Ladies and gentlemen, thank you for standing by, and welcome to the Prudential first 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 and then zero, 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, everyone. In order to help you to understand Prudential Financial, we will make some forward-looking statements in the following presentation. It is possible that actual results may differ materially from the predictions we make today. Additional information regarding factors that could cause such a difference appears in the section titled Forward-Looking Statements and Non-GAAP Measures of our earnings press release for the first quarter of 2010, which can be found on our website at www.investor.prudential.com. In addition, in managing our businesses, we use a non-GAAP measure we call adjusted operating income to measure the performance of our financial services businesses. Adjusted operating income excludes net investment gains and losses as adjusted and related charges and adjustments, as well as results from divested businesses.
Adjusted operating income also excludes recorded changes in asset values that are expected to ultimately accrue to contract holders and recorded changes in contract holder liabilities resulting from changes in related asset values. The comparable GAAP presentation and the reconciliation between the two for the first quarter are set out in our earnings press release on our website. Additional historical information relating to the company's financial performance is also located on our website. As is our practice, we will begin with prepared comments from John Strangfeld, Richard Carbone, and Mark Grier. Then we will welcome your questions. John?
Thank you, Eric, and good morning, everyone. Thank you for joining us. I will be fairly brief. Our earnings per share in the first quarter were up 45% from last year based on after-tax adjusted operating income of the financial services businesses. Overall, we view our earnings this quarter as relatively clean and straightforward. Each of our divisions contributed to our earnings growth in the first quarter. We earned an ROE of 11% for the quarter based on annualized after-tax adjusted operating income of the financial services businesses. We are off to a strong start towards reaching our goals for the year. Our all-in measures were also strong for the quarter. Namely, net income was $536 million, or $1.15 per share.
Our investment portfolio is performing well as we are in a $2.4 billion net unrealized gain position at the end of the quarter. Our GAAP book value per share reached $54.63 at the end of the quarter, up almost $21, or more than 60% from a year ago. Excluding the impact of unrealized gains and losses on investments in pension and post-retirement benefits, book value increased by $5.6 billion or 28%, and Prudential Insurance reported an RBC of 577 as of year-end 2009. Just as important as these measures, our business momentum continues strong, as is demonstrated by strong sales and flows nearly across the board. Sales and individual annuities remained exceptionally robust, and full service retirement recorded its 10th consecutive quarter of positive net additions. Our asset management business continues to enjoy net positive inflows in both institutional and retail AUM.
Finally, international insurance sales reached a new high, as measured by annualized new business premiums based on constant dollars. I would also note that account values in individual annuities and full service retirement reached all-time highs this quarter, as did AUM of our asset management business. We believe this success reflects our excellent products, expanded distribution, financial strength, and most importantly, strong management. We are focusing on adding quality business that can contribute appropriate returns over the market cycles. As we've said in the past, we will also consider opportunities to enhance Prudential's financial performance and strategic positioning through acquisitions. We will evaluate potential acquisitions with our customary care, understanding the need to balance the risks with the opportunities and recognize the need to achieve returns that are appropriate for those risks. To sum up, our financial results are solid and broadly based.
Sales and flows demonstrate our business momentum. Our financial strength has enabled us to take advantage of attractive internal growth opportunities, and our business leadership is the best it's ever been. Overall, we've never felt better about our individual businesses and their prospects, our overall balance and mix of business, the quality of our talent and our leadership team. We are confident but not content. Now, Rich and Mark will take you through the specifics of the first quarter, and then we welcome your questions. Rich?
Thanks, John, and good morning, everyone. As you've seen from yesterday's release, we reported common stock earnings per share of $1.49 for the first quarter, based on adjusted operating income for the financial services business. This represents a 45% increase from the $1.03 per share in a year ago. I view our business results this quarter as strong, giving us a good start towards our objectives for the year. ROE for the quarter was 11%.
Based on after-tax adjusted operating income. The underlying drivers of our business performance are also very strong. Account values in asset management and annuities, our more market-sensitive businesses have increased over the past year, leading to higher fees and lower costs on guaranteed benefits. Our enhanced competitive position has allowed us to write a substantial amount of profitable new business, especially in annuities. Our asset management business is benefiting from strong asset flows. We are beginning to see commercial real estate valuations improve. Growth of our international insurance business is benefiting from expanded distribution. The list of significant market-driven or discrete items affecting current quarter results is short but significant, and all within the annuities business, which I will go through now. We have benefited from about $0.08 per share from the release of a portion of our reserves for guaranteed minimum death and income benefits.
