'm just not clear on, is there a target for total leverage? Is 45% where you're managing to, or can you help provide some context?
We do look at that as sort of a maximum level. We want to be underneath that 45%. We've had discussions with the rating agencies over time about not just our financial leverage, but our total leverage. For most of the rating agencies, if not all, they're increasingly focused on a total leverage exposure, not just a financial leverage exposure. This resonates with them. We began a number of years ago, actually a couple of years ago, to introduce that into the dialogue. We do manage to both our financial leverage ratio and our total leverage ratio. You need to understand that 45% appears high, but that's because we've taken a lot of stuff out of the denominator. All of AOCI, NPR, the FX remeasurement, although that's a negative today, but we've removed all of those things.
You need to put that as not entirely apples to apples with other companies, but it's a level of leverage that we think is manageable and appropriate to the mix of businesses that we have today.
Thanks.
Right behind Tom. Is that John?
Thank you, Mark. John Nadel from Piper Jaffray. I wanted to go back to a comment, Rob, that you made in response to the sort of negative interest rate scenario or the impact of the underhedge. I think you made a comment that as rates fall, you would assume that pretty quickly you would no longer have an underhedge on rates. Is that just essentially an assumption that you'd put in place hedges at some point on the way down on rates, or can you sort of explain that?
Sure. Well, let me say first that in the second part of that question, we do all the time, daily, adjust our hedging position. Yes, as markets move, we do in fact adjust our positions. In direct answer to your question, no. Actually, I think I've described the asymmetric risk that we have as a result of the options that we have embedded in our hedging strategy. Those options provide such that if rates go below a threshold level that we consider. We have a minimum threshold that preserves all those things I spoke about before.
We want to maintain a certain level of excess capital capacity, make sure our RBC remains robust and that our leverage is in line, and that liquidity remains, that when we get to that point, our options kick in and the underhedge goes away by virtue of the exercise of the options. Those are in place today.
Okay, thank you. Then maybe just a broader question on the bigger picture issue of the quote unquote, "this infamous underhedge." I don't know what it's costing Prudential's share price, whether it's five or 10% or something along those lines. My guess is it's considerably more cost to your market capitalization than it would be to actually close that underhedge position. At what point, let's assume rates are up 50 or 100 basis points, is there some level of higher rates that management is looking for to put in place a mechanism where you've covered this risk, and we don't have to talk about it this way?
Good question, John. Let me maybe answer it a little bit more broadly and maybe address the issue of how we're thinking about volatility. If you look at the difference between our reported AOI and our GAAP net income over the last four or five years, what you would find is that about half the volatility between those numbers was actually FX remeasurement. Okay? We knew we had to get on that. We worked long and hard, actually longer than you might understand, in order to come up with a solution for that, ultimately got it implemented. We've eliminated the most significant component of breakage, which I think is part of what you're alluding to, that noise creating an impairment and the potential impairment in the valuation of our stock.
The next most significant contributor to noise is in the annuities business, from the annuities business, about half of it would be the underhedge. As interest rates rise, that underhedge goes away all by itself over time. As interest rates rise, our interest rate exposure within the annuities books actually declines, therefore the underhedge is declining and eventually evaporates. We do match that with an active strategy around wanting to make sure that we lock in our exposure as interest rates rise to certain levels as well. The combination of options that we have in place, actions we would take, and the natural decline in the underhedge as interest rates rise, I think would lead you to conclude that we will get to a point that, just as you described, where the actually the underhedge ceases to be noise within our financial statements.
It's important to keep in mind that it's there for a purpose. We understand that it creates noise, but this is an economic view of our overall interest rate exposure, and that is offsetting other things that are going on. As interest rates change, that exposure changes, and hence the need for that underhedge will decline as well.
