Let's get started. I know those of you in the audience can't see my tie, but I wanted to let you know that it has a design of bulls, as in bull and bear, not any other kind of bull. This is the 2012 Investor Day of Prudential Financial Inc. Welcome. These are the legal disclosures that come with Prudential Financial Inc.'s 2012 Investor Day. They're in your binders for your detailed perusal at a more convenient time. How we were able to limit the number to just two will remain a mystery. We last met with you less than a year ago. It's not too soon to, again, tell our story to you. We welcome the opportunity to do so. Whoops, not that soon. In your binders behind the tab that's titled Schedule, you will indeed find a schedule for today's event.
There's one thing not on the schedule that we do plan. Rest assured, we do expect to have two breaks. The first one will come after John and Mark address your questions. The second one will come after Charlie and Bob address your questions. With that, we're done with the preliminaries, and I will hand off to John Strangfeld to kick the day off.
Thank you, Eric, and good afternoon, everyone. We're pleased to welcome you here, whether you're sitting amongst us or listening to our webcast. It's a pleasure to have you. Before we start the formal presentation, I thought it'd be appropriate to provide some opening comments. In particular, how we're thinking about Q1 results, our overall earnings power, and the achievability of our ROE aspiration of 13% in 2013. In doing this, it helps provide the context for the building blocks that will follow during the course of the day. Our Q1 results, they represent our first real miss since the financial crisis. We weren't happy with it, and obviously, neither were you. Our recent substantial share price decline began with the earnings release. It's off over 20% in two weeks since then. Obviously, part of that's the market, but a lot of that is company specific.
I'm not going to try to explain or reconcile share price moves, rather, I simply want to emphasize that our belief is fundamentals ultimately drive share price, our focus is on delivering the fundamentals. Our earnings power, let me turn to that. We also realize that a miss, even one that principally resides in a relatively small part of the company, can raise concerns about the achievability of our overall goals, particularly when the path to our financial objective is more of a step function than a linear progression. It's very important to say that we do not see Q1 results in any way altering our view regarding the earnings power of Prudential.
We believe that our earnings power is made possible by well-led, high quality, high value-added businesses coupled with capital management, that earnings power is as it was, which leads me to the 13%. We've talked about the 13%-14% as an aspiration since 2010. We believe that achieving and maintaining the 13% will represent breakout performance relative to our peers and relative to most balance sheet-oriented financial institutions. That achieving so is made possible by business mix, business quality, high-quality execution, active capital management, and a strong and deep management team. The active interplay of these five elements is what provides the basis for our conviction. Let me say that 13% is no longer an aspiration. It's now a goal, a very specific goal for 2013. It's close enough and it's real enough to view it that way.
We're very focused on delivering that goal, that determination is reflected in all of our decision making, from expense management to M&A. We intend to achieve it. The primary basis for our confidence in this is our business mix. Our highest growth businesses are some of our highest ROE businesses. Let me speak to the lead horses. First and foremost is international. I'm referring primarily to our unique franchise in Japan. In international, and in Japan in particular, we've had a long track record of delivering a remarkable combination of high ROEs, strong growth, and low volatility, regardless of the external market. This broad and deep presence in Japan, which started over 30 years ago, now accounts for roughly 50% of our earnings, it'll continue to be a major contributor to ROE growth and improvement.
In terms of ROE expansion, international is complemented by other high ROE businesses with strong growth. I'm referring to annuities and asset management in particular. Businesses that are distinctive, that are at scale, with very strong fundamentals. Businesses whose performance is accretive to our ROE objectives. Of course, our other businesses are very solid and important contributors, providing strength, promise, and stability. I should add that those businesses that are not central to our strategy have been systematically weeded out, and the capital redeployed. The portfolio mix today is by design. It's not an aggregation of historical decisions, it is the single biggest driver of ROE expansion. To us, the 13% is not simply a numeric goal. It's a validation of superior business mix, business performance, leadership, and execution.
We think our management team is pretty darn good at execution, be it organic growth of international acquisitions and integration track record in M&A, or the innovation of products and distribution, such as in our areas of annuities and in Japan. We also believe that a company producing a 13% ROE and whose ROE is viewed as sustainable by virtue of strong fundamentals will ultimately enjoy a favorable relative valuation. What that means in an absolute sense will be a function of the market. Our hope is that you come away today with a sense of our conviction about the quality and breadth of our company, the robustness of our business fundamentals, an appreciation of our confidence in our earnings power, and our commitment to our goal of a 13% ROE. Confidence that everything we do is focused upon and consistent with achieving that end.
I'm happy when we get to the Q&A session after Mark Grier speaks to open it up to any questions or comments you might have about this. What I'd now like to do, though, is move to the more formal part of the program. I'm going to work with four slides. First is what we call our ROE roadmap. I want to further expand on my comments on return on equity. I've already talked about it as a goal and discussed our conviction and our focus upon achieving it. I'd like to turn to the roadmap in terms of tracing the achievability. On this slide on the left bar, you see the 2011 baseline ROE of 11%, and the right bar is the target, the goal of 13% plus.
The red box you see in the middle of this slide is drawn approximately to scale and illustrates an important point. That is that the greatest driver of our ROE expansion is business performance. I think that in some circles, people think that capital management and buybacks, in particular, is the single largest driver of ROE expansion, and it is important for sure. In fact, capital deployment, while essential, is a secondary ingredient relative to business mix. By business performance, what we mean is that our greatest growth comes from our highest ROE businesses. That phenomena creates a very strong bias for ROE expansion, and that phenomena is then meaningly enhanced by capital management. Here's a summary of the baseline ROEs last year and the ROEs we believe our businesses can achieve in 2013.
Prudential International Insurance is expected to record the greatest improvement and to reach ROEs in the range of 18%-19%. As I said a few moments ago, it's the lead horse. It's a unique franchise reflective of 30 years of experience and innovation in Japan. The financial attributes reflect that: high returns, strong growth, and low volatility. International is not simply a line of business anymore. It's 50% of our overall earnings power. Given its scale and its trajectory, it is our single biggest driver of ROE expansion. Given its track record and stability, it's an ideal place to have a performance dependency in terms of the attainment of our goals. The annuity, retirement, and asset management businesses are also expected to produce a solid increase in ROE to 14%-15%. In each of these businesses, we have really good fundamentals.
You'll hear a bit more about that later. Looking at the top two bars, you see that deliverability is based upon the performance of our highest ROE businesses. Continuing performance and momentum, not the creation of it, and that is what part of the source of our confidence. Our domestic insurance businesses are expected to achieve a blended ROE of 11%-12% in 2013, lower than their baseline ROE in 2011, as group insurance is unlikely to fully recover by that timeframe. Keep in mind that this third category, U.S. insurance, in normal years, traditionally produce around 20% of our total company AOI. The overall message from this page is achieving these numbers places greatest reliance on those areas that have delivered strong historical ROEs, growth, and consistency. Doing what they do well, not doing something different. Let me turn to capital deployment for a moment.
We speak of capital deployment. When we do, we refer to investments in our business as well as capital as return to our shareholders through share repurchases and dividends. We also include redeployment from divestitures, which has been a source of capital in the past. Going forward, our businesses have the first call on our capital. We prefer to invest in their organic growth, provided that expected returns are appropriate for the risks involved and consistent with our financial goals. We're also receptive to M&A opportunities, but again, we will only do deals that we believe are consistent with and supportive of our financial objectives. We recognize that capital deployment is a subject of great interest to you. Mark will have even more to say about this in just a few minutes. We hope to provide you some clarity around our thinking and our intentions in this area.
That said, we view financial performance, including the ability to pull the various capital levers as an output, the result of many factors that makes Prudential a successful enterprise. Here are the some of those that we view as being most important. We have a very good business and a mix and a balanced set of risks. This mix provides the basis to achieve superior returns. We believe our 13%-14% objective represents a return that we compare highly favorable to others in our space. We're a market leader in distribution in the U.S. and Japan. You'll be hearing more about this later this afternoon from Ed Baird and Bob O'Donnell. We do capital management well, as our history of successful acquisitions and many billions of dollars we've returned to our shareholders through buybacks and dividends will attest.
Finally, probably most importantly, we have a seasoned and deep management team, some of whom will be meeting with you here today, many of whom are not present but are accountable for the results. Thank you for joining us. I look forward to your questions, and I'm now going to hand it the baton over to Mark.
Thanks, John. Good afternoon, or good evening, or good morning, depending on where you're watching this from. Welcome, everyone. I'll second John's point that we appreciate the opportunity to go through the Prudential story today and hopefully send some very positive messages. I'm going to go through capital deployment and business mix issues at the appropriate level. I want to start with a slide that you've seen before. On the left side, we're characterizing the capital management environment of 2008 and 2009 with defense on top and offense on the bottom. I guess maybe the main point is that we were one of the few companies that was able to talk about offense as we went through the crisis, and you see that opportunity for us reflected in the acquisition of Star and Edison, which came as we were coming out of the crisis.
We were able to maintain some focus on offense, not just defense as we went through the middle of the crisis. We're still in a crisis in some ways. If this were a European audience and we were talking in past tense about the crisis, they would be saying, "Look out the window. It's not really over." I think an important part of the context is to remember that. We're still in an environment in which, for example, interest rates are extremely low as a result of policy initiatives that are designed to try to flatten the yield curve and improve liquidity and encourage risk-taking. These are characteristics of policy actions through the crisis, not characteristics of policy actions in a healthy, robust economic recovery.
Maybe a little context around this is that the left side still has some relevance, and we need to pay attention to striking the right balance all the time between defense and offense. On the right, you see the more positive comments about the things that we're thinking about with respect to capital deployment. Supporting growth in the businesses that John talked about, returning capital to shareholders, paying dividends and buying back stock. Maintaining a sound capital structure, and the way we've characterized it is that our earnings power with an appropriate capital structure is reflected in that 13%-14% ROE objective that we've set. That point, though, on the chart links back to the notion that we still have to play some defense. Let me comment on a bullet that's not there on the right.
There's not a bullet that says worry about regulators. I know there are a lot of issues out there around the SIFI question. By the way, the bullet would be divided into two different camps. One camp would say, throw capital overboard because you might be a SIFI and you don't want to have a lot of capital if that happens. Another camp would say, hoard capital and build cushions because you might be a SIFI and you might need it. What we have said repeatedly that we're managing the company based on what we think are the right things to do with respect to managing the businesses and managing capital. We have a bullet here about a sound capital structure, and we're responsible in all respects in terms of balancing the risk in the company and capital and the opportunities to invest.
We don't have a view right now that there's a big thing hanging over our head called SIFI that ought to result in a different approach to capital management. I hope you've noticed recently some very constructive comments and testimony in front of Congress last week, including from some of the important staff members of the Federal Reserve about taking the right approach to managing non-bank SIFIs. The right approach means the context of business models and risks and the way in which non-bank financial institutions operate as opposed to banks. I think that's validation of the consistent view that we've had that if we become a SIFI, we will be in an environment that will reflect what we are and what we do as opposed to being pounded into the bank framework. I want you to understand there's not a SIFI bullet on here.
It's on purpose. It's a topic that's in front of us and an issue that we address all the time constructively. Right now we're doing the right thing, which includes soundness and investments in terms of managing capital. This is a portrayal of the capital capacity picture that you've heard us paint many times. We talk about it every quarter on our earnings call. Just to recap, the top part shows the capital that's available in PICA, Prudential Insurance Company of America, our largest regulated subsidiary. There's a line there called excess. You know that we stopped calling excess capital, excess capital, but that's a sub-point, so we're still allowed to use the word excess at that level.
Adding to that other capital capacity of $2 billion-$2.5 billion, by the way, to the $2 billion of excess in the insurance company, to arrive at a total available on-balance sheet capital number of $4 billion-$4.5 billion. You've also heard discussions about the amount of that, roughly half, that we view as readily deployable. In terms of capital deployment going forward, we plan to deploy more than $3 billion of capital over the next four quarters. This will include the things that we do with capital, share buybacks, the payment of dividends, supporting growth in our business, and the consideration of acquisitions. I will say, though, that in every respect, any deployment of capital will be directly supportive of achieving the 13%-14% ROE objective that we've set for next year.
Think about what that means in terms of the opportunities that we have and the way in which we're going to think about capital deployment. Again, we plan to deploy more than $3 billion of capital over the next four quarters. I would add, by the way, that that plan also includes a reduction in our leverage ratios. You may remember that leverage ratios, at least optically, were disrupted a bit by the accounting change for DAC, and we anticipate improving leverage ratios over the next six quarters. This is a familiar slide, I just want to highlight two points. The theme behind this slide is that deployment of capital is everything, and we think a lot about the risk profile that we create, the earnings power that we create, and what it means for that overall company profile that John talked about.
The two points that I want to comment on specifically are the second bullet, credible diversification in mix of businesses and risks. I want to comment here on low interest rates. We've talked a lot over the past two years about low interest rates. The structure of our company, as you've heard us articulate in the past, is such that our vulnerability to low interest rates is what we describe as modest and gradual. We don't have an explosive situation waiting to impact our balance sheet, and this reflects the reserving practices on our statutory books that we have in place and our conservative approach to recognizing reserves related to cash flow testing and the stress associated in some scenarios with low interest rates.
With respect to the income statement, what we've said is that the impact of low rates will be modest and gradual, and we're seeing that, by the way. There is erosion in our portfolio yields, and we can't reduce all of our liability crediting rates fast enough to keep up with it. The key point is that, as John pointed out, half of our earnings come from Japan, very much insulated from low rates. It's been a low rate environment as long as any of us can remember. We don't have a lot of product concentrations that are either explosive in terms of capital and balance sheet impact, or immediate in terms of an impact on GAAP earnings. The diversification story works very well.
It's worth highlighting here because, again, interest rates remain low, and it's a question that I think we always have to keep in front of us when we talk about diversification and the credibility of our risk profile and our business mix. The other comment I want to make is on the last bullet, which is the consideration of the contribution to ROE prospects and growth potential. As John said, the 13%-14% ROE range for next year is no longer an aspiration, it's a goal. As we consider capital deployment, we will be making sure that we're doing things that are consistent with achieving the objective that we've set. I want to touch on a couple of points related to business mix.
This is the attributed equity of the company, you see the big green slice on the right-hand side is International Insurance, which now has 42% of our capital. As you spin around the circle, the businesses become more market sensitive, and you wind up in the top left with 24% of our equity invested in the annuity business. We've talked about the mix of opportunities represented here between returns and growth and market sensitivity or not. I'm not going to pound on that again, but we think this is a really nice picture of the deployment of capital in the portfolio of businesses. The next slide is a little bit richer portrayal of the portfolio of businesses. This is our so-called bubble chart. Along the horizontal axis, you see a stylized view of ROE prospects.
As I said last year, don't get out your rulers and protractors. On the vertical axis, you see growth potential of the businesses. The size of each bubble reflects the amount of capital that we have deployed in that business, and the color of each bubble reflects an index of volatility, where green you should think of as low, below the market, blue you might think of as roughly consistent with the market, and red you should think of as levered to the market. As we've said in the past, this is a great picture. It's nice to have such a big green bubble in the top right, which is the International Insurance business, but it's also nice to have any other bubbles in that high growth range. This is a graphic portrayal of the statement that our highest returning businesses are our fastest growing businesses.
That's that cluster on the top right. I have to comment on individual life because we sell them short a little bit every time we prepare this picture. Our individual life business has consistently outperformed with respect to ROE. For a long time, we've been saying it's outperforming. That's not really what we think the opportunity looks like. I want to point out that this is a stylized view, and with respect to individual life, you can overlay the question of opportunity here. We earn very attractive returns. We execute extremely well. Our sense is that at the margin, the discretionary opportunity to grow at high returns is limited in that business. You see it reflected as a more middle-of-the-road type business here. As I said, I don't want to sell it short. We execute extremely well.
We earn high returns, I don't want to portray something that might imply that at the margin, we could grow faster at higher returns in that business. We're not sure we could. A little caveat over individual life there in terms of where it's positioned. It could be quite a lot further out to the right, based on the discipline in capital management, underwriting results, and the momentum that we've had in consistently outperforming this sort of earnings power representation of ROE. I want to leave you with a couple of takeaways for each business, I don't want to scoop the business presentations that are coming up. Let me just hit a couple of highlights on each of the business lines. In individual life, our story is very consistent. We're focused on execution.
We're focused on aligning the business model, meaning matching products with channels, with pricing to make it work. We don't want to go out and pound our heads against the wall competing with mutuals, for example, that come from a very different place in terms of return criteria. This is one where we're not aspiring to dominate the league tables. We're aspiring to dominate certain pieces of the business that we're really good at, I think we've demonstrated that that happens. Group insurance, you're going to hear a little more about in a few minutes. It's a business that we have viewed as a steady performer over the years with a reasonable ROE and a reasonable growth rate. Volatility in the first quarter, as John mentioned, is something that we're sorting through and making sure we understand.
