Thank you for joining us for Prudential's Investor Day 2013 edition. To those of you with us via the webcast, I'm going to steal a line from one of my colleagues. Good morning, good afternoon, good evening. An agenda is in your binders. As you can see, we've planned Q and As for Charlie and Bob after Bob's presentation on annuities, and for Ed Baird after Ed's presentation. You will have the opportunity to address questions to John and Mark at the end of the morning. Rest assured, we do plan two breaks in the action along the way. We have another event scheduled to begin in the same room at 1:00 P.M. We're going to have to stick pretty closely to our scheduled end time for this one at 12:30 P.M. Thank you again for coming. Now I'll hand off to John Strangfeld.
Did you just see the legalese? I forgot to give you the legalese. It's all in your binders.
Thank you, Eric. Good morning, everyone. Welcome. Let's get going. Nearly three years ago, we presented to you Prudential's aspiration for ROE in 2013. At that time, we thought it was important to do so to provide some guidance regarding our view of the company's earnings power post-crisis. When we pulled together our views regarding our business mix, our capital deployment opportunities, and ability to execute, we became confident in setting an ROE objective that would be distinctive within our sector and would support our theme of superior performance. Our announcement of 13%-14% may have been ambitious, but it was not abstract nor arbitrary. Last year, we transitioned from an aspiration to a specific goal of 13%-14% for this year, 2013. Today, we believe we are on track to achieve this goal. To achieve it in a manner consistent with what we planned.
Namely, through strong performance of our existing businesses, targeted deployment of capital in new initiatives such as Star Edison, Pension Risk Transfer, Hartford Life, and finally, with very meaningful distribution of capital to our shareholders. Relative to our original expectations, we have faced some headwinds using two examples, one external, one internal. An external example being low interest rates. An internal example would be some of the challenges we've had in group insurance. On the other hand, we've also benefited from tailwinds. Better sales and flows in the U.S. businesses. Consequently, higher assets under management, outstanding results in International Insurance, new initiatives like Pension Risk Transfer, and of course, a stronger stock market. We would expect that many specific things would be different than we envisioned when we set out our goal nearly three years ago.
Taken as a whole, we believe we're clearly on a good track towards meeting our goals. Our objective is to achieve it and to sustain it, and sustain it by remaining true to our investor value proposition. Turning to our investor value proposition, our theme is to build a company that can produce and sustain superior performance, especially defined as ROE. Our focus is on long-term quality and shareholder-friendly approach to managing capital, meaning that capital distribution is a priority and that deals and investments must ultimately enhance our future financing and financial capability. We see four key elements to our value proposition. First, our portfolio of businesses. As we've said before, it's by design. It's not an aggregation of historical decisions. It's highly focused, yet with a balance of risk and an attractive blend of growth and stability. Second, the quality of our businesses.
Our businesses are market leaders. The support for that assertion is reflected in the strong fundamentals or vital signs of each of our individual businesses. Third, capital management, whose dimensions include financial strength, which is a key underpinning to our value proposition to customers, employees, and shareholders, and a disciplined balance of capital deployment between organic growth, innovative new products and businesses such as Pension Risk Transfer, M&A, and return to shareholders. Finally, our most important strategy is not product or even portfolio or even capital management. It's talent. We believe that the single biggest driver of our long-term performance is our talent. Talent is not just about skill sets, it's about culture. It's the way people work with one another. It's the recognition of the power and wisdom of teamwork and diversity. It's an obsession with quality. It's a recognition of the power of collaboration.
Collaboration means it's not enough to have skills that can be used independently. The real powerful impact arises from using skills in combination to create solutions for growing and changing market needs. Some call the talent side of things the soft side of business. We view them as strategic and the key charge of our leadership team. I hope you see it in our people and in our results. It's why Star Edison execution has been close to flawless. It's why POJ has had 25 years of distinctive results. It's what accounts for strong U.S. fundamentals. It's how we utilize multidisciplinary skills to distinguish ourselves in Pension Risk Transfer. It's why we have confidence in our future. When you bring these four elements together, you have our investor proposition. It's not that complicated, but it does require clarity, consistency, and the talent and culture to pull it off.
There you have it. We believe we are on track for distinctive and superior performance, attained and sustained by a clear and consistent investor value proposition and a determination to execute upon it. These themes will carry through in every presentation you hear today. It's not spin, it's substance. It's who we are. With that, I'd like to turn it over to Mark for some commentary on current events. Mark?
Thank you, John. Good morning, good afternoon or good evening. Appreciate your interest today. John characterized my discussion as current events. I want to focus on the intersection of a number of issues and themes that are out in the market that get at the guts of a number of questions around companies. I want to be clear about how we're thinking about Prudential and where we are on the hit parade of current events and issues and items in the marketplace. If there's a message at the end of the day that runs through each of the points that I'm going to talk about, the message is that we are strong, and we're conservative, and we are consistently sensitive to the quality and substance of our balance sheet. Let me go through some of the families of issues that are out there.
One relates to the general question of how we might stand up under group or holding company supervision. We believe that's coming in one form or another. I'm not going to go around the track on SIFI designation again. That's one way in which we could find ourselves with a group supervisor, which would be the Federal Reserve. As you know, there are other things out there in the international arena and in the domestic arena that would result in a form of group supervision. I want to talk a little bit about our confidence in our ability to hold up well in the context of group supervision. There's another family of issues around the impact of assumptions and what's in the balance sheet. We still get questions about the impact of low interest rates. I want to make some brief comments about that.
Finally, there are some general questions around financial structure and around risk and around some elements, as I said earlier, the guts of the company that I want to touch on as well, just to be clear with respect to where we stand. You've heard us, and me in particular, consistently express confidence in the quality of our balance sheet, in our capitalization, and in our capital management processes. I want to hit one headline around the macro view of the company that I think is extremely important, and that is that the GAAP balance sheet is not a very effective portrayal of either solvency or risk.
Our GAAP balance sheet is an umbrella that covers a number of different economic arrangements that they wind up booked on the balance sheet. It's not apples to apples as you look through different categories of liability products or as you look through different investment product or asset management arrangements as they wind up on the GAAP balance sheet. The starting point for solvency in a company like Prudential is to understand reserving practices. That's totally different from the starting point that you might use as your frame of reference for looking at a bank. For us, it's reserves, and it's the assumptions that are embedded in reserves, and it's conservatism, and it's the overall process that we use to create the liability side of our balance sheet. Remember that when we create a reserve, we fund it.
Everything that's on there has an asset on the other side. Those assets are subsequently tested in our cash flow testing processes to ensure that they will support the reserves that we've recognized. Good example of this is the way in which we reserve on our statutory books for low interest rates. We reserve for the low rate shock in the so-called New York 7 in the asset adequacy testing process. What that means specifically is that the low rate shock is not a hypothetical what if. It's actually a funded outcome on our books. It's reserved for and it's invested for on the asset side. The first element of the macro view, I think starts with the idea that reserves are really central, and understanding what's in there and what's in there for contingencies or deviations from expectations are very important concepts and themes.
That really is the guts of where it all begins. Then if you move to the asset side, as I said earlier, there's a range of arrangements covered by the GAAP accounting umbrella that look different. Separate accounts, participating policies, other elements of loss absorption built into either product design or the investment standards that we set and adhere to. All of those things create a very different picture of the economics of the balance sheet relative to the optics of the balance sheet. Our view, which I've expressed a number of times, is that appropriately measured, and this doesn't require a Ph.D. in finance, by the way. This is a pretty straightforward consideration of what's really on the balance sheet.
Appropriately measured, our capital ratios are very, very strong, even considering the context of an equity to assets like measure, which is a little different for an insurance company. Even considering the context of an equity to assets like measure, we believe that we would exceed any even remotely reasonable regulatory standards for financial strength. The starting point with respect to the macro issue is that the big picture is not as it seems, taking accounting numbers at face value, but digging into the guts of statutory and GAAP financials results in a picture of financial strength that we think makes a lot of sense and results in the company being extraordinarily strong with respect to capitalization. By the way, that makes sense. We deal in a world that expects high standards from us.
We deal in a world where we're often, for example, transacting in an environment where the counterparty has to meet a fiduciary standard. That's a high standard. We would expect that in order for this company to be successful in its markets, we would have to be financially strong. Again, understanding it properly leads to that conclusion and reinforces my original point that we're conservative, we're strong, and we're consistently sensitive to the quality of the balance sheet. Let me move to another one that relates to quality capital and current events, and that's the question of captives. We use captives to isolate risk, and when we isolate risk in a captive, we're then able to manage that risk more efficiently. We don't use captives to reduce the reserves that we hold, and we don't use captives to reduce the capital that we hold.
We hold reserve levels that are the same as the reserve levels that would be held in the seeding company, and we capitalize our captives to double A standards. We also hold appropriate assets to ensure that the reserves are adequately backed. We have no offshore captives, and our captives are in the same states as our primary seeding companies. What that means is that within that picture of a state with a primary company and a captive company, we provide full transparency to the regulators in that state. We also, by the way, provide full transparency to the rating agencies with respect to our captives. To repeat this again, we don't use captives to reduce reserves. We don't use captives to reduce capital. We hold appropriate assets, backing reserves in our captives, no letters of credit, no naked parental guarantees, no hollow assets. These are real substantive entities.
The economic benefit to us arises from the efficiency that we get from isolating and managing certain kinds of risks in separate entities. That's the end of the story. Let me comment briefly on market assumptions that are embedded in our balance sheet. You may recall that in the third quarter of last year when we went through our annual assumption reviews, we reduced our expected equity market returns by two percentage points, and we reduced our interest rate assumptions by one percentage point. We also extended the time that we would grade back to more of a reversion to mean type level of returns in either the equity markets or the interest rate markets. We believe, based on what we can tell from disclosures, that we stand out in terms of how conservative we are with respect to the economic assumptions that support our balance sheet.
I would say we also believe that there is more real-time valuation reflected in our balance sheet, meaning more responsiveness to current conditions than there is in some other balance sheets within the industry. What I want to emphasize with respect to market assumptions is that we're on top of it. We have a rigorous process that reviews our market assumptions. We have conservative assumptions, at least as far as we can tell relative to the industry, supporting our balance sheet, and we are responsive to current market conditions in assessing the assumptions that will support reserves. This is another kind of central thing. It relates to that whole balance sheet picture that drives then the investing side and the need to back reserves with high-quality assets. A comment on the impact of low rates on the way in which we're managing.
The question comes up often in investor meetings about what we're doing to reach for yield or generate more investment income. The answer to that is that we're not doing anything. We're investing according to the core competencies that have been reflected in our investing behaviors over many, many years. We're not making dramatic changes in asset mix in response to low interest rates, and we're not reaching for yield. We are, by the way, repricing our products. We are, by the way, cutting expenses. I think I would say that we're probably doing what you as shareholders think we should be doing in this environment. We are aggressively trying to protect our margins, but we're not doing it in the context of reaching or extending the risk profile of the company.
There are changes in the risk profile that result from some of the products we sell. Some of the Pension Risk Transfer deals, for example, as we receive payment in kind of the premium payment there included some asset classes in which we were underweighted and with which we're very comfortable, but that have resulted in some changes at the margin with respect to what in the industry would be known as risk assets. These are actually, by the way, pretty strong seasoned portfolios of private equity. The net point on this one is that we're not reaching for yield. We're not reconfiguring our investment portfolio. We're repricing, we're cutting expenses, and we're investing in the things that we've always been historically good at investing in. I've covered a number of, I guess, what you might call miscellaneous topics.
I think the broad themes that run through all of this tie a number of issues together. They tie issues together around regulatory scrutiny. As you heard, when you peel the onion and understand the economics of leverage in our company and understand the components of the balance sheet as it relates to reserves and captives and assumptions and risk profile, you come up with what we consider to be a great story, what we consider to be a great platform from which to execute the business strategies and fulfill the investor value proposition that John talked about. I'll stop there. We'll have a chance for questions at the end, but I hope that's helpful clarification around a number of current events topics that are important to the industry and important to Prudential, and where I think we have very good, strong, positive messages. Thank you.
Now John and I will depart and Charlie-- Not depart, we're only going right here.
Good morning. This will be a little bit of a different presentation than you've heard before in that we're going to talk more about strategy and priorities of the U.S. businesses than perhaps we have in the past. The bottom line is we really like the opportunities that we're seeing in the U.S. today and believe that there are areas of growth based on significant secular changes in the United States by which we can expand our businesses. We've broken the presentation up into four parts. In the first part, we will review four major themes that will be prevalent throughout the presentation. Second, we'll discuss how we're actually approaching the opportunities in the U.S. Third, we'll briefly talk about each of the U.S. businesses. You all know the U.S. businesses. You hear about them every quarter. You talk to senior management about them.
You talk to Eric and Neal about them. There are some important points that we'd like to make about each of the businesses. Finally, we'll have some summary comments. We believe that our U.S. businesses are well-positioned from a couple of perspectives. First, the wind, we believe, is finally beginning to be at our backs with the changes in the U.S. economy and the improvement there. We still have some headwinds in terms of low interest rates, but we're beginning to feel some winds at our backs. Second, we believe that there are powerful secular changes that play to the strengths of our businesses. The second point is one that Mark mentioned, which is achieving risk-adjusted returns and the appropriate risk-adjusted returns drives our decisions with sales volume as a result of those decisions.
Third, we've worked hard at reducing volatility, especially in the asset management and the annuities business. I'll talk about the asset management business a little later in this presentation, and Bob O'Donnell, after the break, will talk about reducing volatility and risk in the annuities business. Finally, we're working on solutions for clients that reach across many of the businesses and functional areas. Let's begin by looking at the U.S. strategy. There are really three elements to the U.S. strategy. The first is that it's all about execution with regard to pricing discipline and product mix by virtue of managing the distribution systems, and we'll talk about distribution in a few minutes. Second, each business has its own set of growth opportunities within its own universe and within its own competitive set.
Third, we believe we have a unique set of capabilities and combination of capabilities that enables us to create and provide solutions for our institutional and retail clients. Now, we've listed here many of the secular trends to which I've been referring, and we're not going to go through them all, other than to say there are a large number of powerful trends that are going to provide significant opportunities to Prudential, given our skill sets. Now, in the right-hand column, you see some of the solutions that we've either created or are working on, such as retirement income solutions, Pension Risk Transfer, or longevity insurance. Separately or together, the businesses are providing meaningful solutions to real problems of our clients. Now, business mix. We like our business mix. As John said earlier, it's by design, not by default.
It's really derived from a combination of eliminating non-strategic businesses and products such as Prudential Real Estate and Relocation Services or wealth management services, which we announced in the first quarter, or long-term care, or acquisitions such as Hartford. Or as Mark said last year at this time, outsized organic growth opportunities when he was referring to either GM or Verizon. We also think about diversification of risk, whether it's market risk or insurance risk, where to put that risk, and how much of that risk to actually take on. Finally, we have a huge number of institutional and retail customers that we access through multiple distribution channels. We have an extensive presence in the marketplace. We have 30,000 institutional clients, 40 million retail clients, and over 123,000 financial advisors licensed to sell our products. Now we don't state these facts to say that we're big.
Frankly, size for size sake is meaningless. We do believe that these relationships will provide us with an opportunity to grow. There is more we can and there is more we will do with these clients and with these distributors. We spoke a minute ago about business mix, and on the left, you see a pie chart representing AOI. 60% represented by the green is more market sensitive, namely the annuities and the asset management business, and 40% represented by the blue is less market sensitive, which is the insurance and the retirement businesses. On the right, you see attributed equity. On a percentage basis, the less market sensitive businesses have about the same amount of attributed equity as they do AOI.
Obviously, asset management has a little bit less given its business, and annuities has more attributed equity, which would be consistent with some of the remarks that Mark made during his presentation in terms of the conservatism by which we run the company. In the next few slides, we'll attempt to present in a clear and simple fashion how we think about the U.S. business systems and the opportunities that exist. We're in three broad lines of business, each represented by one of the blue circles, all of which are wrapped in risk management and capital management, which we believe are two of our core competencies and areas of competitive advantage for us. We think we have a unique set of capabilities by virtue of the skill sets within asset management, retirement insurance, and annuities.
We are the leaders in each of the businesses in which we choose to compete. Each business transacts business individually, providing a diverse set of products and solutions to its own set of clients. As an example, asset management provides mutual funds to its retail customers and a variety of investment solutions for its sub-advisory and institutional clients. These products and solutions generate a broad and diverse set of sales and flows to each of the businesses. As an example, retirement generates flows from its full-service business, its stable value franchise, its structured settlements business, and obviously Pension Risk Transfer. In the past, we've mainly spoken about third-party flows because this is really the litmus test of performance, right? Either you're doing well and performing well and clients are giving you money, or you're not, and they're taking money away from you.
There's really nothing in between. There are a significant amount of proprietary and affiliate flows that come from the businesses to asset management. Examples of these flows would include retirement from its full-service platform or stable value, annuities from its fund platform, or Pension Risk Transfer in Hartford, which provided about $40 billion worth of assets to asset management. Affiliate flows are an important part of the business system. So are a whole series of other ideas that we're beginning to develop as we combine capabilities. Ideas such as Pension Risk Transfer or target date funds, or target date funds with income solutions embedded within them. Finally, a product we created this year for a client that combined aspects of retirement, individual life, and group life to provide a specialized and customized solution to a problem they had.
