Ladies and gentlemen, thank you for standing by. Welcome to the second quarter 2011 earnings teleconference. At this time, all lines are in a listen only mode. Later, there'll be an opportunity for your questions, and instructions will be given at that time. If you should require assistance during the call, please press star then zero. As a reminder, this conference is being recorded. I'll now turn the conference over to Eric Durand, Head of Investor Relations. Please go ahead, sir.
Thank you very much. Good morning. Thank you for joining our call. We look forward to spending a productive hour with you. Before we begin, some housekeeping. In order to help you to understand Prudential Financial, we will make some forward-looking statements in the following presentation. It is possible that actual results may differ materially from the predictions we make today. Additional information regarding factors that could cause such a difference appears in the section titled Forward-Looking Statements and Non-GAAP Measures of our earnings press release for the second quarter of 2011, which can be found on our website at www.investor.prudential.com. In addition, in managing our businesses, we use a non-GAAP measure we call adjusted operating income to measure the performance of our financial services businesses. Adjusted operating income excludes net investment gains and losses as adjusted and related charges and adjustments, as well as results from divested businesses.
Adjusted operating income also excludes recorded changes in asset values that are expected ultimately to accrue to contract holders and recorded changes in contract holder liabilities resulting from changes in related asset values. Our earnings press release contains information about our definition of adjusted operating income. The comparable GAAP presentation and the reconciliation between the two for the quarter are set out in our earnings press release on our website. Additional historical information relating to the company's financial performance is also located on our website. Participants in this call from Prudential include John Strangfeld, CEO; Mark Grier, Vice Chairman; Rich Carbone, Chief Financial Officer; Peter Sayre, Controller and Principal Accounting Officer; Charlie Lowrey, Head of our U.S. Businesses; and Ed Baird, Head of our International Businesses. John Strangfeld will kick things off with his presentation. John?
Thank you, Eric, and good morning, everyone. Thank you for joining us. We had strong results for the second quarter, both in earnings and in underlying fundamentals. As reported, our earnings per share nearly doubled from last year's second quarter based on adjusted operating income of the financial services business. In a moment, Rich and Mark will review the quarter with you more extensively. In brief, our results reflect solid business performance virtually across the board. Market conditions were generally favorable over the last year, but strong fundamentals and good execution are driving our results more than favorable markets. I'll mention a few highlights. In individual annuities and retirement, account values reached record highs, $116 billion for annuities, $221 billion for retirement.
In annuities, strong sales and net flows reflecting the value proposition of our HD products as well as our consistent presence in the market have driven sustained growth of core results. In retirement, our flows reflect strong sales of Stable Value Wrap products, and current quarter sales also include two groundbreaking transactions in the emerging defined benefit risk transfer market. Our asset management business achieved a new high for assets under management of $583 billion. Sustained growth in AUM is leading to a greater contribution from core fee-based earnings. International insurance had exceptional sales of $737 million, up 76% from a year ago, based on annualized new business premiums in constant dollars. This result includes sales from the acquired Star Edison operations. Even without that contribution, international sales would still be 30% higher than a year ago.
Organic growth, both in our LifePlanner business and Gibraltar Life, is producing higher earnings, and early contributions from Star Edison are solid. I'll wrap up with a few comments on return on equity, which we consider to be the most telling measure of financial performance and the yardstick we manage to above all others. Our ROE in the first half is 11%, based on annualized adjusted operating income for the financial services businesses. This compares to our aspiration of 13%-14% by 2013. We believe that our aspiration is made possible by virtue of an attractive mix of high quality and well-led businesses. In particular, I would like to highlight that there are three key elements to getting from where we are today to our 2013 aspiration. Number one is continued strong performance of our high ROE businesses, namely asset management, annuities, and international.
Each of these businesses recorded outstanding results in the second quarter, as Rich and Mark will discuss in a moment. Number two is successful integration of Star Edison. In spite of the earthquake and tsunami disaster in Japan, business integration is proceeding well, in line with expectations and with no material surprises. We continue to expect eventual expense savings of $250 million a year, and we remain excited by the opportunity to generate higher sales through the expanded distribution provided by Star and Edison. We applaud and thank our dedicated staff in Japan as well as their associates in the U.S., who have overcome extraordinary challenges to keep us on track through this difficult time in Japan. Number three is effective capital deployment through organic growth or acquisitions or through return of excess capital to investors. Quite probably, it'll be through the use of each of these levers.
As we announced in June, our board has authorized share repurchases of up to $1.5 billion through June of next year. We have been buying shares under this authorization since the beginning of July. With that, I'd like to hand the baton to Rich Carbone. Rich?
Thanks, John, and good morning, everyone. As you've seen from yesterday's release and as you've just heard from John, this was another strong quarter for us. We reported common stock earnings per share of $1.71 for the second quarter based on adjusted operating income for the financial services businesses, this compares to $0.88 per share for the comparable quarter of a year ago. The list of significant discrete items affecting the current quarter is fairly short. In the annuities business, flat equity markets caused our account value performance to fall short of our assumptions, resulting in a charge of $0.03 per share for guaranteed minimum death and income benefits and $0.02 per share related to DAC amortization. In international insurance, results include net charges of $0.07 per share for claims and expenses from the March earthquake and tsunami in Japan.
