Ladies and gentlemen, thank you for standing by, and welcome to the third quarter 2010 earnings call. At this time, all participants are in a listen-only mode. Later, we will conduct a question and answer session. Instructions will be given to you at that time. If you do need assistance during the call today, you may press star 0, and an operator will assist you offline. As a reminder, today's conference call is being recorded. I would now like to turn the conference over to Mr. Eric Durant. Please go ahead.
Thank you, Cynthia. Good morning. Thank you for joining us. On today's call, John Strangfeld, Rich Carbone, and Mark Grier have prepared comments to share with you. Rich will be speaking through a deck that's been filed on a Form 8-K that you can get from our investor relations website at www.investor.prudential.com. For the Q&A, John, Rich, and Mark will be joined by Bernard Winograd, Ed Baird, Ken Tanji, and Peter Sayre. 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 displayed slides in the section titled Forward-Looking Statements and Non-GAAP Measures of our earnings press release for the third quarter of 2010, which can be found on our website at www.investor.prudential.com.
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 to ultimately accrue to contract holders and recorded changes in contract holder liabilities resulting from changes in related asset values. The displayed slides in our earnings press release contain information about our definition of adjusted operating income. The comparable GAAP presentation and the reconciliation between the two for the quarter and nine months ending September 30th are set out in our earnings press release on our website. Additional information relating to the company's financial performance is also located on our website. John?
Thank you, Eric. Good morning, everyone. Thank you for joining us. I'll speak briefly at the outset and then close it out after Rich and Mark have finished. Our performance in the third quarter was very solid and continued to reflect our attention to capital deployment, business mix, and effective execution of our individual business strategies. Consistent contributions to earnings and growth from our international insurance businesses, strong results from businesses that are driven by net flows and market conditions, and the stability of our core insurance franchises in the U.S. are the drivers of performance that we expect and that we have promised investors over the years. Our high-quality investment portfolio, high level of liquidity, and strong capitalization provide financial strength that will support significant growth opportunities overseas and in the U.S., giving us upside opportunities and we believe limited downside risk.
In short, our financial performance is progressing well and our business momentum continues to build, as is demonstrated by strong sales and flows in many of our businesses. About a month ago, we announced our agreement to acquire the Star & Edison insurance companies in Japan. This acquisition is expected to close in the first quarter. Given the importance of this transaction, we decided to give you input today on our earnings outlook for 2011 as well as our longer-term goals for ROE, including the impact of Star Edison, just as we would on Investor Day. We canceled next month's Investor Day event. We hope you find today's discussion helpful, and we look forward to answering your questions. I'd like to turn it over to Rich. Rich?
Thanks, John. Good morning, everyone. At the beginning here, I will cover the third quarter results. I'll come back later on and cover our capital and liquidity position, our earnings guidance for 2011, and how we look at our ROE potential. As you've seen from yesterday's release, we recorded common stock earnings per share of $2.12 for the third quarter based on adjusted operating income for the financial services businesses or the FSB. This compares to $1.78 per share in the year-ago quarter. I will start with some high-level comments on the current quarter. I will then discuss the impact of some discrete items. In our annuity and retirement businesses, results have benefited from continued growth in account values driven by strong sales and net flows as well as cumulative market value increases over the past year.
In the asset management business, we are benefiting from higher asset management fees driven by growth in assets under management as well as the absence of credit-related charges in the current quarter. Lower earnings from our U.S. protection businesses resulted from an increase in individual life claims in comparison to better-than-expected experience a year ago and less favorable underwriting in group insurance. Our domestic results are also benefited from net favorable unlockings in the quarter, reflecting updated estimates of profitability based on our annual actuarial reviews as well as market increases in the quarter. Our international businesses are continuing to perform well with record earnings for the quarter and strong sales driven by our competitive position and expanding distribution in Japan. As you saw in our earnings release, we changed our definition of adjusted operating income or AOI.
To exclude hedging differences from our variable annuity living benefits, mark-to-market on our capital hedge, and the non-performance risks that we've referred to as NPR. As a result, these items will no longer be reflected in our business segment results, although they will continue to be included, of course, in GAAP net income. We revised the definition in connection with changes of our hedging program, which Mark will discuss. We believe this presentation will provide a more meaningful measure of adjusted operating income and one that will be more comparable or compatible with our peers. Operating results for the quarter reflected several discrete items, including the impact of our annual actuarial reviews of experience and actuarial assumptions that we typically complete for our insurance and retirement businesses in the third quarter of each year. I'll go through them now.
In the annuity business, we had a benefit of $0.38 per share from an unlocking that reduced amortization of deferred policy acquisition and other costs, and a further benefit of $0.26 per share from the release of a portion of our reserves for guaranteed minimum death and income benefits. Our individual life business, excuse me, benefited $0.08 per share from the reduction of net amortization of DAC and related costs as a result of the completion of their annual review. Group insurance results benefited $0.04 per share from reserve refinements, driven largely by their annual assumption review. Going the other way, an unlocking in the retirement business resulted in net charges of about $0.02 per share. In total, the items I just mentioned had a net favorable impact of about $0.74 on our earnings per share for the third quarter.
Our results in the year-ago quarter also benefited from favorable unlockings, largely driven by a 15% increase in the S&P 500 and other discrete items that we identified then, with an estimated contribution of $0.57 per share. Taking these items out of both the current and prior year quarters would produce an EPS increase of about 14%. Moving on to the GAAP results of the FSB. We reported net income of $1.2 billion or $2.46 per share for the third quarter, compared to $1.1 billion or $2.35 per share a year ago. GAAP pre-tax results for this quarter include amounts characterized as net realized investment gains of $278 million. These gains reflect $89 million from the hedging differences and related items, including NPR, that were previously reported within adjusted operating income.
The remainder of the net gains was largely driven by general portfolio activities and foreign exchange rate fluctuations. Impairments and credit losses were $91 million in the quarter. Book value per share on a GAAP basis amounted to $67.81 at the end of the third quarter. This compares to $49.71 a year ago. Excluding unrealized investment gains and losses and pension and post-retirement benefits, book value per share increased $9.24 from a year ago, reaching $6.40 at the end of the quarter. As mentioned earlier, I'll discuss our capital and liquidity later on after Mark discusses the business results. Now on to Mark.
Thanks, John and Rich, good morning, good afternoon, or good evening. Thanks for joining us on the call today. In the discussion of the businesses, I'll begin with our U.S. businesses. Our annuity business reported adjusted operating income of $588 million for the third quarter, compared to $315 million a year ago. Results for the current quarter reflect the favorable unlocking and reserve adjustments that Rich mentioned. The DAC unlocking contributed $245 million to current quarter results. This unlocking was driven mainly by the annual update of our actuarial assumptions, and in particular, reflects stronger persistency than our earlier estimates. This leads to enhanced overall expected base contract profitability. Favorable market performance in the quarter also contributed to the unlocking. The release of a portion of our reserves for guaranteed minimum death and income benefits contributed $167 million to current quarter results.
This benefit to earnings was mainly driven by the equity market uptick in the quarter and also reflects the annual update of our actuarial assumptions. The items I mentioned sum up to a net favorable impact of $412 million on current quarter results in our annuity business. Results for the year-ago quarter included a net benefit of $211 million from a favorable unlocking and reserve true-ups. Stripping out the unlocking and true-ups, annuity results were $176 million for the current quarter compared to $104 million a year ago. The $72 million increase in what I would consider the underlying results of the business reflects higher fees due to an increase of more than $20 billion in average account values over the past year, driven by nearly $14 billion in net sales. As Rich mentioned, we've made some changes in our hedging strategies for annuity living benefits.
Let me spend a few minutes here to talk about our hedging program and how it fits in with our risk-driven approach to the annuity business. The goal of our living benefits hedging program is to work in tandem with our product-based risk management, and by that I mean our asset allocation algorithm within the product to assure that our product guarantees are supported and our capital is protected in the event of adverse market developments. Our hedging program has performed well since its inception five years ago, protecting our economic exposure from market fluctuations and, at the same time, helping to insulate us from income statement volatility arising from changes in the GAAP liability for embedded derivative product guarantees.
Recently, we have seen the accounting-driven changes in the liabilities begin to diverge widely from the changes in what we consider our economic exposure, especially as a result of the very low discount rates and assumed rates of return we are currently required to apply under GAAP. Let me make a couple of points on how GAAP requires us to determine assumed rates of returns for account balances and to discount cash flows we expect under the contracts in valuing these embedded derivatives. GAAP allows for no credit spreads in either the discount rates or the assumed rates for appreciation of account balances. In other words, it essentially requires us to assume that all of the account balances are invested in Treasury and to then use a similar discount rate for the resulting cash flows.
These interest rates are then used under the accounting rules and reflect a snapshot view of where the market is at a point in time, rather than the long-term view that we must use to manage our guarantees over a period that extends for decades. As a result, we're taking steps to make our hedging programs more cost effective by setting our hedging targets based on a more economic measure of the liability for our guarantees rather than the GAAP model that we had used as a surrogate. Our gross variable annuity sales for the quarter amounted to $5.4 billion compared to $5.8 billion a year ago, which included some acceleration of sales as we transitioned from an older product to our HD6+ living benefit feature. For some time, we have only offered variable annuity living benefits that include an auto-rebalancing feature.