This product was offered by Retirement, it was underwritten by Individual Life, and it's administered by Group. It's a product for a client, so it's not going to be a huge line of business for us, but it's a perfect example of what we're doing because our clients are coming to us more and more and asking for our help in providing solutions to problems, not products, but solutions. We're providing these solutions by virtue of the strengths of our businesses and our ability to collaborate and work together across the businesses, which is part of the Prudential culture that John referred to earlier. As Mark Grier has said, we are really good at solving big, complex problems, and you have to look no further than PRT, Pension Risk Transfer, to find such an issue.
You had business and regulatory catalysts to which we applied a unique set of capabilities from many of our businesses and functional areas to provide customized solutions to our clients. I would tell you that in GM and Verizon's case, they had very different issues. This was not a cookie-cutter approach. They had different problems and different issues, and we provided a customized solution to each of those two clients. This is a perfect example of what we seek to do. We'll take a few minutes and discuss a number of the salient issues in the businesses themselves, and we'll start with Annuities. I'll start with the comment that we like this business. This is an important part of our business mix. We have a disciplined approach to this business that takes into account product profitability as well as overall exposure to the firm.
We've demonstrated this with multiple product changes and introductions that adjusted profitability to the current market environment, as well as reducing risk and volatility. We've demonstrated this with a consistency of execution, and you can see that in the bar chart on the left-hand side that describes sales and flows, were nothing if not consistent with sales and flows. They've decreased slightly over time on a gross basis as we've wanted them to do, and we've indicated that we will continue to lower sales as we calibrate the overall profitability and the business mix of Annuities. On the right-hand side, you see account values, which have increased as a result of positive net flows and market appreciation.
Turning to Retirement, we've invested heavily in both the institutional investment products business, the IIP business, as well as the Full Service business, because we see a lot of synergy between the two, and this may not be entirely intuitive, so let me explain. Being in substantive dialogue with plan sponsors about their DB and DC plans as a record keeper makes us far more effective when we're talking to them about stable value or, as importantly, about Pension Risk Transfer. We've also achieved a better balance between Full Service and IIP. You'll see that on the next page in terms of fees and spreads. By the way, I'm not going to go through all the growth opportunities at the bottom of the page. We'll leave this for your edification or your reference going forward.
Suffice it to say, in each of the business, we think there are growth opportunities about which we're very excited. Looking at the graphs on the upper left, you see the increase in sales in 2012 due to the PRT transactions, which is the medium blue part of the bar chart or at the bar at the top. IOSV sales have declined slightly, that would be the light blue in the middle, as we reach capacity limits with pool providers. We said that would begin to feather off after 2011, and indeed it has. Full service sales remain relatively flat as we focus on profitability, not on sales. Net flows in the upper right have increased substantially as a result of PRT.
As you look at the lower bar chart, that has led to a substantial increase in the assets under management for IIP, which is now about equal to the full service assets under management. Let's talk about asset management. Asset management is a big business for us, $827 billion at the end of the year, $840 billion at the end of the first quarter. It has experienced significant growth. We've had 22 consecutive quarters of positive third-party institutional net flows. Last year marked the successful entry of the business into the closed-end fund market, where we introduced two of the more successful closed-end funds that have occurred in the past three years for a total of about a billion and a half dollars. We have strong investment returns, that's not really what we focus on.
We focus on talent, because we have the simple belief that if you can attract the best talent, it stands to reason that over time you'll have good performance. If you have good performance, you should be able to attract assets. Growth in AUM is not the goal, it's the result of good performance, which is the result of having good talent. Asset management is also becoming a global franchise. Between the asset managers, we have 26 offices in the United States, but we have 15 offices in 15 countries around the world in Europe, the Middle East, Asia, and Latin America. If you look at the left, you see AUM by asset type. Here, if you look at the fixed income assets represented by private and public fixed income, as well as commercial mortgages, you see that they represent just over two-thirds of the assets.
Look on the right-hand side. Here you see that fixed income represents only about half the fees, with equities and real estate representing the other half. There's good diversification from a fee perspective. Now, we said we've been working on volatility within this business, and we have. On the left-hand side, you see 2007 revenues, of which about a third is ORR, or other related revenue. Let me remind you what that is. Other related revenue are the transaction fees, incentive fees, strategic investing, and what was the interim loan portfolio. Strategic investing is when we invest side by side with our clients in funds or create funds with seed capital in order to attract capital later on. Again, on the left, you see that other related revenue was about a third of total revenues, but look at the right in 2012.
It is about a tenth of other related revenue. There has been a decrease on a proportional basis by two-thirds. There are a number of reasons for that decrease. It did not happen. The first is that there was growth in asset management fees from $1.6 billion to $1.9 billion. We said the interim loan portfolio would be in runoff, and it has. It is down 84% from where it was. We concentrated on strategic investing as well, both the quantum and the concentration of strategic investing. In terms of the quantum, that has been reduced by about two-thirds from $2.7 billion down to about $1 billion, and that is about the run rate it will remain. Also the concentration we have reduced by over half from $44 million of fund down to $19 million of fund. In addition, we exited the securitization conduit a while ago.
There will always be volatility in the asset management business. We have incentive fees, we have transaction fees, we have strategic investing. That is not going away. What will occur and what we have done by virtue of the reduction in strategic investing, the elimination of some of the lines of business we were in within other related revenue, is we believe we will have lowered the amplitude of that volatility significantly going forward. In terms of flows, net retail and institutional flows averaged about $30 billion over the past three years. Why is this? We think there are three reasons. The first has to do with stability. Stability at the Prudential level itself, Prudential Financial, so at the parent level. Stability at the Prudential Investment Management level, and organizational stability within each of the asset managers themselves. In addition, they have had very good performance.
Our ability to attract, develop, and retain talent has been, we believe, one of the key reasons why we have been able to attract as much assets under management as we have. In many ways, flows are just a byproduct of this strategy. We think this is kind of a cool slide. We have attempted to describe here the quality of the asset management growth over sequential five-year periods. If you look on the left, in the five years from 2002-2007, the vast majority, almost 80% of the growth in asset management came from market and asset appreciation. Only 20% came from net flows. In the subsequent five years, ignoring the addition of international investments because we did not want to count that, we have isolated that to the side, only 44% came from market or asset appreciation, 56% of the AUM growth came from net flows.
Net flows is a far more important factor in our assets under management or our AUM growth in this five-year period than it was in the previous five-year period. Let us move on to Individual Life. This is an important part of our business mix. This is a profitable business, it is a stable business, and it provides very good cash flow. We think about our product mix within Individual Life relative to market risk, and I will deal with this directly on the next page when I talk about Universal Life. The final comment I would make is that we like The Hartford acquisition. There are specific strategic and financial reasons for which we did the deal, and although it is early days, those appear to be well-founded. On the left, you see new business premiums. The UL premiums increased significantly. That is the green part of the bar chart.
They increased significantly this past year as competitors either cut back or exited the business. We've used this opportunity to do 3 things. First, we raised prices 4 times, in October, February, May, and we will in July. We announced it in June, another price increase as we calibrate the product to the markets. We eliminated the least profitable distribution partners. Finally, we put into place premium caps, all of which will have the effect of ratcheting sales back down. As you can see on the right, while we want and will get UL sales back to a historical proportion of our business, we're not exercised by the increase due to the very small amount of face amount in force that UL actually represents, as you can see by the green sliver in the bar. Let me move on to group.
I stood before you 1 year ago, rather uncomfortably, I might add, and said that we would do whatever it took to quote unquote, "grind the disability ratio back down to where it should be." That's exactly what we're in the process of doing. We brought in new senior management. We repriced or let lapse about a third of the book. We said this was not going to be fixed overnight, that it would take about 3 years to get back to where we wanted to be, and we're 1 year into a 3-year process. We're beginning to see the results of our efforts and make some progress with the ratio decreasing about 960 basis points over its high water mark, which was in the fourth quarter of 2011.
Let me remind you quickly that this is going to take time, it's not going to be linear. This is a multi-year process, there will be bumps in the road, we will get there. Turning to the right-hand chart, about 70% of our life sales last year were voluntary. As you can see in the chart, the first quarter of 2012 had an increase in the benefit ratio, which was indeed an aberration as the ratio decreased subsequently. However, we do think there is room for improvement in terms of pricing on the life side as well, and we're working on it. The left-hand bar chart shows the new business premiums, which decreased about 34% as we repriced the book. Again, this is a demonstration that we put profitability ahead of sales.
On the right-hand, you see that total in-force premium increased only slightly, that's what you'd expect given the lower new business premiums. Let me make a couple of summary remarks. Again, we like our business mix. We work hard at this. It is by design, not by default. We believe that the cyclical recovery is beginning to help us. We believe that we are particularly well-positioned to capitalize on the fundamental secular changes occurring in the U.S. today by virtue of the businesses we have and the overall business system. Finally, the businesses are going to work individually, they're also going to work together to provide relevant solutions to real issues facing our retail and institutional clients. That's the end of my presentation. I'll be happy to answer questions after Bob O'Donnell gives his presentation, and that's after the break.
Eric, should we take a short break?
Let's take a 10-minute break.
Okay. Thanks very much.
Shall we reconvene? Ladies and gentlemen, kindly take your seats. Let's wait a couple minutes. There's Charlie. Here he comes. Charlie. Charlie. Okay, very quickly. Bob O'Donnell is going to give you what I would call a program learner on our annuities business, and then Bob and Charlie will take questions. I'll have my usual short spiel on Q&A protocol between Bob's presentation and the beginning of the Q&A. Without further ado, here is Bob O'Donnell.
Thank you, Eric. I'm going to, like Charlie, share with you a bit of a different presentation than perhaps what you've seen in the past. We're going to construct a framework or a lens largely centered on cash flows, and we're going to share with you the cash flow view of the in-force book of business. We're also going to share with you the inputs into the generation of that cash flow. All of the assumptions, the behavioral assumptions, the capital markets assumptions, as well as the outputs from those assumptions. We're going to stress them all. All the assumptions individually will be stressed. We'll stress the equity and interest rate assumptions. We'll stress the behavioral assumptions. We'll show you the output impact on those stress scenarios, and we're going to bring them all together.
We're going to stress the combined capital markets and behavioral assumptions and give you the outputs on that, all around the in-force book of business. We're going to have a conversation about the risks of the annuities business, and how we stack up our mitigants against those risks and the impact of those mitigants in managing those risks. Lastly, we're going to share with you some observations around the expected performance of our new business, again, constructed in a cash flow view. We're confident around the performance of this business, and when we finish this presentation, we hope to have been completely transparent and install that confidence in you around the annuities business. The annuities value proposition to Prudential Financial is firstly one of diversification.
The core risks associated with the annuities business are that of longevity, and that longevity risk balances the risk that we bring into our balance sheet through our various life insurance businesses. We've got a natural balance of risks associated with this business and others that comprise the portfolio of business at Prudential Financial. There's a bigger picture here. There's a bigger picture that's motivating Prudential Financial around the annuities business, and we talk about demographics, but I don't think we talk about demographics enough, and I don't think we put it in the context of a broader economic issue. The demographic issue, you may have heard the statistics before. Statistics like there's 10,000 Americans retiring every day, and that 10,000 number will be a daily number for the next 20 years. That's a compelling source of demand for our core value proposition.
That gives us confidence that demand will be sustainable and that we can build a franchise for the long term based on just that issue. That only gives you part of the picture. That demand is matched up with a woefully inadequate traditional supply chain. When you put demand that is far outstripping supply, you create, in basic economics 101 classes, a ripe opportunity. That's where we reside right now. Prudential Financial, and Prudential Annuities in particular, is well-positioned to monetize that opportunity. Let's talk about the book. This is just a snapshot of the annuities book of business, and we've captured 2009 and 2012, and there's no real magic to the numbers. I can refer you to, I think it's slide 32 that shows an annual progression of this.
I want to give you some of the driving points around how we got to where we were in 2009 and how we got to where we are in 2012, why that's so important. What we've captured here in these pie charts, again, is a snapshot of the annuities in-force book of business, and I want you to focus on the blue slice of the pie. The blue slice of the pie represents that proportion of our in-force book of business that's associated with an embedded auto-rebalancing mechanism within the contract. What percentage of the annuities in-force book of business in 2009 was connected to a contract-embedded auto-rebalancing program? It was 43%. In 2012, fully 70% of our existing in-force AUM is connected to an auto-rebalancing program within the contract. This is not a passing fad at Prudential Financial.
This is something that we've been doing for many years. We began using contract-embedded risk mitigants in 2001. We understand how they work, and we understand how to use them. We employed them in our core income strategy in 2006. Again, not a fad and not a reaction. A core strategic differentiator long before the capital market stresses of 2008. We delivered in a core focus from 2005 to 2009 through a preponderance of our production and our sales, an AUM distribution by 2009 of 43%. From 43% in 2009, we've achieved 70% of the $132 billion connected with an embedded auto-rebalancing program. The only way to achieve that progress is through a huge proportion of your new sales coming in associated with an auto-rebalancing program or an embedded risk mitigant.
At Prudential Financial and in Prudential Annuities, 94% of all sales that come into the annuities business come into the annuities business through a contract-level auto-rebalancing program. With that strategy, we have fundamentally altered the risk of the annuities franchise, and we have sold our way to a different risk profile. There are other risks in the annuities business beyond those that are managed by the auto-rebalancing program. I'm not going to walk you through all of them. We've talked about mortality and longevity. We've talked about auto-rebalancing. We're going to talk about hedging. We're going to talk about accounting. Within our contract, we don't stop at auto-rebalancing. We start at auto-rebalancing. That's one component of a risk mitigant embedded within an annuity contract at Prudential Financial. We also require that all contracts invest in prepackaged, diversified asset allocation programs.
When you couple the asset allocation programs that have multiple benefits, right? The asset allocation program itself is going to reduce the risk associated with the business. It's also going to help us line up our hedge strategies and reduce the breakage associated with the underlying assets. You wrap on top of that a contract-level risk mitigant, the auto-rebalancing program. You've got multiple levels of risk management within the annuity contract wrapped up with an enterprise view of risk management around hedging and capital management. The point here is that we understand the risks, and we employ effective strategies to mitigate those risks. Let's talk about the in-force book. There's going to be a lot of details here, and on the one hand, I'm going to apologize for those details, but I'll walk you through each of them very clearly.
All of the cash flows that we're going to talk about today are going to be based on these assumptions. This is an important slide. I just want to spend a few minutes walking through it. It doesn't look that complex, but there's some talking points around this that I think are important that we keep in mind. The assumptions are largely broken into 2 categories, those obviously capital markets and behavior. Let's start with capital markets. These cash flow projections and these assumptions are all consistent with the GAAP assumptions for year-end 2012, and again, the assumptions on which we base all of the present value cash flows we're going to walk through in just a minute. We assume annual equity growth rates of 8%, 6% appreciation, 2% dividend. We assume an annual total fixed income return of 3.6% and a blended capital markets return of 6%.
It's also important to note that all of these future cash flows that we're going to go through are fully hedged. The cost of hedging those cash flows are baked into every one of these scenarios. Let's move on to policyholder behavior. There are 3 policyholder behavior categories. Lapsation is one that I think we talk an awful lot about, but even lapsation has 3 components, and let's kind of unpack those for just a minute. We make assumptions around lapsation within the surrender charge period. How many of our policies are going to lapse while they're in their surrender charge period? This is quite honestly not a fairly dynamic assumption, but we thought we'd share it with you. It's 1% during the surrender charge period. The more important number to focus on is the assumption around lapsations for contracts that are outside of their surrender charge period.
We assume for contracts that are outside of their surrender charge period in the baseline assumption that 9% will lapse annually. We have a 9% baseline lapse assumption for contracts outside of the surrender charge period. That's for contracts that are at the money. We'll go into the lapse function in a bit more detail in a couple of slides. What we mean by at the money is a contract who's outside a surrender charge period and whose account balance equals their guaranteed protected withdrawal value. For those scenarios, the baseline assumption is 9%. We then overlay a dynamic lapse function, which takes into account the behavioral impact of in-the-moneyness. As contracts become more in the money or as their account value separates on the downside relative to the protected withdrawal value, we assume they're going to lapse less.
The current in-the-moneyness assumption based on our dynamic lapse function, based on the current year-end in-the-moneyness, leaves our dynamic lapse assumption at 5.4%. I'm going to walk through that in a bit more detail in just a minute, but I think it's important to establish a baseline before we start shocking it. Let's talk about the other two assumptions around behavior that we make. We make assumptions around benefit utilization. What we mean by benefit utilization is what percentage of contract holders who purchase living benefits at Prudential Annuities are actually going to take their guaranteed lifetime income? Of all the contract holders who buy variable annuities with living benefits, how many of them will take guaranteed lifetime income? We assume fully 95% of everyone who buys a lifetime benefit with Prudential at some point will take guaranteed lifetime income. That's the utilization assumption.