Since Gibraltar Life, including the acquired Star and Edison businesses, report earnings on a one-month lag, its claims and expenses from the disaster are included in this quarter's results, along with a revised estimate of these costs for the Japanese Life Planner, which made its accrual in the first quarter. Gibraltar Life results also include integration costs of $0.04 per share relating to the Star and Edison acquisition. Going the other way, the asset management business had a benefit of $0.09 per share from the partial sale of an international real estate seed investment. In total, the items I just mentioned had a net unfavorable impact of about $0.07 per share on our earnings for the second quarter. Adding back the net charges of $0.07 per share to our reported results would bring EPS to $1.78 for the quarter.
Our results in the year-ago quarter included net charges of $0.49 per share from the unfavorable unlockings and reserve strengthenings, largely driven by the 12% decline in the S&P 500 in that quarter. Taking these items out of both the current and year-ago quarters would produce an EPS increase of about 30%, driven largely by organic business growth, improved financial markets, and the initial contribution of the Star and Edison earnings. Moving on to GAAP results of the financial services businesses. We reported net income of $831 million, or $1.68 per share for the second quarter, compared to $798 million or $1.70 per share a year ago. GAAP net income for the current quarter includes amounts characterized as net realized investment losses of $11 million pre-tax, or a charge of about $0.02 per share.
This compares to a $620 million pre-tax realized investment gains, or $1.32 per share in the year-ago quarter, which was driven largely by market value changes in derivatives related to product hedging and other portfolio management activities. The $11 million of current quarter net realized investment losses reflects both impairments and credit losses of about $187 million, half of which came from impairments related to currency exchange rates and declines in equity values, with the remainder resulting mainly from credit issues, including $28 million related to our subprime holdings. Our general account subprime holdings were $2.9 billion based on amortized cost as of the end of the quarter, down from $3.8 billion a year ago. These impairments and credit losses were essentially offset by net gains from general portfolio activities, as well as $62 million of gains from product-related hedging activities.
Book value per share on a GAAP basis amounted to $68.09 at the end of the quarter, this compares to $59.94 of a year earlier. Gross unrealized losses on general account fixed maturities stood at $3.1 billion at the end of the quarter, we were in a net unrealized gain position of $7 billion. Book value per share, excluding unrealized investment gains and losses and pension and post-retirement benefits, increased $6.16 from a year ago, reaching $62.97 at the end of this quarter. Now turning to the capital picture. We continue to manage our insurance companies to capital levels consistent with we believe are double A standards. As we've said in the past We benchmark Prudential Insurance to a 400 RBC ratio. We began the year with an RBC ratio of 533.
During the second quarter, Prudential Insurance paid a $1.2 billion dividend to the holding company, Prudential Financial, Inc. While this dividend had no impact on our overall capital position, it did reduce the statutory capital position of Prudential Insurance, essentially moving excess capital to the parent, which enhanced our capital flexibility. Given effect to the dividend, if we were reporting RBC for Prudential Insurance, as of June 30th, we believe that it would be comfortably above the 400 level. In Japan, Prudential of Japan, Gibraltar Life, Star and Edison each reported solvency margins as of their fiscal year end, March 31st, 2011, comfortably above their benchmarks for double A rating standards.
In estimating our excess on balance sheet capital for the financial services business, we compare the statutory capital in Prudential Insurance to our benchmark of 400 RBC ratio, then add the excess capital held at the parent and other subsidiaries. As Mark told you at our investor day in June, our estimate of our on-balance sheet excess capital was in the range of $4 billion-$4.5 billion as of December 31st, 2010. That was after adjusting for the subsequent Star Edison acquisition and our sale of the global commodities business, which closed on July 1st. Also, as we discussed, we view $2.2 billion-$2.7 billion of our excess on-balance sheet capital as readily redeployable. I can say that our capital position has improved since year-end, both available and total.
Because many of the inputs to our statutory capital are based on annual calculations, I will not be providing a specific current quarter update for these numbers. As you know, we announced a $1.5 billion share repurchase program in June. This program provides us with a means of returning excess capital to shareholders, we commenced repurchases in July under the program, which is authorized through June 30th of next year. Turning to the capital position at the parent, cash and short-term investments at the parent company, net of short-term borrowings and commercial paper amounted to roughly $4.5 billion as of the end of the second quarter. This represents an increase of about $2 billion from March 31st, driven mainly by the dividend paid by Prudential Insurance and returns of capital from several other operating units. We continue to target maintaining $1 billion of liquidity at the parent.
The excess of our capital position over this $1 billion target is available to fund operating needs and to be redeployed over time, including share repurchases. Now Mark will cover our business results.