That's very helpful. If I could ask one follow-up, just thinking about capital deployment. You've talked about for some time that free cash flow as a percentage of earnings would be rising over some period of time towards 60%. I guess that's over some multi-year period, maybe a little bit under, maybe a little bit over in any given year. With the recent buyback authorization, though, remaining at $1 billion, I'm wondering if there was any contemplation about raising that authorization, even modestly, to reflect the likelihood that free cash flow would be rising.
We think about distributions as the two primary tools that we have for that, John, being both buybacks and our dividends. While we have a current authorization, there's nothing that precludes us from revisiting that authorization on an interim basis. As we get visibility toward how much free cash flow we have and the opportunities we have to redeploy that, we can revisit our decisions around how quickly we execute against that buyback, and therefore whether we would have to go back for additional authorization. How that buyback looks in relation to our targeted dividend level, which is another lever that we would look to moderate or to pull over time as well. I would not read too much into the billion-dollar authorization as looking as that's a baseline of buybacks that we feel comfortable with given our current position.
We have complete optionality in adjusting that over time.
Perfect. Thank you very much.
Let's go to Seth.
Hi, thank you. Seth Weiss, Bank of America Merrill Lynch. This question, I think, is probably best for Mark. I appreciate there's been very limited commentary from the Fed in terms of what they're thinking for a framework. I know the industry recently met with the Fed and proposed a framework. Could you help at least summarize how we should think of that? If current statutory requirements are a starting point, what's at least the industry standpoint for how to adjust for international and capital operations happening outside the current regulated statutory entities?
Well, I'm afraid I can't add a lot to what you said. I can't speak for the Fed in terms of what they're actually considering or how they're thinking about current statutory versus any other way to come at the capital issue. Part of the discussion is, as I said, every time we're in front of anybody, anywhere, we talk more about how we do things and how capital and risk, stat and GAAP all work for us. I can't speak for the Fed as to whether or not current stat is a starting point or something else is a starting point.
I'm sorry, but what about what the industry has recommended?
I would characterize the industry's position at this point as still in development, as opposed to specifically recommending or pushing. These are discussions of what goes on.
Okay. Thank you.
We would be happy as an industry with a statutory-based approach to capital, it's not our decision.
I suppose the last time we got an update from you or a formal letter to the Fed was back in 2012. Has there been any updates or evolution to that over the last three years?
I would just say that the process continues.
Okay. Thank you.
Let's go to Eric Berg.
Thank you. Eric Berg from the Royal Bank of Canada. Just one question on pension risk transfer. You have said that a material part, a meaningful part of your earnings in the retirement area related to a favorable case experience, that that was important, I believe, last year. My question is what happened that you priced the business conservatively, and because you knowingly priced the business conservatively, you got people living longer than you priced for? Or was there a genuine surprise in lifespans?
Let Phil answer?
Yeah.
Yeah, I think we should probably go back to Phil.
Let Phil answer that.
Thank you. First of all, the experience gains are people dying sooner than expected. Just to frame that. Sure. Naturally. What I would say is that, of course, we assess base mortality and mortality improvement conservatively with expectations of the level of mortality improvement that will emerge over time. That's sort of a buffer that we have. These cases were written in 2012, and while we've had positive experience, I think it's premature to draw a prospective forward-looking conclusion, meaning these are long-term obligations with long-term trends, and we're comfortable with the conservative assumptions we went into the transactions with. We had a favorable short-term result, which we're happy from an economic perspective, but I wouldn't make a forecast at this stage.
Thank you. Jay with the Jay. With the blue shirt.
Jay Gelb from Barclays. With regard to the new reinsurance arrangement in variable annuities, does that increase your appetite to increase sales beyond sort of that $10 billion annual run rate?
That's Bob's answer.
Yeah. Bob, how about you? Let's get a mic to Robert O'Donnell.
Not necessarily. We view the reinsurance deal as a tool that we use to manage our risk, again, accelerate the diversification of our business, not so much as one that might take the lid off any expectations we might have on production.