The other assumption is the efficiency assumption. Of those 95% of investors, what percentage of their guaranteed amount will they take? We assume of those 95% of investors, they will take 85% of what's available under the guarantee. We'll walk through some more clarity on those in just a minute, and we'll stress every one of these in the generation of cash flows. This is the baseline inputs into the cash flows that we're going to walk through first. Here they are. I'm just going to spend a few minutes, again, unpacking this a little bit and setting the stage for not just the baseline cash flows, but how those perform when we stress each of the assumptions we just talked about and then combine the stresses on each of these assumptions.
We're going to work from left to right, and on the left side, we're looking at $27.5 billion in net fees. The way you should think about net fees, these are the M&E fees, the optional benefit charges, the revenues that come into the business, net of administrative expenses. That's the net revenue line. Moving from left to right, the benefits net of hedge recoveries. Let me just give you a little clarity on this around the $2 billion. That's actually $6 billion of benefit costs offset by $4 billion of hedge recovery, netting to $2 billion of net expenses for our benefits. The next line of $1.6 billion of investment income, that's really spread income off of general account assets largely connected with older annuity contracts. This is an important one.
The hedge costs of $10 billion are an essential component of any cash flow analysis in this business. The best way to think about the hedge costs in this analysis or in the business is to think of it as like a cost of goods sold. This is the sunk cost for doing business with optional living benefits. At Prudential Annuities, the sunk cost is $10.6 billion. You have to include the cost of hedging in any cash flow analysis in this business, and ours is $10.5 billion. All in, with the assumptions that I've made in the prior slide, the capital markets assumptions, the behavioral assumptions, for the book of business at Prudential Annuities, the present value of cash flows under all of those inputs is $16.6 billion.
There's a lot going on here, we're going to now kind of tear it apart and start moving the pieces around. I want to orient you to the middle of this slide. Inside the golden rectangle, that's the $16.6 billion we just showed you. We're not going to walk through the waterfall. We're only going to now show you the output of the present value of cash flows and what drove that output. Again, orienting at the $16.6 billion in the middle of this slide, which is the exact cash flow from the baseline scenario in the prior slide. To the left, let's start with the left. We've immediately shocked equity markets in two levers. First, we've shocked them instantly for 10% equity growth, followed by baseline assumption of equity growth thereafter. We've also shocked this by 30% equity growth, followed by baseline assumption thereafter.
We have also increased the total fixed income return by 100 basis points. The impact of those shocks to the present value of cash flows in the 10% equity scenario is $18.4 billion, and in the 30% equity scenario is $21.1 billion, largely driven by increased fee revenues as claims cannot go much below zero. To the right, we have now shocked equity markets and fixed income in the opposite direction. We have taken an immediate 30% drop in equity markets, coupled with what we are describing here as a flat fixed income market. The flat fixed income market you can think of as a fixed income market where the 10-year treasury is 1.78%. Not where we are today, but the assumptions used here are 1.78% 10-year treasury as a proxy for the fixed income market.
Even in that scenario, where you have got severe stressed equities and severe stressed interest rates, the present value of cash flows remains strong. We figured we would solve for the equity market returns that generate breakeven cash flows. What does the equity market have to do year after year for the life of the installed book to generate a breakeven cash flow? Simply stated, the equity markets have to lose 9% year after year for the life of the business to generate a net present value of cash flows equal to zero. We talked about the capital market shocks. We are going to move into the behavioral shocks. Before we do, I want to provide a little more context around those behaviors. We talked about the lapse function. I want to give you a little more insight into the lapse function.
To the left side of this chart, we are starting with the baseline assumption at 9%. At 9%, a reminder, that is where the account value equals the protected withdrawal value. Then you put the dynamic function, which adjusts that baseline assumption for in-the-moneyness. How far below the protected withdrawal value has the account balance fallen will affect the output in the resulting assumption. In the right side, we are showing the far extreme, where the circled assumption there is in a situation where the account balance is 20% of the protected withdrawal value, we assume lapsation of about 1%. Not a lot of people are going to lapse when the account balance is only 20% of the protected withdrawal value. At year-end, for contracts outside of their surrender charge period, the in-the-moneyness at year-end resulted in a dynamic lapse assumption of 5.4%.
That assumption gets updated as the in-the-moneyness adjusts, and in a situation where you are in the money at the rate we were at year-end 2012, our assumption is 5.4. I want to talk about the other two assumptions very quickly before we start stressing them. Just a reminder on the benefit utilization assumption. We assume that 95% of all contract holders who purchase guaranteed living benefits at Prudential Financial will utilize their guaranteed living benefit by taking that lifetime income out of their contract. Of that 95% of contract holders who take their lifetime income, we assume they will take an amount equal to 85% of the maximum available. Our experience is in line with that expectation, with 82%. Now let us stress them, and let us see the impact on cash flows. Again, orienting you to the middle of the slide, the baseline of 16.6.
To the left, we're going to reduce lapses by 20%. That 5.4% dynamic lapse assumption that's included in the middle is reduced to 4.3% in the left. When you reduce lapses to 4.3%, the present value of cash flows goes up, and the present value of cash flows goes up because the present value of fees offsets more than the present value of the change in the liability. It's a straightforward calculation. To the right, we've now stressed the efficiency assumption. I want to be careful here because the numbers are too similar. Of the 95% of contract holders who utilize this benefit, we assume they will take out 85% of that amount that's available. We've stressed that 85% here to 95%. Even in the stress scenario of benefit efficiency, cash flows remain strong. Let's bring it all together.
We've talked about what impact do capital markets have on cash flows. We've talked about what impact do behavioral assumptions and stresses have on the present value of cash flows. We're going to bring them together now in this slide, again, I'm going to orient you to the 16.6 inside the gold bar. Now we're going to work our way up from the bottom because on the bottom two rows, the stresses are the same for both sides. Let's just walk through those. The fixed income stress is described here as flat. The fixed income total return assumption in the baseline is 3.6, in the flat is 1.78. On top of that, we've layered an immediate 30% equity shock, followed by the baseline assumption. Now let's focus on the left.
In the left, we've reduced lapsation assumption by that same 20%, so the 5.4 goes to 4.3, the present value of cash flows is now $3.4 billion. $12 billion of that driven by the capital market stresses, about $1.5 billion driven by the behavioral stress. Point of connection here. The behavioral stress generated $1.5 billion in a reduction in present value cash flows here. It generated an increase in the present value of cash flows when isolated. The path impacts the outcome. In a positive scenario, the fees will more than offset the impact of the claim. In the negative, that's not the case. The preponderance of the driver here are the capital market shocks, $12 billion sourced from the capital market assumption stress and $1.5 billion sourced from the reduced lapsation.
Now to the right, again, using the same 1.78 interest rate assumption and the same 30% instant equity market drop followed by baseline, we've introduced the efficiency assumption stress, the cash flows again remain strong. Combined equity markets, interest rate markets, and behavioral market shocks, we've torn them all apart, we've brought them all together. Cash flows are positive in all of these, even multi-stress scenarios. Folks look at the risk associated with the individual annuities business, and they point to this notional in-the-moneyness construct. The fact is, the risks associated with the variable annuity business are not properly captured in that notional view. They are. That is, by the way, the effective view when trying to calibrate behavior.
When you're looking at that dynamic lapse function that I highlighted earlier, that's the right view to take when you're looking at how investors and financial advisors are going to behave. It's not the right view to look at the economic risks associated with the business, I'm going to share with you why. The notional in-the-moneyness view or the traditional view of in-the-moneyness is, again, generally measured by the value of the protected withdrawal value as compared to the account balance. This represents the installed book of business for Prudential Annuities as of year-end 2012. Under that view, with a $109 billion aggregate protected withdrawal value and a $95 billion aggregate account value associated with that protected withdrawal value, the notional in-the-moneyness view would suggest $14 billion of risk, if you will, at Prudential Annuities.
The economic view is substantially different, the economic view is substantially different because it is derived by the costs associated with funding the cash flow guarantees on the protected withdrawal value after the account value has been exhausted. The best way to think about that risk is the annuity cost required to fund those cash values. At Prudential Annuities, as of 2012 year-end, the economic cost associated with funding those cash values was $2 billion, not 14. That $2 billion is fully supported with hedge assets on our balance sheet. Spend a few minutes speaking about risk management. There's a lot going on in this slide, let me just explain what we're talking about here. The blue bars represent vintage of AUM. This is the in-force AUM broken out by issue year. I like to think about this as the vintage of our AUM.
Each year represents the total AUM that's on the books today, broken out by the year it was issued. We've then broken out that AUM in the blue portion of the bar to represent the portion that has a living benefit, the yellow portion of the bar is that portion that has no living benefit. The values on the y-axis are connected to the account balance. We've then overlaid the S&P year by year on top of those account balance vintages, the value of the S&P is shown on the right y-axis in the values of that line coming across. There's a couple of things to take away from this slide, again, consistent with some remarks I made earlier.
The first is the vast majority of living benefits that we put on the books, the living benefit risks that we put on the books, we put at S&P low levels. When you put business equity longevity risk on the books where the S&P is at low levels, that's a lower risk business. The business that we put on when the S&P was at higher levels, the majority of that did not have living benefits. That's represented by the gold portion of the bar on the left side of the chart. Another example of selling your way to a new risk profile. This next slide is similar to the last one, I just want to call out the differences here. First, the similarities. This is still the vintage by year. We've just gotten rid of the differentiation for with and without living benefits.
These are all the same numbers in the bars. We've just gotten rid of the bifurcation of blue and gold. Rather than putting the S&P, we've installed the Treasury, 10-year Treasury, and we've overlaid, instead of the S&P line, you can see the Treasury line. The key point here is that Prudential Financial has been deliberate, consistent, and sustainable in our reaction to the pressures, the economic pressures on this business. This is what we have done in where Mark was countering the comments about insurers reaching for yield in low interest rate environments. That's not what we're doing at Prudential Financial. This is what we're doing at Prudential Financial. We're a conservative organization.
We've responded appropriately to the capital market pressures, and we've done that in a way that has enabled us to maintain relevance and importantly, maintain strong relationships with our financial intermediaries, the broker-dealers and financial advisors with whom we partner to sell these products to Americans. Over this time period, we've pulled various valuation levers in response to the capital markets pressures, they all fall into one of 4 categories. We've either increased the fees associated with the guarantee, or we've reduced the value of the guarantee. We've also suspended SUB Pays on older vintages of product, and we've shut down sales of annuity share classes that are more capital demanding. Share classes that consume more capital in a costly environment are share classes we've shut down. Those are the 4 primary levers.
I would point you to the appendix, I think it's slide 30, that gives you more granularity around the specific actions we've taken over this period. We've got every date that we've pulled those levers and what the value of those levers are. I think that's interesting. The more important point there is that they've been consistent, they've been transparent, and they've been well-received and well understood by all constituents. We've talked about cash flows, we've talked about capital markets assumptions, behavioral assumptions, the product design levers that we've pulled in order to manage risk. Beyond product design, we employ a pretty strong hedge strategy that utilizes derivatives to offset the volatility of the liabilities in this business. This is on top of all of the other things that we were just talking about. The hedge performance has been strong over many economic cycles.
This breaks out that hedge performance. Let me just walk through with you what's in this slide. The yellow bars represent the hedge gain loss in the annuities business relative to the annuities hedge target. The red line represents the inception to date cumulative hedge gain loss on the annuities program relative to that hedge target. Inception to date over 8 years, the annuities hedge program has produced a $500 million breakage number. On top of that, we have a corporate underhedge on interest rates. That corporate hedge on interest rates produced 1 year of material loss. The annuities hedge program has performed very well over various economic cycles. Okay, here's the GAAP balance sheet for the annuities organization. I want to spend a few minutes on this. The first thing to note in this balance sheet is that this includes our captive.
Our primary issuing entity is an Arizona-based insurance company, and the captive associated with that is also Arizona-based, as Mark mentioned earlier. The transparency and communication with regulators around what's going on in the issuing entity and its affiliated captive is completely clear. The other thing to note here is that we have $20 billion of liquid assets supporting $20 billion of long-term liabilities. The final point I will make with respect to the annuity GAAP balance sheet is that we have in excess of $8 billion in support of this business. $8 billion is more than 6% of year-end account balance, and $4 billion of the $8 billion resides within our captive. $4 billion of this $8 billion is in our captive, and the $8 billion represents in excess of 6% of year-end account balance. Let's talk about accounting for a minute.
Our view to this point has largely been economic, and that's really what fuels the strategic decisions of Prudential Financial. You can't have a conversation about this business without talking about accounting. I'm going to do my level best to try and connect the disconnects that exist between these two frameworks. We talk about FAS 133 and 157, and we talk about SOP 03-1, and the fact that company A might fall under one and company B might fall under the other. For today's conversation, let's simply accept that whatever accounting valuation you fall under is an accident of history. I can share with you, if you'd like, that full history, but I'd rather do that somewhere not from the main stage. It is simply an act of history.
It has nothing to do with any economic drivers from one company to another or from one methodology to another. It is purely an act of history. I'm going to use our own book as an example. Let's use the Prudential Annuities book of business, and within that exactly same economic value proposition, what would the impact be of a FAS 133 valuation as compared to an SOP 03-1 valuation? The headline is that the required equity and the volatility associated with a 133, 157 methodology is much greater than the volatility in earnings and equity for an SOP 03-1 methodology on the same book. This is not a difference between books. This is a difference between valuation. Why is that? There's a lot of mechanics, and we can confuse ourselves in the conversation around the mechanics of one versus the other.
The headline driver are the assumptions used in calculating the future value of the liability, and they are the assumptions used in bringing the value of that liability back to a present state. Let's talk about that for a minute. Under FAS 133, 157, you're looking at a risk-free world. There's no risk premium in the assumed growth rate with the underlying assets tied to that liability. What happens to the value of a future liability if you're not able to ascribe a risk premium to that growth rate? The value of that future liability is going to be large. Likewise, you bring that value back to a present date with a similar low interest rate, the present value of that liability is going to be large. Compare that to the primary driver of an SOP 03-1.
Where the assumed growth rate is not a risk-free rate, but rather a management's best estimate. The future value of that liability is going to be much smaller because embedded in that is a premium for risk. If you're permitted to grow your underlying assets at a higher rate, the future value of that liability is going to be less. If you discount that future value back at a higher rate, the present value of that now lower future liability is going to be less. That's the primary difference between 133 and 03-1. There are other things, again, we can distract ourselves with, but that's the key driver. We've established that those assumptions will generate a much higher liability in 133 than in 03-1.
When you put stresses on those valuations, the same stresses will have a much greater volatility on 133 than they will be on 03-1. By the way, same book. This is the exact same economic picture we're talking about. We're just employing a different methodology. Let's just use an example. I want to just remind everyone that in this slide we're talking about GAAP net income. We've been talking about cash flows all through this conversation. I want to make sure we don't confuse ourselves with this being a cash flow view. We're talking about valuation methodologies, and now we're going to talk about the GAAP income impact on those methodologies. In this situation, we're going to stress lapsation. This is what happens to GAAP net income under 03-1 versus 133 with the same stress on the same book.
When you employ the same stress on the same book, under 03-1, we have an increase in GAAP income, and on 133, 157, we have a reduction. Oh, by the way, a bigger reduction than the increase. These are intended to be directional and order of magnitude slides. Why is that? In the 03-1 version, the reduced lapse assumption generates a higher present value of fees than it does the increased value of the liability. Under 133, 157, it's just the opposite. Because of that driving interest rate assumption and discount rate, the present value of the change in the liability far exceeds the present value in the change in the fees. It all comes back to those underlying core drivers of the methodology, but it generates unbelievably different results. When you're looking at the volatility of a business, this matters.
By the way, again, this is done on the same economic book. Spend a few minutes talking about capital. I'm not going to go through all of these data points, but I just want to highlight a few of the assumptions. These assumptions will look familiar to you. In these scenarios, we're stressing equity markets by 30%. We're also stressing interest rates by 100 basis points, which puts you again at the 10-year treasury of 78 basis points. With those double stress scenarios, the first thing you'll notice is that the sum is greater than its parts. The $5.1 billion capital call for the annuities business is greater than the individual calls related in either of the single stresses.
The most important thing to take away from this slide is not so much that, as much as the 5.1 is the capital call required to return Prudential Annuities to the financial strength pre-shock. That's the first thing. When you employ these shocks, 5.1 is the call to return us to the financial strength that we were pre-shock. The other is that the capital protection framework is an enterprise instrument, and the capital protection framework has capacity sufficient to meet the capital calls of the Prudential businesses, not just the annuities business, of the Prudential businesses in stress scenarios such as these. Spend just a few minutes talking about new business. Recall that slide that I shared with you that showed the vintage. This was all the blue bars. We talked about the four levers that we've pulled over the years. We overlay the interest rate environment.
At that point, we had highlighted we had, over time, changed fees. We've changed the value of the guarantee itself. We've suspended SUB Pays, and we have shut down more capital-demanding share classes. In 2013, we have once again responded to those pressures. While we didn't pull all of those levers, and I think in every example, we didn't necessarily pull all of those levers at one time, we've pulled those levers in various amounts at various times. In February of 2013, we just launched HDI 2.1. The biggest changes in HDI 2.1 are really around withdrawal rates. We didn't adjust fees, so we brought down some of the value of the guarantee, and we did that by adjusting the withdrawal rates.