This feature shifts customer funds to fixed income investments to protect account values and support our guarantees in equity market downturns. As of September 30th, almost three-quarters of our account values that have living benefits and more than half of our overall variable annuity account values are subject to auto-rebalancing. The Retirement segment reported adjusted operating income of $119 million for the current quarter compared to $117 million a year ago. Current quarter results reflected a charge of $15 million from updating of DAC and other amortization assumptions based on our annual review. While results for the year-ago quarter included charges of $8 million reflecting the results of a similar review. Stripping these items out of the comparison, results for the Retirement business were up $9 million from a year ago. The increase was driven mainly by higher fees reflecting growth in full service account values.
Full service account values stood at a record high $135 billion at September 30th, up $13 billion from a year earlier. The increase was driven by market appreciation and by $4.4 billion of positive net flows, including about $2.1 billion of net additions in the current quarter, which included two large case wins. The Asset Management segment reported adjusted operating income of $148 million for the current quarter compared to $29 million a year ago. This increase came mainly from more favorable results from commercial mortgage and proprietary investing activity. Results for the year-ago quarter were negatively affected by credit and valuation charges on interim loans we hold in the Asset Management portfolio, amounting to roughly $40 million. In addition, the year-ago quarter absorbed losses of about $20 million from proprietary investing activities, mainly on our co-investments in real estate funds that we manage.
While there are still challenges in the commercial real estate market, we are seeing evidence of improving valuations. Current quarter results had no net valuation or reserve charges relating to interim loans, and proprietary investing activities made a modest profit contribution. The remainder of the improvement in Asset Management results came mainly from higher asset management fees driven by growth in assets under management. The segment's assets under management increased by $74 billion or 17% from a year ago, reflecting positive net flows in each of the last four quarters as well as cumulative market appreciation. Adjusted operating income from our Individual Life insurance business was $190 million for the current quarter compared to $243 million a year ago. Current quarter results benefited by $52 million from a favorable unlocking of DAC and other amortization items resulting from our annual actuarial review and related mainly to universal life guarantees.
Results for the year-ago quarter included benefits of $55 million from a favorable unlocking and $30 million from compensation related to our distribution of third-party products under a contract that has been renegotiated. Stripping these items from the comparison, results from Individual Life were down $20 million from a year ago, mainly as a result of less favorable mortality experience. The Group Insurance business reported adjusted operating income of $61 million in the current quarter compared to $64 million a year ago. Results for the current quarter benefited by $28 million from refinements in group life and disability reserves, mainly as a result of our annual review. Excluding these reserve refinements, results were down $31 million from a year ago.
This decrease in earnings came mainly from a negative swing in group life underwriting results, driven primarily by less favorable mortality on our in-force business and by the lapsing of some business that had favorable claims experience in the year-ago quarter. Most of our group insurance business represents large cases where experience emerges over a number of years. While our claims experience for the year-to-date has been at the high end of our historical range, we have no reason to believe that our recent mortality experience is indicative of a trend. Turning now to our international businesses. Within our international insurance segment, Gibraltar Life's adjusted operating income was $207 million in the current quarter compared to $190 million a year ago.
Gibraltar's results for the current quarter benefited by $8 million in comparison to a year ago from translation of yen earnings at a more favorable rate, and results for the year-ago quarter benefited by $15 million from early surrenders, consistent with our expectations within the Yamato Life business that we acquired last year. We were selected by the Japanese regulators to acquire and restructure Yamato following its bankruptcy, and significant surrender charges were imposed as part of the restructuring. Stripping out currency translation and the year-ago benefit from surrender charges, Gibraltar's adjusted operating income was up by $24 million. The increase came almost entirely from a greater contribution from net investment spreads, driven by the growth of Gibraltar's fixed annuity business, as well as more favorable results from non-coupon investments in the general account.
Since Gibraltar's fixed annuities are denominated in US dollars and other non-Japanese currencies, we can offer attractive crediting rates in comparison to the yen-based alternatives that are available in Japan. These fixed annuities have enjoyed sustained popularity in our life advisor channel as well as bank distribution, where they have opened many doors for us. Fixed annuity account values reached $6 billion at September 30th, up more than 25% from a year earlier. Sales from Gibraltar Life, based on annualized premiums in constant dollars, were $218 million in the current quarter, up by $69 million from $149 million a year ago. Bank channel sales were $89 million in the current quarter, up from $39 million a year ago. The increase was driven almost entirely by sales of life insurance protection products, which have grown sequentially in each of the last four quarters.
Sales from the life advisor channel were up by $19 million or 17% from a year ago, driven entirely by sales of life insurance protection products. Life insurance protection sales in both channels benefited from a recently introduced cancer whole life product. Our LifePlanner business reported adjusted operating income of $323 million for the current quarter, compared to $310 million a year ago. Continued business growth, mainly in Japan, was partly offset by a less favorable level of benefits and expenses, which encompasses mortality and true-ups of reserves in DAC, including the impact of our annual reviews. Sales from our LifePlanner operations, based on annualized premiums in constant dollars, were $231 million in the current quarter, up $23 million or 11% from a year ago. The increase was driven by strong sales in Japan, where we are benefiting from increased demand for protection products in the business and executive market.
International insurance sales on an all-in basis, including LifePlanners, life advisors, and the bank channel, were $449 million for the third quarter, up 26% from a year ago. The international investment segment reported adjusted operating income of $1 million for the current quarter, compared to $7 million a year ago. Corporate and other operations reported a loss of $260 million for the current quarter compared to a $203 million loss a year ago. The loss we report for corporate and other operations is primarily driven by interest expense net of investment income. These net financing costs increased from a year ago, mainly due to higher capital debt. Current quarter expenses within corporate and other were higher than a year ago. These expenses reflect some nonlinear items such as corporate advertising and benefit plans.
The increase in net financing costs and expenses was partly offset by a $13 million improvement in results from our real estate and relocation business, which earned $19 million in the current quarter. Briefly on the closed block business. The results of the closed block business are associated with our Class B stock. The closed block business reported net income of $77 million for the current quarter, compared to a net loss of $8 million a year ago. The current quarter results reflect $65 million of pre-tax realized investment gains, while the year-ago loss included $27 million of realized investment losses. We measure results for the closed block business only based on GAAP. Turning back to the financial services businesses. Rich will address our earnings guidance for 2011 and our ROE prospects going forward.
Let me make a few comments now on how we see our mix of businesses contributing to our targeted ROE range in the 2013 timeframe that Rich will present. We printed an ROE of about 11% for the financial services businesses for the first nine months of the year, or just under 10% after normalizing for discrete items such as unlockings. This ROE reflects both the performance of our businesses and the drag from capital capacity awaiting deployment, some of which is expected to fund our acquisition of Star Edison. We measure business and division level ROEs on an unlevered basis. Although our overall ROE has the benefit of leverage consistent with our double A ratings targets, as Rich will discuss. Our annuities, retirement, and asset management businesses account for about 40% of attributed equity for the financial services businesses as of quarter end.
After adjusting for discrete items, these businesses produced an ROE between 11% and 12% for the first nine months of the year. Looking out to 2013, we see these businesses with ROE potential in the low to mid-teens. Here are some of our considerations. In the annuity business, we are growing our book of HD products with auto-rebalancing features, migrating the overall book to a lower risk profile and greater return potential. Our product design limits the range of outcomes for both clients and the company under various market scenarios and allows for more efficient hedging than products without this type of built-in risk management. With this structure, we can offer a highly attractive value proposition with the flexibility to respond to the market by taking market share opportunistically or by adjusting prices or features when warranted.
Our retirement business is well positioned to meet the high-quality standards of plan sponsors. Given our existing scale, new full-service business with stable value balances and asset management opportunities can produce marginal returns in the mid-teens. While RFP activity has been slow in recent periods, given market distractions due to healthcare reform and general economic conditions, we have enjoyed strong full service persistency and positive net flows for the past 12 quarters, we believe that we are in a good competitive position as attractive cases in our target markets go out to bid. Asset management returns have been improving. This business produces a baseline of earnings from asset management activities with typical margins of 20%-30% on annual revenues of more than $1 billion, as well as results from what we call ITPICUM, incentive, transaction, proprietary investing, and commercial mortgage activities, which vary with market cycles.
Strong institutional asset flows, especially from pension fund clients who in some instances are combining our asset management services with risk management solutions offered by Prudential Retirement, have driven sustained growth in our base of asset management fees. The contribution of ITPICUM, the variable portion to reported asset management results for the first nine months of the year, was modest. While we expect a greater contribution from these activities, the majority of growth in asset management is expected to come from an increasing base of core asset management revenues. Our U.S. protection businesses, individual life and group insurance, account for about 15% of attributed equity as of September 30th. These businesses balance the risks of our more market-sensitive businesses and generate strong cash flows that contribute to our financial flexibility.