We had a benefit of about $0.03 per share from a positive unlocking, which reduced the amortization of deferred policy acquisition costs. Mark-to-market of hedging positions and embedded derivatives associated with our living benefits, together with the hedge we put on to help protect our capital from adverse swings in the equity markets, had a favorable impact of about $0.03 per share. We closed out and completed a review of the accounting for a number of reinsurance contracts and other agreements dating back to our acquisition of American Skandia in 2003, resulting in a net benefit of about $0.04 per share. In total, the items I just mentioned had a net favorable impact of about $0.18 per share for the quarter. We don't consider mortality fluctuations to be unusual or discrete.
However, current quarter mortality was less favorable than our expectations in both individual life and group life, partially offsetting the benefit from the items I just mentioned. We view these as random fluctuations in our business results. Moving to the GAAP results of our financial services businesses. We reported net income of $536 million, or $1.15 per share for the first quarter, compared to a net loss of $5 million a year ago. GAAP pretax results for this quarter include amounts characterized as net realized investment losses of $84 million. Impairments and credit losses for the quarter were $292 million, mainly within our Japanese insurance operations, including $169 million of impairments and credit losses of Japanese fixed maturity holdings, mainly driven by securities tied to commercial real estate in Japan, and $60 million of impairments on Japanese equity securities.
The remainder of our impairments and credit losses for the quarter, totaling about $60 million outside of Japan, came mainly from credit losses on subprime securities. These credit losses were at their lowest quarterly level since mid-2007. Our total subprime holdings at amortized cost, which as you know excludes FAS 115, were $4 billion at the end of the quarter, down from $5.5 billion a year ago due largely to pay downs. The impairments in credit losses in the quarter were partially offset by favorable mark-to-market on derivatives, mainly in our duration management and hedging programs. Turning now to where we stand on capital, first in the insurance businesses or in the insurance companies. We're managing our insurance companies to capital levels that we believe are consistent with or above double A rating standards. As of year end, Prudential Insurance reported an RBC of 577.
This included a benefit of about 100 points for the sale of our stake in Wachovia Securities joint venture. Since RBC is an annual calculation, I won't be providing an update, but I can tell you that the key drivers of our statutory capital position have not changed materially since year end. Credit losses and migration were benign during the quarter, and we have not taken a dividend out of Prudential Insurance. Our Japanese insurance companies will soon report solvency margins as of year end, which is March 31st, their fiscal year end. We're confident that these solvency margins will be comfortably above their benchmarks for double A ratings.
Looking at the overall capital position for the financial services business, we measure our capital by starting with the capital we need to run the company, which we call required equity, and compare this amount to what capital we have on the balance sheet, which includes actual equity and long-term debt that we classify as capital debt. Required equity assumes the amount of capital we need to maintain a 400 RBC ratio at Prudential Insurance and solvency margins at our international insurance companies, which we believe are consistent with or above double A ratings targets. We estimate that on-balance sheet capital capacity for our insurance businesses at year end 2009 was in the range of $3.5 billion-$4 billion.
Since many of the inputs to our capital capacity are based on annual calculations, I would not want to provide a current quarter update for this range other than to say we are comfortable that it has not changed materially through the end of the first quarter. Our capital capacity provides us with considerable flexibility for business growth and serves as a buffer against the effects of a stressful economic environment. We have historically maintained on-balance sheet capital capacity in the range of $2 billion to $3 billion. In a base case, we would expect to hold a reasonable margin going forward. We also have capacity for additional leverage, which we think of as off-balance sheet capital capacity. We measure this capacity by comparing the difference between our actual debt-to-capital ratio, which stood at 21.9% as of March 31st, to the potential to go up to a 25% debt-to-capital ratio.
On that basis, we would have additional capacity of roughly $5 billion at March 31st. We continue to hold liquidity at the end of the quarter in excess of our longer-term targets. Cash and short-term investments at the parent company, net of short-term intercompany borrowings and commercial paper, amounted to roughly $2.6 billion at March 31st. This amount includes a portion of the proceeds from our $1.3 billion issue of medium-term notes in January. We expect to utilize a portion of our current cash position to repay existing short-term borrowings at maturity to fund operating needs of our businesses and for tax payments over the course of the year, leaving us with a net cash position in excess of the $1 billion cushion that we believe is appropriate.