We've got an issue in disability that's been sort of building and is right now a major operating challenge in front of us, you'll hear more about that in a few minutes. Asset management, I think the headline here is consistent execution, it's worked. We've had very strong flows in asset management done extremely well, the accumulation of those assets under management will serve us very well over time. In retirement, I spoke last year about how the action is shifting from the mainstream full-service retirement, sort of institutional/retail environment into some of the more institutional businesses like investment-only stable value and hopefully like pension risk transfer. We and others in the industry have spoken about opportunities in pension risk transfer for years. We continue to believe that this is potentially a big opportunity to deploy a lot of capital.
The low rate environment is kind of a drag. There's been a lot to do in terms of dealing with regulations and taxes and accounting. I think in a meeting of CFOs, you would find that pension risk transfer in the industrial sector is a very hot topic with real resources dedicated to the question. We're there with what we think is a capability second to none and hope that when the logjam finally breaks, we'll be in the middle of this, and we'll have the opportunity to contribute meaningfully to the accretion of our ROE and the growth of our business in a market that's absolutely right in our sweet spot, combining the actuarial and retirement skills that we have with the asset management skills that we have. I don't want to oversell it.
I know it's been talked about for a long time, but I do think that work that's been done is now teeing this up in a way that hopefully there's a chance we'll see something start to develop after we've been talking about it for so long. The annuity business you're going to hear a lot about in a few minutes, I will not comment on that one. International insurance, I just want to add the phrase distribution powerhouse to the international insurance business story. We have evolved from basically a distribution business, but a distribution business that was really lifted by the Life Planner model and its productivity and its persistency and its extraordinary product mix that all generated very attractive returns.
Now we've got the product skills, but we've levered the platform to include a wider range of distribution channels and a wider range of applications of our product skills, encompassing now opportunities in retirement in Japan, which we consider to be extremely attractive and huge. I'd add to the international insurance slide the phrase distribution powerhouse. That concludes my comments on capital and business mix. It's a very positive story. We have attractive opportunities, everything that will happen in the arena of capital and business mix will be directed toward fulfilling the ROE targets that we've spoken about. Thank you.
Okay.
Before we invite you to address your questions to John and Mark, just a few comments on Q&A protocol. First, please wait for me to call upon you. Second, please wait for the mic. This presentation is being webcast. It's being archived. Some of you may even want to go back and hear how smart you sound. Please state your name and that of your firm before you ask your question. Try to keep your questions short. Finally, please be respectful of your peers. Don't take too much time. Okay. Questions. First one is from Jay Gelb. Also, if I don't know your name or if I confuse you with somebody else, please forgive me.
Thank you. Jay Gelb with Barclays. On the return of capital, more than $3 billion over the next four quarters, how much of that do you expect to be in buybacks?
Yeah, the phrase wasn't return of capital, the phrase was deployment of capital. I'm not going to parse that into its pieces. We're making judgments all the time about the opportunities that we have. I think the headline to emphasize is the consistency between what we will do and the achievement of our objective without going further than that, because, as I said, we're considering opportunities all the time. That will emerge as we seek board approval for another share buyback authorization at some point.
All right. My follow-up is, what type of debt-to-capital framework should we keep in mind as you look to delever?
Well, we're looking at the sort of traditional rating agency measures as we talk about our capital debt leverage, and that's recently been running 26%, 27%. There are other measures of total leverage, both of which we anticipate will move the same direction. There are different measures of total leverage used by different rating agencies. The benchmark that we've talked about when we've discussed capital has been the capital leverage ratio, which, as I said, has been running somewhere above 25%.
Can you quickly just remind us how that's calculated?
Rob? Wait for a mic.
For simple analysts, what numerator or denominator would we be focusing on?
Well, I'm going to refer to Robert Falzon, our Treasurer.
It's the same legacy capital ratio that we've been using. It's one that mimics. The rating agencies use a variety of different ones, we try to use that mirrors the most of those agencies. The denominator has our capital debt and our equity capital. It excludes from that CTA. The numerator is what we define as our capital debt, which is everything other than the spread lending debt that we have on the balance sheet. Is that helpful?
It is.
Okay.
Exclude OCI.
I'm sorry.
Next question, Mark Finkelstein. Please keep your hand up, Mark, so that Josh can see you.
Mark Finkelstein, Evercore. Wanted to go back to, I guess, the question on the deployment. One of the things, Mark, you said was that capital to support the business is part of the $3 billion. I guess I was interested in that comment because you're always investing in your businesses. If you go back to prior commentary from Rich, I think the ratio was 43% free cash flow, 57% of the earnings was going back into the businesses. I guess what I'm asking is, how do we think about part of that $3 billion as above and beyond that 57% or whatever that number was, that's just part of the breakout of the normal earnings?
I'm highlighting the $3 billion in the context of the excess capital, the capital capacity that I talked about in that slide, and the opportunities that we have to deploy capital in ways that are accretive to ROE and get us closer to the 13% or 14% objective. Growth in the businesses will be part of that, but we view ourselves as having opportunities with respect to either return of capital or possibly other investments that would also be very attractive. I don't want to parse it any finer than that, but there are plans in there that go beyond the business as usual organic investments in our businesses.
Okay.
I know that's a little cryptic, that's the point I can make right now.
Perhaps also a way of reinforcing that is we're not seeing a different level of need of the capital of our normal operating entities, what we're recognizing there may be outsized opportunities beyond the normal organic opportunities that may arise.
Okay, maybe just a follow-up. I know you've been kind of spending capital in the institutional business on some retirement plan transfer, those kinds of things. Are there any other areas that you're particularly highlighting as major deployment opportunities within the businesses above and beyond?
No. If you're thinking about what John just described as possibly outsized organic, I would think of the retirement business.
Thank you.
Next up, Nigel here on the aisle.
Thanks. Nigel Dally from Morgan Stanley. Mark, just wanted to check into the interest rate assumptions you have built into guidance. Do you need rates to head higher to hit the 13%? Or if rates are unchanged at the current level, is the 13% still a good target for us?
When we discussed the 13%-14% objective now a couple of years ago, we used the forward curve for our rate assumptions. There are moving parts in there. We also assumed the stock market would go up 8%. That assumption has not come true. I would say we face a headwind with respect to the level of rates. However, the way in which we've expressed our commitments today is consistent with the environment that we're in today. While we've had headwinds from rates and we've had headwinds from equity markets, we've also had headwinds now from the disability business, which is underperforming. We have some tailwinds from international. We have some tailwinds from very strong flows in our businesses.
We're accumulating productive assets under management, I think we have some tailwinds from competition where there's been a lack of conviction with respect to some of our competitors in some markets, I think that's probably beneficial for us as well. Setting the goal two or three years out in the businesses that we are in means that when we get there, 1,000 things are going to be different. What we've expressed is what we believe is the earnings power of Prudential with an appropriate capital structure and a reasonable environment. I think when we set that goal, we said there was tolerance in there, that there was a range of outcomes within which we anticipated we could achieve that goal, and we're experiencing differences from the core assumptions, and as I just characterized it, we've got some headwinds, and we've got some tailwinds.
Right now, the outlook that we're expressing confidence in reflects current circumstances.
Who's next? Mr. Kligerman, please keep your hand up.
Okay. Andrew Kligerman from UBS for now. Question I had, we hosted a conference about 2 weeks ago, Mark, when we talked about the 13%-14% ROE target, you mentioned several times that it wouldn't be easy and mentioned a few challenges. I want to make sure on the target now, do you still think it won't be easy, or in the last 2 weeks, have you thought through a few issues that might give you more confidence? Yeah.
Won't be easy was never meant to imply that we didn't think we could do it. We have to execute a lot of things to make this happen. We talk about Star and Edison, for example, and we sort of reduce it to, are we spending what we thought we'd spend to achieve the savings we thought we'd achieve? We're combining massive insurance companies in Japan that are large and complicated. We face challenges with respect to some of the headwinds that I talked about a few minutes ago. We benefit from some of the tailwinds, but that's meant more to convey the sense that we have to execute right to make this happen. John emphasized the importance of performance in our businesses, and that is the key for us in terms of where the challenges lie.
I don't think we never met a qualifier when we said it wouldn't be easy, but the fact is it's not. This is a difficult environment. Volatility would probably count as another headwind. We have to execute well, and we're on track to do that, and we're confident in our ability to realize our goal.
Okay. Any questions on the other side of the floor? I don't want to discriminate. Randy Binner?
Thanks, Eric. Randy Binner from FBR Capital Markets. A couple on the capital deployment. I guess the first one is just to clarify the $3 billion. There's $250 million left on the buyback, and then there's maybe [$600 million] and change of dividends. Would we take those out of the $300 to be left with kind of $2 and change?
The share buyback authorization that you're referring to right now expires in June. My reference was to the four quarters beginning at the end of June.
Take the dividends out.
No, I listed dividends as a use of capital, a deployment of capital.
All right, great. Then if that capital deployment included potentially M&A, you said you could still hit the 13% ROE goal. Could hitting that goal include external financing if necessary? Would that be contemplated in still hitting your goal if M&A was part of the capital deployment?
Let me speak to the M&A piece. Our view on M&A is similar to what we've phrased before. It's nice to do, not have to do. It's not critical from a strategic positioning point of view, and it's not critical to obtaining our ROE objective. However, if we were to pursue something, it would be something we would not want to compromise our attainment of our 13% ROE in 2013. You should not expect that we would do something dilutive to our goal and then rationalize it after the fact. It's too important to us in terms of our credibility with you, and in terms of the benefit to the enterprise to achieve that, and that's how we're thinking about it.
When I was speaking and I used the phrase, "Think about what that means," after I commented on the capital actions being consistent with the realization of our objective, that was an oblique reference to the fact that we don't expect to stand up here in February and say, "We're not going to meet our goal, but man, did we do a strategically important deal.
Okay. John Nadel?
Thanks. John Nadel from Sterne, Agee & Leach. I guess the question around the $3 billion, just to beat this dead horse one last time, is when you gave us the guide on the 13%-14% ROE a year and a half ago or so. Is $3 billion or so of annual capital deployment consistent with what you had provided to us a year and a half ago, or is it now different?
What would be consistent with what we provided is the capital configuration that we expect to have in 2013. I can't, off the top of my head, reconstruct where we were two years ago, but we will have made our capital plans to get us to the capital structure that we want to have next year.
Okay. Then, I guess, I've got one, and maybe this is a bit technical, but I'll try to make it quick for you, Eric. In first quarter, your equity, ex-AOCI, was negatively impacted by foreign exchange rates, particularly the yen. I think that resulted in about a $1 billion reduction in your equity. Is it fair from slide two for us to assume that you guys are baking into your capital plan an expectation that that does not change from there, we're dealing with a slightly lower level of equity?
Well, first of all, as I said, when you set a goal three years out, a thousand things are going to be different.
Understood.
There are fluctuations in those below the line items. We're not assuming necessarily unusual benefits or unusual detriments from the things that fluctuate and affect capital below the line or outside of earnings. We right now have a somewhat lower level of capital because of the impact of the yen at the end of the first quarter. Having said that, if you look at where the yen is today, right now, a lot of that would have been retraced, I assume. That's a piece that's a moving part that we just can't control, reflects the structure of our balance sheet and volatility. You've got to think of the 13%-14% in this context as the center of gravity. There may be some volatility, we don't expect to fall short because of what happens to the denominator.
That's helpful. Thank you.
Stephen Schwartz. Josh, the gentleman in front of the gentleman who just asked the last question.
Just a follow-up, I think from last year. It has to do with deployable capital. If I remember correctly, maybe it was two years ago now, Rich gave a very long discussion with regards to the DTA and increasing the amount of capital that would be deployable. I'm just wondering if anything has been done on that front.
Yeah, the answer is that's playing out as Rich had described. What happens is that DTA becomes monetized, and new DTA becomes eligible, if you'll pardon the expression. There is movement through that undeployable or non-monetizable capital piece of DTA that becomes eligible after other DTA is monetized.
Is that-
It's dynamic.
Okay. Is that $2 billion that's sitting there now, is that still DTA or primarily DTA, or is it something else?
That's primarily still. The structure hasn't changed a lot. There's been movement through.
Okay.
The structure hasn't changed a lot.
All right, thank you.
Joanne Smith, the lady just behind the gentleman. Thank you.
I guess I want to follow up on the headwinds and the tailwinds. The way that I look at it is that regulation seems to be a pretty big headwind right now. I know that there's been some productive discussions on Capitol Hill. What the Feds say and what they do are often contradictory.
I guess one comforting point is that 2013 is probably not in the time horizon that we're talking about with respect to meeting whatever SIFI overlay we ultimately do or don't wind up with. The designation process will get us into next year, and there will be time to work through however metrics will be set and calibrated, then there will be time to meet whatever standards are set. I think your question may generally apply looking out further because there is uncertainty, but if you're looking at 2013, it's hard to see an impact. By the way, as I said, I think we're on a constructive track here. We're hearing the right things from the regulators about how they will think about non-bank SIFIs.
I see a hand in the back of the room, but I don't recognize the face.
Hi, Eric. Pierre Sorelle at Fidelity. Mark, I just had a follow-up question on the SIFI buffer. Could you give us some thoughts conceptually on what would make sense for a life insurance company? For the banks, it looks like the SIFI surcharge is about 15%-35%, and it's based on a couple of criteria, size and interconnectedness being the most important ones, regardless of whether you have a whale in London taking on hundreds of billions of CDS. Could you share some thoughts on that?
We're not even close to having the framework in which we would discuss whatever SIFI buffer might be applied. We're not even close yet to being a SIFI. The stage that we're in right now is having commented on the Fed's rules proposal, which included a proposal that non-bank SIFIs be regulated as banks, but our view was that that was in there to elicit comments. The comments that we made were focused on the framework in which we operate with regulated entities and statutory balance sheets and risk-based capital frameworks. I don't have an analogy to the capital buffer concept that banks are now facing. For an insurance company because we don't have the capital framework in place yet. We're not at the point where I can even answer that from a framework perspective, never mind a quantitative perspective.
Who's next? The gentleman here on the aisle. Chris Giovanni.
Thanks. Chris Giovanni, Goldman Sachs. I guess, Mark, you talked about going to the board for an authorization for share repurchases. We go back to last June when you had the $1.5 billion authorization. You came out of the gates with a $750 million buyback in that following quarter. Since then, you've been leveling off at $250 million. In prior calls, you talked about being opportunistic around sort of share price. John made some comments around sort of the reaction post 1Q. To the extent that you get an authorization here in the near term from the board, should we then make the assumption that buybacks would be front-end loaded versus sort of dribbling things in over the next four quarters?
This is the we can't win question. We took an aggressive, opportunistic approach to the implementation of the share buyback over the past year. As you point out, we have since been buying at a pro rata rate that would get us to our full-year objective. I don't want to signal one way or another in terms of how we will be thinking about it. I do want to point out that we have things to think about with respect to the use of capital and the return of capital. We're going to be factoring all of those things in as we think both about timing and magnitude of the various options that we have to deploy capital.
Then one just follow-up. You talked about the 13%-14% ROE now being a goal versus aspirational. Any comments around what would be new from an aspirational standpoint?
Well, let's get to the 13-14. I actually think that part of our thinking is as we get into that 13%-14% range, we are obsessed with sustaining it. The way we sustain it is with robust fundamentals that indicate the continuing ability to sustain it. I don't think that you should necessarily think that when we get into 13-14, we're then thinking, now it's got to be 15-16. I think our view is that there may be times when you get into that 13-14 range where you then think a little different blend between the financial and the strategic while staying within that type of zone.
I wouldn't necessarily presume that what you're going to see upon the attainment of that is we just keep ratcheting it up, rather keep looking at the calibration between our levels of growth and our levels of profitability while certainly staying within that band.
David Small, did I see you?
Thanks a lot. David Small, J.P. Morgan. We've heard about the on-balance sheet capital for a few years now. Since you're not talking about having offensive capital on the balance sheet, you're talking about deploying $3 billion over the next four quarters, you're going to generate in that time period about $1.5 billion probably of capital. How do we think about how many investor days until we come back and this $4 billion-$4.5 billion is zero or a much lower number?
Remember, of the four to four and a half, we've calibrated two to two and a half as immediately deployable. There will be a non-monetizable portion in there. We'll never sail exactly as close to the wind as we can. There will be some room between our minimum capital standards and the amount of capital that we have. However, we do anticipate making progress on capital capacity over the next 6 quarters. More importantly, we anticipate doing what it takes to achieve the objectives that we've set. There's a balancing act here between realizing our goals and the amount of capital that we have to think about in terms of deployment.
Just conceptually speaking, though, the way we should think about it, though, is you're going to deploy three, you're going to generate one and a half, roughly. This number, that's the net number that this goes down is about one and a half.