After adjusting for discrete items, these businesses produced an ROE between 10% and 11% for the first nine months of the year. This return is below historical levels, reflecting an adverse swing in group insurance claims. Looking forward, we would expect returns ranging up to the low teens. Our international insurance business accounted for about 30% of attributed equity as of September 30th. For the first nine months of the year, ROE was roughly 20%, in line with our historical performance. Our basic strategies in this business are unchanged. Our distinctive life planner business model is driven by needs-based selling by a full-time, highly selective, college-educated sales force, emphasizing protection products, resulting in superior agent productivity and retention, superior policy persistency, and superior returns. We adapted key elements of this model to Gibraltar Life as part of a highly successful business integration.
Gibraltar benefits from an association relationship in place for more than half a century that provides access to the education market in Japan. Gibraltar has also served as our platform for bank distribution, where we're seeing strong sales growth based largely on protection products. We see a major opportunity in the retirement market in Japan, driven by an aging Japanese population and increased emphasis on individual responsibility for retirement security, coupled with an estimated $8 trillion of funds invested in low-yielding bank deposits and postal savings. The lifelong relationships established by our life planners as trusted advisors to their clients, our relationship with the Japanese Teachers Association, and our expanding footprint in bank distribution give us substantial competitive advantage in this highly attractive market.
Retirement and savings products, including fixed annuities and policies that combine premature death protection, retirement accumulation, and income features, are already contributing meaningfully to our sales mix. With the addition of Star Edison, we will expand our commitment to the Japanese insurance market. On a pro forma basis at September 30th, the addition of Star and Edison would increase the percentage of our attributed equity in international insurance from about 30% to roughly 40%, with a corresponding reduction in corporate and other attributed equity. Our ROE for the first nine months of 2010 reflects a negligible return on approximately $1 billion of on-balance sheet capital within corporate and other, which will finance a portion of the Star Edison acquisition.
After the integration is complete, we expect the acquired business to produce returns in excess of 12% on an unlevered basis and in excess of 15%, including the effect of leverage in our financing of the transaction, with our expected returns driven almost entirely by the in-force block of business and cost saves that we expect to achieve. I'll turn it over to Rich to work through guidance.
Thanks, Mark. I'm going to start the presentation on slide six. Let me give you a moment to flip to that on your screens. Its title is Assumption for 2010 Outlook. 2011 earnings are dependent on several factors, which are summarized on the slide. The starting point, as always, is 2010 baseline earnings, to which we add 2011 business growth. Next, where is the S&P going to begin, and where is it going to end? For planning purposes, this is not a prediction, we assume the S&P ends the year at 1,170, grows at 8% in 2011, and averages 1,220 for the year. FX will contribute about 1% to growth in 2011, and that is net, as the JPY is stronger and the KRW is weaker. You know they're all hedged for the year.
Our tax rate is up a bit from 26%-27%, and that's consistent with the increase in our pre-tax income. Our liquidity cushion remains at $1 billion. For now, we will likely retain $2 billion-$2.5 billion of on-balance sheet capital capacity during 2011 as financial flexibility to support additional business growth, take advantage of market opportunities, and as a buffer against stress conditions. Our 2011 EPS reflects the impact of the additional shares and debt issuance to finance the Star Edison acquisition. The dilution from the new shares has an outsized impact on 2011 EPS, because eight months of 2011 earnings from the acquired businesses are entirely offset by the sum of the integration costs and 12 months' worth of financing costs.
Due to the strong third quarter and our revised capital projections for 2010, which you will see later on, we've reduced the anticipated capital raise from $1.3 billion of equity and $1.2 billion of debt to $1 billion each. That's $1 billion of equity, $1 billion of debt. This increases the accretion in 2012 to 7% from a little over 5% that we had mentioned to you previously, and increases EPS in dollar terms from $0.40 to $0.50 at that same point in time. Our guidance considers the consideration of the current low interest rate environment, which decreases spread earnings by about $20 million in 2011, as well as pension income by approximately $70 million. The pension income decrease is due to the reduction in the expected return on the plan assets and a lower discount rate used to determine the pension liability.
The modest short-term impact of the low interest rate environment on our earnings is reflective of our business mix, which is different from most of our peers. First, almost 50% of our earnings comes from Japan, where we have been operating profitably in a low interest rate environment for over a decade. In addition, our domestic businesses do not rely heavily on spread lending as a source of their earnings. Finally, our investment management business has benefited from the low interest rate environment due to our large book of fixed income and real estate funds, which have appreciated in value and seen steady net inflows. Let's move to slide seven. That's titled 2011 FSB earnings guidance. Slide seven shows several EPS results driven by the items I just mentioned, as well as some alternative EPS views for your evaluation.
I know you've had the slides for a few hours now, but let's walk through the components from left to right, and I think it would be helpful, despite the fact you've had them for a few hours, not to read ahead as I go through the slides. Reported 2010 EPS is projected to be $5.80 to $5.90 per share. Adjusted for unusual and non-recurring items, we estimate baseline 2010 at between $5.35 to $5.45. The financial service businesses, the FSB businesses, are expected to grow at mid-teens, offset by corporate and other expenses, which I'll talk about in a moment. The projected growth in the U.S. business is driven by continued strong sales, market appreciation, and more normal claims experience in our U.S. life businesses. International's projected growth is driven by continued solid sales and expanded distribution through banks.
The corporate and other loss is expected to increase about $100 million from the reduction in pension income and increased employee benefits. I understand from Eric that there were several questions last night around corporate and other. Our best estimate today is to use a quarterly run rate for 2011 at around $240 million a quarter, and the bump up is mostly driven, or almost all driven, by the items I just mentioned for the pension and other employee benefit costs. If we stopped here on the slide, before the Star Edison acquisition, EPS would be $5.85 to $6.25 a share. This is the most comparable number to the 2010 baseline of $5.35 to $5.45. Neither have the additional share issuances, and both reflect a somewhat normalized view of AOI on a consistent basis. The next four boxes break down the impact of Star Edison on 2011 earnings.
First, we add a full year's earnings for Star Edison, net of the impact of financing costs. That's 12 months worth of financing costs, as well as the dilution from the share issuance. That hasn't appeared yet on the slide until this point. The result is 2011 EPS of $6.15-$6.55 per share with Star Edison and the shares outstanding, but excluding integration costs, is $6.15-$6.55. Next, we adjust this 2011 view to include only eight months of ownership of Star Edison, because that's our estimated timing of the closing. We take out roughly four months. Finally, we deduct the 2011 integration cost, you get 2011 guidance for the financial services business on an AOI basis of $5.60-$6 per share.
Okay, on to slide eight. That is titled "2010 Capital and Liquidity Projection." Once again, I'll just talk a little bit while you orient yourself to the slide, you get it on your screen. Slide eight begins the discussion of capital and potential ROE and ties to some of Mark's comments. As you've seen from past presentations on capital and liquidity, we determine on-balance-sheet capital capacity by comparing on-balance-sheet capital, actual on-balance-sheet capital, which is the sum of common equity, capital debt, and hybrids to required capital. You see here on slide eight, total capital outstanding, the sum of those items at 12/31/10 before financing the Star Edison acquisition, is projected to be $37.2, as compared to required capital of $37.7-$33.2. That leaves $4 billion-$4.5 billion of projected available capital at 12/31/10 prior to the acquisition. The acquisition adds $4.2 billion to required capital.
$2.2 billion will be financed using our existing on-balance-sheet capital capacity. The remaining capital need of $2 billion will be raised in the capital markets, split evenly between debt and equity, as I mentioned earlier. After the acquisition, now I'm in the right-hand column now. After the acquisition, the pro forma debt to the capital ratio is 24%, which is slightly below our 25% target for financial leverage. RBC and solvency ratios are well within their expected double A standards, cash at 12/31/10, again, after the acquisition, is expected to be in the range of $2.5 billion-$3 billion. Of course, that includes the $1 billion cash cushion. On to slide nine, Considerations for Long-Term ROE. This is a pretty dense slide, I want to walk you through it, as I'm sure you've already attempted yourselves.
Slide nine lists the areas we need to consider when thinking about our ROE. Our businesses have higher potential ROEs than experienced in 2010, which are still negatively impacted by the financial crisis. I will review this potential on the next slide. New business growth is expected to be generated at higher margins. We've again assumed an S&P growth of 8% over the multi-year plan period and expect significant capital capacity to emerge from 2010-2013. We have also assumed that this capital will be retained on balance sheet, the amount in excess of $2 billion. This is important. I'm going to repeat this. We have also assumed that this capital capacity will be retained on balance sheet, the amount in excess of $2 billion is invested at a 12% return within the company. This is a simplifying assumption and not the likely outcome.
I will contrast this capital assumption and outcome with buybacks and an acquisition scenario later. Leverage is maintained around 25% over the multi-year period. We've assumed the current forward curve for interest rates. Our foreign exchange assumption are the JPY will be 82. We'll be translating earnings at the out year 2013 with the JPY at 82 and the KRW at 1,190. Lastly, while reg reform is very much up in the air, we don't see it as having a meaningful impact on our ROE expectations at this time. Slide 10, titled "Superior Mix of High-Quality Businesses." Slide 10 provides the detail and is a roadmap to the ROE potential of the company. It would be helpful if we walk through the slide content before launching into the messages.