In addition, a portion of the proceeds from the sale of the Wachovia joint venture currently remains in short-term investments at Prudential Insurance. We have begun to deploy some of the proceeds to finance business growth and still expect to invest the majority of the proceeds in our businesses and longer-term investments over the balance of the year. Before I turn it over to Mark, I want to briefly comment on accounting proposals being considered by the FASB and the IASB that could dramatically change the landscape for accounting and reporting in the insurance sector, the most significant of which are elimination of DAC as an asset, remeasurement of insurance liabilities each quarter based on company models and assumptions, and substitution of today's revenues, which are grounded in premiums or fees based on account values, with a concept of release of margin, also based on company estimates and models.
The proposals are unlike most accounting changes implemented over the past two decades, which have been mainly evolutionary. Also in the past, investors have typically taken a back seat as these changes were considered and implemented. Given the significance of the current proposals, we would encourage you to take a more active interest in ensuring that any new accounting conventions yield results that would be meaningful to your analysis and understanding of insurance companies. Our investor relations department can tell you how to get more information and submit comments. Now I'll turn it over to Mark to speak about our investment portfolio and the business results for the financial services business.
Excuse me. Thank you, Rich, and thank you, John. I'll start with some comments on the investment portfolio. Market conditions improved somewhat in the first quarter, with credit spreads tightening modestly for many asset classes during the quarter. As Rich mentioned, our general account credit losses and impairments this quarter were largely isolated to particular holdings within our Japanese insurance companies and impairments within our domestic general account were insignificant. We have a very high-quality, diversified investment portfolio representing the risks that we want to take and feel that we are appropriately paid for. In our general account fixed maturity portfolio, continued narrowing of credit spreads, together with a modest decline in base interest rates, has increased our net unrealized gain position to $2.4 billion at the end of the first quarter, up from $1 billion at year-end. This compares to net unrealized losses of $7.5 billion a year earlier.
Gross unrealized losses on fixed maturities in our general account stood at $3.7 billion at the end of the quarter. This represents a recovery of more than $7 billion from the $11.2 billion level a year earlier. About 6.5% of our $137 billion general account fixed maturity portfolio ranks below high and highest quality based on amortized cost and NAIC categories as of the end of the first quarter. This compares to roughly 7% as of year-end. Our general account commercial mortgage and other loan holdings amounted to $21 billion as of the end of the quarter, based on principal balances. At March 31st, the average loan-to-value ratio for our commercial mortgage holdings is 65%, and the average debt service coverage ratio is 1.76. Delinquencies are still light, amounting to about 1% of the holdings. Now I'll cover our business results for the quarter, starting with the U.S. businesses.
Our annuity business reported adjusted operating income of $260 million for the first quarter, compared to $17 million a year ago. Results for the current quarter reflect several discrete, largely market-driven items that Rich mentioned, with a net favorable impact of $115 million. Current quarter results include a benefit of $53 million from the release of a portion of our reserves for guaranteed minimum death and income benefits. A further benefit of $21 million from reduced amortization of deferred policy acquisition and other costs, in both cases, reflecting favorable market performance. Results for the current quarter also include a net benefit of $16 million from mark-to-market of hedging positions and embedded derivatives for our living benefit guarantees.
This benefit reflects $70 million of favorable breakage between changes in the value of our living benefit guarantees and the related hedging instruments, including changes in the market-based measure of our non-performance risk. The favorable breakage was partly offset by $54 million of negative mark-to-market, driven by the uptick in the equity markets during the quarter on hedges we put on in mid 2009 to help protect our capital from exposure to lower equity prices. In addition, current quarter results benefited by $25 million from refinements resulting from our closeout of reinsurance contracts and agreements dating back to our acquisition of American Skandia, and a review of the related accounting over the time when these contracts were in effect.