Yeah, if you take that off of the two to two and a half, you're getting into the neighborhood of close.
Thank you.
Mr. Gallagher. The gentleman all the way in the back, or almost all the way.
Thanks, Eric. Tom Gallagher, Credit Suisse. Mark, just wanted to take one more crack at the greater than $3 billion of deployable capital. Can you comment at all, at least on growth in the business and deleveraging part of it? Should we consider that less than half, more than half? The reason I ask that is, getting back to Mark Finkelstein's question, I think if we would have taken your prior commentary around growth in the business, it would have actually consumed a lot of this $3 billion. I just want to make sure that we're getting the messaging correctly here.
Yeah, I don't want to calibrate the mix the way you asked it, but I think I'd emphasize John's phrase about outsized organic opportunities. I would emphasize consistency with the achievement of our objectives. However we have to mix it, we will.
Got it. John, just for you, on areas of focus for M&A, can you just comment a little bit about what your thoughts are there? In particular, from an international standpoint, Japan is now getting close to 50% of the overall mix here. Do you have any longer-term concerns about what's going on from a fiscal standpoint in Japan and whether or not you're willing to move that to more than half of the total enterprise here?
Well, Tom, a couple thoughts. One is, obviously, Japan as a country has some of the challenges our own does in terms of some of the fiscal issues, et cetera. This is a marketplace that Ed Baird will be speaking to more extensively later in terms of the propensity to save, in terms of risk aversion, in terms of liquidity available to the individuals. This, we believe, is a remarkably positive marketplace in the demographics where our products are most relevant. We can see this continuing to be very effective. We are still going through the integration process of Starr and Edison, and we're very determined to validate the conviction we had when we announced that transaction 18 months ago or so. Having said that, we have other businesses that are growing.
The continued growth of Japan doesn't necessarily suggest or imply that it becomes a larger and larger percentage over time, because we have other businesses that have some very promising growth prospects as well. We don't have a magic percentage or cap, if you will. I think we're more driven by the opportunities and by the attributes of the individual markets in which we operate. When you look at our experience in the Japanese marketplace, it's high returns, it's strong growth, and it's low volatility. The nature of the business we do and the nature of the products we do is very consistent with that perspectively as well.
If anyone who hasn't yet asked a question has one, we have time for one more before we break. It's the gentleman here.
Thank you. Joel Gross with ICMA Retirement Corp. Just two quick questions. What were the factors that went behind setting 400% as your RBC target for Prudential Insurance? Two, what is your liquidity goals for the holding company?
The benchmark of 400% RBC reflects a conservative approach to establishing minimum capital standards. It's used as the benchmark against which we define excess capital or capital capacity as you saw it. We're probably more conservative than the norm. Many companies use 350, for example, and it may be true that 350 is more consistent with mainstream rating agency thoughts, but we want to be conservative. We've set a higher standard. Part of our capital planning, just so you know, might allow the RBC to go below that under certain circumstances, but that's the benchmark that we use for defining excess capital. Right now, we have a liquidity target for the holding company in excess of $1 billion, and we're well above that.
Thank you.
I think it's time to break. It's a little bit after 2:00 P.M. Please come back in 10 minutes. Before we get started with the next part of our program, Rob Falzon, our treasurer, has asked for a moment to correct a statement he made in response to a question just moments ago. Rob?
I get asked one question, I blow it. I want to be clear. The capital debt ratio denominator is the book equity net of AOCI, but inclusive of CTA. There's a variety of ratios we look at. The total leverage ratio actually is book equity inclusive of both CTA and AOCI. Again, we use those because they most closely mirror the ones that the rating agencies map to. Just so that's clear. Thank you. Thanks, sir.
I'll be talking about the U.S. businesses for about the next half hour, then Bob O'Donnell will come up and do a deep dive into annuities, and we'll take questions after that. Let me start with a simple slide and augment some of the comments that Mark made in his bubble chart. The first point I'd like to make is on business mix. If you look on the left-hand side of this chart, you see the two protection businesses. What we expect from these two businesses is steady cash flow and strong earnings, albeit with lower growth. On the right-hand side, in progressive order, we expect higher growth and higher ROEs. The other point I'd like to make on this slide has to do with market sensitivities. Going from left to right, you see less market-sensitive businesses with the protection businesses.
You have the retirement business, which is somewhere in the middle. You have asset management and annuities, which are our more market-sensitive businesses. Throughout the presentation, there'll be slides with a lot of words on them and bullet points. I'm not going to go over each one. We have these here for your reference. I do want to make two points on this slide. The first is that the retirement market is coming our way, but we're not just waiting for it because we think we have the expertise, the experience, the products, and the capital to take advantage of this opportunity, and we'll talk about that throughout the presentation. What this slide demonstrates is the diversification of the businesses graphically. If you look at the quadrants, we really have a quadrant for each of the areas.
The first, obviously, is the protection businesses, we have retirement, asset management, and annuities. Another way to look at this is through the market sensitivity lens, where about half of our businesses are less market sensitive. Namely, the protection businesses and the retirement business, and half are more market sensitive, namely asset management and annuities. We think about, as John and Mark said, we think about the diversification of the businesses and the mix of those businesses over time. Let me talk for a minute about market developments and our positioning, I'll first talk about annuities, retirement, and asset management. If you look at the top part of this page, that's about individuals, and the bottom is about pension funds.
You've all heard the statistic that there are 10,000 baby boomers retiring each day, but they're in desperate need of certainty of income and of longevity protection. That's exactly what our annuity product is consistently offering them, and what Bob will talk to you about. On the bottom half of the page, we talk about pension plans and the fact that pension plan sponsors are facing increasing regulatory and financial challenges. Their response is that they're seeking innovative asset management solutions, be it LDI or fixed income barbelled with alternatives, or because of pressures from rating agencies and from PPA, the Pension Protection Act, they're thinking about actually jettisoning those plans, about transferring the risk of those plans to someone else, namely pension risk transfer. We'll talk more about that when we get to the retirement business.
In terms of individual life and group insurance, we talk about individuals and we talk about employers. Individuals in this country are vastly underinsured, and what we seek to do is to expand the market and to serve our customers in as cost-effective and as capital-efficient way as possible. In terms of employers are under tremendous pressure to reduce their benefit costs. One way to moderate this cost is to limit the benefits that employers provide and to allow employees to purchase more voluntary benefits. We're very much in this marketplace. Now what I'd like to do is spend a couple of minutes with you on each business, talking about some salient points, talking about AUM and sales and flows. I won't spend a lot of time on the annuities business because Bob will do that, but I do want to make three points.
The first point is we think we have a really good mousetrap. We're the only ones with the Highest Daily product. We think that provides value to customers and it provides value to shareholders, and we don't think those two concepts are mutually exclusive. The second point I make is that we are committed to profitable growth. This is a theme that will run throughout all five businesses, that sales and flows and AUM are a consequence of profitable growth. They are not a goal in and of themselves. The third point I'd like to make is something you may or may not have seen, which is consistent with this idea of profitable growth. We have just filed product revisions to recalibrate our product to our view of the new interest rate levels, and Bob can talk more about that if you wish.
When we look at account values and sales and flows for annuities, the word that comes to mind is consistent. We have consistent growth in terms of AUM, and we have consistent sales. Sales last year were down slightly from 2010 after price increases and benefit reductions at the beginning of the year, and that's just fine with us. Again, we're going to sell profitable business, and we'd rather sell slightly less profitable business than more unprofitable business. Let's spend a few minutes on Prudential Retirement. Prudential Retirement is divided into two parts. The first is full service record keeping, and the second is the Institutional Investment Product division, what we call IIP. We'll talk about three different parts. We'll talk about full service stable value, investment-only stable value, and of course, pension risk transfer.
Before we do that, let's look at account values and flows. On this page, we look at the consolidated business. I'll unpack it on the next page, here we look at the consolidated numbers. We do that because the mix of the business is changing. Last year at this time, 70% of AUM was full service and 30% was IIP. This year, I'm going to round by a percentage or so don't get out your calculators, it's 60/40. Full service AUM has stayed about flat and the IIP has increased. As that mix changes, we look at the consolidated numbers. What you see is consistent AUM growth and very strong sales and flows, which contribute, obviously, to the AUM.
If we go to the next page and we unpack that. You see full service at the top, and you see the institutional at the bottom, institutional investment products at the bottom. The full service has progressively had weaker sales and flows, which is precisely what we've been telling you on the call, but this shows it graphically. We cited four reasons on the earnings call for these lower flows, and I just want to go through those with you because what we do at the end of every quarter is we look at every single client that we lost, and we analyze why we lost them. Did we lose them because of price? Would we rather have kept them? What could we have done differently? Et cetera. We do a postmortem on all the clients.
What we said in the first quarter call, which is really emblematic of what has happened historically, is that we lost about 50% of the clients because of either M&A or bankruptcy. We were on the acquiree side as opposed to the acquirer side. The second reason, which comprised probably 10% or 20% of the cases, was due to an employee change or personnel change, either at the plan sponsor or at the consultant, meaning someone came in and had preexisting relationships and they wanted one of those. The third was pricing. Again, these percentages aren't mutually exclusive. The third was pricing. Probably 60%-65% of the business that we lost was below our target rate.
Obviously, some of that had to do with M&A, so it's better to be lucky than smart, but much of it also had to do with the rigor we place and the discipline we place on profitable business. There was a fourth category as well. Those were cases we would rather not have lost. There's always a handful of those, which are good companies with a high rate of return. We would have rather kept them, and that's just life. That's business. The point here is that we have extraordinary discipline when we look at the cases we want to write and the cases we want to keep. If you look at the bottom part of the chart in IIP, you see there's been very strong growth, most of this having to do with investment-only stable value sales and flows.
They've been very strong. We feel very good about our position and our ability to continue this business going forward. There are other things in this number as well, including pension risk transfer. We'll go over that later on. Let me now spend just a minute on each of the three products. The first is full service stable value. This is our general account product. It's a spread product. It has significant protections. The majority of the AUM, about three-quarters of the AUM, is not at the crediting floor yet. Don't get too excited because you can't take the 125 basis points that you see in the last bullet and reduce that all at once because there are competitive pressures around.
What we do is we try and maintain a spread margin, and we will reduce or increase the crediting rate, in this case, mainly reduce the crediting rate, in order to try and protect that spread margin. On a cohort of the $31 billion, we reduced spreads by 25 basis points in the fourth quarter. We have another trigger point coming up in June. In terms of investment-only stable value, I want to make three points on the page. The first is this is really attractive business. We enjoy attractive returns both on an absolute and a risk-adjusted basis. The second point is that this is a twofer. In other words, we mandate that we manage 50% of the assets through Prudential Investment Management, so we get the investment management fees. Right now, we're managing over 60% of the assets.
The final point is there are significant protections here as well. We set the investment guidelines. There's a 0% crediting floor. There are liquidity buffers. We are extremely comfortable with this product. Now let's talk about pension risk transfer. This is a big market, as Mark said. We like the product. It's a product with relatively limited exposure from financial market volatility. We have the skill set to do this. We've been doing it for over 80 years. We have the capital to do it. We have the track record. I would argue in a bold statement, we have the best team in the business. We have been investing in this team for a long time. Don't take my word for it. Many of you work for investment banks. Talk to your investment banking brethren about this team. We're working with them. Talk to consultants.
Talk to our clients. Talk to people and see who has the best team in the business and who's made the commitment to be in this business for the long term. The final point is that this is a great fit for us. This product involves longevity risk, which is a natural hedge to the mortality risk of our insurance product. This really is a good fit for us. Now, there are four types of products when we talk about pension risk transfer. The first is the traditional closed-out annuity that goes into our general account. That's in green. The second is the buy-in product. Now, this is a product that's been done for years in the U.K.
A couple of years ago, we imported this technology to the U.S., worked with regulators, and last year executed the first transaction for a small company in North Carolina called Hickory Springs, a small furniture company. It was only a $75 million transaction, but it was a shot heard around the country because it was the first one ever done in this country. What a buy-in is when you take an annuity and you embed it into an existing pension plan. You immunize a certain portion of the pension plan. Because it's part of the pension plan, you don't trigger settlement accounting. The third product is portfolio protected buyout, where we assume liabilities and place the assets into a separate account, and you do that for larger transactions. The fourth is longevity insurance.
Again, something done all the time in the U.K., and we've become a large reinsurer of longevity risk in the U.K. All told, in 2011, we did just over $2 billion of business. That's not enough to really move the needle, but it's a very good start for what we think is going to be a very big business going forward. Let's move on to asset management. We like this business. This is a business that doesn't use a lot of capital, has high ROEs, it's been growing well, and we think it provides a competitive advantage to our other businesses within the Prudential business system. We think the greatest competitive advantage we have is experience and track record, because we focus on one thing and one thing only in this business, and that is talent.
If you can attract, develop, and retain the right talent, reason would stand that you'll get good performance, and we have very good performance. If you have good performance, you will grow your AUM. Growth in AUM is not a goal in itself. It is a result of good performance, which is a result of good talent, which is why we focus solely on talent. If you look at our AUM, we have $637 billion at the end of the first quarter. 80% of that is in public securities, either public equities or public fixed income. The remaining 20% is in our private businesses, commercial mortgage, real estate, and private fixed income. If you look on the right-hand side and you compare this to last year's chart, you'll see that the institutional customers has grown.
It's not that the general account or retail didn't grow, it's that institutional customers grew more, 64% of our assets are now third-party assets. We had very strong flows in 2011, not as strong as 2010, which was a record year, but there we picked up some CDO business as well. The retail flows appear slightly weaker and in fact were weaker, but it's not because the mutual fund sales or flows were weaker. They weren't. In fact, they were stronger, and they were stronger because of the strong performance and because of our investment in the distribution we made. The retail flows were slightly weaker because there was some rebalancing in some of our sub-advisory accounts due to Prudential concentration risk. They had too much Pru, and they had to rebalance. It was not due to performance.
You can mark this against the first quarter of this year when we had $3.2 billion of net retail flows. Those flows have driven assets under management, as you can see, with consistent growth. We had $619 billion at the end of the year. We have $637 billion at the end of the first quarter. If you look at asset management fees, you'll see considerable growth as a result of the growth in AUM. The asset management fee growth is really important because it's becoming a larger portion of the overall asset management revenues. You can see that in the blue part of the pie chart here. The green part is what we fondly call ITSICM, incentive fees, transaction fees, strategic investing, and commercial mortgages. That has become a smaller part. It's become a smaller part for two reasons.
The first is the large growth in asset management fees. The other is a consistent emphasis on our part to reduce ITSICM. We talked last year about reducing the size of strategic investing, the runoff of the interim portfolio and commercial mortgages. We continue to do that. That will become smaller, and over time, it will become less volatile. The point on this page is that the business itself, the asset management business, is less reliant on ITSICM. I do have a piece of breaking news for you because ITSICM or ITPICM drives us nuts. Okay. We're changing that to other related revenues. Okay. There are three reasons why we're doing that. One, it's comprehensible, two, it's pronounceable, and three, it's utterly bland. Our aspiration for other related revenues going forward is to make it small and to make it bland.
Hopefully, it will become less volatile. Let's move on to group insurance. Let me go back to the first slide. We manage the protection part of our businesses to provide stable earnings and steady cash flow. 75%, three-quarters of this business is life. What we said on the earnings call was that when we looked at the first quarter results, and just to remind you, the first quarter results was the worst benefit ratio we've had in five years after the fourth quarter of last year, which was the best benefit ratio we had in five years. What we said is we did not see anything that would indicate a continuation of this issue.
What I will tell you today, after continuing to analyze the book, we continue to see nothing that would make us to believe that the first quarter was anything more than an abnormal fluctuation. Oops. Let me move on to disability. Obviously, we've had trouble in disability, one of you said something that we really appreciated, and that was that Pru has a history of dealing with its problems quickly, and that's exactly what we're doing. As I said on the call, we didn't just wake up and discover that the benefit ratio was increasing. On the other hand, this does take a while to fix. There are things we can do and are doing to remediate, to accelerate the remediation of cases. First of all, not all cases are underpriced. This wasn't a rampant case of all the cases being underpriced.
We've identified the cases that are, we're accelerating the repricing where we can, and we're eliminating other cases where we can't. I want to caution you that even if you eliminate cases, you won't see a significant change in the benefit ratio immediately because you have the claims that are still outstanding. I will tell you this, it is our intention, it is our commitment to grind the ratio back down to where it should be, and we will do it as quickly as we can. This is an interesting slide. You can see that the premiums have grown over the past three years. In 2011, if you take one large case, one large life case out, which was $180 million, the premiums last year were significantly below that in 2009.