Thank you, John and Eric, good morning, good afternoon, good evening or good night. I'll start with our U.S. businesses. Our annuity business reported adjusted operating income of $221 million for the second quarter compared to a loss of $131 million a year ago. The reserve true-ups and DAC unlocking that Rich mentioned had a net unfavorable impact of $36 million on current quarter results. This includes a charge of $20 million to strengthen our reserves for guaranteed minimum death and income benefits, and a further charge of $16 million from increased amortization of deferred policy acquisition and other costs, in both cases reflecting market performance in the quarter that fell short of our assumptions. Results for the year-ago quarter included a net charge of $284 million from an unfavorable DAC unlocking and reserve true-ups, largely driven by the equity market downturn in that quarter.
Stripping out these items, annuity results were $257 million for the current quarter compared to $153 million a year ago for an increase of $104 million. These results translate to a return of 89 basis points on average asset account values for the current quarter compared to 70 basis points a year ago. Essentially, we have higher returns on a growing base, with results benefiting from the addition of profitable business over the past year, lapsing of lower margin older business, and account value appreciation driving higher fees and lower benefit costs. Our gross variable annuity sales for the quarter amounted to $4.5 billion. This compares to $5.3 billion a year ago and represents a decline, as we expected, from the $6.8 billion of gross sales we recorded in the first quarter.
Our sales are driven by the strong value proposition of our Highest Daily protected value feature, which clearly differentiates our products, coupled with a proven contract-level auto rebalancing mechanism that has performed well through the financial crisis and beyond. Our take-up rate for Highest Daily living benefits packaged with auto rebalancing has been 90% or better for our variable annuity sales over the past four quarters. In recent years, our sales have also been bolstered by dislocations in the marketplace, as some competitors have trimmed features or exited the space. We are now seeing a number of competitors revamping their products, in some cases leading to an initial surge in sales. In doing so, a majority of our mainline competitors have followed our lead by introducing some form of account value protection embedded in product design.
Many of these new products implement this protection at the fund level. Require investment in a very limited set of funds. This differs from our contract-level approach, which is tailored to each client's account composition and guarantee profile, and therefore allows us to offer a broader choice of investments within the asset allocation programs that are required for our living benefit guarantees. Excuse me. I would also note that our experience with auto rebalancing goes back to 2003 and has been a core element of our product design for nearly five years since we introduced Highest Daily products to the marketplace. As of June 30th, about 80% of our account values with living benefits and over 60% of our entire book of variable annuities has our auto rebalancing feature.
While changes in the marketplace can cause some lumpiness in our sales from one quarter to another, we feel that the consistency of our value proposition, based on Highest Daily value and auto rebalancing, and our commitment to the market, give us a sustained competitive advantage. The retirement segment reported adjusted operating income of $173 million for the current quarter, compared to $137 million a year ago. Current quarter results benefited from higher fees driven by growth in account values, both in full service retirement and in institutional products. Overall retirement account values were $221 billion at the end of the quarter, up $40 billion from a year ago. Higher net investment spreads, reflecting crediting rate reductions we implemented earlier this year, also contributed to the improvement in results. In full service retirement, gross deposits and sales were $4.1 billion in the current quarter, about flat with a year ago.
Industry case turnover continues to be slow in the mid to large case market, which is our main focus. We have done well in retaining existing business in this environment, with net full service flows at about breakeven for the quarter and persistency at a solid 96%. Gross sales of institutional products were $5.6 billion for the quarter, up from $3.7 billion a year ago. The increase was mainly driven by sales of Stable Value Wrap products to plan sponsors on a standalone basis. Current quarter sales included two groundbreaking cases in the emerging defined benefit risk transfer market, where we are developing innovative solutions to help plan sponsors manage the risks of defined benefit pension plans. These sales, totaling about $250 million, include a longevity reinsurance case and a pension plan buy-in of a specially designed annuity product.
While this market is in its infancy, we see this as a long-term opportunity where we will be among just a few companies that can offer these solutions. Overall, net additions to the retirement business were $4.1 billion for the quarter, compared to about $2 billion a year ago. The asset management segment reported adjusted operating income of $227 million for the current quarter, compared to $124 million a year ago. Current quarter results benefited from a $61 million gain on the sale of 80% of our interest in a real estate property that we acquired as a seed investment and have had on the books for several years. Excluding that gain, results were up $42 million from a year ago.
About one-third of that increase came from more favorable results from commercial mortgage activities, reflecting loan payoffs during the quarter, where we realized more than the carrying amount of the loans. The remainder of the improvement in results came mainly from higher asset management fees, driven by growth in assets under management. The segment's assets under management increased nearly $100 billion from a year ago, including $15 billion of primarily U.S. dollar general account assets from the Star and Edison acquisitions. The rest of the increase in assets under management was driven by cumulative market appreciation and about $31 billion of positive net flows in institutional and retail business over the past year. adjusted operating income for our individual life insurance business was $130 million for the current quarter, compared to $88 million a year ago.
Results for the year ago quarter included charges of about $30 million to accelerate amortization of DAC and other items, driven by unfavorable separate account performance linked to the 12% decline in the S&P 500 in that quarter. For the current quarter, overall separate account performance, which reflects the equity and fixed income investments underlying our variable life policy, did not have a significant impact on results. Excluding the impact of market performance, results were up about $10 million from a year ago, driven mainly by more favorable mortality experience. Sales amounted to $68 million for the current quarter, up from $61 million a year ago. The increase came mainly from third-party sales of our universal life insurance products, as our relative competitive position has improved. The group insurance business reported adjusted operating income of $49 million in the current quarter, compared to $32 million a year ago.