The box on the top left shows the projected consolidated levered ROE for the financial services business in 2010. The box on the top right shows 2013 FSB potential levered ROE. The box in the middle at the top reflects the total projected equity capital used by the business segments at 12/31/2010. The pie chart shows the relative proportions of our projected equity capital, again, used by the businesses as of 12/31/2010, post the Star Edison acquisition. Now the Star Edison capital is now sitting in the international blue piece of the pie. The boxes on the left of the pie chart show the baseline unlevered ROE ranges for 2010 for each of the business groupings, while the boxes on the right of the pie chart show the unlevered ROE potential for the business groupings in 2013.
These ROEs are based on the FSB's consolidated effective tax rate applicable to AOI. The annuities, retirement, and asset management businesses are projected to have an average ROE in the range of 11%-12% in 2010. Their ROE potential for 2013 is projected at 14%-15%. The improvement is driven by lower capital needs, higher margins, the elimination of certain earnings drags, and increased fees in our core asset management businesses. For group and individual life, ROE in 2010 is projected to be in the range of 10%-11%. The ROE potential of this business grouping in 2013 is 12%-13%, driven primarily by a return to normal claims experience.
International's ROE for 2010 is projected in the range of 19%-20%. Their ROE potential for 2013 is projected to be in the 17%-18% range, driven by the acquisition, business growth, and continued capital distributions back to the U.S. 2013 ROE does not reflect the full ROE potential for the Star Edison acquisition, which I will review on the next slide. On to slide 11. Okay. That should be titled Business Plan for ROE Growth 2010 to 2013. Slide 11 illustrates the impact of most of what I just said, hopefully all of what I just said. 2010 is expected to deliver an ROE of around 10% based on the baseline earnings.
Realization of the 2013 ROE potential of our businesses will drive the ROE higher, partially offset by that assumption on the return on the capital capacity during the period that is invested at 12% after-tax, resulting in a potential ROE of 13%-14%. I referenced this earlier, redeploying our capital in share repurchases, and that's the capital above the $2 billion that I had mentioned earlier was not invested at the 12% return. Let me try that again. Redeploying our capital in share repurchases or in an acquisition at an APE versus that 12% after-tax investment assumption, would still result in an ROE for 2013 in this range. Finally, on the slide. We show the glide path of the Star Edison ROE potential in the multi-year plan period, reaching its full run rate of approximately 15%, and that is on a levered basis by 2013.
What I mean by a levered basis is it is simply the capital structure of the company imposed on the acquisition throughout that time horizon. John?
Thank you, Rich. As Mark and Rich have described, Prudential has been steadily and consistently gaining ground through this period of financial and economic challenges. Looking down the road, we are confident that we will achieve the 13%-14% ROE objective for 2013 that Rich has shared with you. Our businesses operate in attractive markets. They are highly competitive. They are well-led, and collectively, they make up a very attractive portfolio, a portfolio with both growth prospects and downside protection. In addition, effective capital management remains an important lever. We believe we have shown we have the skills to identify attractive properties, to acquire on favorable terms, and to integrate successfully. We believe our just-announced acquisition of Star Edison Insurance Companies fulfills the criteria of a successful deal. We expect Star Edison to contribute an ROE in 2013 that is compatible with our corporate goal for that year.
We consider this to be an excellent financial result, especially considering our confidence in achieving the expense savings that drive our expected returns. As those saves are more fully achieved over time, Star Edison's ROE will further increase. Star Edison also has significant benefits that we have not attributed to its financial results. First, Star Edison significantly broadens and deepens our distribution in captive agency and bank distribution in Japan while adding a substantial independent agency channel. Although we expect to generate meaningful sales from this distribution, our purchase price attributed almost no value to new business. On the contrary, the value of the in-force block we are acquiring, as well as the expense savings we expect to achieve, support virtually the entire price we are paying. That's why we expect to record almost no goodwill from this transaction.
Second, product manufacturing and administration of our Japanese insurance companies are increasingly done from common platforms. That means the benefit of greater scale will accrue to Prudential Japan and to Gibraltar and not just to Star Edison, leading to enhanced margins across the board. Finally, Star Edison is expected to improve both the amount and diversity of cash flow to our parent company to support shareholder dividends, potential acquisitions, and other activities. Star Edison builds upon our success in Japan, making our business there even stronger, and from an enterprise context, represents a very positive enhancement to our overall portfolio. As I close the portion of this meeting that has been dedicated to our prepared remarks, I want to provide some broad context to a call whose content has straddled both current and longer-term strategic issues.
We have been consistent in our focus on maintaining an attractive mix of very good businesses with the earnings power to produce superior returns with above-average consistency. Our successful execution has put our businesses in leadership positions in our chosen markets, as evidenced by gains in sales and flows, business momentum is strong. We are very well positioned to serve the attractive broad markets for retirement accumulation and income products in the U.S. and Japan. The multiple dimensions of Prudential provide valuable and high-quality diversification, whether it's distribution channels, geographies, business models, risk and profit drivers, and market focus. Mixed together, it's very attractive. Our capital, liquidity, and investment portfolio provide strength and flexibility. Finally, our seasoned management team has proven execution skills as operators, innovators, acquirers, and leaders. With that, I'll stop. We appreciate your interest in Prudential, we now welcome your questions.
Thank you. Ladies and gentlemen, if you wish to ask a question, please press star followed by one on your touch-tone phone. You will hear a tone indicating that you have been placed in queue. You may remove yourself from queue by pressing the pound key. If you are using a speakerphone, please pick up your handset before pressing the numbers. Once again, press star and then one for your questions or comments. Our first question will come from the line of Andrew Kligerman from UBS. Your line is open.
Great. Rich, could you just come back and just before I ask my questions, clarify what that $2 billion was that you were talking about? Is that excess capital that you plan to invest at a 12% return, whether that be investments, buyback, et cetera? What exactly was that $2 billion?
Okay, Andrew. During the multi-year plan, well, right now, you've seen on the balance sheet on that slide that listed all of our capital, our capital position. You saw after the Star Edison acquisition, we had about $1.8 billion-$2.3 billion of capital capacity or available capital capacity. My remarks during the projected period were that from 2011 through 2013, that number would grow significantly. The assumption in the multi-year ROE projection is that the excess capital or the capital above that $2 billion number will be invested at a 12% return, and that $2 billion number will be sitting at sort of a short-term bond rate or embedded in the general account but not delivering a 12% return. It's the capital above that that will deliver the 12% return.
Okay. No way that's ever going to deliver above 12% because you need it there, right?
Say that again.
The money below the $2 billion base will never get above 12% because you need to have it in fully liquid securities, et cetera.
I wouldn't say never.
Okay.
I wouldn't say never, I wouldn't say it's always going to be $2 billion. It's a planning assumption for the multi-year period.
Got it.
Yeah, Andrew, you should think of that as a conservative baseline assumption and not something that's cast in stone with respect to a target. Also don't link it too closely to being held in very low yielding liquid assets.
Great. One other.
That's kind of a broad 40,000 foot sort of normal piece of capital that sits there.
Helpful. Just one other. Where would RBC be post the close of the capital raise and the Star Edison transaction? Where do you expect that?
RBC is still going to be over 400.
Over 400. Okay. Any plans to, if you do a buyback, when might you be positioned to start doing that? Would that have to be an O12 event at the earliest?
Well, Andrew, the plans that we'll be making for the excess capital that we're going to generate, that we already have and will subsequently generate are things that we'll talk about as we go forward.
Okay. Just in terms of the acquisition, I noticed that Gibraltar saw a decline in advisors from 6,100 to 5,900 sequentially. Maybe a little color around that. As you're integrating Star Edison, is that going to put more pressure on your advisor count and your ability to grow Gibraltar just because there's so much going on with this new acquisition?
Yeah, Andrew, this is Ed Baird.
The numbers on the Gibraltar Life Advisor, as you've seen historically over the quarters of the last few years, tend to bounce around for all kinds of reasons. It has to do with the timing of recruiting cycles, those kinds of things. You'll also recall that, frankly, we focus less on the firm number than we do on the quality of the recruits themselves, which is one of the reasons you'll always see that kind of fluctuation. As far as the impact of the acquisitions of Star Edison, I think longer term, it's more likely to have a positive than a negative impact. In the immediate short term, you're probably right in terms of distraction of management capacity.
Longer term, what we're seeing already are early signs that these acquisitions, which are being highly publicized, are adding to the credibility and are in effect, almost a form of advertising for the organization. While in the short term, yes, there could be some distractive factor, I think in the medium to long term, it's much more likely to be beneficial.
Super. Thanks a lot.
Sure.
Thank you. Our next question comes from the line of Nigel Dally from Morgan Stanley. Your line is open.
Great, thanks. First question just gets on slide 11. You lay out the three different buckets kind of driving the ROE improvement. I think we've got the Star Edison numbers, how much accretion they have provided. Is it possible to break apart sort of how much is coming from organic business mix versus the capital generation and deployment? Second, just to follow up on the previous question about the capital buffer, you mentioned the potential for that to decline going forward. What would you need to see in order to be comfortable in reducing down that buffer? Thanks.