We also brought down some of the value of the guarantee by eliminating a guaranteed doubling of the protected withdrawal value after 12 years, so that's no longer in the product. We didn't change the fees, but we did install a fifth lever. In my recollection, it's the first time in 10 or 15 years that a company has adjusted the commission payable to a broker-dealer. We did that in February of 2013, largely with an eye towards preserving the market-facing value proposition. We are very interested in maintaining a balance, although we were the first to do this, we felt it was a prudent decision to reduce the commission payable to the broker-dealer in balancing the market-facing value proposition to the contract holder. By the way, we did that in complete transparency.
We worked with our broker-dealer partners and shared with them the plan to do that, we have, again, maintained strong and stable relationships with our broker-dealers and financial advisors through even the recent change. The product that we're now offering in 2013 continues to deliver strong performance, we're going to show you that in the form of cash flows like we have before. What you see here is the present value of cash flows for a $1 billion block of sales in our HDI 2.1 product. For a billion dollars in production, the present value of cash flows is $146 million. There's a noticeable, visible difference in this cash flow presentation than the ones we delivered earlier, that's the big red bar to the left side. The big red bar to the left side is acquisition cost.
In this present value of cash flows, since these are new sales, they're baked into that cash flow analysis. In the present value of cash flows that we showed before, that was a present value of cash flows of the in-force book as of year-end. There aren't future acquisition costs in that picture. I just wanted to highlight that difference. The big takeaway here is that the new business performance is strong and generates robust cash flows. I guess I'll end where I started. I think it's important first to take an economic view of the business. The economics of this business remain strong over intermittent periods of volatility. When you look at the accounting framework, you're going to see a tremendous amount of short-term volatility that is not necessarily consistent with the long-term economic value of this business.
We've gone through a view of the in-force business. We've shown you all of the assumptions that go into that business, again, consistent with 2012 GAAP assumptions. We've stressed all of those assumptions individually, both capital markets and behavior, then we've brought all of those stresses together in one scenario. We've shared with you our view on risk management, some of the risks that we've observed, and the tools that we use to mitigate that risk. Finally, we've given you, I hope, a very clear picture of our view of the new business. We're proud of this business. This is a noble effort with respect to the needs of Americans, and it's a quality book of business. We view this as a quality book of business for Prudential Financial investors, and we think you should, too.
Thank you for your time today, thank you for your interest in Prudential, I think now we will open it up for questions.
I don't know, I'm guessing that some of you may have some questions for Charlie and Bob. Before we launch into the questions, just a few rules of the road. First, I'll call on you. Second, please wait for the mic. Third, please state your name and that of your firm. Finally, please be brief. One question and one follow-up for each time I call on you. Let's start on this side of the room. Who has a question? Oh, one other thing. I am all but legally blind. The lights in the room are very challenging. I can't even see Neil Stern in the back of the room. If I grunt and point instead of recognizing you by name, I apologize. Okay. The gentleman in the back with his hand up.
Hi. Thanks. Seth Levine from Guardian. Just a quick question on slide seven in the annuity presentation. Just curious how your baseline assumptions have changed over the years. Thanks again for all the disclosure. This is very helpful.
Probably the biggest change has been with respect to the baseline lapse assumption outside of surrender charge period. Most recently, that came down, I think it was in 2012, from 10% to 9%. Then we've adjusted over time the dynamic function that we apply to that. The slope of that function has been adjusted as we observe deviations from our prior assumptions. We're feeling confident about the assumptions we've made, and again, we continue to update those. I guess the headline issue would be, I'm just looking at the slide here, the outside of surrender charge period from 10%-9%, and then the slope of the dynamic function. The others, I think you saw on the utilization assumption and the efficiency assumption, they're pretty much in line. The capital markets assumptions are fairly straightforward.
Jeff Schumann, I can see you. Keep your hand up, please.
Thanks. Jeff Schumann from KBW. A question about the balance sheet and the captive. Mark said earlier that, I'm probably oversimplifying, but that you basically don't derive an enormous, obvious financial advantage from the captives, presumably including the VA captive. Yet you have established and maintain these very large captives, including the VA captive. What exactly is the practical advantage of the VA captive that makes you want to maintain it?
The headline issue that I'll respond to, and then we could either turn it to Rob for a later response, is really one of efficiency and cost. We are able to aggregate risks in a captive and manage our capital against those risks more effectively. That's the primary purpose of the captive.
I guess I'm confused because I think some other companies write VAs on the number of entities. The idea of collecting in a single captive maybe makes more sense. I thought you primarily wrote the VAs out of a single Arizona company, why does moving it from one single spot to another single spot create a more efficient?
We write out of three different statutory entities. The largest one is the one in Arizona, but there are two other ones.
Okay, just basically the execution of the hedging, for example, is that what's more practical, or?
Do you want to
Yeah.
Turn toward Yeah. It's really just trying to bring together the assets and the liabilities in one place to manage them in aggregate. As Mark said, we're not trying to use hollow assets. The assets are fairly transparent, and all we're doing in our captive is bringing together the liabilities of multiple entities in order to stack up our strategies in a unified approach against those liabilities.
Okay. Thank you.
Yeah.
Okay. We're just going to move up, the gentleman in the blue shirt up here, a little further up.
Mark Finkelstein, Evercore. I guess my first question is just a clarification on the baseline scenario cash flows. Are those done as of 12/31, so all the cash flows from 12/31 onward?
Yes.
That theoretically excludes the reserve build that's accumulated. That's not included in these cash flow numbers.
Nothing since year-end other than the cash flows. The baseline is year-end 2012.
Okay, theoretically, we should be adding some form of reserves and capital against that to the total cash. Okay. My follow-up is on the GAAP balance sheet. Maybe my question is, I'm trying to understand how the hedged target liability is set. Is the liability actually set at a CTE97 level?
Do you want to take that, Rob?
Is the hedged target liability set at CTE 97?
Are the total liabilities that we're seeing here, is it set as I'm trying to figure out, if I've got $20 billion of liquid assets, which is equal to my liabilities, I thought we were capitalizing it at a CTE 97.
We are capitalizing the capital at the CTE 97, I'm not sure I'm fully grasping your question. Maybe we should defer that one till the end of the day.
Okay, fair enough.
All right. David Small, the fellow next to the fellow who just asked the question. There you go.
Thanks. David Small, J.P. Morgan. I have a question on page 23 of the annuity presentation. I guess I'm just trying to understand the capital requirements, particularly on the equity sensitivity here. I'm surprised, given that you have an auto rebalancing product, the increase in capital requirements when you move from down 10% to down 30% is larger than I would've thought, and it also seems like the asymmetry of it when you go to the up 30% is also a little. Maybe you could understand what's going on there, and then also help us explain, because you have talked about how you hedge the interest rate component of it, why we have that cumulative impact of $5.1 at the bottom.
Let me take a stab at that, if we're going to need more detail, I'll suggest that we provide it later in the day. Let me take the combined $5.1 billion and bifurcate it, I think that'll suggest an answer to your question. Of the $5.1 billion of capital we would need, $3.1 billion is in Pruco Re, and $2 billion is in our direct writing statutory entities. The vast majority of the $2 billion is increased capital to support greater GMDB risk. Remember, we don't hedge GMDB risk explicitly, although the auto rebalancing is a form of a hedge to mitigate the equity market risk there.
If you look at the $3.1 billion out of the $5.1 billion that's in Pruco Re, $1.3 billion is additional capital to mitigate or to support greater living benefit risk, and the other $1.8 billion is to fill a hole from a loss from assumed greater hedge breakage. We do not assume 100% hedge effectiveness in tail scenarios. Does that help, David? I can't break it apart like that for the individual equity and interest rate risk, I think that clearly it's mostly GMDB that you're looking at there. Let's go back to the fellow on the end in the blue shirt.
Hi. Thanks a lot. Seth Weiss, Bank of America Merrill Lynch. I had a question about slide 14 in the annuity section with the $2 billion economic in the money in this there, it's described as being defeased by buying an immediate annuity in the market. Maybe this goes to the intricacies between a income benefit product versus a withdrawal benefit product. Isn't there optionality that the policyholder has that would make the economic in the moneyness maybe a little bit more than if this was more of a traditional GMIB product?
Yeah. The first is, I don't think the view would be altered at all under an IB versus a WB. We could construct this exact same economic output with a WB as we can with an IB. This is not at all driven by the optionality. This $2 billion assumes the cost if we had to fund this full deficiency, if you will, at year-end 2012. The cost of funding the cash flows over and above the cash flows that would be supported by the $95 billion is $2 billion. That is irrespective of an IB versus a WB.
Thank you. Okay, further up on the same side. Suneet, you're next. Keep your hand up, please. Gentleman in the third row, green tie.
Thanks, Eric. Just two quick ones. The first is on the captives again, just to set it all out there. If you had to consolidate your captives with your writing entities, would there be any impact on risk-based capital ratios that you have?
That is a great question. That's one I'd like to defer till the end of the day.
Okay. My VA question is, I think in the footnotes of maybe page four, your slide shows that about 43% of account values are in, I think, fixed income instruments, fixed income funds. Can you just talk a little bit about how that auto rebalance feature would perform in a period of, say, rising interest rates as well as not robust equity markets, maybe stable to slightly down?
I just want to take a look at the footnote here for a minute. 52%. One thing I need some clarity on, and I'm going to look to my team here. I don't know if that fixed income represents That's not so much the allocation to the safe harbor asset as it is the allocation of client-directed assets to a fixed income fund. I'm looking, which is what that is. This says that of the client-directed assets, 52% of those are allocated to one, and 48 are allocated to fixed income. Equity versus fixed income. The auto rebalance program, on a prorated basis, moves money from both of those pools, the fixed income and the equity, into the safe harbor constant maturity bond fund. That's what that footnote refers to.
What would happen to the book in a rising interest rate environment is going to be largely a function of how much of the book is sitting in the safe harbor asset. In a rising interest rate environment, the bond values will lose money, and depending on how much money those bond values lose, would impact whether or not transfers would be made. That wouldn't matter whether the bond allocations were in the client-directed assets or they were in the safe harbor asset.
May I embellish that response very quickly? If you look at slide number nine, the outcome that we would expect in this scenario that you posited, Suneet, would be roughly comparable to that shown in the negative market scenario where equity prices are down by 30% and interest rates are flat. We don't have it in the book, but we have looked at that particular scenario.
The yield on that portfolio will also increase after that. The performance and the ability to mitigate our risk long term is preserved.
Now you're going to get a commercial. Auto rebalancing is a risk mitigant. Auto rebalancing allows us to offer attractive guarantees at a competitive price and still make money. It is not a portfolio optimizer. There is a cost associated with auto rebalancing. We estimate that the give-up in returns relative to the same portfolio without auto rebalancing is 0.4% a year.
That immediate bond loss that you talked about, I think when rates go up, how would that show? Would that show up at all on the income statement or in the financials?
That wouldn't show up in the income statement. That would show up in the client's account balance. As the client's account balance would suffer stress under a rising rate environment, it would show up in the income statement by reason of the account balance separating from the guaranteed value.
Right.
Anything that would need to be put behind that change.
Just one other embellishment to something that Bob said earlier. Remember that the duration of the liability is much longer than the duration of the bonds we hold as assets. Over time, the higher coupons will swamp the initial loss from rising rates.
Thanks, Eric.
The gentleman right behind Suneet on the aisle.
Good morning. Yaron Kinar from Deutsche Bank. I have a couple of questions on slides 10 and 13, basically the lapse rate assumptions. One is, I'm still a little bit surprised by the lapse rate assumptions given the degree of in the money-ness, and maybe you could help us think about what would drive a policyholder to lapse when they have 20%, 30%, 40% upside with a guarantee. With that in mind, if we turn a page to slide 13, could you give us any sense of what the, on the left column, what the break-even number would be by changing lapse rate assumptions?
On slide 13, if we in a 30% equity shock and 100 basis point interest rate shock, what would the break-even lapse assumption need to be in order to generate break-even cash flows?
Right.
Is that the question? I don't know that off the top of my head.
You know what?
I apologize.
I'm going to suggest-
That's a tall ask.
That we not be asked to provide similar present values for scenarios that we haven't presented here.
More than 20 is all I can do at this point. I apologize. The other, on slide 10. I think if I remember the question correctly, why would somebody who is so deeply in the money lapse their policy? The simple, and I apologize, not terribly scientific answer is they're human, and humans have needs, and they're not always the most efficient behaviors. We've seen that time and time again in many observations, and this is no different. People have events that happen that are unexpected, or maybe they are expected, and certain of their plans didn't meet those objectives. I apologize. That is the fact, and it's manifest in the data. The answer is just that they're human, and they have human needs.
Sometimes we forget that unlike analysts, annuity contract holders are human. Forgive me. Any more questions? Let's go to the other side of the room. Chris Giovanni in the back. All the way in the back.
That's Eric Durant, Head of Investor Relations.
Thanks. Helpful disclosure. The calls on capital scenario, I guess in the inverse, how do we think about your ability to get capital out of the business? You point to $8 billion or over $8 billion of capital backing that. You show the new business cash flows. When does that come back to the shareholder?
By the way, that $8 billion is GAAP capital. The statutory capital, including the modified GAAP capital in Pruco, is about $4 billion. This one for you, Bob, or do you want to?
No, I would run a different.
Let's defer that one till the end of the day. We will address that question at the end of the day.
Okay. Then in the break-even scenario where you show 9% declines in equity markets, are you implementing the auto rebalance throughout that cash flows where you're shifting then in that scenario into fixed income where you're generating the baseline close to 3.5%?
We are. What happens is at some point, that money ends up in fixed income. You're seeing some of the preservation impact of the algorithm in generating those cash flows. That's exactly why it's there, is to preserve the account balance during stress scenarios.
Any sense how quickly we get from where we are today in fixed income portion versus a few years out in that down to 9 scenario?
I'm sorry, I didn't hear what you said.
How quickly do we get to kind of the higher elevated fixed income component within that auto rebalance function in the down nine?
Let me just make sure I understand the question. What's the slope of migration from equity to fixed income?
Correct.
I apologize. I don't know off the top of my head, but I can tell you it's Let's see, nine. There's going to be some in the first year, in the 9% year, because I know we'll trade in the first year. The first trade will happen when there's a separation of 7%. We'll put maybe 15% in the first year. Then I'm going to speculate here, but it's going to be less than that each successive year.
Thank you.
Fair, Dan? Okay.
Let's stay on the same side of the room. I'm sorry. Is that Jimmy? Okay, Jimmy, I'm sorry.
Hi. Jimmy Bhullar, J.P. Morgan. I'll ask on something other than annuities, I guess. On disability, as you're repricing, maybe talk a little bit more about how much you're raising rates. Even if the margins improve a couple of years out and you go back to where you used to be, should we expect that the block would shrink a lot just because you'd see lapses or cancellations of contracts? On the FSA, on the full service pension business, what are you seeing in the market there? If I remember several years ago, you used to be relatively positive on the business. The last few years have not been as positive just on pricing and market trends.
In terms of disability, I would say high single digits is where we are. It depends. It's on a case-by-case basis. What was the other question? I'm sorry, Jimmy.
Just-
I got so-
On disability, should we assume that the block would be a lot smaller as you are raising prices?
I think it's fair to assume if you look that we were down 34% in sales year-over-year, that the block will be smaller. I think that will kind of feather out at some point and level off, if you will. We are letting some cases lapse as we pursue profitability over sales. I got so excited that you actually asked me a question, I forgot your second question. Your other question was?
On the full service business.
Thank you. Okay. In full service, we actually like this business a lot. We continue to invest in the business. We are pursuing, again, this is a consistent theme across all the businesses that we pursue the appropriate risk-adjusted returns over the degree of sales we have. Sales have been relatively flat. We are seeing a pickup in RFPs, and we're excited about the business going forward. As we've said, you're not going to see a hockey stick in terms of a huge increase in sales, but I think you'll see consistent sales that we feel are at a profitable level. We like the business and we're committed to the business.
Pricing trends in the market? We heard from other companies that there's been a lot of price cuts going on, especially on the part of asset managers in this mid-market.
There's been a lot of what, sorry?
Price reductions and price competition.
It's a fairly competitive market, which is why I think a couple of years ago when we were here, we said that we were pulling back slightly from the marketplace in terms of being as aggressive. I think there is still ample opportunity to create appropriate returns. You just have to be selective about the cases you take. I also think that there is a trend toward looking at pricing, but also looking at service level as we go forward, and there is more of a focus on service level than there perhaps has been in the past, and that's in part because the buying proposition now is moving back from procurement to HR. They're looking very much at the service levels that's provided.
Thanks. Okay. Let's move up a little bit. Ryan Krueger, you're next.
Thanks. Ryan Krueger with Dowling. I guess I'll move it back to annuities. On slide 23 on the capital calls in the tail scenarios, I wanted to clarify. I thought the footnote made it sound like these impacts were actually prior to the change in hedge assets in these scenarios. Can you just clarify if they are before or after the impact of hedges?
No, I can't, honestly. I thought they were after, but yeah.
They're after.