The increase came mainly from more favorable group life underwriting results. Group insurance sales for the quarter were $52 million, compared to $42 million a year ago. Most of our group insurance sales are recorded in the first quarter based on the effective date of the business. Turning now to our international businesses. Gibraltar Life's adjusted operating income was $244 million in the current quarter, compared to $175 million a year ago. Current quarter results include charges of $56 million, representing our estimate of claims and expenses for Gibraltar, including Star & Edison, from the earthquake and tsunami in Japan. As Rich mentioned, this is a second quarter event for Gibraltar due to the one-month reporting lag. In addition, Gibraltar's results for the quarter absorbed $29 million of integration costs for the Star and Edison acquisitions.
Excluding the impact of the earthquake and tsunami and the integration costs, Gibraltar's adjusted operating income was up to $154 million from a year ago. This increase includes a contribution of $113 million from the operations of the acquired Star and Edison businesses. The increase also reflects higher net investment spreads, mainly reflecting growth of Gibraltar's fixed annuity business and includes business growth driven by protection products, including the growing book of life insurance protection business distributed through the bank channel. Sales from Gibraltar Life, based on annualized premiums in constant dollars, were $499 million in the current quarter. This represents an increase of $277 million from a year ago, including $84 million of organic growth, driven largely by the bank channel, and $193 million from production through the distribution that came to us in the Star and Edison acquisition, including about $80 million from independent agents.
As part of the business integration, we are adapting the products sold through the Star and Edison distribution systems to align with Gibraltar's product portfolio. These changes may lead to some sales lumpiness from time to time. In the current quarter, about $30 million of the independent agency channel sales came from a Star Edison term insurance product for which we are implementing revisions. Our Life Planner business reported adjusted operating income of $346 million for the current quarter compared to $291 million a year ago. Current quarter results included a benefit of $6 million from an update of our estimate of claims and expenses from the earthquake and tsunami in Japan. Excluding this item, results were up $49 million from a year ago, tracking continued business growth, mainly in Japan, together with more favorable mortality and lower expenses.
Sales from our Life Planner operations, based on annualized premiums in constant dollars, were $238 million in the current quarter, up $41 million or 21% from a year ago. The increase was driven mainly by strong sales in Japan, where we are benefiting from increased demand for retirement income products, and in Korea. Corporate and other operations reported a loss of $231 million for the current quarter compared to a $180 million loss a year ago. Greater loss in the current quarter was mainly a result of higher expenses. The expenses within corporate and other include nonlinear items such as corporate advertising. To sum up, in our annuities business, a distinctive and consistent value proposition, together with a steady commitment to the market, have driven a growing book of profitable business with an improving risk profile, leading to solid growth in core results.
Retirement results benefited from higher fees driven by growth in account values, along with greater investment spread income. In asset management, strong net flows have contributed to a growing base of assets under management, leading to higher fee-based core results. Current quarter results also benefited from a gain on a sale of a real estate seed investment that increased in value over our holding period. Our U.S. protection businesses performed well in the quarter, with more favorable mortality compared to a year ago in both individual life and group life. In our international operations, results benefited from continued organic growth both in our Life Planner businesses and Gibraltar Life, along with a solid contribution for this early period from the Star and Edison businesses that we acquired in February.
Sales are benefiting from continued expansion of the bank channel and the additional distribution opportunities that came to us with the Star and Edison acquisitions, where business integration is on track. Thank you for your interest in Prudential. Now we look forward to hearing your questions.
Thank you. Ladies and gentlemen, if you'd like to ask a question, please press * then 1 on your touch tone phone. You'll hear a tone indicating you've been placed in queue. You may remove yourself from the queue at any time by pressing the # key. If you're using a speakerphone, please pick up your handset before dialing. Our first question will come from Suneet Kamath with Sanford Bernstein. Go ahead, please.
Thanks. Good morning. A couple questions on capital and then one on the full service business, if I could. Starting with capital, if I take the $2.2 billion-$2.7 billion of immediately spendable capital back out the $1.5 billion of buyback, that still leaves you with midpoint $950 million of, I guess, immediately deployable capital that as of right now, you've not talked about immediately deploying. Just wondering, is that $950 earmarked for potential dividend increase or acquisitions or is there something that would preclude you from using that sooner rather than later?
There's nothing that would preclude us from using it sooner rather than later. It's not restricted in any way, but we don't have any intended use for it at this point in time.
I guess, why is that the case?
We don't see any opportunities at this point, and we've announced the buyback program that we think is sufficient at this point.
Okay. On the buyback program, I guess in years past, your annual buybacks have been relatively stable over a course of a given year, roughly the same amount per quarter. Given how your stock is trading and the ROE upside that you see. Would you imagine that pattern of stability continues, or would you expect to be more opportunistic based on how the stock is trading? Thanks.