Let me address the second question first, and then I'll hand it over to Rich. Excuse me. In terms of the $2 billion assumption, we've characterized our thoughts on capital around three considerations. One is broadly mixing offense and defense and watching the environment, making sure that we're careful and we're well protected in the possibility of another round of stress with respect to the markets or the business. The comfort level with respect to that dimension would matter. The second thing that we've focused on under the offense category is the growth potential in our businesses. As we've commented on now for five or six earnings calls, we continue to experience very good sales results and very good flows. The opportunities to deploy capital organically remain pretty attractive.
The third influence on that consideration is the external market environment as it relates to possible acquisition opportunities or other discrete applications or deployments of capital into the market beyond our normal organic capacity. We'll continue to weigh all three of those factors, the offense-defense mix, the organic growth opportunities, which we think are considerable and attractive, and the possibility of an opportunity in the market to put more capital to work through some sort of a non-organic transaction. You want to think about that $2 billion as representing upside. In the sense that the way you worded the question, as we go through time and things become clearer with respect to any of the three elements that I talked about, you want to think about that $2 billion as representing upside.
Nigel, this is Rich. I'm looking now at slide 11. Your question relates to that blue box on the left, capital generation and deployment. Okay. Our assumption in this ROE progression is that available capital in excess of the $2 billion that Mark just talked about is reinvested over this time horizon at a 12% after-tax return. There's a 12% impact in the numerator, in earnings of that capital that's being generated over this three-year time horizon. I think it's important to know that is pretty neutral assumption to buybacks and to an acquisition in APE. If we took that same capital, and I can't tell you what it is, in a buyback or in an acquisition in APE, or it was invested in the balance sheet in our businesses.
This is the capital above the $2 billion. This is important. At 12%, you would see an ROE in 2013 of 13%-14%.
This is John. Nigel, just to add one other thought to that, to, I think, an aspect of your question. Most of this growth is attributable to the organic progress of the business, not to the excess capital. Within organic, most of that progress is not about the S&P, it is about strong fundamentals, sales and flows, and the like. That we think is a particularly strong underpinning to this outlook.
Okay.
Maybe just one elaboration on the arithmetic that is in this. As you heard in my comments, the incremental return opportunities in several of our businesses related to organic growth are higher than 12%. As Rich characterized that as a neutral assumption, it is. In fact, with respect to the businesses that I highlighted in my comments on ROE emergence, we have opportunities better than 12%.
Okay. That is very clear. I guess.
That's a neutral assumption.
Yeah.
That's very clear. I guess I was just trying to work out how much capital generation we would have over the next three years beyond what you see being absorbed by your strong organic growth opportunities.
Yeah. Nigel, that's not something I think we're prepared to discuss.
As Mark mentioned, and as John mentioned, it's not the lion's share of that ROE progression.
Okay. Fair enough.
It's neutral to dilutive to getting to the 13%-14%.
Okay, got it. Thanks.
Whatever capital generation is coming out of our multi-year plan is reflected in the numbers that Rich talked about. It's all in there.
Our next question will come from the line of Mark Finkelstein with Macquarie. Your line is open.
Okay. I've got a few here. I guess just one follow-up to that. Maybe I'll take a stab at it this way. Historically, you've kind of suggested that a 60% ratio of free cash flow to operating. Is that a baseline number we should continue to use? What would that change by?
You're correct in your prior assumption. Right now, I think we're using that 50/50. 50% is going to be plowed back into the businesses and used for dividends, the other 50% may arise as available capital.
Okay. I guess if you're going to be $1.8 billion-$2.3 billion of capital margin following the deal, you're kind of targeting a, was it 2-2.5 level? I guess, should we be assuming some capital management in 2011, is that baked into guidance?
We're not targeting 2-2.5. We will have 1.8-2.3 after the Star Edison acquisition, and where that bounces around during the year will depend upon sales, business growth, and capital generation. I wouldn't get too obsessed with the 2-2.5. I think the best way to understand it is we think that that's sort of where we're going to be throughout the year.
Okay.
I would add again that there is probably upside in that as well.
Okay. All right. Can we just talk about the VA commentary around a change in the hedging strategy? I guess, just thinking about the sales that you generated in the quarter, where we are from an interest rate standpoint, knowing that really the hedging costs in this product are largely interest rate related because a lot of the equity stuff gets adjusted for under auto-rebalancing. How should we think about the margin on new sales in the context, I guess, of the adjusted hedging strategy, and how do they compare to kind of targeted levels?
Mark, it's Bernard Winograd. I would return to the comment I made at the last quarter, which is the product cycles here are pretty short, but sometimes they're a little too long in the sense that you can have significant moves in the markets that put you above or below what your expected return is on the long term, which is how we think about it and how we price. We have to react to that, of course, and we will, and we in the normal course of the product cycle of the business. You can certainly have periods like this where things like the current environment that are outside what you would have anticipated. The hedging strategy change is only indirectly associated with this.
In the sense that we take a view of the degree of logic that is embedded in a strict market neutral calculation of our approach to hedging. When it's completely illogical as it can be when interest rates are either very high or very low, we're going to step away from that. Once you say that's how you're thinking about it, then you also have the accounting consequences. It's not a driver of the pricing decision.
Okay. I guess, let me ask a follow-up. I'm not sure I followed all of that. My understanding is you kind of hedge to a certain assumed yield, and you lock that hedge in on day one, which can lock in various returns across vintages of business. You kind of set that return early, and you kind of go long on your interest rate hedges. I guess, wouldn't that suggest that I guess the question is that correct, yes or no? Then secondly, I guess just going back to my original question is, if I'm going to change my hedging strategy even with lower hedging costs, if that's correct, are we or are we not kind of with our targeted margins?
It's Mark. Let me make a couple of comments on the way you're approaching this. In terms of the broad view of hedging and the change that we've made. What we've done is basically taken the same framework, the same fundamental approach, but applied to the metrics somewhat more realistic economic assumptions. That relates to the comments that I made about the use of risk-free rates for asset accumulation results as well as discounting cash flows that are far in the future.
You should think about what we're working with is a reference point that we've defined that's more or less constructed the same way, but in fact, in the current environment, scaled down Relative to the GAAP liability because of the use of somewhat more realistic, but still what I think almost anyone would consider to be very conservative market type assumptions that drive the conclusion about the value. At this level of rates, we believe that the calculation according to GAAP substantially overstates the liability. At this level of rates, we also believe that movements in rates, changes in rates, generate larger changes in the value of the liability than are reflective of the actual underlying economics.
Again, we've defined a reference point that, in this current environment, is basically a scaled-down version of the definition of the liability and the changes in the liability as rates change from this very low level. As a result of that, in terms of the pure GAAP liability, for example, we will benefit as rates go up. To think about your question of having locked-in returns, with respect to the GAAP liability and ultimate GAAP results, we haven't. We have some exposure there because there is now a difference between the economics of our hedging and the GAAP-reported liability, and in any particular period, changes in that liability that might go through the income statement. We think as a result of this, we can manage more effectively over time as rates change, and also as we employ more realistic interest rate assumptions to achieve our margin objectives.
Having said that, part of what you're saying is right, which is that interest rates are locked in when we book the product. As Bernard has said in the past, that at this point in the cycle, we're not achieving necessarily upfront the return objectives that we expect to achieve over time.
Okay. All right, thank you.
Is that helpful?
Yeah, it is.
Thank you. Our next question will come from the line of Thomas Gallagher with Credit Suisse. Your line is open.
Hi, I have several questions, so I'll just ask them one at a time. First, I wanted to follow up on the one Mark was getting at. The first part of it is on the variable annuity side. Do you still have the macro hedge in place, which I guess you would consider a capital hedge, and if so, is that being attributed back to the ROE in the variable annuity business when you consider defining ROEs?
Just to refresh your memory, for a while, we had on what we described as a plain vanilla short that was carried as and characterized as a macro hedge within the annuity business. We don't have that hedge on anymore. We've replaced it with a somewhat scaled-down version of a highly structured trade that will get very interesting if the S&P gets back down in the 600-700 range, but is not so interesting at this level of the S&P. The amortization of the cost of that is not in the annuity business anymore. It's in corporate and other. It is a more general capital macro hedge. At the current level of the market, you ought to consider it to be irrelevant. Again, it'll get very interesting at very low levels of the market, but around this level, it doesn't matter.
the actual results of the hedge are also not in the ROE of the annuities business.
Yeah, both parts of that. The results of that hedge and the amortization of the costs are now outside the annuity business.
Okay.
It's immaterial.
I guess, if the amortization of the cost of that, Mark, is material, and I'm not sure what that number is.
It's a premium. It's the amortization of a premium.
If the amortization of the premium of the option is a meaningful number, shouldn't that be directly tied back to the annuity business since that's the reason you have it in the first place?
It's Rich. It's not a meaningful number, Tom, number 1, because it's so far out of the money, it's relatively cheap to put it on, because it doesn't really, as Mark puts it, become interesting until the S&P hits 800. That's number 1. Two, it's more of a capital hedge across the company. When we put this in place, it's not just for the S&P. There are other things that we think about when we're trying to protect the capital of the company. The bottom line is, it's really small.