Consistent with the other businesses, the mispricing was not done in order to drive sales. The mispricing was done because there was a misjudgment in terms of the effect of the economy on the disability market. Let's turn to life. Individual life has historically had solid cash flows, and as Mark said, a very solid ROE. They exhibit a very high degree of discipline in terms of pricing and underwriting, and they focus on returns through capital management. Perhaps this graphically shows the theme that we've been trying to state throughout, which is we focus on profitable business and let sales and flows fall out where they may. In 2009, we raised prices twice, we watched sales plummet in 2010. They've come back as other competitors have either left the market or raised prices back to us.
Sales will be what they may, we're going to write profitable business. That led to modestly increasing face amount in force at the end of this year. There's a lot of words on this page. In conclusion, I'm not going to talk about what's on the page, but I do want to make three specific points. The first is we believe we're well positioned for what we think will be significant changes in the retirement marketplace. We have the talent, the expertise, the experience, the products, and the capital to take advantage of this opportunity. Second, we are absolutely committed to profitable growth. You've seen what we've done in life, in annuities, in retirement, and you will see what we will do in group. Finally, the business mix.
Our business mix, defined as the businesses themselves and the market sensitivity of those businesses, should limit downside if we hit choppy waters but enable us to participate significantly in a market recovery. We very much look forward to proving that to you. Thank you, and I'll turn this over to Bob O'Donnell.
Thanks, Charlie. I welcome the opportunity today to present to you an update on the annuities business. First, Prudential is strongly positioned in an attractive market. I say an attractive market because of a number of things. Firstly, the demographics are compelling, the number one self-stated need of retirees and near retirees is the fear of outliving their assets, that's a space that we reside in daily. We offer a superior value proposition in a sustainable manner, that sustainability is born from a philosophy of aligning the key demands of our key constituents, namingly our shareholder, our investor, the buyer, sorry, of the contract, also the financial intermediary, the broker dealer, and financial advisor with whom we partner to deliver our value proposition.
It's through an alignment of those interests on the same side of a challenge that we are allowed and are permitted to deliver a sustainable strategy. As opposed to stacking those constituents up on either side of a strategy, which can generate zero-sum game type strategic development, which inherently is unsustainable. Our risk management approach embedded in our product design is just one example of the results of a strategy born from aligning interests on the same side of a challenge. The idea that we can put a safety net underneath an investor's account balance in order to reduce the risk of a guarantee issued by an insurance company is a good thing for the insurance company, but it's also a good thing for the investor and a good thing for the financial advisor.
Later in the presentation, I'll provide an update on how that has affected the risk profile of our business. From a client perspective, the marketplace can be characterized by an increasing shift towards the individual responsibility. That has a number of implications, right? We can think about the obvious reasons, the reduced availability of defined benefit pension plans, also the expectation of reduced benefits from Social Security plans. What that means is that the individual has to take an increasing role, and that can create anxiety on behalf of the buyers of our products. That gets magnified by a number of other events, and those events include the volatility of the assets that they are intending to use to manage that future liability, and the headlines that oftentimes fuel that volatility.
The reduced availability of traditional safe harbor investments that generally could produce a meaningful return is simply not available in today's marketplace. At Prudential, we address those issues directly. Our HD strategy is attempting to fuel and fill the gap associated with that future liability by allowing a guarantee to step up and lock in on a daily basis, thereby closing that future gap in funding a liability. We address the concern associated with the reduced availability of traditional alternatives. While our product-embedded risk management approach reduces risk to the shareholder, it also eases the minds of the buyer during these volatile periods. The feedback we've received during volatile times from investors who have participated in our mechanism and enjoyed a smoother ride during those times has created remarkable value for our franchise and has been replicated in certain circumstances across the industry.
Our investment platform offers diversity and flexibility for both the investor and the financial advisor, and preserves a key component of the financial advisor's value proposition, and that's really important, the idea that they can continue to manage the asset for their investor. From a distributor perspective, our industry has gone through an interesting few years. I describe the activities of our peers as creating a volatile participation by the insurance manufacturer. That takes the form of key players perhaps exiting the marketplace, key players modifying the value of their market-facing value proposition on an increasing basis. That has an impact on the financial advisor, who now has to invest more time and energy in training and learning what's going on in the marketplace so that they can responsibly deliver our core value proposition, our industry's core value proposition to their clients.
We've seen increased utilization of new risk management approaches. These risk management approaches generally take on the form of fund level embedded risk mitigants. We'll talk a little bit more about those in the future. They're new. We view them as an encouraging sign and a requisite element of sustainability in our space. These approaches have a tendency to reduce the role, to some degree, of the financial advisor. The idea that an embedded fund mechanism for reducing risk is delivered through a restricted offering of funds leaves the financial advisor less opportunity to employ their analysis and discretion over those assets to hopefully close the earnings gap between what the current investor has and what they might need in the future. Again, Prudential has an approach that goes at these directly. Our presence in this marketplace has not been volatile. It's been consistent.
We've essentially been delivering the same annuity value proposition since 2006. We've been doing so with a concept that we've been working with since 2001. It's market tested, it's model tested, and it's market tested, and it's delivered results consistent with our expectations. The contract level mechanism, as opposed to the fund level mechanism that many of our competitors have employed, enables, again, the advisor to stay front and center with respect to the asset management component of the value proposition. Again, we view these broadly as encouraging developments for the industry. We think they add value to the risk mitigants or the risk management approaches of our competitors. I'm just drawing out some distinctions between the methods that we employ and some of the reasons why we do that. What we see taking place in the marketplace is really an evolution.
I know I talked about volatility of participation. That's for a prescribed period of time. What we're beginning to see is increased normalization. This slide shows you Prudential's place in the industry at number 2 in assets and sales, but it also shows you something different than it showed you a number of years ago, and that's consistency on both sides. If I were to show you this slide two or three years ago, I'd be pointing out how many firms were on the asset side and how many were not on the sales side. You had new players from the sales side and old players from an asset side. What that meant was that traditional players in this space were no longer here.
What we've had over the past few years is new entrants into the space who are producing higher levels of sales and rising on the asset side as well. I submit to you that we're emerging into a new normal for industry participation. I suspect what I describe as the volatility of participation in the future will return to more normal levels. There's a few takeaways from this next slide. The first is the growth in sales, obviously, over the past few years. In 2008, our organization produced just over $10 billion. Today we're producing somewhere in the neighborhood of $20 billion. That $20 billion is not a new number. That's a number that we've been producing at a stabilized and consistent level for quite some time. That's why I included the 2010 number here.
You can see from 2010 through 2011. If you've looked at the numbers for 2012, you can see remarkable consistent production levels in our business. Again, delivered through that philosophy of aligning constituents on the same side of a challenge with a sustainable strategy. It shows in the numbers. Our sales numbers have been remarkably consistent over this period. There's going to be some lumpiness in the intermittent reporting periods. That's going to happen by reason of crowding out of other activities in the marketplace, perhaps competitor activities that will move those numbers around. The sustainable level and constant level of sales has been there in our organization. The other thing that this slide is intending to show is the difference in our distribution strategy. We have now a fully comprehensive, diversified distribution strategy, as evidenced by the strength in all four channels.
There's a unique evenness in the slices of our distribution pattern, which again, delivers a sustainable approach to a broad marketplace and diversifies our business opportunity among a number of major key partners. I just want to spend a few minutes talking about the high level value proposition of what the buyers of our products are looking for. This chart is a very simplified conceptual view of what we're delivering from a guaranteed value standpoint. Just to explain what's here, the tannish mountain chart represents the value of the underlying invested asset of a particular investor. You could see that those are going to go up and down as the value of the underlying investments go up and down. This is basically the value of the underlying assets in their contract.
The large locks that are indicated here, and there are three, are intended to represent the daily step-up of our guarantee. You'll see that at the three peaks, the large locks represent a capture of that step-up. Then there's a gently upward sloping from left to right line. That's intended to represent the contractual growth component of the variable annuity guarantee. In our product, it's a 5% what we call roll-up on that daily step-up. What you see is an opportunity to participate in the investment platform to drive increases in the notional value of a future guarantee, and then an ability to participate at a modest growth rate during periods of what otherwise might be more tumultuous or volatile experiences for the underlying asset. We'll talk a little bit more about how we manage the gap between those in just a minute.
That blue line is a notional value on which future withdrawal payments will be based, and those future withdrawal payments will first be funded by the existence of the underlying tan account balance. You could see why it's important for a company who's providing the guarantee to, as much as possible, align the value of the underlying account with the value of the guarantee. We're working to make sure that that gap doesn't get too great. With respect to the opportunity, these are some pretty straightforward statistics, and we had S&P take a look at this. With a daily guarantee, you have absolute certainty as a buyer that you will participate in the best day that your contract ever reached. We have products in our industry that don't employ a daily structure.
We have some quarterly and many annual, the statistics around those are pretty straightforward, right? If you've got a quarterly benefit, you have about a 4% chance in achieving or capturing the highest value that your contract reached in that contract year. If you have an annual structure, you have approximately a 1% chance. What we're selling in this structure is the certainty and simplicity associated with a daily step-up in our product. We've seen a lot of activity around risk management in our business. I mentioned this briefly a few minutes ago. What we see are increasingly insurers are constructing what we call embedded risk mitigation solutions. I think it's important for us just to spend a few minutes talking about how those have taken hold in the industry and perhaps how those differ from what Prudential has been offering for quite some time.
Again, I want to start by saying we view these as very encouraging developments for the annuities industry. Again, I use the term requisite, but certainly prudent with respect to sustainability of the value proposition for quite some time. We talk about our product as being a product specific or contract specific risk mitigant. Many of those that you see in the marketplace today are constructed at a fund level. What those funds will generally do is employ some macro indicator as a proxy for the risk associated with an underlying asset. Generally, volatility is a common indicator. As vol goes up, monies will move to a safe harbor asset. As vol goes down, monies will move to the client-directed component of the fund.
There's a couple of concerns or distinctions rather, that I would make between those mechanisms than the way that the mechanisms that we employ at Prudential. Firstly, if you have an investor who purchases into a fund level risk mitigant, let's say they buy at the money and the fund is currently fully allocated to its directed assets, meaning the core strategy. No money has yet moved to the safe harbor asset or the bond instrument. That's followed by some period of economic strain, and the allocation increases to the bond side, maybe 20, 30, 40%, whatever it is, some months later. Just a hypothetical example. Now a new buyer will come in to your company and purchase a contract in that same fund.
The first buyer has an in-the-money benefit, meaning their guarantee exceeds the value of their underlying asset, as indicated by the loss in the fund and the movements to the fixed account. The new buyer has an at-the-money guarantee. Both will be invested the same way. Both will be experiencing those increased bond allocations. That is a key distinction between the way those mechanisms work and the way our mechanism works. Because we operate at an individual level, the buyer who purchased in the first contract would have allocations moving to a bond portfolio, and maybe they're at 20, 30 or 40% to the safe harbor asset. Months later, when a new buyer comes in, they get fully invested in the client-directed assets with no allocation to the bond instrument because each contract is managed with respect to its liability.
The liability you can think of as the difference between the notional value of the guarantee and the underlying asset. When we look at contract level and fund level, that's the essential difference between the two. We view that the contract level is more precise, yet many in our industry are employing the fund level approach. When you look at the sheer utilization of strategies, you might conclude that the fund level must be better. More people are using it, so it must be better. I would argue that that's not the case. In fact, we believe that the contract level mechanism is better simply because it's more precise. It also creates, we think, an enhanced client and financial advisor experience.
The reason that we believe the industry is more broadly employing a fund level approach is that it's something that can be executed in a timely fashion. A lot of what we're seeing today in the industry is a reaction to the events of the past years, and you can meaningfully mitigate risk with a fund level embedded approach, and you can do so much more quickly than you can with a contract level. Again, less precise, but you can get it done quickly. We've been involved in this type of a structure since 2001 and employed it in the guaranteed income space for a number of years, beginning in 2006. Just evidence to the fact that it takes quite a bit of time to get it done.
Just going to walk through some conceptual examples first and then some actual numbers as to how this concept will work and how it has worked. This represents an admittedly oversimplified scenario. We're looking at a 1-year, 30% drop in an equity account followed by 11 years of 0% equity performance and a 3% bond return in this example. When I say a 30% equity drop, the way to think about that, and I apologize for being very specific here, is a 30% reduction in the NAV or a 30% reduction in the unit value of the subaccount. I'm making that distinction because in this contract that has a contract-specific risk mitigant, while that NAV is going down, we're moving money into the bond portfolio. The green line in this example is not going down 30%. In fact, it's only going down 19%.
Therein lies the big difference between our mechanism and many others. This contract only lost 19%, as evidenced by the drop in the green line, and that green line was supported, that safety net I mentioned earlier, by our systematic allocations to a bond portfolio as referenced in this diagram by the increased allocation to the yellow line. What you see in the yellow line here is a growing allocation to a bond portfolio, and the green line represents the total value of the client's invested assets. Again, the blue line here represents the notional value of the guarantee. In this case, since there's been nothing but equity losses, there's no step up, so it's just a straight 5% escalating line over this period. Our contract has an embedded doubling guarantee. That's why you see the hockey stick at the end.
When you reach year 12, we automatically increase the guarantee to 200% of premium. That's the concept. The key point there is what happened to that 30% drop and the fact that it went down 19%. Again, preserving account balance to fund future liabilities. Wrong way. Sorry. This is a more detailed look at that same picture. In the top graph, we've got an account balance or an invested asset with no embedded risk mitigant, and the bottom one, we have an invested asset with the risk mitigant that I just outlined before. The most important thing to notice here first is the size of the dip. Look at this again on this top graph. The amount that this contract loses in that first year is significantly more than the amount on the bottom contract. Again, the bottom one is the mechanism that we employ.
That shows up in future claims. The right side of this chart is intended to represent the funding of withdrawals for guaranteed lifetime income under the contract. The green component of the bars represent that portion of funding that's provided by the value of the underlying contract. In the top graph, you've got just shy of four years' worth of annual withdrawals. In our contract down below, you have more than four years longer of contract-funded withdrawals. What that means in this guarantee, if you recall, the guarantee was a 200% guarantee. That's $10,000 a year. That's a difference of $40,000 on an original investment of $100,000. The impact of the embedded risk mitigant is meaningful, and this just highlights, admittedly, one overly simplified example. The impact that putting a safety net under an equity-based asset can have a big impact on future claims.
We've walked through the theoretical. Now I'm going to walk through the actual, and we've got in this diagram an actual individual contract, and then I'll walk through the broader book in just a minute. This represents a contract that would have been sold on January 1st of 2008. Let me just explain what all the lines here are. The black line represents the S&P. As the S&P is performing on a daily basis, that's reflected in the black line. The red line represents the AST, our Advanced Series Trust capital growth portfolio over the same time period. That contract or that portfolio has some allocation to a bond instrument, and it's more diversified, which explains why it doesn't correlate directly to the S&P. The blue line represents the actual value of that invested contract when connected with our embedded risk mitigant.
The portion to focus on here is not the far right side of the graph. The portion to focus on here is late 2008, early 2009, and that explains why we did this. This is the value that we derive out of this, the shareholder derives out of this. This is the value that the investor, the buyer, derives out of this, and that is how much more closely aligned the underlying asset is to the notional value of that guarantee, which in this chart is represented by the green line. That fuels a remarkably different experience for our organization. The financial statement performance associated with that blue line, as you can imagine, is remarkably different than the red line. The red line is what most in our industry have been working with for years, and we've been working with the blue line since 2006. Point of caution.
This particular time period would seem to imply that our mechanism can operate as an account optimization tool. That if you do business with Prudential Annuities, your account balance will be stronger during volatile market periods than if you don't. That's not the case. This is first and foremost a risk mitigant that is intended to put a floor on the underlying asset supporting the guarantee. In fact, if I were to share with you this same slide for a contract issued in 2011, you would see that there is an inversion of these. Not quite this magnitude. Obviously, 2011 was a very different year than 2008 and how we got into this period in this slide. In 2011, a contract issued would have had a modest opportunity cost associated with being in this guarantee, and that's more what we expect.
When we sell this contract, when we sell this mechanism, we're selling it for the primary purpose of putting in downside risk protection on the underlying asset. On average, we expect that to run in the neighborhood of 40 basis points per year. Again, we don't live in the averages, as evidenced by this slide, where we had a near tail event that caused this to actually operate more like an account optimization mechanism. We expect on average that this will create a bit of a drag in the form of opportunity cost on the underlying asset. If you're interested in seeing the marketing materials that support that, we put that right out as part of our training and marketing. You can contact Eric, and I'm sure he'd be happy to get those to you.
This now represents the book level view of that same concept. It shouldn't be any surprise to see what happens here as well. What you've got in this chart is the yellow line indicating the periodic performance of the S&P, and the bar charts represent the total value of assets connected to contract level embedded risk mitigant at Prudential Annuities. The colors represent the relative value of the safe harbor asset or the bond portfolio as compared to the client-directed assets. As you can see, there is an inverse correlation in these lines. As the equity markets go down, our book is losing money. The value of the guarantee becomes at risk. We move monies into the safe harbor instrument to support that guarantee, and you can see that very clearly in 3Q 2011.