I know how we did this in the past. Going forward, we'll disclose our buybacks at the end of each quarter. I really think that's a better way to handle this disclosure.
Okay. The last question is just on the full service business. We talked about this a little bit at Investor Day and then follow-on conversations. I think it's a fair comment that some others have raised that the full service business commentary at Investor Day was probably a little less enthusiastic relative to past Investor Days. We talked about this with Principal earlier this week, and they are clearly as enthusiastic, to use their words, as they've ever been. I was just wondering if you could provide some thoughts in terms of what you're seeing there. Is there really a change in your view of this business, or how should we think about kind of growth going forward? Is it just tied to the economy and things will resume once the economy picks up, or any additional thoughts would be helpful. Thanks.
Sure. No, happy to do it. This is Charlie. A couple of things. We are mainly in the mid to large case market. What we're seeing there, I'll give you some context and then something specific to what we're doing. The context is that we see very low new plan formation, not a lot of RFPs out in the marketplace. There is low industry turnover, you see a lot of us, including ourselves, with very strong persistency numbers. Finally, plan sponsors continue to be distracted in terms of their focus on healthcare and other things. With that as context, there aren't a lot of plans coming up for renewal or out in the marketplace. There's a lot of check fitting going on where plan sponsors will look at, go out, and check the prices, but they don't want to move the plans.
In terms of our own business, I think we're exhibiting a fair amount of discipline in that we're targeting specific ROEs and hurdle rates. As a result, we'll take a look at the business we have and the business that's out there, but we'll, at times, decline to bid on or let lapse business that doesn't meet our hurdles. What you're seeing is fairly flat flows, but that's in part due to the context and in part due to the discipline that we're showing.
Bottom line, you are seeing some irrational pricing in the market these days?
We're seeing very aggressive pricing, especially on the record-keeping full service side of things. I don't know if it's irrational or not. I won't comment on that. We are very disciplined in terms of what we'll bid on and what we'll let lapse.
Understood. Is that coming from other insurance companies or more asset managers or any color there?
Not particularly. It's coming from all over. There are a lot of different players in this marketplace, and you see different kinds of firms bidding on different kinds of business.
Okay, thanks.
Thank you. Our next question will come from John Nadel with Sterne, Agee & Leach. Go ahead, please.
Hey, good morning, everybody. Question on Edison Star. In the second quarter, the earnings contribution, excluding the integration costs, was about 10% higher than what I think the one month of the first quarter would have implied if I'd run rated that for a three-month period of time. I don't know if there's anything we can read into that. Can you give us a sense for why the second quarter is better?
I think you're right, John. There's not much you can read into that. If you take any one month and extrapolate it, that's a somewhat risky exercise. That was our first and only month last quarter. Now this is our first and only full quarter. I think it's still pretty early to draw any conclusions other than to say that both sets of numbers, the one month and the quarter, are quite consistent with our overall expectations in terms of the valuation and what we're expecting to get from these businesses. To that extent, it's reassuring.
Okay. That's helpful. Just maybe a 50,000-foot question for John or Mark. If the U.S. economy were to fall back into a recession, if the, I guess, growing consensus view now of the potential for a double dip were to prove to be true, how do we think about the 13%-14% ROE aspiration by 2013 under that type of a scenario? I know that's a very open-ended question.
Well, a couple things, John, I'd offer, it's hard to answer it. Also, I think you have to overlay what level of severity you're talking about.
Yeah.
If you take a look, one thing I would offer in this context is if you take a look at where we are today and say even compared to where we were in 2007, a lot less of our business is being driven by appreciation. It's much more being driven by underlying fundamentals, meaning sales and flows. That's a big difference. It's almost a reciprocal of what it was at that time. That's not a criticism of that time, it's more a statement about the strength and the underpinnings of our individual lines of business. Will those fundamentals be affected? They absolutely will have some effect. Are we as dependent on appreciation as we once were? Absolutely not. The second piece to look at that is over 40%, 45% of our business is now coming out of Japan.
We got very unique aspects in there. We don't expect. Those are markets that are even less market sensitive than they are in the U.S., given the nature of the products, given their level of interest rates, et cetera. Again, I think our portfolio effect in broader terms also works to our advantage.
In that context as well. That gives us a sense that we've got a better prospect for sustaining strong fundamentals and a better prospect for strength and stability through challenging times. I don't know, Mark, if you'd add anything to that.
If I can interject, maybe you could focus too, on your assessment of the general account today versus maybe a couple of years ago too, and how that might or might not be a significant source of capital strain.
Yeah, that was going to be my second point. Let me make the first one, which is, if you look at the points that John made in his discussion of the drivers of ROE improvement, the high return business is growing more rapidly than the others. The Star and Edison results coming online and having the impact we want them to have and capital redeployment. Within that picture, there is some equity market sensitivity, particularly in the annuity business. That would be one of the things to think about as you're extrapolating forward. As John said, we're less dependent on appreciation and more dependent on fundamentals and have a less market-sensitive earnings profile than we had several years ago. You could see things going better in some ways and maybe making up for some of the equity market sensitivity in a downturn.