Okay. Is it rich?
Right. We're amortizing the premium here. Really, the mark to market of this thing can only be on the upside because we're writing off the premium because it's a purchased option.
Right. I guess my point simply, I hear your point, and I suppose the answer is the ROE within the variable annuity business, if you did ascribe the premium, would not meaningfully change. Is that a fair to say?
It would not, Tom. Thomas, $4 million a quarter. Come on, it's a very small number.
Okay, that's helpful.
The other thing is you'd have to reduce equity because you'd give yourself credit for having the hedge. The ROE might go up.
Okay. No, it's helpful to get the number to put it in context. The next question I had is, I'm focusing on this because this is your biggest ROE delta when I look at 2013, the annuities retirement and asset management business. It sort of strikes me that part, tell me if you agree with this, part of the reason you're holding on to a $2 billion capital cushion is largely driven by the capital volatility within the variable annuity business, or the potential in case the market declines. Should we really be thinking about this as a business that really is more of a capital hog. Not maybe as you define it explicitly, because you're probably defining ROE as a 400 RBC.
If in practice, the reason you're really holding on to, let's say, an extra $1 billion of capital is in case the market declines, because there would be a hit to capital specifically for this business, doesn't it stand to reason that the practical ROE is materially lower? It's more of a capital hog.
Why don't I take a crack at that, then I think Mark has a couple of things he might want to add. That $2 billion is not cast in stone. It's going to ebb and flow, I think it's going to more ebb than flow. It means it should decline over time. That's one. Two, we are holding that today. It's there today. We think about it for business growth. Annuities may go the other way. They may have excess sales, we'll need to use that to fund their DAC and support the capital and the business on the growth side, not on the downside. It's there for the credit cycles that we can't predict and when they come. It's there for surplus or regulatory capital in the event we have got to put up some AATs for the interest rate environment that we face.
I guess I could take the entire amount and whack it up against every segment and reduce their ROE. I think it's also fair to say, now I'm really going to get on my skis. It's financed with debt, Thomas. It's not technically financed with equity of the company. It's debt capital.
Let me extend Rich's comments on the sort of overall stress test aspect of having that capital on the balance sheet, as well as potential other applications. In the annuity business, with the market where it is, you can't do a calculation that would tell you you need that $2 billion to support the annuity business. That's not part of any economic reality today. If you wanted to fine-tune an assessment of a capital protection strategy, given the exposure. Now let's talk about statutory capital, because that's really what we worry about if we're in a stressed environment.
Right.
If you wanted to look at how you would protect statutory capital against the real stress environment and the ultimate sort of downside tail, you would come up with a cost that's much less than the $2 billion aggregate capital cushion on the balance sheet. We can talk about this maybe offline, but if you crunched through this and looked at tail protection strategies and what it would mean for the annuity business, you wouldn't have the conclusion of a capital hog, particularly given the downside protection we get from our auto-rebalancing product features. You wouldn't have the portrayal of this as a capital hog, and you wouldn't have anything like $2 billion of raw capital on the balance sheet. You might have a structured protection strategy that would be much less expensive and effective in the range over which you need it.
Okay. No, that's very helpful. If I could just squeeze in one last one on Star Edison. Rich, I guess this is directed for you. Just when you gave out the original way of looking at the deal, we had that $500 million purchase GAAP accounting adjustment, even if I overlay the expected cost synergies, what you're paying is something like a 10.5 PE, and that's using the purchase GAAP accounting adjustments. How do you guys think about that economically? I assume, and I know you talked about the $300 million adjustment that you're actually going to get back in cash over time. Do you view it as economically you paid actually a much lower PE than 10.5 times when you think about it on a cash flow basis?
Well, we've got the CFO of the international businesses here, Ken Tanji. He worked on the deal. Let me have him take a crack at that since I didn't do such a good job the last time.
Yes. Just to go over the reduction in earnings real briefly. There are three primary components of why our reported earnings on an accounting basis will be less than AIG reported historically. Two have to do with purely accounting. Purchase accounting requires that we value the business, both the assets and liabilities at current rates. On the investment portfolio, it'll have a mark-to-market premium because the coupons of that portfolio are above today's level of rates. That higher stride value will lower our reported investment income, lower than reported by AIG. Again, the cash flow remains unchanged. That's about $300 million of the reduction. The other accounting difference is really about expense recognition timing. We will record certain acquisition costs earlier than they did historically. Again, non-cash, having to do with accounting timing, and that's about another $100 million.
The last of the three components is our plans to de-risk the portfolio. We plan to lower their risk assets primarily in corporate credit, real estate, and foreign exchange risks. That's about another $100 million reduction. Most importantly, that will reduce our risk and our capital volatility.
When looking at this deal, we were really focused on the cash flows. Again, the cash flows of this business remain very strong and will be strengthened by our synergy opportunity. We expect distributable cash flows to run about $400 million, and you can think of that as about 100% of our expected after-tax GAAP earnings. We think that's a strong cash flow picture and a strong payout ratio. That's what we were thinking about in terms of the accounting and the cash flows.
Tom, let me just add one thing to that and maybe really address your question. We could agree to disagree on this because of timing, but those cash flows that Ken is talking about are constantly reducing the investment in that company. When we look at the 5-year time horizon and reduce that investment by those healthy cash flows, because we're not needing to fund new business. They will be writing some business. As Ken mentioned, 100% of their earnings is coming back to us. New businesses must be funded internally with capital generation. We're taking down that purchase price. As we take down that purchase price, by the time all the dealing is done and the synergies are out, we're looking at it in the range of an 8 multiple, because we're looking at it as an unlevered 12% ROE.
That's, I think, the disconnect between you and I on this. It's a timing thing. We're not going to see it until all, as I said, the dealing is done. That cash flow is the critical point here. It's constantly paying down the investment.
Got it. Okay. That was helpful. Thanks.
Tom, maybe one more comment on something that you'll identify with, which is we paid about 80% of the appraisal value at a 12% discount rate for this. Bridging that to the ROE outcome that we think is very attractive, even with purchase accounting and everything else in it a few years down the road, is kind of the connection between the upfront economics, and again, at a 12% discount rate, that's probably a pretty healthy discount rate to apply to these cash flows. Paying 80% of that appraisal value is real value. Then as you see it play out in our ROE discussion, that this will make a meaningful and attractive contribution.
I've seen too many numbers to comment on your PE arithmetic, but we like where this goes on a GAAP basis, all in, and we also like the upfront economics as reflected in the ability to generate cash, but also maybe more concisely as reflected in what we paid versus a 12% appraisal.
Got it. Thanks.
Thank you. Our next question comes from the line of David Haas with Level Global Investors. Your line is open.
Hi, guys. Can you hear me?
Hi, David.
Thanks. Just a real simple question. Just thinking about the target ROE and where book is today, sort of flowing numbers forward. If I just take consensus earnings numbers, back out the dividend, assume no major losses in your business, your book goes from around $58, $59 ex-BAS this quarter to something around a mid-$70s at the end of 2013. If I just simply apply a 13% ROE off of the average book values over the next few years, recognizing that the world changes, if I just do that, you're looking at an EPS number somewhere in the mid-$9s for 2013, which is about a 22%-24% CAGR EPS from the midpoint of your actual guidance for 2011, including eight months of Star Edison.
I guess the real question, it gets back to either capital usage or where the juice is coming from in terms of growth. It seems like there would be significant EPS growth from end of 2011 to end of 2013. I was just wondering if you could break that out, where you thought that came organically or versus capital usage.
David, I'm afraid you're on your own with that calculation.
Okay.
You want to ask another question?
No, that's it.
Thank you. Our next question will come from the line of Eric Berg with Barclays Capital. Your line is open.
Thanks very much. Good afternoon to everyone. Two questions. First, getting back to the whole decision to sort of change the definition of operating earnings and to, importantly, change your hedge. By, in effect, driving a wedge between the accounting and the economics so as to create better alignment now than would otherwise have been the case between your hedge and the economics. Are you also creating a situation in which your book value will become more volatile than would otherwise? It's going to be moving around a lot more because you're going to be getting an accounting result that will not be offset by the hedge to the same degree that would have been the case if you had stuck with your old approach. I know that was a lot, but I'm hoping you're able to follow what I'm saying. I'd be pleased to say it again.
Well, thanks, Mark. The short answer to a lot is yes.
Okay.
Let me just qualify it. The volatility piece that you're talking about will be scaled down considerably in what you might think of as a more normal rate environment. The things that drive the difference between the economics and the accounting right now, I don't want to get too elaborate. The things that drive that difference have a lot of convexity. If you think about interest rates, for example, returning to even somewhat more normal levels from what looked to be extraordinarily low levels, those differences will get smaller and smaller. The answer is yes, but it's to some extent driven by the environment that we're in. They are more volatile in this neighborhood than they will be in an environment that you might think of as more normal.