Results for the year ago quarter included a $327 million negative effect from unfavorable unlockings, reserve strengthening, and market-driven true-ups, offset by a net benefit of $261 million of negative hedging breakage, mainly driven by an update of the market-based measure of our non-performance risk. Stripping these items out of the comparison, annuity results were $145 million for the current quarter, compared to $83 million a year ago. A $62 million increase, in what I would think of as underlying results, reflects higher fees due to a $28 billion increase in account values over the past year. Nearly half representing net sales driven largely by our auto rebalancing products and lower costs for guaranteed benefits as rising account values have brought guarantees out of the money. Our gross variable annuity sales for the quarter amounted to $4.9 billion, compared to $2.1 billion a year ago.
We completed the transition to our new HD6 Plus living benefit product feature, which was introduced last summer during the fourth quarter of last year. Like our earlier Highest Daily, or HD products, HD6 Plus includes an auto rebalancing feature that shifts customer funds to fixed income investments to protect account values and support our guarantees in market downturns. With the strong appeal of HD6 Plus to clients focused on retirement income security, our gross variable annuity sales have kept pace with the fourth quarter of 2009, when we recorded about $1 billion of sales of our earlier product, HD7 Plus. Our take rate for HD features, the percentage of eligible premiums on new sales where the customer has elected that benefit, was over 90% for each of the past four quarters.
The popularity of these features has driven the growth of our auto rebalancing book of business, reducing our risk profile and limiting our exposure to changes in hedging costs. As of March 31st, about 70% of our account values with living benefits and nearly half of our overall variable annuity account values are subject to auto rebalancing. This compares to about one third of the overall account values a year earlier. The auto rebalancing algorithm is functioning as intended, returning customer funds to participate in market appreciation as account values become adequate to support our guarantees. As a result of our algorithm and our new sales, at March 31st, less than 20% of account values for auto rebalancing products were in our fixed income rebalancing accounts, compared to nearly 80% a year earlier.
Turning to the Retirement segment, which reported adjusted operating income of $171 million for the current quarter, compared to $159 million a year ago. Results for the year ago quarter benefited by $13 million from updating our market-based measure of non-performance risk for Retirement product guarantees that we account for as embedded derivatives. Stripping that benefit out of the comparison, results for the Retirement business were up $25 million from a year ago, driven mainly by higher investment spreads and higher fees due to growth in full service account values. The higher spreads reflecting crediting rate reductions in our full service stable value business in June of last year and January of this year. Full service account values reached a record high $131 billion at March 31st, up $29 billion from a year earlier.
The increase was driven by market appreciation and $3.6 billion of positive net flows, with $1.1 billion of net additions in the current quarter, marking our tenth consecutive quarter of positive net flows. Current quarter full service gross sales and deposits were $5.6 billion, compared to $10.5 billion a year ago, which included a $4.2 billion major case win. Our full service persistency was a very strong 97% for the quarter. The Asset Management segment reported adjusted operating income of $83 million for the current quarter, compared to a loss of $1 million a year ago. The favorable comparison reflected improved investment results associated with proprietary investing activities, which contributed income of about $5 million in the current quarter, compared to losses of about $40 million a year ago.
The year ago quarter losses came mainly from investments in fixed income funds we manage, which we later redeemed, and in our institutional real estate funds. Current quarter results also benefited from growth in asset management fees. The segment's assets under management increased by $86 billion, or 22% from a year ago, driven by market appreciation as well as positive net flows in each of the last four quarters. Performance-based fees, which are based on changes in the value of some of the funds we manage, as well as transactions on behalf of clients, also contributed to the improved results for the quarter. Commercial mortgage operations are continuing to hold back results of the Asset Management business, but to a lesser degree than the later part of last year, as we are seeing evidence of improvement in commercial real estate values.
Charges on interim loans we hold in the asset management portfolio amounted to about $30 million in the current quarter, roughly in line with a year ago, but nearly $80 million below the level of the fourth quarter. adjusted operating income from our individual life insurance business was $91 million for the current quarter, compared to $40 million a year ago. Results for the year-ago quarter were negatively affected by accelerated amortization of DAC and other items, together with related costs driven by unfavorable separate account performance linked to the 12% decline in the S&P 500. The improvement in results largely reflects the absence of these market-driven charges. Mortality was less favorable than our average expectations in both the current quarter and the year-ago quarter, with an estimated impact of about $25 million in each case when compared to a midpoint level.