Okay. Thanks. Then on the lapse rates, the 5.4% dynamic lapse assumption seems to jive with something in the magnitude of 40% in the money on a notional basis, which is higher than I would've thought. I guess, first of all, is that the correct read of that chart that deposit holders are about 40% in the money?
That's the correct read.
That's just on deposit holders that are out of the surrender charge period?
That's right. It's not a terribly big book.
Okay
That are outside of the surrender charge period.
Thank you.
Yeah.
Erik Bass is next. We'll get to you, Tom.
Thank you. Erik Bass with Citigroup. I was hoping you could talk a little bit more about the current dynamics in the Pension Risk Transfer market, particularly, since the GM and Verizon deals, we haven't seen any more large transactions in the marketplace. Is that a function more of companies not wanting to act with underfunded plans, or is it kind of a gap in the bid-ask on the product? Just one other, in terms of international, some of those markets appear to be opening up as well, whether it's Canada or the Netherlands. Does Pru have the ability to participate in those transactions if they do happen?
Sure. Okay. In terms of the Pension Risk Transfer market, I think you can divide it into really three parts. The first part is the jumbo market, that would be what we define as sort of $1 billion and above. There are a limited number of players that can play in that market from our perspective. What we're seeing is that you have a large number of companies that are seriously considering this, but obviously haven't moved yet. There's a very long lead time. A lead time will be defined as sort of 12 months to go through regulatory approvals, go through board of directors, go through all the machinations that they need to go through. I think there are a fair number of companies that are thinking about it, but obviously, they haven't acted on it for a variety of reasons.
You have the sort of $1 billion and below. There you see a reasonable flow of Pension Risk Transfer deals. We are not as competitive in that deal. There are a lot more players that play in that market. It tends to be more of an auction market. Going back to a comment we made earlier, we are really good at big, complex deals. That's where we think we add value. That's where our businesses work together. In Pension Risk Transfer, on the larger side, you really have to have a lot of businesses work very closely together as well as the functional areas. That's where we think we can add value. On the smaller side, it's more an auction market. There are deals that are being done. They have been done. It's sort of a consistent market.
The third market you referred to would be the international market, and there you see the U.K. market. The U.K. market has been in business for years. They are way ahead of us here. We are active there. We are looking at Canada and the Netherlands. We would operate as a reinsurer of longevity risk in that case. Yes, we can operate there, and we are seriously looking at those markets. I think you're right, Canada would be the next one to open, and we say that the Netherlands would probably be after that. The U.K. is definitely in the lead.
Okay. Thank you.
Okay, Tom, you're next. The gentleman on the aisle right in front of you. There we go.
Thanks. Thomas Gallagher, Credit Suisse. Pardon my voice. Bob, just a question for you in terms of, is there any consideration about the GAAP net income volatility that's caused by the type of product you sell for VAs? I know on slide 21, you make the point that the type of product you sell is hit disproportionately hard. The reason I ask that is if we think about what's likely to be coming down the pike over the next few years with non-bank safety rules, GAAP net income is I think going to be of growing importance for you on an annual basis. If the market's as hard as it is, and as you point out, why can't you also tailor products where you don't have the kind of wild swings in GAAP net income? Any thoughts on that would be appreciated.
Yeah. I'll remind you of the comment I made earlier. It's an accident of history. It's not a choice. We have explored constructing value propositions that we would think would fall under SOP 03-1, because of how and from where we grew, we will only be permitted to issue longevity products under FAS 133. This, again, is not an economic issue. You can't construct an annuity product that has a different economic value that will land you in SOP 03-1. It's simply not an economic issue. I can construct the exact same value proposition, and because I'm delivering it under the Prudential logo, it will be valued under FAS 133.
Well, I guess asked another way, are there different structures within the VA space, whether it's an IB or some other type of product offering? I'm saying that because you look at your GAAP net income volatility, it's been dramatically higher than most others in the industry. Is that something that you would contemplate or consider?
Tom, I promise you, it's not for lack of trying. We have explored this for years in trying to figure out what would the required fact pattern of a product have to look like in order to get SOP 03-1 versus FAS 133. We've worked with the accounting community in an attempt to construct longevity products today that we could get valued under SOP 03-1. The simple answer is we cannot. I'll give you the headline history lesson here. The headline history lesson is that IBs originally were valued under SOP 03-1 because they did not contain liquidity provisions. IBs had a 10-year blackout period, and under that original blackout period, they were valued under SOP 03-1. The original WBs, if you'll remember when they first came out, they didn't even have a longevity component. It was a straight return of principal, 7% a year type of a product.
Because of that liquidity and the way that product was structured, it was valued under a mark-to-market structure. As these companies competed against each other, the lines between the two evaporated, the valuation regimes persisted. That's the world that we're in today. We are a FAS 133 company because of from where we came. Other companies are SOP 03-1 companies because of from where they came, having nothing to do with the economic values. I can even construct a GMIB with a blackout period and not achieve SOP 03-1. Again, it's genuinely an accident of history having no connection to economics. My hope is someday these will be reconciled because the economics are certainly not the drivers.
Okay. The gentleman two rows behind, Ian Gutterman.
Hi. Ian Gutterman with Adage. First, thank you for the enhanced disclosure. It's much appreciated.
You're welcome.
I want to take one more shot at slide 23 because I'm still a little confused. The $5 billion of capital requirements in that bad scenario, how does that get funded today? How much on-balance sheet capacity, whether it be your excess capital or just regular VA cover reserves and so forth, that would fund that versus required new capital?
That's a great question. I'd like to defer it till the end of the day.
I thought you might say that. I thought I'd try.
It's a capital protection program question. That's an enterprise level program. This is really not the time to discuss it. We're happy to address it later on.
Fair enough. My other questions were on policy holder behavior. You honestly described what would happen if the efficiency got worse and how that could harm you. On the other hand, the utilization of 95% of people using withdrawals seems conservative. How much of a benefit could that be if that was 90% or 85% or something lower? Just order of nine, rough ballpark.
Yeah. I can't give you a delta on the present value of cash flows by reason of that going from 95 to 90. If you think about what would happen, obviously our claims would be reduced and our fees would be increased. The utilization assumption coming down would have a positive impact. I simply don't have the data. I have no problem sharing it, I just don't have it available. I can tell you we're tracking nicely along that trajectory to 95, so there's no reason to believe that's in jeopardy. Certainly, there's not a lot of room on the upside for that to go up. I think we're fairly conservative there. There may be some opportunity.
The other one, which is probably more involuntary behavior, but you guys have been running some new ads that emphasize the ability of how many people are living to 90 and 100 and so forth. They make me a little bit nervous when I think about this book. If mortality extends a year or two or whatever in the future, is that as bad as lapses changing or not as severe? How should we think about mortality versus lapses?
We've baked in mortality improvements in our mortality assumptions. As we look at mortality risk, we're assuming that when we put business on, that mortality will improve in future years. We've tried to account for that.
Okay. Thanks.
Okay, who have we missed who would like to ask a question? A couple in the back of the room. William Rubin is
Great. William Rubin from BlackRock. First, just the $20 billion a year in growth sales for VAs, is that something that we could expect going forward to be typical to be expected? Then second question after that I'll ask in a moment.
The short answer is no on the $20 billion. We've actually adjusted our value propositions throughout 2012. Our Q4 run rate dropped us down in the end of 2012, and we've maintained that run rate through 2013 to an annualized run rate-
We don't want to give a number
lower than 20.
Yeah. Thank you.
If you look at the first quarter, we had a gross sales of $4.2 billion, that included in it probably $400 million of fire sales, you're down to $3.8 billion. We've said that we expect sales to be lower than that. That's about all we're saying.
Remember that our latest product only hit the market on the 25th of February, you're not seeing the full effect of that in the first quarter sales.
Okay. The second question is on page eight of the baseline scenario cash flows. The $10.5 billion in hedging costs, just curious, I know you didn't break out the specific in the sensitivity analyses, the different cost of hedging changes, but just wondering how sensitive either in a benign environment or in a stressed environment, how those hedge costs would change.
They will change. Again, I can't give you specific dollar numbers associated with the $10.5, but in the cash flows, in the stress scenarios, we adjusted our hedge effectiveness assumption. In the baseline assumption, we're assuming 100% hedge effectiveness. In the stresses, we're assuming 80%. We've accounted for some increased costs associated with hedging in the stress.
In that stressed environment, though, would that number go up by 20%, 30% in cost?
I'm not prepared to answer. I'm not sure if Dan or Rob are prepared.
We'd be way underwater if they did. Right now, the $10.5 billion represents more than 90% of the rider fees, including transaction costs.
Okay, thanks.
One more. Is that Randy Binner back there?
Thanks. Randy Binner, FBR Capital Markets. Sorry if I missed this in the PRT discussion, but when you did GM and Verizon, there was a kind of a capital-friendly treatment because it was done last year, so the discount rate you were able to use is higher, which kind of negated the impact to RBC. It's kind of a two-part question. One, is there any way to quantify what the RBC impact would be if you did a GM this year? I'll follow up. Meaning, if we were going to expect one, we'd have to have a bigger RBC impact, and that's how we think of capital. Is there any way to size what that would look like this year?
No. It's too hypothetical, Randy. I'm sorry. It's an interesting question, but not one we're going to be able to address.
Do you have a sense from your competitors in the market that there's less appetite for these transactions given that the discount rate is harder, and it's capital intensive and the discount rate treatment is potentially harder this year than last? Has the competitive environment for these opportunities changed at all this year versus last?
We can't really talk about the competitive environment. We don't see a lot of competition at the level in which we play. If we're looking at the larger end of the transactions, all I can say is that we're in substantive dialogue with a great many firms about doing something eventually. Who knows when eventually is. We don't talk to them about who else they may be talking to. At the smaller end of the market, we don't see any letup, if you will, in terms of the competition that's there. There are a fair number of players that play in the small end of the market, and they continue to be active in the market.
Thank you.
Okay. Let's take a 15-minute break. Let's get restarted, if we may. Okay, we're falling behind schedule. Is everybody coming back? Remember, we can't stay much beyond 12:30 P.M. because we've got another date at 1:00 P.M. Okay, our next speaker is Edward Baird, who will be addressing our international insurance businesses. Ed?
Thank you, Eric. Now for the easy part. I'm going to talk about international insurance. I'll briefly recap what it is the businesses have achieved. Since most of you are quite familiar with that, I'll concentrate most of my time on trying to explain to you how it is the businesses have achieved this, so that you can have a deeper understanding of how it is that the business delivers what I sometimes like to refer to as the trifecta of results. That is a high ROE, steady and stable growth in AOI, and very low volatility. I'll try and take you inside both the strategy, the business model, and the execution of that to really understand what's common across the businesses. Let me first start with just some key messages and a brief recap, as I stated, of what it is these businesses are achieving.
We see here in the very first slide, what we have is a very steady, and over the years, consistent strategy, which is evolving very gradually, and I'll highlight that for you. Also, while it's simple to say, it's hard to do, and that is to execute these strategies in a very high degree of quality and consistency. As a result, you get this set of results financially, which really characterizes this business and defines what it is that international contributes to the portfolio of businesses within PFI. The fundamental part of the business, which I will stress throughout, is our proprietary agency system. That's characterized at its highest level with the Life Planner, then followed up by its close relative inside the Life Consultant, and then more recently supplemented with the bank channel, which I'll also talk about in some detail.
The result is that we have a leading position in Japan, and we have an expanding presence in other markets. This is the set of results that the business achieved last year. I won't spend time on this other than to cite to you the numerical support for the statements I just made regarding the ROE, the AOI, and as we'll see in future slides, the very low volatility in these results. Let me briefly recap the evolution of the strategy. There's been very little change, but it has evolved over the last decade or so in ways that I think are worth noting. Let's start with first our M&A strategy, if you will, the number of countries in which we operate. Last year with our entrance into China, we rose to 10 countries in which we operate.
We see growth more by getting expansion within the countries in which we operate than we do by entering new markets. Having said that, we do remain open to slowly and selectively entering new markets, but that's not necessary for us to achieve our objectives. The historical basis of Life Planner was to focus on the affluent and the mass affluent market, always using need protection and with an emphasis on the proprietary distribution and on the debt protection needs. That continues to be our foundational strategy. We have been supplementing that by expanding, as you can see on the right-hand side, with the acquisition of Kyoei, now Gibraltar. We've been reaching into the middle market, not just the high-end market of POJ, the Life Planner company. We've also been addressing both some accident and health and some retirement needs as well.
Finally, we have been adding some supplemental distribution. Common to all of these business models is a focus on discipline, which again, I'll evidence for you with concrete examples as we go through. Let me start by drawing attention to Japan. This is where I'm going to concentrate my remarks because this is where we concentrate our business. Japan is very much in the news these days, as it is frankly, periodically for different reasons. I do want to remind us of some fundamental aspects of this marketplace, which we find to be core to our success. Let me start with the obvious, which is this is a very big market. In fact, it is bigger not only than any of the other markets in Asia, it's bigger than the combination of all the others combined.
This is a market that we are pleased to be in and to have entered initially in 1979 with a joint venture and in 1987, when we first launched POJ as a freestanding company. If you look at the next column where it's Asia next Japan, we have highlighted the four biggest markets there, and I will draw your attention to the fact that we are in all four of those. We have a presence in China, Korea, Taiwan, and in India. We purposely highlighted Southeast Asia as the next up for two purposes. One is it gets a lot of attention, but there's more attention than there is substance to date in those markets. I take nothing away from its future potential.
It's an area that we are spending some time looking at to see if it offers potential for us to potentially slowly and selectively enter. I do want to put in perspective that whatever growth one might get there, it's going to take a very long time before that market represents an opportunity on a scale anywhere commensurate with what's available to us in our home market there in Japan, a market that we purposely refer to as Prudential's second home. Latin America is a place where we also have a meaningful presence, in particular in Brazil, to a much smaller degree in Mexico. Those two countries, by the way, represent 70%-80% of the entire Latin American market. We feel very comfortable with the markets in which we operate. We purposely are not spending meaningful time in Western Europe.
It's a market that is both mature and slow-growing, and one where we don't believe we can meaningfully answer the question, why Pru? Which is a question that we always very candidly challenge ourselves with. What is it that we can bring to the marketplace that allows us to achieve superior returns on a sustainable basis? It is precisely that question that I will attempt to answer for you in Japan, business model by business model. Let's take a look at the sales results that we have achieved, and let's break them down by the business channels before we enter into a description of how those results were achieved. As always, we'll start with Life Planner, and here I'm going to be describing the totality of PII, not just Japan, which we'll drill down into in a few moments.
We see a very steady growth in sales in our Life Planner business. That's quite typical. You're not going to get explosive growth through a proprietary agency system, but you can get very steady growth, and that's precisely what you see here. That's equally true in the proprietary distribution that we refer to as Life Consultant, which is more of a middle-market proprietary agency system. You see a meaningful jump there in the last two years. That, of course, is the result of the acquisition of two companies, Star and Edison, which were folded into Gibraltar, and which we'll talk about in more detail a little later on. This classic fundamental growth in our core businesses has been supplemented meaningfully in the last couple of years, only in Japan with the addition of bank distribution.
Finally, a certain amount also limited primarily to Japan in the introduction of independent agency system. So it's through the aggregation of those four that you see the very dramatic growth that has taken place over the last five years or so. I want to draw just a little bit of attention, and then I'll move on to the non-Japan part here. Not because it's important now, but because of what it could represent in the medium and long term. Because we want to make sure that we're planting seeds that can grow to supplement over time the growth that we've achieved and continue to achieve in our dominant position in Japan. So what you see here is Korea, Brazil, and Taiwan, the only three markets we're currently in of the collection I've mentioned that I think could have a material aggregate impact over the medium term.
I think in the long term, by which I'm referring to a decade and out, you can look to markets like India and China to contribute to the overall portfolio. Given the short to medium-term focus that I think is appropriate here, I'm going to concentrate my remarks going forward on Japan. Let me spend a little bit more time just at the PII level to take a look at the earnings that we've been getting out of it. So let me draw your attention first to the double-digit growth, but let me draw your attention to a few other features which I think are worth noting. One is the source of earnings, and that's illustrated by the colors. If you look at the blue bar, you see the vast majority of the earnings are coming out of the blue, which is mortality and expense.
That's precisely the source of earnings that we prefer. It's what allows us to deliver that kind of steady earnings. You see a smaller portion that's coming out of investment margin. There are two sources of that. The primary one, both historically and currently, is Gibraltar. And the reason for that is you will recall when we acquired Kyoei, took it through bankruptcy, it gave us the opportunity to reset the crediting rate. That gave us an immediate positive investment spread, which has continued throughout that period of time. Now, more recently, the bank products, which we'll talk about in some detail, have contributed to this because the bank products are further along on the spectrum from pure insurance to savings.
The nature of a bank distribution lends itself more to products that tilt towards the savings end of the spectrum. Therefore, are more dependent than is the traditional insurance distribution on that investment margin. You can see even today, after very substantial growth in the bank channel, the vast majority of our earnings comes out of mortality and expense margin. I would also point out to you before we move on one other thing. That is in today's environment, we frequently get questions that are in the what if category. What if something happens in Japan? We will show you some stress tests with some examples, but I don't know that I could come up with a better stress test than the history that is portrayed to you in this slide.