Okay. That's helpful, and I follow the spirit of your comment. My second question, it certainly relates to the future of profitability in the annuity business. I certainly heard Eric's answer to the question from David, that you're not going to get into sort of where the organic growth comes from. With respect to the annuity business, I still want to ask this question and see whether you can say something. You're a huge annuity company already. I don't recall the exact number of the AUM, but you already have a huge business. Why does the annuity business not only generate more profits? I don't doubt for a minute that you can become a bigger annuity company. Why does profitability in the annuity business, and by profitability, I don't mean dollar profits, I mean ROE.
Why does an already highly profitable annuity company, or a very large one, why does it get even more profitable if you already have scale in the business?
Eric, it's Bernard Winograd. I think the answer to that is that we do feel that we have, through our product design, a competitive, sustainable advantage here. That scale is modestly helpful, but it's really driven by the product design. The auto-rebalancing feature, which shifts so much of the cost and therefore the risk out of our economics, compared to what we see in the competitive universe, means that we feel like we can either take market, as Mark said, either take market share or margin sort of at will, in the business. We can't predict the exact shape of the competitive response this will ultimately call out, although it hasn't created an on-point competitive response yet.
As long as we're the only people out there selling something that works for both the customer and the manufacturer and the distributor, it's going to continue to grow.
If I could just interject.
I'll just add one more thing.
Sure.
I do think that we will reach a practical limit as to our penetration of distribution channels that we haven't reached in the past couple of years. That is, when we started this, so to speak, we had a fairly dominant position in the independent broker-dealer channel, but we didn't have that significant penetration in either the bank or the warehouse world, and that ramp up will at some point have to flatten out. We're just not there yet.
Is the point here, too, that if we think of you're having sort of a variable annuity factory, variable annuity back office, that you can add, I'm surmising that you can add substantial assets, business, without increasing commensurately your investment in the infrastructure of this business?
That's correct. We have actually significantly increased our investment in infrastructure. We've gone from 12 servers to 24 to 36, in order to be able to process the business every night, and do all the calculations that are involved in this product. The incremental operating cost is not in any way proportionate to the incremental profit opportunity.
Thank you.
Eric, also a reminder from Mark. Prudential, along with just about everybody else that was in this business, wrote a lot of business at higher levels of the market. Remember how this was booming in 2005, 2006, and 2007.
Right.
The accounting economics of that, of the older pieces of business, have quite a lot of leverage as the market goes up from this level. We will be based on just the planning assumptions and, I guess, what seems to be coming true in the policy environment, moving through layers of business that had been booked at higher levels of the market that will kick in with respect to earnings in ways that are also going to drive those numbers to improve. That's complemented by the fact that we have been growing a lot at lower levels of the market when others weren't necessarily as active in the market.
Bernard's made the point that we attach a lot of value to being in there day in and day out and having sort of the qualitative comparison to dollar cost averaging with respect to the booking of the business. The fact that we have business that went on at much lower levels, and that as the market goes up, we'll be moving through business that went on at much higher levels, will also both contribute to the financial outcome.
Are you referring specifically, Mark, to, among other things, the release of GMDB and IB reserves?
Well, we've got all those aspects as well as the historical old Lifetime Five embedded derivative book.
Thank you.
Thank you. Our next question comes from the line of Randy Binner with Friedman Billings Ramsey Capital Markets. Your line is open.
Hi. Thanks. Just a few quick ones, I think. A follow-up for Rich. I just want to clarify with the $2 billion of on-balance sheet capacity, is that comparable to the old two to three range that you were comfortable keeping in place?
Yes, it is.
Okay, good. All right. Thanks for that. Effectively, what you're saying is you're willing to let more of the excess capital generation go to better purposes?
Yes.
Okay, very good. On interest rate sensitivity, you commented on this a little bit with the guidance. For the business that is in the U.S. general account and is subject to lower reinvestment rates, you said that the guidance was adjusted for the lower rate environment. Is there a targeted year-end 10-year Treasury yield we could think of when we think of kind of what you're budgeted to relative to the guidance?
Yes, we use the forward curve. We simply use the forward curve, the forward Treasury curve.
Okay, just follow the curve out. I was wondering if you could just expand on, in the asset management segment, are you expecting a continuation of the kind of current pickup you've had with lower rates to continue there? Is that in the guidance, or is that more of kind of a stable assumption going forward in 2011?
Well, it's Bernard again. The assumption underlying the plan is consistent, which is we've used the forward curve. That has some marginal impact on values in the accounts under management. The primary driver of growth there has much more to do with the flows and the expected flows because the world is looking for fixed income investing, and we have good track records that are winning business in that contest.
I guess, put another way, I should've been more specific. I was really thinking more about it pick-em. I guess, what would the it pick-em assumption be in the 2011 guidance?
Oh, we're not prepared to give you an assumption for the it pick-em contribution in the 2011 guidance, Randy. Sorry.
Fair enough. Just one last one. The tax rate on the guide was a little higher than we had previously modeled. Is anything changed there that's noteworthy?
It's just the proportion of permanent items to taxable income. As your permanent items become less proportional to your higher taxable income, your effective tax rate naturally rises.
That's not DRG slippage or anything like that?
No.
No, it's just more income at the basically statutory marginal rate.
Mark's right, of course.
One last one. This should help with everyone's modeling. Can you disclose, and you may not, given the kind of bar chart format in the presentation here, just the timing of how we could think about the Star Edison earnings coming in once the acquisition is closed in 2011 on a quarterly basis?
That's difficult given the integration plans that we have and the one-time costs. The pattern will be lumpy as we incur those costs. We can't break that down to a specific period.
We can't break it down by quarter. Keep in mind my earlier comments. That the eight months’ worth of earnings of Star Edison in 2011 are completely offset by the financing costs and the integration costs. Net at the end of the year, they'll be zero, and that's in the guidance. The only thing we'll be left with is the additional shares outstanding.
All right. Thank you.
Thank you. Our next question will come from the line of Chris Giovanni with Goldman Sachs. Your line is open.
Thanks so much. Two questions. One on the ROE. If we look at the baseline assumption for 2010, the ROE target for 2013, coupled with what you provided at last year's Investor Day for the 2012 target, it basically implies a 100-basis point increase in the ROE per year. I guess the first question is that the way we should be looking at the ROE progression? And at what point does that 100-basis point progression dwindle? And then when we think about the drivers for the ROE, what's the biggest lever in terms of the ROE expansion? Is it business growth, equity markets, or capital deployment?
On the first one, we've got to wait until 2011 is gone, and all that we've talked about on Star Edison is behind us. The ROE pickup from Star Edison is not going to begin until 2012 because we've got the drag of what I think repeated now twice in 2011 from the Star Edison economics. Okay?
Okay.
The biggest drivers of the ROE are actually flows, number one.
Business growth and flow.
It's really business growth.
Okay. Then just one on the variable annuity product, if we think about the HD6. Is there any talks about taking the guarantees down? The reason I ask is if we look at the market share gains you guys have had, they've been pretty significant as we've talked about, and it's really just you and one or two others that have seen this mix. Most companies have basically said, "We're comfortable with the mix that we have. We don't want to get bigger." You've seen a number of companies get out of it entirely. To me, it seems like you could reduce the benefits offered, improve your return outlook even further, and still be able to keep a pretty significant and healthy market share. Any comments around that would be helpful.
Well, I think first of all, we appreciate the advice. Secondly, we do feel, as we've said, that we have a lot of flexibility to adjust to the market and that the product cycle here gives us the opportunity to do that. With regard to whether the 6 will come down or not, I think the only thing I will say about that is that our 6 is not the same as everybody else's 6.
Because of the auto-rebalancing feature, the consequences to us of maintaining 6 are not the same as they would be to others.
Thanks. Appreciate it.
Thank you. Our next question comes from the line of John Nadel with Sterne, Agee. Your line is open.
Good afternoon, everybody. I am going to preface this one by saying this might get a little circular. If I take your assumption of the midpoint of your $5.60 to $6 for next year. Take the midpoint of $5.80, which is obviously inclusive of your one-time charges for Edison and Star. Then if I assume, based on, Rich, your comments of 50% free cash flow. If I assume 50% of that is free, and because you are already essentially at your $2 billion capital cushion, it means, I think, that you have to invest about $1.4 billion-$1.5 billion of cash during 2011 at a 12% after-tax return just to get to your $5.80, the midpoint of that guidance. Because you are telling us you are assuming you are investing above $2 billion cushion at 12% after tax.
I think it actually does, respectfully, it does require you to actually tell us whether you can be buyers of your stock during 2011, because without a buyback or an acquisition, it appears you cannot make that guidance because it is already baking in a 12% after-tax return assumption.
It is not linear. The emergence of capital is not linear. In 2011, and it is not 50/50 in 2011, including the part that is coming back from Star Edison. Star Edison is going to use a pile of its money for the one-time cost. You make a fair point. Most of the 2011 capital emergence is going to be plowed back into businesses, but there is some that will emerge, and by the end of the year, we will still have some excess capital.
I think, John, it is also fair to say, this is John, that we have not lost sight of the fact that if we do not think we can put it to work, we have got to give it back, and from a standpoint of achieving our own expectations of ourselves. We still think this remains an attractive environment prospectively in terms of potential opportunities to invest in our business beyond the outsized growth that we have achieved in some of these areas. Obviously, AIG concluded we are a very attractive counterparty to fulfill their objectives. It is possible other circumstances may arise. It is hard to predict.