As markets return and values of the underlying assets perform well, those monies move back in the opposite direction. You can see that the blue portion of the chart, representing the bond allocation, has reduced accordingly. I'd like to spend a few minutes talking about the mix of assets. In the annuities business at Prudential, and I would argue broadly across the industry, there's a thought that I think needs to be clarified, and specifically the investing behavior of an advisor and/or an investor with respect to assets that have a guarantee. This image clearly shows a diversity of positions within our book of business, and I would submit this is not anomalistic across the industry. Investors in this space are generally diversifying their assets, some because they have to, because that's the way the contracts are now structured.
Because that's what they need to do anyway to be consistent with their risk tolerance. This is something that has not changed in over a decade. Before our industry was delivering rich guarantees, investors still adhered to their primary core risk objectives. You can see here that investors are not allocating huge portions of their variable annuity contract with Pru to highly concentrated equity positions. In fact, our analysis suggests that on average, the investor in a protected asset increases their equity allocation by merely 1%. I would argue that's statistically insignificant. Just one other update with respect to the detail around the fixed allocations. You could see from 2010 to 2011, we had an increase in the blue portion of the pie here. This again is representing the same blue portion that we saw on the prior slide.
We had an increased allocation to 19%, I can tell you , in the first quarter of 2011. Approximately half of that has moved back to the green and back into the directed assets of the buyer. Just some clarity on the demographics of our buyer. We're selling to Middle America, the average issue age of 60 and $100,000, representing approximately a third of their net worth. These are people who have a fundamental need of insuring against the risk of outliving their assets. That's who we're selling these products to. We're selling them to these individuals through a financial advisor. There are a lot of them, as evidenced by some of the statistics on the bottom. When we talk about a strong position and a rich opportunity, this is what we're talking about. We're talking about an unparalleled need in this country for income security for retirees.
We are working in that space. The space that we're working in today is different than it was 10 years ago. It will likely be different 10 years from now. At Prudential, being a leader in that space, we expect to have a hand in the formation of this industry. Just one example of how we participate in that regard and try to deliver on our objectives of innovative solutions is our partnership with Edward Jones. Edward Jones, as you likely know, is a major producer of variable annuity products. Traditionally has done so through what we call A-share variable annuities, which you can think of as analogous to an A-share mutual fund. An A-share variable annuity has a front-end load that comes right off the premium that's invested in the contract.
That began to create some unusual situations for the financial advisors at Jones when you begin selling A-share annuities with a guarantee. We worked with Edward Jones to better align the value of their underlying contracts with the value of the guarantee and structured a new contract, which is now called an O-share, only distributed through Jones, that has a premium-based load with an expiration period. There's a prescribed duration in the contract where rather than assessing a front-end load on premium, we assess an annual load. It's based on premium. There's that stabilizing premium-based component to it. That now has become the standard product offering at Edward Jones.
As we've constructed this with their partnership, they have now reached out to all of their other partners, and they have constructed what we now call an O-share product in Jones as well. Just a few minutes on sales. This slide, we like to think that green and yellow make blue. What you have here is our growth sales reflected in the vertical green charts and our net sales represented in the vertical yellow charts. You can see the growth that's coming from our industry and from our business in the form of net sales. That translates directly into the size of the blue charts down below. What you can see, and I think what you should take away from here, is a consistency of presence. We have made changes in our product portfolio over the years.
Those changes have been, again, consistent with our philosophy of sustainable approach, and they manifest in a remarkably stable asset growth over what otherwise might be considered some volatile periods. As Charlie mentioned earlier, that includes a product change that we just filed last week, which we expect to launch later in the summer. Some of the headline items around that product change I'll share with you. We will be increasing the fee to 100 basis points. We'll be increasing the minimum issue age by five years to age 50, and we'll also be adjusting certain of the withdrawal bands. In particular, a 59 band of 5% will be moving back five years. That tends to be a pretty valuable economic lever for us to pull.
What we're working on always is modifying the economic levers of a product strategy that have meaningful financial impact and less meaningful market impact. That's the work that we do on a regular basis to ensure a stable ride around assets and sales. I made reference to selling our way to a different risk profile, and this is something we've been talking about for years, and this slide continues to reinforce that story. These bars represent the assets under management by measure period by quarter for Prudential Annuities. You can see that there's growth in those assets under management. While that growth is welcome, I think what's more welcome is the character of the asset underpinning that growth. When you look at the blue portion, that's really what we're talking about.
That's the percentage of our book that is connected to a contract level embedded risk mitigant, which means the risk profile of the blue portion of our business is fundamentally different. It has a fundamentally different risk profile associated with it than certainly the red and the green, but also much of what's been sold in our industry by others. The red and the green can be considered to be largely run off. We don't sell very much business without an optional protection feature. In fact, it's somewhere around 5% of our sales come without it. Said another way, 95% of all the business that we write has an embedded risk mitigant, and then the other business without any protection feature, just a modest portion of our book. We can expect this trajectory to continue. With respect to lapsation, we're well-positioned to retain our business.
Lapsation declined broadly across the market, as you might expect, as investors have equity-based assets, and they have a guarantee on those. They're less likely to walk away from that guarantee when it's more deeply in the money. We've also got good reason to feel comfortable about the buying behaviors of our business and what those buying behaviors say about the expected persistency. The fact that 93%-95% of all of our business is sold with a long-term optional protection feature tells us that the folks who are buying these contracts are looking at this business with a long-term view. That doesn't mean that there aren't going to be opportunities for lapse, but those are numbers that we hadn't seen five and 10 years ago.
Clearly, optional protection features largely take in the form of death benefits and other previous versions of what we're selling today never reached the levels that we're seeing now, and I think that says good things about the intended use of an annuity contract and its persistency with the manufacturer. That said, we also have surrender charges that help protect us against lapsation, and you can see that the portion of the book that represents the blue part of the chart represents a portion of our business that we're very interested in retaining. The product-embedded risk mitigant also happens to represent a large portion of our business that also has surrender charges, which should, again, bode well for our view of persistency. As you can see there, the average of the surrender charge on that book is about 6%. There we go.
Just a little bit about the numbers. I think this is my last slide. Our reported AOI, it contains some disclosed items that reflect accounting entries that are purely based on market events. While we understand the importance of these, they tend to make modeling the business a bit more complicated. We suggest that it's a better measure, and it's more appropriate to track the underlying drivers of our business through what we'll call the core earnings at the bottom of the slide. There you can see a much more clear pattern between the growth in assets under management and the growth in associated earnings. The key takeaways. We have a market-leading value proposition, and it's not a new value proposition.
This is something that we've been working with in the income space, again, as I said, for now six years, but a concept that we've employed in our business for more than 10. It's something we know quite well, and it's something that we are constantly looking to enhance, but it will remain a core component of our strategy and one of the more important mechanisms that we employ to manage the risk associated with this business. We also expect to maintain a consistent approach in this space. Product-embedded risk management is a key component of that. As we continue to sell our business in the way that we sell it, we like to talk about selling our way to a new risk profile. That chart showing the blue, red, and green bars is intended to do that.
Again, a commitment to balancing our strategy with our key constituents, our shareholder, our financial partners, the financial intermediary, the broker-dealer, and the investment advisor, and the buyer, the end customer of our product, to align against the challenges that we all face will remain as a core bedrock of our strategy and the fuel for a sustainable strategy. Those conclude my remarks. Thank you.
Okay, we're ready for questions for Charlie and Bob, we'll start on this side of the floor. Jimmy.
Hi, thanks. It's Jamminder Bhullar, J.P. Morgan. Question on your annuity business. If you look at your flows the last several quarters, they've been close to, on the separate account side, about 2%-3% of your AUM. On a quarterly basis, you combine with that market performance, it seems like the separate account assets at least should grow at a teens rate, and earnings should follow in a normal market. The business now accounts, I think, for about 24% of your equity. What's the level at which it becomes sort of uncomfortably large as a percentage of your overall business mix?
Let me take that one, John and Mark will probably comment later on this. We continually look at the business mix. I think what John has said is that at about 25%, we'd review this over time. I don't think you can take a spot rate at any particular quarter and take a look at it. I think it's over time. That's generally what we've said, I think John and Mark will comment more later. You could ask the question again to them, they may be able to give more feedback.
One on the full-service pension business. You mentioned the outflows. If we think about the last several years, your commentary on that business has gotten incrementally cautious every single year. If you just discuss on what's going on in that market, is it more of a change in your franchise in that business or just a change in focus, or is it something market related?
That makes you less positive on that part of your pension business.
I think I'd change the wording slightly and not say incrementally negative, but consistently negative. That may be a nitpick, but I think it's an important one because we have looked at this business and said that there are changes that are being made in the business. If you look at the unbundling, you look at the increasing in transparency, you look at some of the other aspects that are going on. That's not to say that you can't make money or that it can't be a good business. It is to say you have to do business smartly, and you have to do business in a way that I think intelligently takes on incremental risk.
I think we're making the appropriate investments in the business, but we're doing it with our eyes open, and we'll take on business that we think is the appropriate level of business to take on.
Thanks.
Lauren. The gentleman in the back, Sean.
Thank you. In regards to Charlie's comment about filing a product revision to reflect interest rate levels, can you maybe try to quantify what impact the current interest rate environment is having on returns in the VA product line?
You want to tell us your name and firm?
I'm sorry, Sean Dargan from Macquarie.
Sure. Obviously, our business is sensitive to the changes in interest rates, but I think it's important to point out that our product filing wasn't made and our pricing is not driven from the fact that the 10-year fell below 2%. Our product filing has been driven by a sustainable new level of interest rates, and it was through the observation that that new sustainable level is probably going to be here for longer than not, that we thought it appropriate to recognize that and other inputs into the product change.
A second question about annuities. Regarding lapsation. At a certain point, if a contract owner is in the money, wouldn't you want those contracts to lapse?
When they're in the money? I'm sorry.
Yes. When they're in the money.
I think firstly, we need to acknowledge the integrity of the agreement between the insurer and the buyer, which is to provide a guarantee when they need it. That's the underpinnings of our business relationship with them. Financially, it would be better that if a contract that was deeply in the money decided to lapse versus persist. That generally isn't what happens for a bunch of logical reasons, but we account for that in our assumptions as well. We assume that a contract that's kind of underwater or deeply in the money logically would persist, and that's baked into all of our modeling. It's called what we call a dynamic lapse function, that as those contracts lose more money and their guarantees become more in the money, they're increasingly likely to stick around.
Okay. Thank you.
Okay. On the other side of the room, in the back, Jeff Schuman, please. Then we'll move up.
Thanks, Eric. Jeff Schuman from KBW. Charlie, I'm wondering if you could give us a little more perspective on the disability business in order that we can kind of have the right expectations about the timeline for the workout. In other words, as you look at the underpriced business, is that more recent business where it's going to take a long time for the guarantees to mature or some of this business that was written two or three years ago that can be repriced relatively sooner?
The answer to that is yes. In other words, there's some of both. In other words, if you look at some of the business that was done two or three years ago, a lot of it's experience rated. We were looking back at our experience in the past. If you look at the businesses that was written in 2009, for instance, looking back at 2008 and 2007 and 2006, those were actually pretty good years for the disability business. That business that's going to be coming up for repricing, I think soon, we'll be able to do that reasonably quickly. However, a lot of these cases or I'd say a lot, a fair number are two to three-year cases, right? It's going to take a little while for the lump to get through the snake.
As I talked about, though, not all cases have been mispriced. What we're doing is systematically going through, identifying the cases that have been mispriced that need to be repriced, and are going back and trying to accelerate the repricing where we can. Sometimes you'll be successful, sometimes you won't. Sometimes you can eliminate the case, sometimes you won't. What I think it's fair to say is that we have a laser-like focus on these cases, and to the extent we can, we will accelerate these, or we will eliminate those cases.
I'm not sure I understand the mechanism for acceleration. Contractually, how do you get the customer to accelerate the repricing?
You can go back to the broker and say, "We are going to reprice this case. Would you like to take it out to the market now, or do you want to wait?" Sometimes the broker will take the case back out to the market sooner than later. There are cases where, in fact, that can take place.
Okay. Thank you.
Eric Berg. A little further up, please. Josh.
Thanks, Eric. Eric Berg from RBC Capital Markets. My question is about the willingness of individuals to pay for the variable annuity. In particular, I'm thinking that now that you're raising your guarantee fee to 100 basis points, if you add on top of that the separate mortality and expense charge of whatever it is now, call it 150 basis points, then on top of that, the money management fees of, call it another 100 basis points, you're north of what? Between 300 and 400 basis points. When do you think we're going to get to the point that customers will say, "This is too much?
The variable annuity industry has proven to be remarkably price insensitive. In fact, it's our belief that the model will break before the market says it's too expensive. What I mean by that is there's a diminishing return on the fee you can charge, because as you increase your fee, you're increasing the drag on the performance of the underlying asset, which simply increases your future claim. For every basis point you increase your charge, you begin to increase your future claim by some percentage of that. The models are reaching that point. I won't get into too much detail, but the efficiency of fee increases is going down. Again, my term is, I think the models will break before the market says it's too expensive.
Just as a quick follow-up, why do you think that consumers have shown such sensitivity to the price of mutual funds, witness the growth of low-priced passive options, but we're not seeing the same price sensitivity in the annuity business?
Just a personal view, I think it's as simple as an appreciation for the value of the guarantee. I can tell you that fees have been a conversation in our industry as long as I've been a part of it. They have been as small a part of the action as ever. It's something that our industry talks about a lot, and it spoke about fees in a lot of detail back even before we had guarantees when we were largely a tax-deferred investment industry. The fact that we are now primarily a provider of guarantees to equity-based assets and the value that the market ascribes to those guarantees is, I think, the answer.
Mr. Spehar. Margolle, you get one.
Thank you. Ed Spehar from BofA Merrill. I was wondering if you could help us understand the risk from a scenario where interest rates rise a lot and we have an equity bear market. Specifically for two businesses. In VA, the charts you show assume a 3% annual return for bonds when returns could be substantially negative. Then also in the IIP business, where I would think there could be an ALM mismatch risk, considering you've put on a lot of business in the last couple of years with rates at very low levels.
The scenario was interest rates spiking up, equity prices going down.
Correct.
I'll take the IIP business first. Most of what we put on is investment-only stable value. That's what I would call a mid-duration product. The risk in that product, if you will, for which we have significant mitigants, by the way, would be if there was a significant spike in interest rates and people said, "Gosh, I have a crediting rate of X, but I can go over here and get Y." We have all sorts of mitigants within the product to compensate for that. First of all, there are obviously thousands or tens of thousands of people, and not everybody acts at once. Secondly, there are liquidity buffers. Third, not everybody can get out at once, et cetera. There are significant mitigants in the product. That's the one scenario, if there was a significant spike in interest rates that you have to prepare for.
What would that be defined as? 300 basis points?
Depends where it starts. You could say 300.
From today.
250. Who knows? In other words, I don't mean to be cavalier about it's how fast and how far it goes up, call it 300 basis points within a very short period of time where crediting rates can't catch up.
With respect to the annuities business, I'm going to assume the question is focused on the operation of the embedded risk mitigant and the impact that that scenario might have. The answer comes in, unfortunately, a number of forms, and it's really driven by when, right? Where were the assets at the time these events happened. If equity markets drop and interest rates spike, when did the move into fixed take place is going to be, unfortunately, the answer. Let's assume that money has already moved into the bond instrument and interest rates spike after money has already moved. That's going to be a bad scenario for us. The position of that bond portfolio is going to go down.
That bond position is a kind of an intermediate duration bond portfolio, it's got flows coming into it on a regular basis so that there's some diversity associated with the interest rate exposure. The scenario you painted is a bad scenario for us. More times than not, the opposite tends to happen, we focus more on what I call serial correlation, not coincident correlation, because for our mechanism, it's important when these events happen and in what order. As we've done our analysis, what generally happens is the exact opposite of this. 2008 is kind of a textbook, albeit exaggerated example of the sequence of how markets tend to have behaved over time. It is absolutely possible, and if it does happen, it would not be a good scenario for us.
How do you protect yourself? Because right now we're in an environment where there's fear about equity markets going down, Europe, everybody thinks rates are going to stay low forever. What happens if that scenario that doesn't happen often, it seems like it's a possibility?
Yeah. There's a couple of things that are working there. First, I mentioned the investment strategy of the portfolio itself. It's going to be rolling over into assets that have a higher credited rate. Also we have a hedge portfolio that's intended to work in concert with our product structure to help protect against the risk of exactly what you outlined.