If you look at the global financial crisis that occurred in 2008, you think about the events that occurred over the last five years in Japan, in terms of the tsunami, literally a nuclear meltdown, extraordinary volatility in terms of interest rates, currency, equity market movement, change in administration, and even more parochially, change within our industry. Carriers who, as a result of the financial crisis, either changed their portfolio or in some cases literally left the country, others who entered the country. Yet if you look at that slide, you see no evidence of any of that. That's a key point I'd like to emphasize to you.
The source of earnings, the nature of our business model, the manner in which we execute it, reinforces the theme that I hope has been coming through in all of the preceding presentations, which is we take a conservative approach. We focus on earnings. We're much less interested in bragging rights about top line and much less dependent on the macro of an environment in which to operate. We're not immune. This slide shows you we are largely insensitive to that. In terms of return on equity, the first of the trifecta results that I referred to, a high ROE.
You see the historic 20% ROE that has characterized this business temporarily suppressed as a result of the Star Edison acquisitions, as you can see, rising already as a result of a successful implementation of the integration and the achievements of the financial result for which we acquired those two companies. Let me begin the first of three drill downs. I am going to talk first about POJ and how is it that this business achieves continued growth and high ROE in a marketplace that has some of the macro challenges that we have seen Japan has. I will then talk about the Gibraltar business and the integration of Star and Edison. Finally, I will talk about the bank channel model as well. Let me drill down into what it is that makes this business, as we like to describe it, truly different and better.
Rather than leave that out there as just sort of a sales pitch, I am going to substantiate why it is different. Then, as you have seen already, it clearly is achieving better financial results than any of the companies in that marketplace. At the most simple level, it can be characterized as defined by these three elements: highly productive agents who therefore stay in the business and who largely therefore influence our ability to keep our customers. Let me back that up with some numbers, which you have before you. I think if you take a look at the productivity, both the number of cases sold per month and the average premium per Life Planner per month, I think you will find that literally unmatched, not only in Japan, but quite possibly in any company you look at as you analyze around the world.
The reason I highlight that is that I think most people will tell you the single biggest challenge in this industry is distribution. The most difficult, the most expensive part of the business. This is where our source of greatest strength is. As a result of that, you get manifold benefits. One is quite simply, you get retention. An agent who can produce stays in the business, and an agent who stays in the business can keep a customer stay in the business. You get the beginning of what we refer to as the virtuous or beneficial cycle. This is the characteristic that most separates us from many of our competitors. If you look, for example, at that productivity, as a result of that, very high average income. That income means they stay in the business.
Staying in the business means we do not have to spend the time and money that our competitors do to recruit and develop. Think of that for a moment. We can have the same sales as another competitor and make a lot more money because they have to spend a lot more time, energy, and in most cases, people and rent to achieve that same result. That efficiency is a key source of the high margin and of our differentiated ability to sustain this. It also leads to customer satisfaction and as a result, the persistency. Another benefit, by the way, of the persistency is the fact that you can get referred leads from it. That quality referral is an understated, significant element. Because the biggest problem any agent in the world has is what is sometimes referred to as an empty waiting room.
They have no one to talk to. Three things an agent must do to survive, let alone succeed. They have to prospect, they have to present, and they have to sell. By far, the single greatest cause of failure is the first one, prospecting. I'll show you in a few moments why for our people, that's less of a problem. Before doing that, I do want to emphasize in the upper right that this virtuous cycle I just described to you is the beginning of what we refer to as 3 Qs. These are very simple concepts, but they're very important, and the simplicity should never lead one to underestimate their significance. You will see repeated here again the theme that from John on has been repeated, which is the criticality of quality people, and I will show you the material benefit of that momentarily.
Quality products and also quality service. Products can be copied, prices can be cut, but building an organization of high-quality, productive people is neither easy nor quick, and in many cases, it's simply non-reproducible. It is the source of our sustainable competitive advantage, which is elusive, if not impossible, to achieve in the financial services industry. It is the single biggest reason that we get superior returns and we get steady growth. Let me try to back up for you a moment to further reinforce what I mean by quality. I think the most tangible is the numbers I just gave you, the actual productivity. Let's use a commonly used denomination of quality, which is the Million Dollar Round Table, and this is another way to quantify that intangible. You can see here that 29% of POJ's Life Planners are Million Dollar Round Table.
To put that in perspective, the average in Japan is 1%. I'll also draw your attention to the fourth column over, Gibraltar. This is a company that a decade ago was a bankrupt, domestic, classic Japanese insurance company. Yet you see today, while we have not attempted to turn it into POJ, we have turned it into the highest quality company of the segment in which it operates for the middle market. If you look at the number of MDRT people inside Gibraltar, and if you look at some of the names to the right, names you will quickly recognize, those are organizations that are far bigger. As a result of what we've achieved there, the POJ and the Gibraltar MDRT, that combination represents one out of every three MDRT people in Japan in the industry.
My assertion about the quality here, I think, is not just an assertion. It is indeed a factual representation that you can see demonstrated in terms of the performance and this industry benchmark. The quality of what they produce here is meaningful. At times, the word quality can seem like it's admirable, but it's an intangible. I want to demonstrate for you that it's both real and it's economic. Let's start with taking a look just at the productivity. You'll see that, by the way, it has measurably improved in the last few years. It was outstanding. It's gotten even more so. Here, what we're looking at is their productivity average premium per month. One of the reasons it's growing is because the Life Planner force in POJ is maturing.
Last year, POJ celebrated its 25th anniversary, and because the retention is so high, we still have people who joined us 10, 15, 20 years ago, some 25. The clientele tends to match the same demographic socioeconomically as the person doing the selling. We are now selling to an older group of people, more discretionary income, more and somewhat different needs. That's one of the reasons we're able to sell at a higher premium. The retention. 12 months. The first year in the business is the toughest. This is where retention tends to be the lowest. I would suggest if you make a comparison to any other company, you'll find this among, if not the top numbers. As a result, the retention for the entire POJ, in other words, not just the first year, but over the entire period of the career, is 90%.
Any time you can keep 90% of the people inside the sales force, you have an enormous economic engine for being successful. On the service side, one of the other Qs. Quality people, quality products, quality service. J.D. Power routinely rates POJ customer satisfaction number 1. Again, can seem admirable but intangible. Keep in mind, there's an old adage in this business, "The best prospect is a current customer." Let me give you proof of that. These are the sales that have been made each year by POJ to existing customers. Keep in mind the point I made earlier. Biggest problem any agent in the world has is the empty waiting room. These people, these Life Planners, are talking to customers they already have. The sales, as a result, are growing year after year as you get a momentum growing in that in-force book of business.
Not only are you getting the economic benefits of a maturing book of business, you're getting a growing new business opportunity that's embedded therein. Tremendous advantage associated with that. I'll also draw your attention to the slight shift that's taking place in the color of the bars. If you look at the blue on the bottom, that's death protection. That's telling us that an agent is going back and selling a second or third policy to an existing customer as that individual's needs expand through the life cycle and as their ability to address those needs further expands. I'll also draw your attention to the red. That's the retirement. That's often the unrecognized opportunity of a maturing population with great wealth, and there is no country in the world that characterizes better those two features. It's maturing, but it has unprecedented liquid wealth to address that need.
We're tapping into that. Here, I'll attempt to illustrate for you what the significance over the career of a single agent is to having those characteristics I just described. What you see here with the so-called traditional agent, we've simply taken public data, gleaned them to put together an illustrative traditional agent, using the traditional averages for productivity and retention. That's a lifetime career contribution to sales. Let me modify one thing in that, and that is just the rate of retention inside the Life Planner. Just the fact that this individual survives at a higher rate, as I showed you with the 80% and 90% numbers, they achieve over their career substantially higher contribution in terms of what they can bring in with sales. Now let me show you what happens when you overlay the productivity. You get a geometric compounding.
You have someone performing at a much higher level for a much longer period of time, the significance here is dramatic. That's what goes on inside Life Planner. It's the reason that we are quite content to grow at even modest single-digit rates because the economic value of each of these individuals is tremendous. You will not see us, in contrast to others, talking about large numbers of people. We're much more interested in the economic impact each one can make. Within POJ, while you see modest growth here, that growth is enormously meaningful, both in the short but in particular in the long-term consequences of it. Here I'll shift back to Life Planner in total, not just POJ. If you look on the lower left there, you'll see that the Life Planner system has been growing about 3%.
POJ is about half that number. We have about 7,000 Life Planners spread around the world. A little over 3,000 of them or so, as we just saw, 3,300 or so inside POJ. That's growing only about 3%. Because of productivity gains, we can add to that. We get another five coming from there. We get to about 8% annualized growth over the last five years or so. Again, POJ's is stronger than this. I'm showing you the totality, which is a number of new and small or less developed markets. Let's try to take this as always to the bottom line. If we're getting maybe an 8% growth, we're getting a more significant growth because of the extraordinary persistency in the revenue. This is something that, at times, gets overlooked.
A lot of attention goes to new business, but the business that sticks is what matters. In some situations, if the back door is spinning as fast as the front door, that's not a profitable arrangement. We're much more interested in the quality of what comes in and in keeping it on board. That's what allows us to deliver a sustainable double-digit, both in terms of the revenue and on the adjusted operating income. I'll also draw your attention to the relative stability, clearly in the bottom line, but even to some degree in the top line, this might be harder for you to detect on the quarterly earnings call.
I've purposely here tried to lay out for you, I think, 16 or so quarters, just so you can see that while there are quarters where there will be episodic events that prompt some volatility, if you stand back a bit and you look at it over any period of time, you see very steady growth taking place. We saw evidence of this last year when, as you recall, there were some external events having to do with the change in the tax treatment in Japan of some of the health-related products. Similarly, we had some internal events in terms of pre-announcing changes in crediting rates. These caused the advancement of some sales, which are clearly illustrated there during the four quarters of last year, big rise in the first two quarters, drop in the next two.
You see a return to the more traditional steady growth in the regression line throughout. That's our Life Planner business, one that you're more familiar with, one that we continue to seek to grow in some of these other markets. In particular, the three markets I highlighted for you, Korea, Taiwan, and Brazil, the last one being maybe the most promising long-term Life Planner of any of the non-Japan ones. Let me shift here and talk about Gibraltar. This has similar characteristics but purposefully at a more middle-market level. It doesn't have that same level of intense quality, but it has a broader footprint. The Star Edison acquisition and integration has gone exceedingly well. John briefly referenced this, borderline flawless. You'll recall 95% of that valuation that we gave was purely on the financials.
We knew that we could get the expense synergies, which by the way, is another reason we seek to get scale in limited markets. Scale achieved through broad diversification of markets does not deliver to the bottom line, and for us, it's all about getting the bottom line. You will see us continue to give higher priority for growth, organic and acquisition, in markets we're already in than planting them in a lot of new locations. We've continued to Prudentialize the sales force, which I'm going to elaborate on in detail in a moment. The investment portfolio has been de-risked to fit our standards, and other changes have been made to Prudentialize this. One item I will draw your attention to, which is the middle number there.
Some of you will recall when we first announced the deal, we said that we estimated we would spend $500 million in integration costs to do this. We subsequently modified it, and today I can tell you we're now modifying it further to $400 million. This is a further example of what Mark and John both referenced. I think you'll find us to be consistent in being focused on quality and conservative in anything we estimate for you. That's especially true given our Japan's colleagues, both reputation and historical achievements. We continue to be on track to achieve the $250 million in terms of run rate improvements. I want to step back for a moment to when we acquired Kyoei and turned it into Gibraltar. Of course, Gibraltar is the company that just acquired Star and Edison.
I want to draw your attention to what they did because we're now repeating it. What they did at that time, they acquired 7,000 approximately agents, and what you see represented with the bar graph is a steady drop in the number of agents. What you also see through the dots and the line is a steady growth in sales. They simultaneously shrank the sales force and grew the sales. That's that same phenomenon I referenced under Life Planner. It's higher productivity, lower cost. The economics of that are dramatic. We continued that throughout the decade. Even 10 years later, we had fewer Life Consultants than when we acquired the company, and yet look at the sales, which have virtually doubled over that period of time.
That gives us both the top line, but more importantly, and even more dramatic growth in the bottom line. That's what separates us from the competition. It also is the basis for what we're doing right now. We are repeating that performance. What you see here is coincidentally, when we acquired Star and Edison, we acquired roughly 7,000 people in the field. That's what got us from the six plus the seven to roughly 13,000 salespeople. Each quarter, you have heard that we continue to shrink that. That's not the goal, but it's an inevitable byproduct of putting in place the standards that we require for someone to be in the field. We put in place a variable comp system, and we require and we support their ability to do it. We give them the training necessary.
If there is one core competency that I think we can credibly claim to have is we know how to build and develop proprietary agency systems as well or better than anyone in the world, and I think the numbers here will back that up. As a result, the Life Consultant system, both through organic growth and through the acquisitions, have also achieved very steady growth. Again, as in the case of POJ, you can see quarterly fluctuations driven by internal or external events, but what you have seen and what I believe you'll continue to see is very steady growth in that business. The third and final business model is the bank channel. This does have fundamentally different characteristics than either of the two businesses I just covered, I want to highlight them for you.
It does give us a couple of advantages, it brings us some challenges. The advantage is it gives us an expanded customer base to reach to. Because in spite of our continued growth, we still have a relatively small geographic footprint. One of the things that a bank distribution allows us to do is to really reach deeper into the country. It gives extraordinary growth potential, not just strong, but extraordinary. You've seen the growth that has taken place. You can hit triple-digit growth through a third-party bank channel. You cannot achieve that through a captive proprietary agency system. Along with that comes some challenges. One is you get volatility, and the other is you really have to manage the profitability. I'll emphasize again, that's our primary objective.
With the bank channel, we get some challenges we haven't had to deal with up until now through proprietary distribution. Our philosophy remains the same. It doesn't matter which distribution. The tools we use to implement that philosophy does change, but our goal does not. What we're after is profitable growth, and we never separate those two words. That's our objective. As a result, we have to manage that channel quite actively. You will see us move in, you will see us move out of a market in order to stay focused on our objective. As a result, end of last year, you saw us start to take actions we never had to in a proprietary system and never would. First of all, we put in a cap. We've never done that before.
In a bank channel, you have to be careful because the sales can be so explosive so quickly. Because they are more sensitive to the interest environment, to the investment margin, we have to be very careful. What we did is we lowered what was already a fairly low crediting rate of 1% on the yen-denominated single premium to 80 basis points. We did that, I think, back in January. We also lowered the commission. Just to make sure, we put a sales cap on. We have and will continue to manage this business very carefully to ensure that it gets supplemental growth, but not at the expense of cutting into our AOI objectives. What I just said to you verbally is graphically borne out here.
What you see is in the early years of the bank channel, it was the more traditional products, U.S. dollar whole life and other recurring premium kind of products. Suddenly in 2011 and more dramatically in 2012, you saw an explosion in the yen-denominated single premium. It was that product that prompted us to put in place the constraints I just described. In light of the volatility that the marketplace has continued to show, I'll announce here what we recently announced in Japan, and that is, as of the end of September, we are going to stop the sale of this product until such time as we feel comfortable that the marketplace is stable enough to allow us to put out a pricing that gives us confidence that the investments we can put behind it on a single premium basis will sustain our profit objective.
Let me now put in place for you a framework for thinking about how these three business models relate to one another and how the combination of them gives us a strategic footprint that allows us to reach deeper into our single market and get growth without having to go beyond those borders. If we look at the Life Planner, and we can think of the business model in the most simple terms, the customer we're going after, the need we're trying to solve, and the product we're offering as a solution. In Life Planner, we're going after and have for 25 years an affluent, focused initially exclusively on debt protection and using traditional whole life and term products. Over the years, as I mentioned, we have evolved.
The basic strategy has stayed in place, but it has evolved to include not just mass affluent, but also the business market, which today represents anywhere from 35%-45% of the business that POJ does. This is an example of a sophisticated distribution taking advantage of that and working with a sophisticated clientele to differentiate. In addition to offering traditional death protection, also focusing on retirement, and in the instance of business segment, dealing also with business planning needs. The product solution has also evolved over the years to include not only death protection, but as we referenced, accident and health, the retirement, and also multicurrency, primarily dollar-denominated but multicurrency, which curiously to this day in Japan remains relatively uncommon. The Life Consultant, this is our mid-market Gibraltar business. A lot of similarities, a couple of differences which we highlight in red.
This is more of a middle market with a particular focus and advantage in the Teachers. We've talked about that before, so I won't emphasize it here, but I will briefly remind you. We have what at this stage is almost a 60-year exclusive relationship with the Teachers Association, a 1 million school teachers in Japan with whom we have an exclusive sponsorship by their association. They have and continue to represent a very meaningful portion of the client base for us in Japan. Traditional death protection, but also retirement, very key to this market as well. Finally, you see the set of products that we use there. In particular, we've given them the opportunity because of some of the retirement needs embedded in the Teachers market to use multicurrency fixed annuities. Here again, you'll see our conservative approach.