I think our core story holds together very well. On the second point, which is the one you just asked about, we've not compromised credit risk in reaching for yield since we've come out of the financial crisis and as we've gone through a couple of episodes of very low interest rates. We're feeling quite confident with respect to overall credit quality and the strength of our balance sheet, liquidity, credit quality, capital, across the board. I think we're also in a good position to weather the storm with respect to the general account. Would not anticipate a significant amount of capital strain there, but rather from the bottoms up right now, looking at a pretty strong credit picture.
I think we've got ourselves in good shape there on the overall strength of the balance sheet, credit quality, and the mix of businesses and the management agenda that John talked about.
Appreciate that color. Thank you very much.
We'll go next to Nigel Dally with Morgan Stanley. Go ahead, please.
Great. Thanks, and good morning. You mentioned this in passing, but wanted to come back to the issue of the impact of low interest rates on your annuity business. With your new annuity product, you talked previously about it being priced for a high teens ROE. Can you discuss how sensitive that ROE is to changes in rates? If rates remain at around the 2.5% level, any need to make further recalibrations to your product design? Thanks.
Nigel, this is Charlie. I think we anticipated a low interest rate environment when we made the changes, and we did that on a prospective basis earlier this year. As of now, we don't anticipate making further changes. I think the product is designed for a low interest rate environment, and we're pleased with the returns we're getting.
Would the new business returns still be in the teens given the current rates there?
Yeah.
Okay.
That's a fair comment.
Okay. The second question I had was just on POJ. Continue to see very solid sales results, but I'm guessing at some point to maintain that momentum, you're going to need to grow the Life Planner account. For the most recent quarter, Planner account was actually down a touch from the previous year. Can you discuss what's holding that back and what needs to be done to get the Planner numbers growing again?
Yeah, actually, it's an interesting point that historically, you're absolutely right. There was a strong correlation between new business growth and Life Planner growth. If you look over the quarters of the last two years, you'll see that those two have largely separated now. This quarter, as you fairly point out, is yet another example, probably for the last six or eight quarters. That is, in spite of it being flat in head count with the Life Planner, sales are up about 20%. Keep in mind that sales are driven by three things. You've cited one, which is the head count. The second is productivity. The third is the interesting one I draw your attention to, and that is growth in average premium.
That has been happening now for a while, and I think has some sustainability to it because of this long-term secular shift that we're making from pure debt protection to that which is more heavily oriented to retirement. We're seeing that not only in Japan, but in Korea, Taiwan, and elsewhere. I will never downplay the long-term positive potential of continued growth. I would cite that now it's important to pay attention as well to the average premium. I'm actually encouraged by the fact that in spite of having no growth, we're having quarter-over-quarter of growth of 20% or more. What I'm hoping to see is really a balance over time of growth being strong double digit as a result of spreading growth over each of those three factors, i.e., head count, productivity, and average premium.
That's great. Thanks a lot.
Sure.
Thank you. Our next question is from Thomas Gallagher with Credit Suisse. Please go ahead.
Hi. One question on interest rates, another question on Japan. On the interest rate side, I guess my question is, as a firm for planning purposes, are you treating the recent swift decline in rates as a potential aberration, or are you preparing the firm for an extension of this kind of environment? In a related question, as rates have moved down, you revised your HD6 to HD5. If rates stay where they are now, are we looking at HD4? That's my first question on rates, I'll follow up on Japan.
Tom, it's Mark. I'll take the first part and let Charlie answer the annuity question. We have had in front of us for a while now, the consideration of a scenario in which rates are very low for a long time. We continue to consider the situation that we're in with respect to our ability to achieve our objectives in that scenario. It is part of our thinking. Whether or not I want to particularly forecast rates and tell you if we think this is temporary or not is a little bit different question. I think the main point with respect to where we are, is that it's something that we pay a lot of attention to and have been paying attention to for a while.
Remember that our business mix individual businesses are intrinsically somewhat less rate sensitive than some of the sensitivities that show up in other companies that would be considered our peers. Our mix is actually pretty attractive and somewhat less affected by low rates. Again, it's something that we pay attention to. We have that scenario in front of us, and we keep worrying about it.
Tom, this is Charlie. Just to follow up on your comment. At this point again, we've designed the product for a low interest rate environment. We'll always reevaluate the environment as we go forward, at this point, we have no plans to change it in the near future.
Okay. Charlie, just as a follow-up, am I correct in saying the biggest hedge outlay cost would be interest rate related based on your product design? I presume that's where you'd get squeezed on the margins here if rates remain low, would be hedging your long-term interest rate risk as it relates to that product. Is that the right way to think about it?
Well, in terms of the mix of risk, you're right. The bulk of the risk in these HD products is interest rate risk. That's also a relatively less expensive risk to hedge than some of the more exotic equity market exposures. You're right in terms of thinking about the risk mix, but the cost of that is pretty low because those are very efficient markets and more plain vanilla type hedges.