The other thing I would say is, in your scenario, how far down does the equity markets go and how fast? The algorithm would actually cut the tail off of the equity market. The customer may in fact lose because interest rates go up when they get into bonds, but they may have cut the tail off of the equity market downturn. Ultimately, they may be in the same or a better position.
Anybody else who hasn't asked a question yet who'd like to ask one? The gentleman all the way in the back. Is that Jeff?
Yes. Thanks. Jeff Eric with Florida Abbott. I had a question along the same lines as Ed. A couple of questions, if I may. What is the hedge you were just referring to when you said, well, we would have a hedge as the final risk mitigant on the annuity side if equity markets went down and rates spiked?
Hold on one moment.
I give it to Mark. One second. Yes, he is. He's in the back of the room.
Oh.
There he is.
Mark.
You're calling on me?
Yes. Didn't want you to feel neglected.
I wasn't feeling neglected.
We have a pretty robust approach to hedging, and the reference was to the hedge assets that we would use to meet client obligations in the event of the kind of scenario that either Ed asked about or Jeff asked about. With respect to equity market risk, as Charlie pointed out, a lot of it is defeased within the account. Beyond that, we do have structural type equity hedges against the obligations that would result from a bear market in equities. When I say structural, these are generally long duration, exotic options, look back puts and things like that would protect us from the risks that we model in the account behavior in the event that the market goes against us, and we're pretty well protected against what happens in the equity market. With respect to that bear market scenario, we have hedges that would protect us.
Again, to point out, the tail risk is taken out by the asset allocation algorithm, which will result in all the assets being in fixed income. At some point, a stylized view would be that the assets would be in fixed income after a 20% decline. We have a portfolio of equity derivatives hedging. You can think of it as that 20% where we've got to worry about the assets being exposed to equities and the account becoming more in the money as a result of that. With respect to interest rates, we hedge against what we call a hedge target, which is not the value of the book liability. There are a lot of reasons which we don't need to get into today in detail that book liability is overstated.
The methodologies that value the embedded derivative result in both an overstatement of the size of the liability and also an overstatement of the sensitivity of the liability to the movement in some things in the markets, particularly volatility. We have a concept that we call a hedge target, which is smaller than the full book liability, and we hedge a portion. This is the famous underhedge, as you've heard us talk about it. We hedge right now a portion of that hedge target. That reflects, in terms of interest rates, the view of a number of aspects of the current environment, as well as a number of moving parts with respect to Prudential. In terms of the environment, as I mentioned, we're still in a crisis. We're dealing with interest rates and prices that reflect policy actions that will not be sustainable.
Over an intermediate term horizon, I think there's probably a lot more upside in rates than there is in downside in rates. The unasked question is, are you making a big bet that rates go up? The answer is no. I believe that we're still very well protected on the economics. At the same time, we have other moving parts like duration hedges that are positively marked if interest rates go down further. We have capital that we can use if we have to protect our balance sheet against rates going down further. I think the notion right now of under hedging relative to the rate side makes sense in a strategic economic context, but also makes sense in terms of the dynamics of our balance sheet and the things that will move around.
If you look at our quarterly results, you see that things have moved around in ways that tend to offset the impact of these narrowly defined under hedges on annuities. We would benefit in terms of the hedge portfolio from rates going up. There would be some offset relative to the client accounts from the hedging position relative to interest rates. This has been a longer and more complicated answer than you probably wanted. The short headlines are that we're very well protected against equities. We're well protected against the economics of interest rates in the context of Prudential, but there is volatility as a result of the accounting for the annuity products related to our under hedge.
Thanks, Mark. The next question was, as I look at the, I guess, what I'll call tactical allocation, which protects you guys, and you talked about an algorithm, it reminds me somewhat of a concept of portfolio insurance. I think that was in the 1980s, where it looked great, but there was no liquidity when everybody wanted to move at once. As you're pushing around $78 billion and going from equity to fixed income or fixed income to equity, my question is, how does liquidity or the absence thereof factor into what you guys are doing? I don't understand the product enough. Are these funds you're buying and selling? Is this the Prudential general account, buying individual bonds and individual stocks? How does liquidity factor into what you're actually doing and the planning?
There's a couple of mechanisms that we employ to manage liquidity. Firstly, the portfolio of assets that we're talking about that this is connected to is pretty broadly diversified. They are funds. They're funds that sit within an insurance separate account, but you should think of them as operating much like a mutual fund would. The mechanism itself has embedded within it a component to acknowledge liquidity, which has what we call a three-day rule. It's kind of a mechanism to stall the trades over a three-day period. That's the first mechanism. The second is that each of our portfolios has embedded within it a derivative sleeve of varying percentages, but you might think of 5 plus or minus or even more % of each portfolio as containing a liquidity sleeve, which is fully dedicated towards funding what might be more stress periods of liquidity.
I think that addresses probably the biggest issues of liquidity. We also have other mechanisms that get a bit more esoteric, but we've been able to go through what I would describe as remarkably stressful periods without creating liquidity problems. In fact, we've got much greater capacity than we've tested. As to your question about portfolio insurance, the concepts are remarkably similar. There's a couple of differences. The portfolio insurance construct has a terminal date. Generally, there's a date through which you're working your mechanism, which creates actually a tremendous amount of pressure on the trading rules. When you've got a terminal date and you're trying to meet a future liability that has a shorter duration, you're going to have increased pressure with the passage of time on the trading rule. Our mechanism actually does exactly the opposite, given that the liability is a longevity guarantee.
As the investor ages, the mechanism becomes more liberal and puts less pressure on allocations to the safe harbor instrument. That works in an inverse fashion with respect to what you might consider portfolio insurance. In an interesting way, the longer we conduct this business, the more liberal it gets and the more tolerant it gets because our liability is actually going down as the investor ages.
With that, I'm afraid we need to break. Let's resume in 10 minutes. Hi again. I think I've kept you waiting, which wasn't very nice of me. We will resume with Ed Baird to talk about our international insurance juggernaut.
Good afternoon. It's my pleasure to have this segment to wake you up with that voice. To have this opportunity to describe to you the recent performance of international, and I think more importantly, and I hope constructively, to give you some insight as to what's driving that performance so that you can form your own points of view as to what the future is likely to be. Let me start by briefly describing the strategy. On the left-hand side of this slide, you see a recap of what has been our traditional strategy. Over the last 10 years, starting with the acquisitions of Gibraltar, and more importantly, over the last five years, I would want to point out to you that this strategy has evolved in three meaningful ways. First, the customer segments we're serving. Secondly, the needs that we're addressing.
Third, the distribution that we're using to access those customers. Let me briefly touch on each of those. First, the segments. The historical Life Planner model addressed almost exclusively the mass affluent and addressed almost exclusively death protection, and clearly, it was done just through that one distribution system. That was, and it remains today, the foundation of our business. There has been very significant supplemental evolution to that. When we acquired Kyoei Life Insurance Co. and renamed it Gibraltar and grew it, we started to move from the mass affluent to the mass middle market. In addition, as POJ matured and their Life Planners aged, they started to move more upscale into the truly affluent. With the bank channel, we further expanded and have reached now an even more affluent group, as we'll show you in a few minutes.
The customer segment group we're reaching is much broader than it was historically, higher, and also more in the middle. Secondly, we've supplemented the traditional focus on pure death protection with two other categories of needs. First is accident and health. Second, and really more significantly, both presently and especially in the future, the retirement need. Finally, the distribution, which was historically just Life Planner, then the so-called middle market, life advisor, life consultants, as we now call them, then the bank channel, and more recently, the independent agent channel. One of the reasons you're seeing this steady growth in new business is we have this compounding growth of the segments we're targeting, the specific needs that we're serving, and the distribution channels that we're utilizing to target those groups.
That growth is reflected in a number of ways, one being obviously the profitability, which this slide is designed to evidence. I would want to draw your attention in particular to the sustainability and the steadiness of it. I don't need to remind you that over this four-year period, there was an extraordinary amount of volatility, both in the macro world generally, in particular in Japan, all kinds of events, economically, psychologically, et cetera. In spite of that, you see this steady performance. This is evidence of the first of the three key characteristics that has always distinguished and continues to distinguish the role of PII within Prudential. By PII, I simply mean Prudential International Insurance. John mentioned that there are three characteristics that define this business and that really serve the role of this business.
The first is high ROE, the second is steady double-digit growth in AOI, and the third is stability, i.e., low volatility. As you would admit, I believe that's a very rare combination. It has historically and continuously characterized this business. I will tell you that it is the balance of those three that informs all of our decision-making. Whether we're looking at a market, a product, or a distribution channel, we evaluate it through the lens of its ability to serve and sustain that combination of characteristics. Here's the first of those in terms of the AOI and the steady double-digit growth in terms of the profitability. I'd like to draw your attention to one other important aspect of the earnings that is evidenced by this slide, that is the heavy weighting towards mortality and expense as opposed to investment. That's quite conscious.
It has a lot to do with not only the products we design and sell but the way we price them. Our emphasis is very heavily on death protection, which remains the number one product category. Even the so-called retirement products are indeed insurance products, which simply have a heavier weighting towards the savings component than the traditional, let's say, term insurance, which would define the typical death protection. This is one of the reasons you see that steady earning, because there's very little beta built into this. Indeed, about the only business that has meaningful earnings coming from the investment spread is Gibraltar. The reason for that is the historical one you're familiar with, which is when we acquired Kyoei out of bankruptcy, we had the opportunity to reset the crediting rate.
By so doing, we were able to establish a baseline, which has allowed us ever since then to have a positive earning on that. All of our other businesses, including importantly POJ, et cetera, do not rely on that as the key determinant of earnings. The ROE, this is now the second key characteristic. You see here the traditional 20% plus earnings, which as a result of the acquisition of Star and Edison, was temporarily brought down to this range. It will, in the coming years, move steadily upward as we both reap the benefits of the integration, continue to grow with the new business, and apply the capital management.
Here again, we see the growth on the new business in addition to having looked at the AOI. You'll see even without the benefit of the acquisition of Star and Edison highlighted in the red, we have the very steady growth in the new business. This is coming from the cumulative benefit of the three drivers I mentioned, targeting more customer segments, addressing more needs, utilizing a broader range of distribution. It is the steadiness and the consistency of this that I think is really notable. We'll see more detail underlying this by channel, by product a little later on in the presentation.
Of course, the acquisition of Star and Edison has allowed us to bring that up by a step function to a whole another level at the $3 billion range, a number that I think you'll find by comparison stands up very well across the board. I'll now focus on Japan for a number of obvious reasons. The slides up till now had to do with the division as a whole. Japan clearly constitutes, always has, the driving force of the division, even more so now with the acquisitions of Star and Edison. It's here we see the adjusted operating income as well as the new business. If you see some differences between these numbers and the division 1, they have to do with some differences in the definitions, which you'll find in the footnotes for those of you that have that level of detailed interest.
The point being that what we've seen at the division is driven very much by what has been going on inside of Japan. Let's spend a few minutes talking about Japan. We've listed here a half dozen characteristics of the market. A couple of them I'll delve into in more detail because I think it's important to understand why it is that we have invested an additional $4-plus billion into a market in which we already had a significant presence. I'll talk a little bit about the market size, the household wealth, the characteristics of that wealth, the retirement market, the products, finally, the distribution. Let's start by talking about the market size. The Japan insurance market is second only to the U.S. To me, the more interesting bar is the next one over from it.
What this shows is that the Japan insurance market is bigger than all the rest of Asia combined. That's Korea, Taiwan, China, India, Singapore, Hong Kong, you name it. This is a very big market. At times, the CAGRs in some of these other newer markets can be very eye-popping and legitimately exciting. I would suggest that there's value in the considerable absolute size of the Japanese market. As you can see, this stacks up well against any market in Europe or anywhere else in the world. If you're going to be concentrated, as we are, in only two insurance markets in the world, these are two pretty good places to be. The second point, it's a big market. There's tremendous wealth here in the households. We've touched on this before. I'd like to offer you an update.
You see the wealth of the financial assets of households in the U.S., you see the number in Japan. Let's compare that against comparable numbers in other markets in the world, you see there really is no comparison. Japan's numbers simply dwarf those of other major advanced industrialized nations. When you break that number down and you take a look at just the blue segment. Here, what I'm concentrating on is the currency and short-term deposits embedded in that overall financial assets of the household. Japan goes from number 2 in the world to number 1 with about a $10 trillion pool. There is no comparable pool anywhere in the world. These are immediately available. This is our target of opportunity. This is the mine that we have been tapping into and will continue to tap into over the next 20 years.
As we get into a discussion about demographics, you'll see the momentum that exists with the aging population that causes me to make that statement about the next 20 years. What does this $10 trillion look like? Here, you have other points of comparison, as you see, you have to aggregate three, four other major countries to get to a pool anywhere remotely close to this amount of money. This pie chart simply shows those same numbers from a slightly different angle. I particularly want to draw your attention to what is small in Japan versus much bigger in the U.S., and that is the equities portion. The Japanese simply do not have the appetite for risk, which characterizes the U.S. and other markets. They have this pool of assets. It is sitting in banks.
To give you a sense of how little it's earning, a five-year CD at a major mega bank in Japan today will earn you five basis points. A 10-year will give you 15, which could cover the cab fare if you don't live too far from the bank and you bring a lot of money. This is the pool we're after. There aren't a lot of alternatives. Leaving it in the bank is one. The other is going into the equity market, which as you have seen, the Japanese retail consumer has very little appetite for. Given the performance of the Nikkei over the last 20 years, it's an understandable position. This is what we're tapping into. The history is that Japan consumers are very comfortable with a general account portfolio, have been for many years.
Which is why even before we showed up 30 years ago, they had some of the largest insurance companies in the world. We went there not because they were underinsured, but because they were underserviced. On that basis, we have built a business. This pool today, addressing not just death protection, but increasingly retirement protection, is what is driving the growth, it provides us the opportunity to continue to do so for the foreseeable future. Let me talk a little bit about what the Star Edison acquisition provided us in the way of additional resources. The first thing it did was it grew our policy account by 50%, from about six and a half million to 10 million. There's several benefits to that. One is, you'll recall I mentioned that we make a lot of our money out of the mortality and expense. This is a scale business.
A 50% increase in business in force is a tremendous benefit to the expense ratios. To do this, one has to be within the same country, which is one of the reasons you find us historically and still presently conservative about expansion. Having a lot of scale but spreading it over many countries is far more difficult challenge from which to take out these sort of expense savings. Being able to do it in Japan here with this 50% growth, tremendous opportunity. Captive agents, this number has gone up significantly. I will caution you, these numbers are the peak, and these numbers will go down for the foreseeable future. I won't predict a number, but I will just harken back to the experience of 10 years ago. When we acquired Kyoei, there were about 7,000. Over the next couple of years, we credentialized, i.e., we focused on quality.
That's a phrase that I will use repeatedly because we're much more focused on the quality of our people, of our products, and of our earnings than we are on chasing top-line numbers. Here, we are in the process, as we speak, of credentializing these agents who came to us from Star and Edison. Going through that process means taking them off of a more subsidized salary-based compensation onto a variabilized compensation, which has always characterized our approach. Not surprisingly, what we anticipate is that in spite of what we will put in as a major investment in training, which we started last year, some of these individuals will not meet the higher standards that we require and have historically applied. We know this will work. The reason I say it to you is history.
Keep in mind that the company that purchased and acquired and merged these two is the same bankrupt company that we acquired a decade ago. In 2011, Gibraltar celebrated its 10th anniversary. An enormously successful company that we had started to acquire when it was bankrupt. It has now gotten to a level of success where it has acquired these two other companies, which were by no means as distressed as Kyoei was. These are not bankrupt companies. They had gone through that experience themselves a decade ago, much stronger, more vibrant, so they don't have that same challenge. This company now has been aggregated so that all three merged legally and operationally going forward. Finally, the bank relationships. Here you'll see that roughly the number of relationships has doubled as a result of the acquisition. Here again, I will stress, we're not chasing the number of relationships.
It's the quality and the penetration of the relationship that matters to us. For instance, even today, we get more than half of our business from one bank, the Bank of Tokyo-Mitsubishi, which happens to be the biggest mega bank in Japan, and it was one of the very first relationships that we had, and it continues to be a powerhouse. That number has steadily come down as a % as we've added additional relationships. We will be much more focused on a controlled expansion of relationships than we will be on simply growing this to a big number. The opportunity embedded in that, for us, is very significant. The integration is very much on track. As I mentioned, we closed early last year, a couple of months ahead of schedule. We merged right at the target date of January 1st.