Yeah.
Whether it's investing in our business and outsized growth, whether it's M&A or whether it's stock buybacks, the concept of active capital management is not lost upon us.
Okay. I understand. For sort of order of magnitude, I guess my math is probably off, but it is fair to say that some portion of your 2011 guidance for us does assume that you're deploying some excess capital, right?
Yes, it's the magnitude that I don't think we can talk about right now.
Okay.
John, directionally, in terms of how you're asking the question, I'd go back to what John said. We face the rich man's problem of generating and having capital to deploy, and we have an approach to managing capital that we believe has historically been very shareholder-friendly, but also directly supportive of high quality and attractive business initiatives, and that won't change.
Mark, you're preaching to the choir. I do fully appreciate that about Pru. I'm just getting really concerned that there's belt suspenders and everything else going on with capital cushion 400% plus. I don't know if that means 500. RBC capital creation, it seems to me Edison Star should be dividend-ing way more than $400 million annually up to the holding company. It seems to me the rating agencies or something else, whether it's interest rates or some other macro factor, has got everybody, even companies like yours who are well-positioned from a capital perspective, scared to death to start deploying it. I don't understand how long we have to wait. The S&P is at 1,200. How much longer does that have to be a noose?
Well, I will tell you that, first of all, we're on very good terms with the rating agencies. Second of all, we've scrubbed the place pretty clearly with respect to our exposures around rates and markets and credit and anything else that can happen. The positioning with respect to thinking about capital is exactly as we've portrayed it and as I discussed earlier, and as John, I think, reiterated. We have a healthy attitude about it, and we will do things to enhance the value of the company and provide an attractive investment for our shareholders.
Okay. I'll get off my soapbox.
I'd say, since last quarter, I've had the earnings call where we talked about excess capital. We've obviously taken very meaningful steps in this vis-à-vis Star Edison. Now, granted, not dollar for dollar by virtue of the way we've approached this.
Yeah
We're at it.
I understand. Last quick one for you. Obviously, the S&P can do anything between now and year-end, but as of right now, it's well above where you guys are starting your baseline off of, it sort of begs the question if we can think about what's the sensitivity of a 1% change or some way of thinking about the sensitivity to a move in the S&P above or below your assumed rate.
I think it's been our practice, John, not to give sensitivities. They're not linear. There are so many knock-on effects and other things that can happen. If the S&P ends the year higher than we thought, everything keeps going on after that under our assumptions, the 8%, we'll do a little better.
Thank you.
Thank you. Our next question will come from the line of Colin Devine with Citi. Your line is open.
Good morning. I was wondering if we could focus on a couple of things. First, actually, if we could talk a little bit about the quarter's earnings. Rich, you highlighted a bunch of one-time items, and I'm just trying to reconcile a couple of these to get to a base earnings run rate for the quarter. If I think about what happened, for example, on individual life and the DAC adjustment, you referred to it as $52 million as the benefit. And yet there's a credit showing there in the expense line for $67, which suggests to me that it's, looking at your past run rate, it's probably double that.
Are you netting the change in URR against the DAC?
I'm just going by what you've provided, Herk.
Well, maybe.
You provided $52 million.
We net the offset in URR against the DAC.
It seems to me there's probably about a $150 million swing.
No. The swing is the one that Rich shared with you, and I'd be happy to get into all the detail with you offline.
Okay. I'll enjoy that. Secondly, I'm happy to see you're able to raise a little less capital to fund Star Edison. I was wondering, Rich, if you could just walk us through. You brought in $5 billion of proceeds for the sale of the JV. Where did all of that go that in effect there's only $2.2 billion of it left that you can redeploy into Star Edison, if you can help us with that. Then for Mark, you made a comment on the call here about what happens to your variable annuity business and its ability, I guess, to generate a lot of earnings if markets rise. That seems to me that you're overlooking what if interest rates don't, and you see an uptick in utilization of the lifetime benefits on the product from clients who elect to use them for their income feature.
Perhaps you could comment on that.
Let me start, Colin. The Wachovia JV proceeds. A long time ago, in a very different time, but we contributed that JV to PICA. That bolstered the RBC of PICA, and I don't remember, by over 100 basis points. The capital benefit or the surplus benefit that PICA got was $2 billion. When we monetized that put, we got gross proceeds of $4.5 billion. We paid a bunch of taxes. I think we paid, Peter is here, we paid $700 million, $800 million in taxes. We left $2 billion in PICA because they needed that. That's in their RBC. That's sitting in their RBC in excess of 400 today. Then they dividended up about $2 billion in the first quarter of this year up to the holding company. Some of that was used to fund some other activities, and that's where the money is coming from.
Part of the money, of course, is coming from off the balance sheet to fund Star Edison. That's where it's all been used.
Yeah. The addition, of course, PICA also raised a $500 million surplus note. Is that correct?
Oh.
It's the Nippon.
Oh, yeah, sure.
Transaction.
Yeah.
Yes.
Colin, it's Mark. Reflecting consideration of the current low rate environment, we did make changes to our annuity lapse assumptions in the quarter, particularly reducing the assumed lapses. That's all reflected in the numbers that I went through. Your point's well taken. This is something to which we're sensitive, and we're paying attention to the behavioral implications of where rates are and how we should be translating that into what we're recognizing. I believe based on what I've sort of generally been paying attention to in the market, we may be toward the leading edge of addressing the persistency issues. The fact is that a higher persistency net is positive for us. That has been considered, is reflected in the adjustments that were made this quarter.
Okay. Just to clarify, have you changed your utilization assumption, point one? Point two, was there any change to your DAC amortization period such as Ameriprise did?
Well, on utilization, I guess I'm using the word lapse to reflect the business staying on the books longer. I'll let Peter talk about.
Hey, Mark.
more technical DAC issues.
Mark, utilization is not lapse, to be fair. Utilization is starting the lifetime withdrawal. That's not a lapse.
utilization. I want to-.
Colin, we do look at utilization. We did change. We were ultra-conservative, very conservative in utilization assumptions. We have taken a look at that. There has been an adjustment to the utilization pattern or rate, if you will.
Colin, on the DAC, I was a bit puzzled by some of those remarks because when you have a change in lapse, and we now think that more of our customers will remain with us over time rather than less. That shouldn't necessarily change the amortization period. In other words, we have a 25-year amortization period for DAC. Yes, there'll be more customers around for that 25 years, but we're not expecting the mortality tables to change. We've got a 25-year amortization period because we think they're not going to be with us after 25 years for other reasons, and not surrender. What we do is, we have moved some of that DAC amortization towards the back end of that 25-year period.
We're not going to extend the 25-year period without a mortality change. We did not do that. The other thing I think is important, it's our practice to have amortized at least 50% of the DAC, and Ken used to be the CFO of the annuity business, if I'm misquoting something here. It's our practice to have expense spent or written off at least 50% of the DAC before the surrender period expires.
Rich, that was very helpful. That certainly reconciles with how I thought industry practice was. Thank you.
Oh, good.
Thank you. Our final question will come from the line of Darin Arita with Deutsche Bank. Your line is open.
Thank you. Was hoping to go back to slide eight in the presentation and looking at the line on required capital, going from 2009 to 2010, pre-Star Edison, it is going up by about $3 billion. It is a 10% increase. I was wondering if you could comment on what was the drivers of growth in the required capital.
Yeah. It is going to be the annuities business and international.
Okay. As you thought about that 2013 ROE target, what was the assumed rate of growth of the required capital there?
There's no assumed growth rate. We build it up by the earnings growth rate. Each individual business has an earnings growth rate. We figure out what the regulatory capital needs are based on those growth rates. It's not an assumption. It's actually a calculation driven from their growth rates.
I guess I was just trying to reconcile the comments that the line on the net on balance sheet capital capacity would be growing, based on that, there would be an assumption in the growth rate of that required capital.
Once again, no, there's not an assumption in the growth rate of required capital. There's an assumption, or there's all a build up of all of the multi-year plans. There's a calculation of the capital needs that those plans require. Any excess is what I was assuming would be the substantial excess of available capital over the multi-year period above the $2 billion placekeeper cushion, which is, once again, it's just an assumption at this point in time, and it's going to be reevaluated every quarter.
Okay, fine. Just looking at the bottom line there, the net cash, we're ending 2010 at $4 billion-$4.5 billion, but also, adjusted for STAR and Edison, it's down by $1.5 billion. How does that reconcile with the $2.2 billion capital usage to finance this?
Oh, great question. Some of that capital is coming from our international insurance businesses in Japan, with the remainder coming from PFI, which is where you see that cash. That cash is all at PFI, of course.
Are we assuming that by including this, it frees up capital overall in Japan? Is that
It doesn't free it up. It uses it.
It uses it. It uses about $700 million that's already on the books in Japan.
I see. I understand. Got it. Thank you.
Thank you. Ladies and gentlemen, today's conference call will be available for replay after 3:00 P.M. today until midnight, November 11th. You may access the AT&T teleconference replay system by dialing 800-475-6701 and entering the access code of 144585.