We reprice these biweekly, they have market value adjustments, and we don't allow for drop-ins on recurring premium. Again, a consistent conservative approach, a product that addresses a need, but in a way that satisfies our economic objectives as well. Finally, the bank channel here. Maybe the more curious aspect of this is the fact that it's so high-end. The average premium in here sometimes is multiples of what it is even in our Life Planner. It is giving us access to a very high-end clientele. As I referenced earlier, the focus in the bank channel is more towards the savings end. I think this is not surprising when you consider the nature of that environment.
What's encouraging to me is some of the more sophisticated banks, in particular, the ones we've been dealing with for several years, see the advantage both to themselves and to their clients, and clearly to us, as moving along that spectrum, away from the more savings-oriented to the more traditional products. I would give you as an example, the USD-denominated retirement income has been a lead product in our POJ business for 6, 7 years now. Tremendously advantageous for the client who's willing to take their currency risk, tremendously advantageous to us. In particular, for many years in the beginning, this whole life product benefits enormously from mortality and expense gains, and to the latter stages of its maturation, has a rapid buildup of cash value, which enables the client to then fund a retirement.
It's in a very nice, almost sweet spot on that spectrum between pure death protection and savings. It's my belief that over time, as these relationships with the bank mature and as the bank clientele and the servicing staff mature in their ability to deal with this, we'll see a shift more in that direction. In the meantime, we will be careful and conservative in how we manage the distribution of the more savings-oriented products. Having described the three businesses, let me spend a few minutes just talking about some background issues that do come up on a routine basis when we talk about Japan. One would be on the whole foreign currency issue. We have, on a quarter-by-quarter basis, in particular over the last year or so, explained what we refer to as FX remeasurement.
This is simply the disparity between the accounting treatment of U.S. dollar-denominated products and the actual economics. There's no economic significance to this, as we have described earlier, but it does represent noise. So we try to address that on a regular basis in terms of explanations. The asset liability, we're very careful and conservative on this. If it's a dollar-denominated liability, we back it up with a dollar-denominated asset. We do not attempt to mismatch those and cover some of that with a hedge, which inevitably results in a certain amount of residual exposure because the durations frequently are not the same. We take a very careful and conservative approach to that. In terms of overall shareholder value, we have, at the enterprise level, a capital management system whereby we hedge both the income and our equity through a comprehensive hedging program.
In that regard, I'd remind you of something that often comes as a surprise. That is in Japan, 50% of our earnings are yen-based, 50% are dollar-based. What that comes from is the fact that for some years now, anywhere from a quarter to a third of our sales have been dollar-denominated. You'll notice that an even higher percentage of our earnings are dollar-denominated. That's because all of the expenses, including those associated with the dollar-denominated product, are yen-based. Half of our earnings coming out of Japan are not exposed to that yen currency risk. Even for that, we do and have for many years now, I think you're quite familiar, used a multi-year hedging strategy, which rolls in essentially on a monthly basis over a prospective 36-month basis and allows us therefore to have this profile of coverage.
Another key point is about capital deployment, the issue that comes up regularly. Here I want to cite purposely a decade's worth of experience. What you see is that steadily over a period of time, obviously with annual fluctuations, but it's occurred in every single year, whether it's a financial crisis, regardless of what's going on, we've been able to redeploy capital out of Japan at the rate of about 60%. We have multiple mechanisms available to us, but they have always been effective. Also, just to spend a moment on interest rates. This has become a much more visible topic in the last few years in the U.S., but a low interest rate environment is nothing new in Japan. As demonstrated by the low end of this chart, we've been living with low interest rates for a very long time there. It's built into our pricing mechanisms.
It's built into our assumptions. As you saw from our source of earnings, it's not a basis for how we make our money there. In fact, we use here an illustration of what its impact would be. If we take a look at a 50 basis point movement, it represents about $25 million in the short term, which within the perspective of our overall returns, represents about 1% of AOI. Again, we're not immune, but compared to most anybody else, we're highly insensitive to those movements. Another way of looking at this is the solvency margin. Keep in mind, as I'm sure you're aware, the solvency margin rules changed last year. These numbers are under the new stricter solvency margin. I think you'll find those to be quite strong by most any standard. Certainly consistent with our understanding of what a AA expectation would be.
The other is based on what the competition is doing, by any of those measures, I think you'll agree these are strong numbers. In spite of that, we have put together stress scenarios to see how will this perform under various cases. Here, what we've done is a stress test. We've stress-tested real estate, the dollar exchange, interest rates, and we've stress-tested them all simultaneously. In spite of that, you'll see results that, in many cases, exceed current results for some of the top carriers in Japan. Now, there are many reasons for that having to do with the product design, the kinds of products and risks that we underwrite. One of the elements backing this up is our investment portfolio.
Again, those of you that have watched this year after year will see extremely conservative, more than half of the portfolio sits in sovereign. The corporate bonds, dominantly investment grade. The so-called risk assets over there on the far right, very small percentage. Our exposure to the Nikkei, our exposure to some of the risks that are more typical of other insurance companies, for us, are a very minor element. Some of the key takeaways that I hope are demonstrated by these slides, this is a very proven business model. It's one that is changing through gradual evolution, there's nothing dramatic taking place there, and a very sustained track record of success. What we have achieved is what we focus on continuing to achieve, and that is the trifecta of strong, high ROE, steady growth in AOI, and relatively low volatility.
Dominant position in Japan, the second-largest insurance market in the world. Planting seeds for future growth. Competitive advantage that is rooted in a fundamental of the business, in particular, around the proprietary distribution. Finally, providing growth, particularly over the life cycle. We believe that over time, the opportunities embedded in retirement income will supplement the ever-present opportunities with the traditional death protection. It's the combination of those two, the growth in both of the segments that we serve and in our ability to address them through expanding distribution, that gives us the confidence we can continue the kind of growth that we've achieved historically. Thank you for the time and attention for this. I think at this point.
Questions for Ed?
Be happy to take questions.
Let's start on the left-hand side. We'll go front to back. Prudential people are not eligible. They're ineligible receivers. Eric. Hand up, please.
Thanks. Erik Bass with Citigroup. You talked about how POJ, you've had the benefit as kind of the life cycle of your agents if they've matured. Just wondering, as you draw that out to the conclusion, eventually they will reach retirement age as well. Is there a risk to growth in the future as you have some of your more productive agents retire? Maybe talk about how successful you've been in terms of bringing new Life Planners in to kind of backfill that.
There would be if we weren't continuing to grow. In point of fact, if you were to look at this as almost a demographic shape, you'll realize that when we started out, the group that is now 25 years into the business, that was a very small group of people, a relative handful of people that got started. Since then, the base that we have built behind them gets bigger and bigger. Over time, that mature group that is in the high productivity will, for quite some time, actually expand as long as we continue to feed it, which we do on a regular basis. We hire between 400 and 500 every year. Of course, some of them either retire or fail.
It gives us the confidence because we're very focused on it, that we'll continue to feed that highly productive group that has been in the business 10, 15, 20 years.
Do you have just the average age of Life Planners currently?
I don't know off the top of my head. We do have in the audience, John Hanrahan, who was the president of POJ for the last three years, so I'll give him a pop quiz here. John, do you know an average age, top of the head? Mid-30s. Mid-30s. It's still quite young, which evidences the point I was making. We still work hard to feed into that group. What we do, and always have, is try to hire people between the ages of, say, 25 and 35.
Perfect. Thanks.
Okay, next is Thomas Gallagher, the gentleman on the aisle one row up. There we go.
Thanks. Thomas Gallagher, Credit Suisse. Ed, couple of questions. First, page 24, the Life Consultant count dropped by about 2,000 over the last year. I guess historically, it was very hard to fire people in Japan, and I guess that's changing. Can you talk a bit about how that's gone? Any backlash from that kind of headcount reduction? That's my first question.
Sure. It's still hard to fire, and in point of fact, we don't fire. What we do is this. The Star and Edison companies were typical of the way many of the domestic Japanese insurance companies work, which is they gave quite substantial baseline support and then would give a bonus on top of that. We migrated the compensation plan from that to our approach, which is much more pure variable compensation. Over that period of time, a number of individuals found that the level of productivity that they had to sustain in order to hit their target income was not something that they could do. We work hard to train them to be able to do that. A fair number of them are not able to. This drop is not the goal, but it is a predicted outcome.
For example, that's the reason I showed Kyoei. We experienced the same kind of thing when we first acquired Kyoei. When we acquired that, they too had about 7,000. I think it bottomed out at around 4,000, and then in the subsequent 10 years grew up to about 6,000. We have now acquired these two groups. About 7,000, what you're seeing now is a very similar pattern of shrinkage. We'll see where it bottoms out, and then we'll grow it back up. The key for us, while we're attentive to that, what we're really focused on is getting the sales up with fewer people.
You think we've bottomed out?
I doubt it at this stage. A little hard to know, but this is typically a multi-year phenomenon.
Got it. The other question I had, which was not, I guess, a point of your focus here, but if you look at what your JGAAP earnings have been, they've been materially lower than your US GAAP earnings or the translation of Japan back into US GAAP. I don't think that's been an issue for cash flow because you've done the internal borrowing to be able to take money out of Japan. Assuming you'll hit a limit on your ability to do that at some point within the next couple of years, are we likely to see some kind of inflection here where cash flows actually are depressed for a while as a result of this sort of transition? Or are you likely to see JGAAP earnings get meaningfully better from current levels?
I wouldn't want to predict what could happen to JGAAP earnings, but let's take the worst case scenario that you're describing. Let's say it stays suppressed. The JGAAP earnings influence and can cap the dividends, but they don't influence or cap the other sources of redeployment, such as affiliate lending and affiliate debt repayment. The JGAAP reserves are actually quite conservative. Some portion of that exceeds what the cash values or the And as a result, some of that excess contributes towards your solvency margin calculation. That can be used, not for dividends, but for the redeployment through inter affiliate transactions. Long-winded way of saying there remains for us maneuvering room to continue to get a flow of funds from Japan.
My understanding is you've done $4 billion of internal leverage, and the maximum is 6. Your point being that even if you hit that $6 billion cap with the internal leverage, that there's other means to go to take cash out beyond that. Is that?
Yeah, I wouldn't want to say specifically on the 4 and 6, but I would just reiterate that the JGAAP reserves limit what you can do on the dividends, but not what you can necessarily do through the other sources. In particular, as I mentioned, the inter affiliate lending, and debt repayment.
Okay. Thanks.
Sure.
Who's next? Towards the back. Jimmy. Hand up, please.
Hi. I had a question related to page 29. You had very strong sales in the Japanese yen single premium whole life policy, and subsequently you're slowing that down. It's in the bank channel. Third party distribution, you grow a lot, all of a sudden you slow down. It many times indicates a pricing problem. If you could maybe give us a little bit of color on what type of margins you've seen or you expect on those products and how comfortable you are that this will not weigh down on your profitability?
Sure. The yen denominated single premium has a unique characteristic in contrast to all of our traditional products in two respects. Number one, a big part of it, unlike the others, is not coming from mortality expense, but rather from investment margin. Number two, unlike the traditional products, you're not getting recurring premiums, you're getting a single premium. That means you have to be particularly sensitive to what you're going to get at that particular moment in the market when you take that in. That would work out fine if you could adjust your price on a regular basis. For a lot of practical reasons, the banks look for anywhere from three to six months advance notice of a change. Frankly, that's not an exposure that we're prepared to live with on any long-term basis.
That's why when it became clear that there was more volatility in the market than we could feel comfortable in accepting the risk on this single premium, we moved quickly. First, to cut the crediting rate, as I mentioned, which was already pretty conservative. Those of you that are familiar with what the crediting rates were in Japan last year will recognize that a 1.0 was pretty conservative. We took that down to the 0.8. We cut the commissions on it. Finally, just to give ourselves further protection, we also put in a cap on top of that.
Watching the market since then, there continues to be enough volatility there that for us, given our risk reward, which is a conservative approach, we simply don't want to live with that product in this current investment market because we want to achieve the kind of returns that are more comparable to what we would get on our traditional portfolio. That's why, as I mentioned, we've announced to the market, and again, trying to be respectful of these relationships, giving them advance notice of a quarter or so, that look, we're going to withdraw from this. In the meantime, we have the protection of the caps imposed so that we know we're not too greatly exposed. Frankly, given the changes we took with the rate changes, it's quite a sensitive market. We already saw a dramatic reduction.
I don't have short-term concerns about that, and as I say, longer-term, we've shut that down. We'll reenter that if we believe that the market conditions make it possible for us to take that on a basis we're comfortable with.
It's not in the presentation, but maybe talk a little bit about what the trends that you're seeing in the Korean market. You've talked about high churning and competition in the past, but what are you seeing there?
I would continue to characterize the Korean market the way we have historically. Just to elaborate on your accurate description of it's a highly competitive market. I think there tends to be more irrational competition than we see in Japan. More competitors who are focused on market share and revenue than on bottom line. When that happens, we tend to back off. What we have seen is some improvement of that over the last couple of years. The fallout of the financial crisis either took some of those players out or sobered them up. It did not eliminate them.
One of the reasons I say that is if you look at our headcount, which for some years leading up to the crisis had been steadily dropping, it stabilized not long after that, and we've been slowly growing our Life Planner counts over the last two years in Korea. I would say it remains a very competitive market, where we have found a little more maneuvering room in terms of achieving our dual objectives of growth and profit over the last two years.
Thanks.
Okay. Let's again go front to back. The gentleman in the blue shirt with the red tie, Mr. Finkelstein.
Mark Finkelstein, Evercore. Just going back to slide 36, where you have the high capital redeployment, maybe an extension to Tom's question. Just thinking about the last 10 years, there's been a lot going on. Obviously, M&A activity, you've had integration costs. How should we think about that ratio of kind of capital redeployment relative to AOI going forward if you just assumed a steady state environment?
Yeah. As you fairly point out, no one of those years is a steady state. If you take that long-term horizon, we think that range of in the 50%-60% that you've seen demonstrated over the last decade, we see that as sustainable.
Are the integration costs considered redeployment in this chart?
Uh-
No.
Not integration costs, no.
No.
Why shouldn't the ratio actually go up over time?
I think you'll find that, again, I think you'll find 50%-60% to be pretty strong in this area. Some things, like the integration costs, come and go. I can't think of any reason why it would go higher than the 60%, frankly. If you look at any one year, you could see it possibly go higher than it was over the last year or two. To your point, over the last decade, which is what you see in front of you, I think you've seen enough one-times, both positive and negative, that it's representative of what we're likely to experience over the next 10 years. Could it go up over that one period where the integration costs were? Yeah, maybe. I think overall, I wouldn't want to suggest it could go higher than 60%.
Thank you.
Sure.
Josh?
Josh Smith, TIAA-CREF. Question on JPY sensitivities, might apply to the broader management group. You've talked about adjusting your ROE goal for the NPR, the non-economic. You do a good job of hedging the JPY results. You have the dollar denominated, it's not that big an impact as it would otherwise be. I've seen some analysis that if the JPY went from 80 to 110, that could be like 100 basis points on ROE. How are you adjusting like your management comp in terms of ROE goals? Clearly it's a tailwind for 2013, it's probably going to be a bit of a headwind going forward for the next couple of years, or certainly by 2015 when you're out of the hedge period, the JPY stays weaker.
Your question is how are we adjusting management comp?
I'm assuming the 13%-14% ROE goal is part of management comp. If the JPY was at 110, that would be a sort of 100 basis points drag. I'm talking about going forward or to tailwind this year. That's what I'm asking, how are you adjusting, or are you adjusting for the movements in the JPY?
Well, the good news for me is I don't have anything to do with that. The bad news for you is you'll have to wait a few minutes to get a response to it. If you'd like, you can try and keep that question alive for John and Mark.
We've got time for one more question before we have to break for our last Q&A session. Randy, it goes to you. The gentleman on the aisle.
Thanks, Eric. Randy Binner, FBR Capital Markets. I don't know if we need to go to the slide 40, the JGB exposure is obviously significant, and you refer to it as kind of a non-risk asset, which I agree with. It's a big concentration. There's other companies that have been kind of more actively harvesting gains with that security. Those are probably marking down maybe 3% quarter to date. Is there any thought to trying to diversify away from the huge JGB exposure that you have in Japan? Is there anything you can do to kind of lessen that exposure?
Are there things we could do? Sure. Are there things others have done in terms of taking a currency play? Yes. When we've looked at them, that tends to introduce a whole different kind of risk. For instance, I know some companies have moved into, let's say, the higher yield of a U.S. market, and attempted to hedge that. Typically then there's a mismatch between the duration of the liability and the duration of the hedge. That's not a game we're really interested in playing. We stay very firm in terms of having a currency match between the asset and the liability, given the long duration of the liabilities that we underwrite there, we find that, in fact, the super long JGBs, et cetera, are the right fit for us.
I'd also make the point that some of the competitors that you have in mind, possibly when you frame the question, are reaching, Bob made a somewhat similar comment in his presentation. Some of them will reach for higher risk on the asset side in order to support a higher price or a higher promise. That is not the nature of our value proposition. If you reflect back on what I've emphasized about our value proposition, you recall we mentioned quality people, quality product, quality service. You did not hear me talk about the price. We frankly feel very comfortable that the nature of our value proposition supports and warrants not only a competitive price but frankly a premium price. That gives us the luxury of not having to make a reach on the investment side in order to support that.