The local Japanese team there in Gibraltar has done an extraordinary job with this. In every respect, as you would imagine, all kinds of challenges on the human resource side, that has gone exceedingly well. On the system side, as of January 1st, most of the Star Edison products were shut off. They are now selling Gibraltar products, which are consistent with our pricing standards. I will take a moment here to remind you, our approach is a conservative approach. That track record that you saw over the last half dozen years was never based on being a price leader. Those of you familiar with our organization know that has never been the basis of our competition, starting back with POJ and continuing on through. These are conservatively designed, conservatively priced products where our focus, our distinguishing characteristic, is the quality of our distribution. The investment portfolio was de-risked.
That's meaningful. If you take a look at our portfolio, which we routinely describe, I will just briefly verbalize it to you. About half of that is in JGBs. A major portion of the remainder is in investment grade. We only have about 3% in equity or other risk categories. We keep that very small. That back end is very consistent with what I just described to you about our front end. We don't design products that require a highly aggressive investment portfolio. It's also the reason that we have very strong solvency margins, which I will get to later on. The market share improvement over the last four years, as you can see, has been very steady based on what I've just described to you, largely taking market share from others, in spite of the fact that the market itself has shown very little growth.
To put those numbers in perspective for you will see that the sales in Japan are equal to the sales or slightly greater than the top four carriers in the United States. The solvency margin. These are the new solvency margin. You will recall, starting three years ago or more, the FSA announced that they would be revising the solvency margins. These became official in April. We have been reporting them unofficially for the last year or so. I think you will find by comparison, these are very strong numbers. By the way, when we shock these, they still remain above 600 even when we hit them with a 25% equity market deterioration, even with currency changes, interest rate changes. This is very strong because of the profile I described to you of what the investment portfolio is.
This has become important to the reputation of companies in Japan, particularly coming through the financial crisis. Recently, some of you may have read the FSA has indicated they're going to do some kind of a rating, which will be broader than a solvency margin, that will describe the rating characteristics as they perceive them as organizations. There's much more attention being paid to the quality and the solvency and stability of the organizations, both officially by the regulators, and I would argue, unofficially in the marketplace as well. The annualized new business. Here, we provide you a breakdown by the product category. I'd like to draw your attention to a couple of features here. One, if you start at the bottom, you'll see that traditional death protection by itself has steadily grown.
Without any of the additional sales that I was describing having to do with additional needs or additional customer segments, we've got steady growth here. This is important, and frankly, it's somewhat unusual in this regard. Introducing new product, one of the classic challenges is to make that product supplemental, not substitutionary. What does that mean? It means many times when you introduce a new product, you really cannibalize on business that you would have sold anyway, net-net, it's not a big gain. What this slide shows very graphically is that these additional sales are exactly that. They're additional sales. It's not a cannibalization on the death protection. I will also point out that the number 1 product category in every one of our distribution channels, including the bank, is death protection. This remains the foundation of our business.
It has been supplemented by accident and health. Here, by the way, a major chunk of that is actually cancer whole life, so there's an insurance element to that as well. The retirement is exclusively insurance. This is not pure investment. The biggest selling product we have there is retirement income product, an unusually aptly and accurately named product. It's simply an insurance product with a very high cash value associated with it. Finally, the annuity. For us within PII as a whole, 88% of that is fixed annuity. In Japan, 97% of it is. It's very little variable in these particular markets that we participate in. If you look at the most recent quarter, the first quarter, you'll see that that historic growth rate has been, if anything, not only sustained, but enhanced. I do want to temper this a little.
I would not want you to annualize that because I think inside there are 2 things. One is a continuation of the momentum you see from all the prior years. That has further been enhanced in this particular quarter by 2 things. Number 1, a bit of a fire sale caused by the regulators when they announced that they were going to change the tax treatment on the cancer products, which they indeed did in April. Essentially what they did is they changed the prior rule, which allowed for 100% expensing of this product by a business to 50% at time of sale, and the other 50% over the duration of the product. We'll have to wait to see what that does. Early indications are it will slow down, but by no means eliminate the appeal of that product.
The anticipation of that, I believed, did move some sales into the first quarter that would not otherwise have been there. Secondly, we, like many, have announced a reduction in the crediting rates, as is often the case there, you bring forward some sales that would not otherwise have happened. I believe here you have very strong, what I'll call natural organic sales, but that has been further increased as a result of those 2 changes. Some of that is likely to spill into the second quarter because we do have some of those reductions in crediting rates taking place in the second quarter, having been announced earlier. This slide is simply designed to illustrate the point I made in the very beginning, that we are now serving broader segments, but in any 1 segment, we're now addressing a life cycle of need.
For a younger couple, the classic death protection. Middle-aged, more savings accumulation. Finally, those reaching retirement, we've taken the concept from the U.S. of the retirement red zone and really emphasized that to get the accumulation going sooner. Throughout that process, the opportunity to protect against morbidity risks associated with the accident and health products. Having spoken a bit about the product, I'd like to speak a little bit here about the opportunity to sell to an existing customer. This is POJ. This is the best we have. We will not get comparable results elsewhere, but we have an opportunity elsewhere. What this slide shows you is a couple of things. The first is every year, POJ sells more and more business to their in-force customer.
This is simply proof positive of the old adage in the industry, which is the best prospect is a current customer, and POJ proves that. The second thing this slide illustrates is this life cycle idea. You will notice that the sales of death protection in the blue have been growing. Growing even faster in the yellow is the sale of retirement. This is almost the ideal scenario. Emphasize through our training, sell death protection first. Later, go back and sell retirement. That's the ideal scenario, and that's precisely what's happening in POJ. Having added $3.5 million customers to the organization there, we now have a very rich opportunity. The opportunity is one that we are training our people more and more to pay attention to this concept of in-force marketing.
It is not radical, it is not new, but it is profound and it has tremendous potential. The aging population. Again, this will show you the positive side of what some could superficially conclude is a negative in insurance, and that is the aging population. What you'll see here is an update of a slide that we had shown in previous occasions, and that is that as the target segment customer ages, the average premium goes up. You'll see this increase is not simply a slight shift having to do with the greater mortality risk of being older. It has to do with the fact these individuals are buying richer products, more retirement-oriented, more high cash value-oriented products. The reason that's interesting to us is shown on this chart, which is the demographic chart.
If you look out over the next 20 years, which is why I made that statement earlier, what you see is that the three age cohorts starting 45 and above are all growing, and the three younger cohorts are all shrinking. This is precisely the group for which this retirement red zone is ideally suited. This is the group that we are having conversations with, whether it's for the first product or the second product, this is the group that we're going after. The need is there, and what's almost unique, certainly unusual, the means are there to address the need. They have the accumulated wealth. It's there, it's in the bank, it's earning 5 to 15 basis points. We can offer them a very attractive alternative.
This points out the fact that focusing specifically on the Japanese Life Planner and life consultant, their distribution, what you see here is the average premium by product category, you see for the retirement how much higher that is. When you look below, you see evidence of a point I made earlier. The foundation remains in death protection. That is the biggest premium category for us. Second is the retirement, the accident and health, which has the cancer whole life, the annuities bringing up at the tail end. Here we look at the same sales numbers, now the cut is by the distribution channel. What you see is the Life Planner, which historically at one point defined the totality of our business, remains the foundation, it is no longer the ceiling, it's the floor of the business.
What we see here in the red is the life consultant. You'll see that grew steadily, then took a step leap with the acquisition of Star and Edison. The bank channel has been the most dramatic. This has been the most dramatic over the last 3 to 4 years, as you can see. Finally, the independent agency channel, which has been a more recent addition to this. We had just started to grow this. Then with the acquisition of Star and Edison, we were able to bring on a lot more. Let me spend just a moment, one slide reminder about Life Planners since it is the foundation. The concept is very simple. Highly selective recruiting, three or four out of every 100 that we interview, so it's very high quality. That's not just a self-assessment. I'll give you a number to back it up.
This year, in Japan, POJ had the most MDRT qualifiers of any company in Japan for the 15th year in a row. It's tangible evidence this is a very high-quality organization. It has grown steadily, very slowly. It's only got about 3,300, their productivity is simply unmatched. Their productivity runs six to seven policies. Their average premium has moved up to 4,000. I think anyone who knows that level of granularity about a business will tell you if you can have 3,000 agents producing six or seven policies with an annual premium averaging 4,000, you have a highly profitable business, which is why this business makes over $1 billion a year. The focus remains very much on protection, although, as you can imagine, they have been doing more on the retirement with that second sale I showed you.
The other thing they've been able to do is go after the small business owner. As they've matured, because again, when we started them 25 years ago, they were mostly in their 30s selling to the same socioeconomic group. Now, as they're in their late 40s and 50s, they're targeting more small business owners, which further drives up the average premium that they can get. Gibraltar. There's one unique aspect that I simply want to update you on with this organization. Its unique aspect is the Teachers Association. This is a client. In the U.S., we'd call them an association business. As you can see, the relationship goes back now 60 years, about 600,000 members in this group, We write over $200 million a year consistently with this. The reason we write it is illustrated by this chart. There are something close to 1 million, 950,000 teachers.
I would look at this in three ways. First, 20,000 to 30,000 new teachers join every year. Almost an ideal scenario for selling classic death protection for someone starting out. The second is you have the 950,000 active, slowly building a deeper penetration with them, and then culminating in the 20,000 to 30,000 who retire every year. They get a lump sum pension. Today's exchange rate, that's probably $350,000. That's a tremendous opportunity for us, which to a large extent used to define the primary focus. As we have educated this group more about getting into retirement needs much earlier, we're starting to penetrate that second, that active group much more. Really a three-pronged approach. The new hires, 20,000 to 30,000, the retirees, 20,000 to 30,000, and then the active group in the middle.
This is an outstanding group, as you can see, we get about half of the active market, and then you'll notice 87% of the retirees. Steadily, as they move towards retirement, we're able to get a deeper and deeper penetration. The banc assurance, I would draw your attention to two things that distinguish us, and that's one of the reasons we have been particularly successful here. Number one, if you look on the left-hand side, you'll get a reminder that the way Japanese banks got into insurance 10 years ago when they first were given authority, was they went at the variable annuity market. We all know how that chapter ended. We chose not to play. Kudos to our local folks who had the self-restraint to avoid chasing the revenue associated with that.
Starting about five years ago, they were given permission, they being the banks, to get into insurance. That was our opening. From then to this day, we have concentrated on going in and making the far more difficult sale, which is death protection. The second distinguishing characteristic is from the very beginning with The Bank of Tokyo-Mitsubishi. Rather than just sending them a product, we sent a product and we sent a person. We sent people from POJ, people who were struggling from a productivity perspective to maintain the high standards that are required in POJ. By sending them to the bank, they didn't have to prospect. They just did the presentation and close, and they were outstanding. To this day, BTMU currently has about 175, 180 of our people in there on a seconded basis.
That has been a differentiation for us, the quality of these people. That has been a sustaining characteristic, and it's one of the reasons I believe that we are such a major producer with them. The bank for us gave us an opportunity to leverage some of our classic captive agency skills and bring it into a new form in a way that allowed us to tap into the growth there. The growth that you see here, as you can see, is primarily death protection. You get some accident health, some retirement, and some fixed annuities. I mentioned that's almost entirely fixed. I do want to spend a moment here talking about one aspect of this business, which I think may have misled some of you on the first quarter earnings, and that's this.
A lot of the bank business, due to the nature of that venue, is either limited pay, single premium, or three to five-year pay. You get a fair bit that's still your typical recurring, but you do get limited pay. During the first quarter, in particular, there was about $70 million or so of single premium pay. The accounting for this is quite different and it's what distorted the benefit ratio. Had nothing to do with the fact that in that quarter there was a minor mortality adjustment, but that was very minor fluctuation, quite within the normal standards. What happens here is you take that $70 million of sales and you recognize the following two factors. Number 1, what's booked as a sale is only 10% of the premium that was collected. That's simply the LIMRA rules that we apply.
Really, there was $700 million of premium collected on single premium. The accounting rules require that on single premium, you have to set up a reserve equal to virtually 100% of that. Your benefit ratio for $700 million is about 100%. That's going to wreak havoc on your benefit ratio. To the extent that you're trying to ascertain what a margin might be by looking at the benefit ratio, this change, this shift in the product payment will distort and not allow that. Now, what we do with all of our products is we focus primarily on the IRR, not on the margin, because the margin will vary for a lot of reasons, I've given you just one accounting reason, based on the product shifts. What we do is we focus on IRR. There we remain quite consistent.
Regardless of whether it's what the product category is or what the distribution is, we look for consistency where we're targeting in the teens for these kinds of products. That's the reason that you see that consistency both of the earnings and of the ROE. I just wanted to clarify a point that was raised during the earnings call, and I forget exactly who it was, but they were spot on that, yes, there's a little bit of seasonality, but this is largely a product shift that's driving this. Here again, you see tremendous first quarter growth. I would apply again the same caution. I think some of what took place in terms of some fire sale phenomenon applied here, although quite clearly this is a continuation of the strong momentum through the bank channel.
I think that as we continue to deepen our penetration in some of these banking relationships we've inherited, I think we have the opportunity to continue to grow these businesses. The one number I'd like to draw your attention to here is on the lower right, the average premium per policy in the bank channel, $8,500. That's a big premium. To put that in perspective, POJ is about $4,000, and Gibraltar is probably around $2,000. Here we talked about the banks. We are now in three of the top four banks. Bank of Tokyo-Mitsubishi, I've mentioned a couple of times. Mizuho, we entered into a relationship late in last year. Resona, I believe, was also the early part of last year. We have three of the top four. Increasingly, we're moving into the regional banks. A lot of points of distribution that flow from this.
Again, don't want to chase the number of banks so much as focus on the quality and depth of the penetration and of the relationship. Independent agent channel, still quite new for us. Got off to a fast start. Again, tremendous opportunity. You see here 4,000 independent agent relationships that we inherited from Star and Edison. Unlikely that we're going to utilize all those. That number will not go up. It will come down. Again, that same philosophy. Let's get a deeper, closer relationship with the number that are truly productive. Key takeaways that I hope come through from these slides in our discussion. This is a very solid business model, high ROE, strong AOI with very low volatility, a very leading position, which is steadily strengthening. The Star Edison acquisition going very well. In fact, I'll use this opportunity to update you. We are revising one number on this.
We have indicated to you in the past that we would spend $500 million in order to achieve a $250 million run rate improvement. The integration is going well enough. We're revising downward that expense by $50 million, from $500 million to $450 million. It's now deep enough along, successfully accomplished, that we feel confident in making that change. A number of competitive advantages, as you can see through the distribution. That's it. Let me stop here. I'm happy to try and take any questions, clarify any points.
Questions for Ed, the gentleman in the middle of the row in the middle of the room. Sorry, I don't know your name.
Oh. Hey, Eric, it's Ryan Krueger .
Hi, Ryan. I'm sorry.
Ed, I have a question. Given the increased focus on retirement products, especially going forward, given the demographic shift, can you just discuss how new business returns compared on retirement products versus your more traditional A&H and debt protection products?
Sure. Again, we target in the teens, so we try to make them comparable. I would say in general, though, two things. One, the more savings component to it, the margin will clearly be lower. The IRR may or may not be lower, probably a little lower than it would be under a recurring premium whole life. That's probably the ultimate, if you will, in terms of return. As you either shorten up the payment period or you increase the savings component, you will dilute that somewhat. In our case, we still keep that into the teens.
Okay. I was a little surprised by your comment on the solvency margin that in a stress case, it would still be 600%.
Yeah.
I think all the JGBs are available for sale securities. If interest rates ever did actually go up in Japan, wouldn't there be a fairly material impact due to the mark to market on those assets?
Actually, we stress it in three ways, if I can recall this correctly. The scenario I'm recalling, we stressed 25% to the equity market. We stressed a 20% appreciation to the JPY and a 100 basis point movement in the portfolio, excuse me, in the interest rate. Actually, this echoes an earlier discussion here about interest rate movement. Movement in the interest rate upward is generally a positive for the business. The time it becomes a threat is if it's very large and very quickly, because then it leads to sort of a behavioral economics in the terms of people disintermediating and saying, "Well, I'll take the hit on the surrender charge to cash that in." There hasn't been a history of that. Is that possible? Yes, but again, it's sort of an echoing of the conversation that took place earlier.
Thank you.
Sure.
Nigel.
Great. Thanks. Nigel Dally from Morgan Stanley. Two more capital questions. First, any restrictions getting dividends out of Japan back to the U.S. as we're looking at your overall capital position? Second, I believe the FSA toward the end of the year is likely looking at reducing down the reserve discount rate. What impact would that have on your capital position then as a result?
Sure. First, as you know, we've had no problems getting capital from our companies in Japan back to the U.S., and there's a whole variety of ways of doing it, from formal dividends to reinsurance arrangements, et cetera. No, that's never been, nor do we see that being a problem. Secondly, what you're referring to for the benefit of others who may not be as familiar, what the FSA is talking about doing for early next year is reducing the discount rate that gets applied for new business going forward. If that takes place, they're talking about bringing it down to 1.0. We currently, I think, are averaging around a 1.2. Others, I think, may be higher. To the extent it brings it down, what it simply requires is for the new business, you either have to raise the premium or reduce the crediting rate on the particular product.