Thanks. Maybe you can, just as a follow-up, give us a bit more insight in terms of why you wanted to engage in the reinsurance transaction. In the past, we've gotten the sense from Prudential that you've been very comfortable with your living benefits exposure, now to reinsure it away, with all the associated fees, that seems to be a bit of a change.
It is, and it's consistent with the strategic direction to diversify our risk profile further than we had within our single solution. As you know, the HDI product creates an embedded risk mitigant, and we have expanded our approach to managing the business risk to beyond that within a single solution to the entire portfolio, and the reinsurance deal is consistent with that strategy. We began that focus about two years ago and have now executed on the deal, again, consistent with the strategy. Thank you.
Go to Colin.
Colin Devine, Jefferies. Three questions. First, we're almost at the end of the quarter. I wondered if you can give us any update on the annual reserve review for number 1. Number 2 for John, in your prepared remarks, you did not talk about the DOL fiduciary proposal. Perhaps you could share your thoughts on how that may impact your thinking if it goes through essentially unchanged on some of your businesses, whether it's DC, annuities, or the career agency, perhaps. Lastly, on ROE. I think we heard from Charles, he's pretty confident international's going to continue to crank out a high teens ROE, perhaps 19%. If you're sticking to the guidance of 13-14, that suggests to me the other half of the business you think is going to be in the 8-9 to 10.
Are there parts inside that, maybe domestic Group, that can be improved more or may not make the cut as we look forward?
Why don't we start with the assumption?
We can't comment on the assumption updates. The only bone I can throw you, Colin, is I think Yanela made the remark about the enhancement in the modeling that we did in the 3rd quarter of last year, in order to bring pricing assumptions in line with the actual experience. Having something which reflects that, is reflecting our current actual experience, and being able to hedge that, I think that's been a major advance in our annuities business. But with respect to any specific outcomes from our annuity assumption update, you'll have to wait till the 2nd quarter on that. John, do you want to handle-
I'll take the ROE topic, and then I'll ask Steve if there's anything he'd like to add on the DOL question. If you think about the ROE subject, this is an area of intense focus for us for a long time. What we did in 2010 was express our goal of being in the 13%-14% range. We achieved that beginning in 2013 and again in 2014, and in fact, in both cases, we did materially better. We haven't altered our stated goal, but we're obviously not trying to hold it back from where it will naturally go. But the reality of it is, as we go through these different phases of the cycle, we'll be a beneficiary of some tailwinds, and from time to time, we'll be a beneficiary of headwinds. We've had some good tailwinds in terms of adverse headwinds in terms of interest rates.
We've had good tailwinds in terms of market levels and particularly in terms of income, investment income from alternative investments. We know those won't always be the case. They won't be linear in experience. Our view is that this goal is for goals to achieve throughout the cycle. The other dimension of this is that there will be from time to time things we do that will be highly supportive of the ROE objective over the long run, but won't always be in the early days. Certainly, that was true with POJ when we started that. It's true today with Brazil. It's true with a number of our other more emerging markets. It's not as though we have a less robust view of individual lines of business. It's more a function of the blended effect and looking through the cycle and different forces at work.
Some of our businesses do have different return profiles than Japan. Japan has the unique aspects of both being very high ROE and very high stability. It's an uncommon phenomena. In some of our other businesses that have less volatility or more normally less volatility, they tend to have naturally associated with it lower return aspects. It's not as though we have a different view of the outlook for the ROEs for our businesses, the U.S. businesses from what they produce, with the exception of the fact that we recognize that some of the tailwinds we've experienced are going to not always be as robust as they've been in recent times.
Steve, do you want to address the DOL?
Colin, first of all, on ROE, I would just add to John's comments that a given return level in international doesn't mean the mathematical exercise of that means, I think you said 8%-9% domestic. There is the corporate sector and corporate and other expenses that have to be factored into the math as well. In regard to DOL, I really don't think there's a lot to add to my comments earlier and that Chris and Bob amplified. This is something that could have significant impact, has the risk of unintended consequences, as I mentioned, around restricting access to advice and solutions. We're working to avoid those unintended consequences. At the same time, we feel that while we're working towards a constructive solution, we are relatively well-positioned to adjust to any changes that the regulation might produce.