Got it. Okay. Then just on shifting gears to Japan, the absolute sales number was quite strong, up 30% ex-Star Edison. Can you comment a little bit about what do you think is actually happening there? I guess my question is geared at, do you think, is this a market improvement situation where post the earthquake, you're seeing a pickup in demand for insurance products in the industry, or is this more Prudential specific in terms of the strength?
I think it's more of the latter, Tom. This is Ed speaking. I say that because this is not isolated. This is part of a trend we've seen now going on, as I mentioned earlier, for the last six or eight quarters. It's, I think, coming from several areas and for several reasons. Let me go into each of them. As far as the Life Planner organization, specifically POJ, I believe this is the result of this steady shift into the retirement because we're seeing growth in the average premium there that's making up the bulk of the increase in sales. Of course, the second contributor is the bank channel, which for, again, two years now, we have seen very steady growth in that quarter-over-quarter. The vast bulk of that continues to be insurance with a smaller amount in the fixed annuity area.
Again, this is heavily retirement oriented. Then the final third one, which I would temper slightly, is the both organic growth as well as the acquisition growth in the independent agent channel. Of the $118 million that was reported there, $34 million of that is coming from the Gibraltar channel, which we just started a year ago, and that was only about $6 million this time last year. We've got strong organic growth in that channel, which is well priced. Then we have the additional growth that came from the new Star and Edison IA channel. Whereas Mark pointed out earlier, I would want to temper your expectations on that because we will revisit some of the pricing and commissions on that to ensure that it has the same margins that we get out of our traditional Gibraltar IA channel.
Long-winded way of saying one of the encouraging aspects of the growth here is that it's very broad-based. We're getting it from our traditional Life Planner, which is mostly through growth in average premium, and I believe that's driven by this long-term shift to retirement. We continue to get steady growth in the bank channel. What's encouraging about that is it's less concentrated. You recall in the past, almost 90% of it was coming out of The Bank of Tokyo-Mitsubishi. That's now down to about 60% as we steadily grow the number of banks. Which is still currently out of Gibraltar, only in about 37, I think 32 of them are active. We have scores more where we've picked up relationships, but not new business as a result of Star and Edison. That's the second contributor. Then the third would be the IA.
I think there's three legs of this stool that are supporting the growth that you're observing.
Got it. That's helpful. Ed, you're not seeing necessarily any meaningful change in the industry sales momentum as far as you know?
Well, as far as the industry, as you know, the large domestics have been steadily losing market share of new business. That trend's been going on for about five years. While I've not looked at the most recent quarter, I think it will evidence that we continue to grow our market share of new business for some of the reasons I just mentioned, that are driven partly by strategic product shifts and partly by the expansion of distribution.
Okay, thanks.
We'll go next to Jimmy Bhullar with J.P. Morgan. Please go ahead.
Hi, thank you. The first question, just following up on the international business. Just wondering if you could address whether you feel you've got more room for expansion through the bank channel, and are you adding any more outlets, or is that mostly done? Related to that, just your thoughts on production at Star and Edison and how much potential you believe you have to improve the sales results there. I have one on the disability business after this.
Sure. This is Ed. Let me take your bank question first. On the bank side, given the numbers I just mentioned about the number of banks we're dealing with, I think we still have quite a way to go in terms of growth. I want to be cautious about this because the historic growth has been so dramatic. Obviously, that cannot continue indefinitely. If you look at the fact that through Gibraltar, which is producing over 90% of our distribution on the banks right now, meaning specifically the PGLS subsidiary as opposed to the acquisitions, we only have 32 active banks. Through Star and Edison and their relationships, which are more than double that, we're producing very little. That's understandable because their capacity for production was severely impaired as a result of the prior ownership and the situation they were in.
I'm hopeful that as we rehabilitate those relationships, we will be able to expand the footprint. To be specific in terms of new relationships, we just started with the Citibank relationship in the last quarter, that has started to be productive. I'm optimistic that as a result of adding additional number of banks, particularly the more powerful regional banks, we have three or four of those relationships, which I believe have future opportunities. Now, as far as the Star and Edison life advisor opportunity, I think what you'll see there will probably be akin to what we went through when we took over the Kyoei, but this situation will be easier. The Kyoei was a situation where that company was bankrupt, but we did introduce some credentialization, if you will, in terms of strengthening the management as well as the training of the organization.
That led to a short-term reduction in the number of salespeople, that in turn was offset by a steady improvement in the productivity. Now, granted, the situation we have here with both Star and Edison is a far more positive situation. These are by no means bankrupt organizations. Nonetheless, I anticipate that as we begin to introduce some of our core competency in sales management of captive agency system, it is possible you'll see some reduction in the numbers, but I think that will be offset through improvements in the productivity. Long term, I'm quite sanguine about it, particularly when one keeps in mind that in the valuation of this, I believe we attached 5% or less of the value to this to growth in new business. I think relative to the expectations and the pricing, there's a lot more upside opportunity here than there is downside risk.
All right. That's helpful. Then for Charlie, on the disability business, your margins have kept declining in the last few quarters, even as other companies' results, for the most part, have stabilized. Just wondering how much of this you feel is related to the economy and whether you feel you've got a pricing issue in your book.