Yes, it would drive up the price of a product.
Stephen Schwartz, on the other side of the aisle.
Thank you, Ed. A few, if I may. First, you talked about the fire sale in cancer whole life. Can you go over that? That was confusing. I thought that was new news probably to people.
Well, cancer whole life is a popular product with small business owners. It's used primarily for funding retirement type programs. It's sold in particular within our organization by the independent agent channel, and to some extent by the POJ, the more executive type Life Planners. For some time, the FSA had been saying they would look at the tax authorities, that they would take a look at the tax treatment. Historically, companies were able to write off 100% of that premium as a business expense. What the regulators announced was they would be able to write off half of it at point of purchase and the other half over time. It dampened to some extent the tax advantage of it. Nonetheless, I'm told the anticipation is that remains sufficiently attractive from a tax perspective, that that's likely to remain an attractive product.
This is like a cancer COLI product?
You could call it that, yes.
Okay.
Yes.
Interesting. You had a slide and you talked about the decrease in agents. There looked to be a decrease in the number of banks you were doing business with as well. You were at 31, I think it went up to 98, then it dropped back down to 58. I don't think you referenced.
Yeah, the slide's misleading. Let me clarify.
Okay.
Thank you for giving me this opportunity. We were growing the number of banks on our own, because again, we had just started this about five years ago, and so we were up to a 40 or 50. That was the blue part, if I get my colors right. When we acquired Star and Edison, they had been doing this much longer because they had been in variable annuities. They had been doing a number of things much earlier than we had. They had another 50. There had been some overlap. I'm giving you rough numbers. That brought the total up to about 90. We did not immediately convert, novate those relationships. We are going through it methodically, so we will steadily grow to some portion of that. It wasn't a matter of we had 90 and then shrunk it.
We inherited these relationships and now we're revisiting, and we'll steadily grow them. It's just, again, I want to de-emphasize the big number aspect, whether it's lots of banks or lots of IAs necessarily being the key ingredient to growth in the business. We don't see that. We do see it as a tremendous opportunity to vet those relationships and to pick out of them those that we think have real potential.
Okay. Can you go over the stress test one more time that you answered for Ryan? You were assuming equity markets went down 25%. You were assuming JPY rates-
Went up.
Went up.
100, and the exchange yen to the dollar appreciated by 20.
All three of those things hurts the SMR.
In that scenario, both solvency margins remained above 600.
Okay, all three of those things by themselves hurt the solvency margin, right?
Yes.
Okay.
Yeah.
Just making sure.
Again, you're taking me into a little deeper water than is my comfort zone. The key point I would want to make to you is this, we believe, it's still a little early to know, that the new standard for top tier companies is going to be between 600 and 700. We'll have to wait both to see how the competitors play out, to see what opinions, if any, the rating agencies provide on this, we think that's going to be the new gold standard.
Okay. Thank you
versus what was there before.
Thank you.
When we stressed it, because of the conservativeness of the portfolio, there's not a lot of volatility. I think you'll see with others, if they do sensitivity modeling, if they're more heavily weighted to equities and so forth, the fact that the whole point of the new solvency margin was to put a much higher capital charge against those higher risk assets.
We've got a couple more minutes, but I wanted to give anybody else who hasn't yet had a chance to ask a question and wants to do so to do so. John Hall, there you go.
Thank you, Eric. John Hall with Wells Fargo. Ed, could you just address how that higher, more stringent SMR ratio might have an effect on the M&A marketplace in Japan?
The solvency margin?
Yeah.
Yeah. Here's pure nickel and dime theory you're about to get. One theory is that these solvency margin rules were put in place for a couple of reasons. One is capital rules in general are tightening, but another is that over the last 10 years, there have been a series of bankruptcies, several of which we ended up acquiring, where technically their solvency margin was above the 200, which is the definition of insolvency. I believe that one possible interpretation of the new solvency margin rules is to ensure that that standard has more validity to it, so that you don't have a company who may be reporting 300 to 400 as a solvency margin, they are de facto bankrupt. I think the last 10 years showed there were some examples of that.
This will put more emphasis on the quality of the capital at hand in those organizations and potentially prompt some of them to take action a little bit sooner than they otherwise would have.
Great. Just a follow-up. Is the integration of Star Edison at a point where you could reasonably be able to handle a bolt-on transaction of your own again?
I think if I were to suggest that to our local colleagues today, it would not be well-received. Having said that, they are very much not only on schedule but ahead of schedule. Our history and track record there has been so successful that I think the answer to your question would be temporized only by timing.
Great. Thank you.
We've got time for one more. Mark Finkelstein, it's yours. Fellow with whatever that is.
Thanks. Mark Finkelstein, Evercore. Couple of questions, actually. Just on Star Edison, you talked about changes in what you expect to spend to gain those synergies. I guess I'm more interested in what is the actual performance of that block since you acquired it against your original pricing assumptions when you made the acquisition, whether it's mortality, lapsation, which I believe may have been a little bit higher. What is the story in terms of the original versus expected?
Sure. First, just a reminder, 95% or so of the valuation was in the in-force book. We only did about 5% for new business. On the new business, by the way, so far, a sigh of relief. What I'm getting at there is that effective as of the merger, we changed the products, we changed the system, and obviously, we changed a whole number of environmental aspects in which they operate. The first month, there was a big drop, not surprisingly. They have started to come back, even within the second month of the year, which would be the third month of their calendar in the first quarter, a real strong bounce back. Very reassured as to how quickly they are adapting to the new situation. In terms of the in-force, performing very consistently with the valuation model.
For instance, in the mortality issue that I briefly alluded to in the first quarter, that was below what was assumed, the four quarters before were all better. On average, it's very consistent with what's in the valuation. Far, very pleased.
The second one. I understand that mortality and expense is where the margins come out in the product, but you're obviously making some interest rate assumptions in the product.
I guess the question is just how sensitive are IRRs to 20 or 25 or 30 basis point moves in interest rates?
Depends very much on the product. If you're looking at a single premium, it's going to be more sensitive to it. If you're looking at it as a recurring premium, the traditional debt protection 20-year product, much less so. Very hard to offer a generalization. I would say on the vast bulk of the book of business, not terribly sensitive to any particular movement. The single premium, there we tend to be more attentive to it in both, A, pay less and, B, make an adjustment.
Before I make a couple of very brief closing comments, are there any further questions that we could answer?
Other than greater specificity around capital deployment.
There's always someone. Jay?
Maybe while we're waiting for the question.
On capital.
Just to be clear, in the presentation, I'm talking about the deployment of capital above the routine plowback of earnings into our businesses. We've called it outsized organic or excess organic, but it's in the context of opportunities that go beyond the routine business as usual investments in the businesses that we would be making. Just to be clear on that one, the terminology is new, but that's how we're thinking about it. Sorry.
Jay Gelb from Barclays. I just wanted to follow up on a, I believe it was a prior question around your comfort level in terms of having the variable annuity business being in excess of 25% of attributed capital. It sounds like we're about there now, and I just wanted to get a sense of how you might moderate the amount of capital that may need to be attributed to that business or whether you need to slow the growth going forward.
In terms of the overall picture, as I think Charlie mentioned earlier, our thinking of this is that we would not want to see it on a sustained basis exceed the 25% range. We think there's enough growth in our other lines of business that we're not envisioning that happening. Secondly, I would acknowledge that within that 25% or 20%-25% range that we're in, the risk profile of that today is considerably different than it was when we initially set that limit years ago by virtue of the proportion of the book that's now represented by the auto rebalancing component. We're staying within the same confines as we discussed before, but actually the risk profile that represents is considerably lower today than it was at the time we initially set that out. I don't know, Mark, if you'd add anything to that.
It's a challenging question because there's a lot of frustration around the accounting volatility, much of which I don't believe is real and doesn't reflect the underlying economics. There are stat to GAAP disconnects that also affect the messaging because we talk about GAAP numbers, but there may be a very different impact on stat. The bottom line here is that we're building up very productive, very attractive account values or assets under management. You use whichever term you want to. There's a core that's accumulating here that throws off fees close to 2%. Now, if you're in the mutual fund business, you're excited about 35 basis points. Think about the momentum here and the accumulation of extremely productive asset values, but trade that off against accounting volatility, maybe some capital volatility, some stat GAAP disconnects. That's kind of the dilemma that we face. We're very productive.
We're a low-cost producer with respect to guarantees and very productive at gathering attractive assets under management. There are trade-offs, and that's the dilemma. We've set thresholds at which we would trigger the consideration of the exposure, and we'll live by that. We'll rethink it if the time comes, as John said. It's a dilemma because there are things that just rub me the wrong way about the non-economic volatility against the real economics of the business.
Jeff Schuman in the back. Same side of the room.
Thanks. Jeff Schuman from KBW. I've noticed that lately when you put up charts and show the success of the auto rebalancing, you seem to make a great effort to deliver the caveat about the fact that it's not an optimization algorithm. I'm just wondering, what is the risk that advisors based on that track record, have experienced this as a very successful optimization algorithm, that customers are attracted to that track record, and that at some point, even if the product functions correctly for its risk mitigation purpose, that you see the flip side of this, that you see a performance of really sub-optimized performance and whether there's an implication in terms of sales and even persistency and some unhappiness in the marketplace?
That's exactly why we made that clarification, again, reminding ourselves as to why it's there, right? It's there to protect against the downside risk. We experienced a period of time where it behaved as an account optimization mechanism, right? 2008, 2009. We took steps immediately while we were in the middle of that to reinforce the messaging that we put out upon its construction was that in spite of recent events, it's intended to be an account preservation instrument. We've put forth great efforts both in our marketing materials as well as our continuing education. We have a robust training program, where we put all of our wholesalers through certification on these products.
Bruce, our head of sales, has a team of folks fully dedicated to training to make sure that the message that we send out, both in collateral material, meaning our marketing materials, and the training programs that Bruce and his team put together, as well as the words that go along with those materials by our wholesalers, are adequately disclosing and training on both possibilities within the construct.
Thank you.
Chris Giovanni. Just a couple to follow up.
Thanks. Just to follow up on the pension risk transfer business. I get the attractiveness of the product, the stickiness and the liability to hedge against the mortality business. I guess, how do we think about the ROEs of that versus maybe the FSA, the IO business? It sounds like this is an area where you're interested in maybe giving some of that capital up, in terms of a growth opportunity. Given the low rate environment, what's the feasibility of sort of this growth kind of continuing if we assume that rates are staying here for the next several years?
You want me to take that? In terms of returns, large deals haven't yet happened, so we don't really have a sample to draw from. These will be sophisticated markets. They'll be sophisticated clients working with sophisticated advisors. Our assumption is that pricing will be fair, meaning we'll earn an appropriate return for the risk. It will be a return that we want to earn. Because of the competitive and sophisticated nature of the market, I would assume that returns will be very much consistent with the underlying economics and the risk profile. That would put it somewhere between the investment only stable value and full service retirement, just as a ballpark figure. In terms of the level of interest rates, I think that's the wild card. We know that a lot of resources are being dedicated to studying pension risk transfer.
Consultants are engaged, regulators are being talked to, and as I said earlier, at a CFO forum, that would be a very hot topic. It's generally widely discussed among corporations in the U.S. Whether or not someone thinks that the economics make sense or there's a timing bet relative to interest rates is up to each individual company, and we haven't yet seen a really big deal done. I don't know whether it's for some other reason or because of the level of rates, but certainly rates aren't helping.
If you got a big deal, would it be outside of sort of the normal capital that you've allocated to the regular growth in the business? Would this be in sort of the $3 billion bucket that you talked about earlier?
Yeah. We've talked about this as potentially an opportunity to put a meaningful amount of capital to work, and we would still think about it that way. It would be one of the kinds of things that would be in outsized organic. Yeah.
The one other thing I would add to what Mark said is that low interest rates cuts both ways, right? On the one hand, it increases the liability when you discount it back at a low interest rate, and therefore the cost of doing a transaction might be greater. On the other hand, it's far less costly to borrow. Corporations can borrow and say, "You know what? This would be a great time to get this off my balance sheet, and the cost of doing so by virtue of borrowing would be much less, and I have access to the markets." Low interest rates can cut both ways.
Thomas Gallagher.
Thomas Gallagher, Credit Suisse. I guess this question is for Ed, just back on the international. The growth driver in Japan has been on the retirement and annuity side in terms of the outsize growth. Can you just provide a little color for what the product profile is? Are those mainly non-JPY based products? Are those mainly $ products? I just had a follow-up question.
Sure. Actually. Is this on?
Yes.
Actually, death protection has been the biggest selling product, including in the bank channel. The main driver has been more the shift in distribution than the shift in product. Having said that, retirement income is growing in all of those channels. What's inside retirement? Retirement is essentially a high cash value life insurance product. In this country, you couldn't have it because it would be a MEC. It'd be a modified endowment contract. That's essentially what it is.
From a currency standpoint?
From a currency, in POJ, about a third of it now is dollar denominated. The reason for that is by taking the currency risk, the customer, because it's dollar denominated at both ends, they take that risk in exchange for the higher yield that they can get in a dollar-denominated market than they can get in the yen. Even though the dollar is at a historically low level, 185, 190, it's still about double what's going on with JGB. It's still an attractive currency arbitrage, which they choose to take.
The two-thirds that's yen, are you pretty much just buying JGBs?
Yes
to back those products, and you're still able to make acceptable spreads and margins and returns there?
Yes, because of the mortality and expense, and again, keep in mind, what the customer is doing is comparing it to the five bips they're getting on a five-year CD.
Thanks.
Sure.
Time for one last question. Who hasn't asked a second one? Is that John Hall back there? Is that Ian?
I didn't have any today. Ian Gutterman, hostage. I kind of want to follow up on Jay's question about the role of the annuity business in the total Prudential. I guess what struck me today is we spent almost as much time on annuity as international, which is more than twice the earnings, and obviously, a business that should have a higher valuation, and we don't get to spend enough time on it because we've spent so much time on annuity. That makes sense because there's a lot of interest on it, but it also strikes me that every year, it's the exact same questions about what can go wrong here and what can go wrong there. It's just different people asking them, right?
You guys do a good job explaining it, but yet we ask the same questions every year, which tells us that it's too complicated a business for us to get our arms around. There's real world consequences of that, right? Your stock is suffering because of it. Your cost of capital is higher. It's harder for you to maybe compete for acquisitions you like overseas. The rating agencies don't like it. Maybe the SIFI regulators won't like it, I don't know. There's real implications for it, and I'm just wondering how you think about what the costs are of being in that business because we can't understand it. Secondly, you guys have a lot of confidence, and I trust you guys in that because you obviously have a lot more data than we do.
Given you have so much confidence, what more can you do to teach us or disclose more to help us get more comfortable? It's frankly hurting the whole sector that investors just can't understand the annuity business as well as we would like to.
Well, a couple of observations. One is that, if you have the issues that Mark described about the overall economics versus the accounting, clearly we do spend more time talking about it than others because we find that, number 1, it's an area there's a lot of questions, and number 2, the decay rate on people's retention of this is low enough that we have to keep revisiting it. One of the things though that really keeps us motivated is that on this, though, is you look at where the needs are for Americans for predictable retirement streams that replace that pension check that used to show up in the mailbox. There is very, very clearly a need here.
We think that this is a need that's a lot of role and a lot of relevance for our company and perhaps our industry, but certainly for our company, and it fits very naturally with many of the things we do. It is not the most simple line of business, and that accounts for it. When you think about areas to grow or relevance for the societal needs and to create long-term opportunities to make a difference in a way that can earn attractive returns for the house, we think there's a lot to be said for this. Mark, would you add anything to that?
Just quickly. You haven't raised any issues that we haven't thought of.
Okay.
The challenge around transparency and comfort is a point well taken. We'll continue to make efforts to be clear and to be effective and to consider the issues that you raised.
Fair. Again, I think you're trying your best. I'm not criticizing the disclosures. It just feels like there's a real cost to it. I just don't know how you guys internally evaluate that cost. Maybe you don't think it is. Maybe you just think over time we're going to be right and people will figure it out.
Oh, no. We're very sensitive to the issues that I listed around volatility and around lack of transparency and around comfort in the market.
Okay. Thank you.
We'll continue to try to explicate it for you, Ian, and maybe you'll come again next year. Thank you for that thought. The closing comments are very brief. I hope you come away with a strong sense for the confidence and enthusiasm that we have for our individual lines of business and how they roll up in terms of an overall portfolio, our conviction about our earnings power, and our ability to achieve breakout status in terms of the overall ROE of the enterprise. We have a lot of determination and conviction around this, and we intend to prove it out. Thanks for your time. Thanks for your interest. Appreciate you coming.