I don't see us making material change in the risk profile of our investment portfolio.
Thank you.
Sure.
Thank you, Ed. Okay. It's now time for our final Q&A. John Strangfeld, Mark Grier, and Robert Falzon will be coming up. Before we actually open the floor to your questions, there are a number of questions that we've already deferred that my colleagues would like to address, then we will open the floor up to additional questions that you may have. Did you know that you were going to help? The cliche expression for me to use at this point would be to say that for those of you who haven't met him, Robert Falzon is our new Chief Financial Officer, replaced the retiring Richard Carbone. The fact is for those of you who have also met him, he's still Robert Falzon. Thank you.
We're going to try to clean up a few of the questions about captives and capital that came up and were deferred to the end. I'll start, then I'll hand it off to Rob. In terms of the annuity hedge target, let me back up a notch on annuities and make a comment on part of the reason that we're doing what we're doing. That is that this is a long-term product, we sell a product today, and the first benefit payment that we'll make in a bad outcome may be 17 years down the road. We're going to try to tell you how much money we made on that product next quarter.
There's a big mismatch between the way in which these benefits roll out, the way in which risk is realized, and the way in which we put that into the embedded derivative accounting Cuisinart and show you a quarterly result. That's part of what's involved in thinking about the answer to the hedge target. As Bob pointed out in his presentation, the valuation methodologies roll out and discount cash flows at risk-free rates for purposes of arriving at a so-called market consistent valuation of the embedded derivative. In determining our hedge target, we assess the outcomes based on more realistic assumptions about actual investing behavior, particularly incorporating the opportunity to earn spreads, for example. You should think about the hedge target as scaling down the accounting liability to reflect better, more real-world assumptions about the actual possible outcomes for us.
The result, as I said, is that that accounting liability is scaled down. An overlay on this is our tolerance for interest rate risk in the product relative to the total company. The interest rate exposures within the annuity product go in the opposite direction from some other interest rate exposures that we have, for example, marking derivatives to market where those derivatives are long and use the hedge duration in the general account. Part of the hedge target picture also includes the tolerance, actually the conscious appetite that we have to underhedge the interest rate exposure in the product because of the way in which it fits into the broader risk profile of Prudential. The core hedge target concept is more real-world valuation of the liability. Rob has a few things to go through on captives and capital that came up.
Well, I tried to take notes, hopefully I've got this right. If not, obviously you can follow up with questions. Let me start with the question on why are we using PruCo Re as a captive with respect to the annuities business, because I think we got the answer right, but there's another part to the answer. The large motivation there is that it allows us to aggregate risks in a way that we can then hedge those risks very efficiently, both mechanically and economically. The other part to the story, however, is that in that entity, from a statutory accounting standpoint, we use something called modified GAAP accounting, and that modified GAAP accounting is exactly what Mark just described.
Namely, what it does is it looks at the reserve that we need to book, and it does the risk adjustments in the calculation of that reserve that are otherwise calculated according to GAAP. That's how we hold from a statutory standpoint, the liability or the reserves in order to fund assets that we need to back the potential liability there. Now, the importance of that is that's how we're hedging. Our statutory accounting and our hedge strategy match up with each other. As a result of that, we don't get a lot of volatility in our statutory results. Now, what's important to add onto this is that, and I'm sorry, there's one more piece to that. From a statutory standpoint, there is no NPR.
You take that GAAP liability, you eliminate NPR, and then you put in the risk margins. The reserves in PruCo Re today are significantly in excess of what the reserves would be under CTE70, which is the sort of classic or traditional statutory accounting. That can change over time, and we get markets that are more ebullient, both from an equity standpoint and particularly from an interest rate standpoint. That modified GAAP accounting could result in a calculation where the reserves would be lower than might be calculated under CTE70 in the ceding insurance company. In that instance, what we've told the regulator is that we would floor the assets that we have available to support the reserve release at the ceding company at that magnitude. We never hold less than what the reserve might otherwise be under a CTE70 calculation at the ceding entity. Okay.
Second question that sort of comes off of that then, I think, was on the hedge target versus capital and reserves, if I got it right. Just to clarify on that, the reserves that we're holding are $5.8 billion. The capital is $4.3 billion. The reserves are calculated just the way we described them. It's that modified GAAP, which excludes NPR but includes the risk margins in the calculation.
Those are statutory numbers, by the way.
I'm sorry.
That's not the GAAP balance sheet that Bob showed.
The capital is 4.3. That's calculated under CTE97. I think that was the specific question. CTE97 is a capital calculation, you calculate the total required. We look what we hold in reserves, and the difference is what we hold in capital. Third question was around stress, GAAP versus stat impact of that. Again, if you think back to what I've just described, there's a difference in the reserve calculation, not a difference in the equity calculation, and those two differences would be in a stress environment, you're not going to get the benefit or the relief associated with the NPR calculation. On the other hand, the liability calculation is going to be reduced by the fact that we've got the risk margins in there. In the past, those things have surprisingly been roughly offsetting each other. That doesn't mean that will always happen in the future.
There was a specific question around the $5.1 billion equity stress, and I think some surprise at the order of magnitude of that. Eric's gunning for my job because he got it exactly right. There's $2 billion of that, which is the DB that's in the ceding companies. Within Pruco Re, it's $3.1 billion. $1.8 billion of that is the breakage. That's an assumed number. Okay? We just assume that we won't be perfect in our hedging. Recognize that cuts both ways. There are times when we get positive hedge breakage and negative hedge breakage. In that $5.1 billion, there's a death benefit piece. That's highly cyclical and sensitive to equity markets and pro-cyclical. When equity markets return, we get that capital back, so it's just a temporary impact on our capital.
We have to fund it, as we saw from the crisis going forward, that capital returns to us. In Pruco Re, the 3.1, similarly on the breakage, that could go both ways. The remaining 1.3 is the CTE97 calculation. Again, very equity market sensitive and pro-cyclical. It will come back as equity markets come back. I think there was one last question on captives, and that was what happens if we consolidate the captives to the capital ratios that we have in the ceding companies. First, I want to caveat that with this is highly unlikely, okay? There's been no discussion about actually unwinding captives. The discussion has been about what might happen with captives on a prospective basis.
Having said that, we don't believe that there would be a material impact to us of having to reconsolidate the subsidiaries, that's on the assumption of a managed outcome. We have our captives, and as Mark described, in the same jurisdictions as the ceding companies. We are not playing a capital or reserve relief game with respect to that. We believe, therefore, it is a reasonable expectation that if we were to talk to our regulators about combining the entities, that the outcome of that would not have an impairment of any material sort to our ratios or adequacy. I think that was it on captives unless I missed anything.
Now the floor is open to additional questions. Chris Giovanni in the back.
Thanks. One just clarification, just in terms of, I guess, getting capital out of the annuities business from earlier, just in terms of thinking about timelines on that. Mark, last year at the Investor Day, you talked specifically about looking to deploy more than $3 billion of capital over the next four quarters, and I think you guys got pretty close to that based on the Pension Risk Transfer, HIG, and some of the buybacks. Curious if you can comment around how you're thinking about capital deployment over the next four quarters.
First thing about getting capital out of annuities. As the growth rate of the annuities business slows down, it is a business that throws off a lot of cash, right? As a growing business, it is a working capital-intense business and therefore will throw off less cash. As the existing book grows and the sales relative to that existing book moderate on a relative basis, you find that the business begins to throw off cash, and therefore, that we can get capital back out of the business. What you saw post the crisis was an enormous release of capital, we redeployed a lot of that capital back into the business in order to support the growth that we experienced in significantly increasing the book.
The ability to get capital out of the business as markets are improving and business moderates, we should begin to see capital coming back. I don't have anything quantified for you, but that's essentially how the math works in the business.
On the capital deployment, we were very successful at deploying, actually, I believe, more capital than we had contemplated a year ago on Investor Day. That was an important point to make at the time because we had the Pension Risk Transfer deals in mind but weren't really free to talk about those deals. Right now, I'd say we're in a balanced situation. You've seen a recent share repurchase authorization from the board. You see continued distribution of capital through now quarterly dividends, as well as that share repurchase program. We're investing in growth in the businesses, and we are maintaining some flexibility to either be opportunistic with respect to acquisitions or support additional Pension Risk Transfer type of outsized organic growth.
My answer would be right now, to the extent that it's ever possible for us, we're kind of in a business as usual mode with respect to the different ways in which we're deploying capital.
Okay. Nigel, you haven't asked one yet.
Great. Thanks. Nigel Daly from Morgan Stanley. Just on the buyback authorization, given the SIFI designation, can you just run through what approvals you need from the Fed to actually go ahead and execute that? Are you free to execute it now without their approval at this stage?
Yeah. Process-wise, right now we're in the preliminary designation phase. It does not, at this point, require specific approval from the Fed or Treasury or any other federal regulator.
Assuming that the designation was to go ahead, what would be the approval process at that point?
If the designation went ahead, the day we were designated, we would become Fed regulated. The process that might be imposed on us right up front is highly uncertain. We don't really know exactly what might happen. We've had experience with the Fed as a thrift holding company. We were regulated by the Fed from mid-2011 until late 2012. In that environment, we were subject to oversight and supervision from the Boston Federal Reserve. That relationship, I would say, went very well in terms of our ability to work with them and focus on capital planning and capital management, as well as broader issues in risk and governance. I don't know exactly what might happen day one of a SIFI designation.
Anyone else who hasn't yet asked a question who would like to? Okay, Ian, you're next. Oh, I'm sorry, was there someone back there who hadn't?
I can't see anybody else.
We'll get you after Ian.
Thanks. Ian Gutterman, Adage. I guess one for Rob, one for Mark. Rob, I think you had a very thorough list of the laundry list from earlier, but I'm not sure I heard, or maybe I missed it, how you fund the $5 billion in the average or whatever it is, $1 billion, $2 billion. Are the numbers in that the capital requirements? Does that all come out of excess capital and the rest has to be raised from capital markets? Via existing reserves and other means on balance sheet today, so we shouldn't just think of that number as public equity or debt raise?
Yeah. The number that I referred to, both the reserves and the capital are sitting on the balance sheet and today down in PruCo Re, there are assets backing those reserves and that equity. Those assets are both classic investment assets and the derivatives that we're using in order to hedge the liability on the right or particularly the interest rate derivatives.
You used the capital protection.
Oh, I'm sorry, the capital protection?
Well, it's the $5 billion.
If I understood the question.
Oh, the hole. I'm sorry. I misunderstood.
How do we raise the $5 billion to meet our need for additional capital in the annuities business?
I apologize. I misunderstood the question. We have a capital protection framework, which is fairly robust. We've not been specific as to the quantums of the sources within there. Let me walk you through what's in there, and then hopefully that'll give you sort of some comfort with that. To the extent we have a hole, I thought you were referring to the actual existing reserve.
That's okay.
That hole gets backfilled through a combination. First, we have a significant amount of excess capital above what we would target to be an RBC under a variety of different stress events. We want to maintain our AA ratings. We have an ability to move the capital down from where we're currently holding because we're holding in excess of what would really be required. There's some trap capital down there that absorbs it as well. That's the first and frankly, most significant component of the protection framework. The other components in there really fall into a basket of hedging and a basket of contingent capital. Within the hedging, we have two primary forms of hedging. We have equity positions where they're essentially structured puts against the equity market. Then we have protection against rising interest rates.
The combination of those two provides specific protection in sort of those two events. Then we have contingent capital, and that also takes two forms. One, we have a significant amount of reinsurance that is available for whatever the variety of stress that may occur that would affect primarily PICA. Then secondly, we have committed facilities in the form of revolvers from our banks. We have a five-year facility with no MAC clause of a couple of billion dollars that's available to us to draw down and then fund down its subsidiaries in the event that we would need it. The combination of those items gives us a substantial amount of capital which, as Bob described, would be available to fund the specific events that he described under the stresses for the annuities business.
That $5.1 billion or whatever it was that you were referring to.
Got it. Very helpful. Thank you. Mark, I just was wondering how you think about as far as running the business, this is largely an annuity question, but I'm sure there's other businesses this applies to. In a world where you're going to have different regulators using different accounting, this goes back to the accounting stuff, right? We're used to the constraint being, well, we think about economic first, right? We have this constraint of what the stat impact is. If SIFI sounds like it's going to be GAAP, now we have this other thing of what the GAAP impact is, and it may be a net income, not even an AOI, which is harder to control.
On top of that, it seems any week now, we're going to get new GAAP accounting standards that are going to make the current GAAP even more onerous. How do you balance which one you focus on? We're used to kind of thinking about economic versus stat. Does GAAP become more important, and can you hedge GAAP and still hedge stat and not give up all your economics of your margin in the business? Do the regulators understand that?
I think on the last question, the regulators have been very engaged in thinking about how we realize risk and how our accounting models work, and how the numbers then are portrayed relative to the underlying economics. We continue to focus on what we've described as getting it right as opposed to arguing about how it's labeled.
Okay.
I'm encouraged by what I would say has been constructive engagement at this point around the regulatory side and the efforts to understand how we work and why we work. I would extend that to the point that we have a lot of confidence in our own methodologies and processes and management capabilities. We pay a lot of attention to the economics of risk and capital. We have to export that to the world of statutory accounting, and we have to export that to the world of GAAP accounting, and we have to reconcile all three, and we have to balance all three and make judgments around exactly how we're going to view the different influences on GAAP and stat, given the economics.
As I pointed out when I started my earlier remarks, we're conservative and we're strong, and we're sensitive to the elements of financial strength and the quality of our balance sheet. We'll continue to focus on exactly that kind of an approach to what we do. It's not just the static allocation of capital. You saw, by the way, in the annuity business, a very healthy attributed capital number relative to the risks that we take there.
Okay.
It's the dynamic process of managing the capital protection plan and understanding how we actually realize risk and what all that means. Stress isn't necessarily an event for us. It's in some ways a process. I think we're good at it. I think we understand the real drivers of risk, the real cash influences on the profile of the company. Then, as I said, we have to export it to stat and GAAP, and we have to strike the right balance. It's not easy, but we get paid for optimizing the outcome for you in the context of those considerations.
Does your comment about the regulators suggest that there's, I'm not going to ask you to prognosticate, but at least a prospect of something more of a modified GAAP than a strict GAAP for SIFI?
I don't want to go that far yet. We're talking about a lot of different approaches and a lot of different ways to think about it.
Okay.
We need to move on.
Okay, thanks.
The lady in the middle of the back section, please.
Can you talk about your earnings and capital sensitivity to a gradually rising long-term interest rate environment as well as a spike in interest rate? Thank you.
Well, the former is nirvana as far as I can tell. Slow and rising interest rates are a very healthy thing for our underlying businesses. That would be a good thing for us. A spike in interest rates would be less good. The result of that is generally going to be an impact on capital, as a result of primarily, the derivatives that we're holding. Our duration extension derivatives would be marked down within PICA, and then on the international side, we would have some mark on the AFS assets that we hold in Japan on the presumption that that spike occurred there as well. To boot on that, you'd have to think about what behavior might manifest itself that would lead to some turnover in your policies.
That's why we have interest rate protection in the capital protection plan would be the short answer to that. The actual RBC hit for, I think, 100 basis points up on interest rates wouldn't be all that severe in, call it, 25 or so basis points of RBC. In the solvency margin, it would vary between the two entities. In all cases, it'd be less than 100 points of solvency margin, I think significantly less than that in the case of Gibraltar. It doesn't have a highly material impact at that order of magnitude. We nonetheless have put in these interest rate hedges so that we have sources of capital to backfill, particularly if spikes were well in excess of 100 basis points.
We also do a lot of work on the liquidity side of it to ensure that we're protected if there is some rate impact on behavior that results in products.
Anybody else who hasn't yet asked a question who would like to do so? Because we're getting down to short strokes. Okay. Who's asked a question who would like to ask another one? Mr. Finkelstein, you get it. This will be our last question.
Hopefully, it's an okay one. Mark Finkelstein, Evercore. Mark, you talked about the balanced approach to capital deployment and you talked about the authorization, the $1 billion that you put out the other day. You also talked about kind of keeping dry powder to outsized organic growth or M&A. How should we frame out that level of dry powder that you're thinking about above and beyond what you've deployed or what you have in the authorization on the buyback?
We never skate right up to the edge of the capital standards that we set. We have our 400 basis points RBC benchmark against which we calculate the capital ratios, but we're well above that. You should think that the amount of capital that we have right now is consistent roughly with the kind of cushion that we generally have. $1.5 billion to $2 billion of readily deployable capital is consistent with our history. It's not outsized, and it's also not unusual relative to where we've generally been.
Maybe I'll ask it slightly differently. Just thinking about economic capital allocation, not statutory necessarily, do you feel you could do the $1 billion authorization as well as maybe doing another GM-size transaction with what you have on balance sheet?
Well, there are no absolutes. It depends on the totality of the circumstances, but the general answer would be yes. Our capital plan contemplates business growth as well as distribution of capital.
Thank you.
Okay. I think we've exhausted your questions.