Steve, just to follow up. For something like the career agency, would Pru be prepared to go for the opt-out and take on the enhanced fiduciary standard? Obviously your agents do sell annuities. They are selling into retirement accounts.
We would consider that among other solutions on the career agency front. As I mentioned though, given the evolution of our business mix over the past 10+ years, a lot of our business is done, or put it this way, the aspects of, say, the IRA rollovers that are done specifically in our agency force, while certainly significant for our agency business, is a relatively small portion of Prudential's overall business mix. That's what I mean when I talk about our business mix, our franchise, and our business models within our individual lines of business positioning us relatively well in this regard.
Okay. We'll take one last question. Is that Ron Bobman?
Hi, Ron Bobman, Capital Returns. I've got a PRT question. The presenter mentioned 11%-15% sort of range for IRRs when pricing is set. I was wondering, are there certain elements to the transactions or dynamics to the transactions that group a certain type of transaction in the lower band and other elements to the transactions that tend to group them in the high end of the band? Thanks.
Sure. I'd use a couple of examples that would put you at one end or the other end of that range. First of all, the conviction that we would have on the mortality experience would help with our appetite. The higher IRRs we would want if we had a higher risk profile on the asset portfolio backing the liability. For example, if you had a slice in small single digit amounts of private equity as an example, that would be the sort of transaction where we'd expect a higher IRR. It's based on the risk profile of the liability and the risk profile of the assets.
All right. We'll take one last question for Steve.
Hi, Steven Schwartz, Raymond James. Just a couple of quickies. Rob, I just want to paraphrase your statement on the underhedge and how that goes away. What you're really saying here is that the benefit from higher rates goes down over time as they go up in the products themselves, there's really no point of this. There's no benefit from rates going up after some period of time?
No, I think what I'm saying is that when you look at the hedge and the liability, the Rho, the interest rate exposure on that, as rates rise, the sensitivity of that liability for further increases in rates declines, the need for interest rate hedging declines, the underhedge as a result of that begins to decline.
Okay. Got it. On Arizona and the reinsurance, you talked about the benefit from hedging. Voya has talked about the benefit of not being susceptible to the standard scenario under C3P2. Is that part of the discussion here or part of your thought process of why this exists?
I'm not sure I understood the question.
Voya has argued that the standard scenario would be very negative if they were forced to use statutory accounting.
Yeah. I might defer to someone from the annuities team on the specific answer to that. I think the stress scenarios that Yanela showed you, and Bob and Yanela went through, are significantly more draconian than the standard scenario. I'm not sure that's relevant unless I'm missing the substance of your question. Maybe said differently, the implications of the standard scenario have not factored into our decision-making as to how we're hedging or how we might think about reinsuring or not reinsuring the living benefit rider. Yanela, you want to elaborate?
I agree. The standard scenario, it's different by company and by product. Bob's point is the standard scenario alone is not the driver of our decision. There is a lot of moving parts when you think about coming from the captive, going to the statutory entity, as Bob mentioned. On our slide, we show the difference in the reserve, RBC is a completely different calculation that would play in when you take the business back from the captive into the insurance company.
Okay. Then one more, if I may, for Phil. Phil, can you talk about Solvency II and maybe the implications of what's coming down from that vis-a-vis the demand for pension risk transfer?
Well, I'd give you the answer from a global perspective in terms of to what extent are U.K. or European insurers interested in optimizing their business mix. The outcome of that is potentially more longevity reinsurance opportunities from U.K. insurers. It doesn't obviously have a direct impact on U.S. plan sponsor appetite for pension risk transfer. In terms of the U.K. market, that's one of the drivers, one of the considerations as U.K. insurers are optimizing their balance sheet.
Okay. I think that will conclude our 2015 Investor Day, and thank you all for attending.