Okay. Well, the benefit ratio is certainly up from the first quarter, it's actually down from 270 basis points from the third quarter of last year. It is bouncing around. It's higher than we want, clearly, I do think it reflects the economic conditions that are out there. Having said that, in the first quarter, or rather the second quarter, there was good news, bad news. That is that the good news was that the rate of incidence decreased and terminations actually increased. What happened, this was a severity issue, and the severity is up in most part because industries with the increase in the number of claims are the ones with well-compensated employees. We'll see what happens going forward, we think we understand the reason why the benefit ratio was up, we'll monitor it carefully.
Thank you.
Okay, thank you. We'll go next to Jeffrey Schuman with KBW. Go ahead, please.
Thanks. Good morning. I'm probably forgetting or missing something I should remember, but maybe Rich can humor me. I think you said, Rich, that the holding company had $4.5 billion of net liquidity, and that the target was $1 billion. I guess the question is, why isn't $4.5 minus $1 equals $3.5? Why is that not the amount of readily deployable capital at this point?
There's $900 million of that's operating debt. There's $900 million of that cash financed with operating debt.
Okay, that's straightforward enough. I was just curious. You announced the share repurchase program on June 9th, and obviously had plenty of liquidity and interest and didn't see any repurchases in June. Was there a technical reason why you were out of the market in June?
Sure. We were in blackout.
Okay, great. Thank you.
We have time for one final question. That will come from Jay Gelb with Barclays Capital.
Thanks. Good morning. I want to follow up on two things. First, once the expense efficiencies are realized in Star and Edison, what do you think the normalized return on equity could be for that business? I have a follow-up. Thanks.
Yeah. First, let me recap what the expectations are there. You'll recall that we expected that we'll have one-time expenses of $500 million. We'll incur 80% of that over the next couple of years, that we will reap $250 million in terms of improvement in AOI coming out of that, and that about 80% of that'll be reaped over the same period of time. This was priced during the valuation to come in on a levered ROE basis in the mid-teens. So far, as we've indicated a couple of times, every indication, admittedly very early, is that this is performing consistent with those expectations.
Mid-teens levered ROE just for Star and Edison. What about for the entire international operation?
Well, that has consistently performed in the high teens, near 20%. Because this Star and Edison numbers that we just talked about are lower than the traditional 20%, it will pull that overall number down into the high teens. I think it's reasonable to expect performance for the total PII international organization in the high teens.
Thanks. Then my follow-up question is, to what extent might there be consideration to moving to a quarterly shareholder dividend rather than annual?
Well, the payment of the annual dividend reflects the history of a shareholder base that included a lot of small shareholders coming out of demutualization. That question has come up, and it is something that we will consider, and we'll discuss it if necessary when we announce our dividend later this year.
Makes sense. Thank you.
Okay, we do have time for one more question. That will be Chris Giovanni with Goldman Sachs. Go ahead, please.
Thanks so much. Can you guys maybe just comment a little bit on sort of the regulatory front, what you guys are thinking related to SIFI and maybe other ancillary regulatory matters?
Yeah, Chris, this is Mark. There haven't been a lot of new developments in terms of, excuse me, stunning revelations in Washington. Let me reiterate a couple of points that we've made in the past. Excuse me. One is that financial strength is part of our value proposition, and being well-regulated is important to us and can play a role in that. We don't go into the consideration of the regulatory environment looking for loopholes or trying to lean hard against anything that anybody thinks of that might be regulatory in nature. Secondly, we believe that it's more important that we be viewed as an insurance company with the financial dynamics that are actually part of our business models, as opposed to viewed as a bank and regulated as a bank.
That it's more important that that distinction be drawn than that we argue about which label or bucket or tag we wind up with respect to consideration of things like systemically important or not. On July 21st, we became regulated by the Federal Reserve. That was part of the Dodd-Frank bill, where we moved from the OTS, the Office of Thrift Supervision, to Federal Reserve regulation. We're encouraged by our engagement with the Fed at this point, more broadly, we look forward to constructive engagement with the Federal Reserve and Treasury and others involved in Washington and the NAIC and the state regulators as this overall regulatory picture falls into place. It remains right now fairly fragmented and uncertain, so far, we think we're going to have the opportunity, as I said, for constructive engagement, and we'll see where it goes.
Okay. Appreciate the thoughts there. Just lastly, you made the decision to get back into the CMBS market in terms of originations for securitization, but you've decided to go about it sort of with a JV. Can you talk sort of around that decision, maybe to get back in and then why the JV route?
Sure. Just to be clear, we're not reentering the CMBS market in terms of taking any kind of warehouse risk going forward, right? We're not warehousing any assets. We have an interest in the JV, and that's limited to about $10 million. Our interest in getting back in is so that we can originate loans and service those loans and create additional fee income. It helps our potential borrowers or our clients because it means we offer another product to them, i.e., the CMBS product, along with our general account product. It expands the suite of our offerings to potential borrowers, so it helps there. It also increases fee income, which is one of the main goals of the asset management business.
Okay. Thanks so much.
Without the principal risk that we've taken in the past. Exactly.
Understood.
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