While mortality experience fluctuates from one quarter to another, it has been largely consistent with our expectations when viewed over the past several years. Sales in individual life amounted to $68 million in the current quarter, compared to $84 million a year ago. We price our products for appropriate returns rather than maintenance of market share, and we increased our prices on universal life and term products late last year in view of the current interest rate environment and anticipated reserve financing costs. Some competitors in these markets maintained or even reduced their prices, and this has held back our sales in the current quarter. The group insurance business reported adjusted operating income of $53 million in the current quarter, compared to $93 million a year ago. The decrease came mainly from less favorable group life claims experience.
Like individual life, group life claims experience can vary from one quarter to another, and we regard the current quarter swing in experience as a random fluctuation. In addition, expenses were higher than a year ago, reflecting ongoing investments in our claims management operations and development of our product portfolio. Group life sales for the quarter were $346 million compared to $344 million a year ago. Most of our group insurance sales are recorded in the first quarter based on the effective dates of the business. Turning now to our international businesses. Within our international insurance segment, Gibraltar Life's adjusted operating income was $157 million in the current quarter, compared to $131 million a year ago. Gibraltar's current quarter results include income of $6 million from the Yamato Life business, which we acquired in May of 2009.
Current quarter results benefited from lower expenses, which included an assessment for the Japanese Insurance Guarantee Fund a year ago, and from growth of our fixed annuity business, which is mainly denominated in U.S. dollars. In addition, Gibraltar's results for the current quarter benefited by $5 million in comparison to a year ago, from translation of yen earnings at a more favorable rate. Sales from Gibraltar Life, based on annualized premiums in constant dollars, were $155 million in the current quarter, up $47 million from $108 million a year ago. Bank channel sales were $55 million in the current quarter, up from $21 million a year ago. The increase was driven almost entirely by sales of life insurance protection products that we began to distribute through banks late in 2008.
Sales from the Life Advisor channel were up $13 million or 15% from a year ago, driven by sales of life insurance protection products and fixed annuities. Our Life Planner business reported adjusted operating income of $327 million for the current quarter, up $33 million from a year ago, primarily from continued business growth. More favorable mortality experience in the current quarter also contributed to the increase. Sales from our Life Planner operations, based on annualized premiums in constant dollars, were $241 million in the current quarter, up $12 million from $229 million a year ago. International insurance sales on an all-in basis, including Life Planners, Life Advisors, and the bank channel, reached a record high $396 million for the first quarter, up 18% from a year ago. The international investment segment reported adjusted operating income of $12 million for the current quarter, compared to $7 million a year ago.
These results now exclude our Korean asset management operation, which we have agreed to sell and have classified as discontinued operations. Corporate and other operations reported a loss of $202 million for the current quarter, compared to a $175 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 due to higher capital debt, as well as the negative spread associated with the investment of debt proceeds in cash and short-term investments. Expenses were higher in the current quarter than a year ago, including the impact of certain liabilities that we mark to market.
The increases in net financing costs and expenses were partly offset by a $56 million reduction in the loss from our real estate relocation business to $7 million in the current quarter. Briefly on our closed block business, the results of the closed block business are associated with our Class B stock. Closed block business reported net income of $161 million for the current quarter, compared to $19 million a year ago. The current quarter results reflect $274 million of pre-tax realized investment gains, mainly from mark-to-market on derivatives. We measure results for the closed block business only based on GAAP. Turning back to the financial services businesses.
Results for our more market sensitive U.S. businesses, annuities and asset management, as well as our retirement business, are showing strong favorable comparisons to a year ago, reflecting improving financial markets and growth in account values benefiting from sustained positive net flows. Our U.S. insurance protection businesses, individual life and group insurance, were negatively affected in the current quarter by mortality less favorable than our average expectation, but at a level that we would essentially regard as statistical noise. Mortality aside, both businesses continue to perform well. Our international businesses recorded significant growth in earnings and achieved record insurance sales for the quarter, benefiting from solid value propositions in their markets and expanding distribution. Across our businesses, we are taking advantage of our enhanced competitive position to write new business that we believe will continue to contribute appropriate returns over market cycles. Thank you for your interest in Prudential.
Now we look forward to hearing 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, it's star and then one for any questions or comments. Our first question will come from the line of Andrew Kligerman from UBS. Please go ahead.
Great. Good morning. Just first quick question around capital and thoughts about redeployment, share repurchase, time frame.
Well, that's a pretty broad question, Andrew.
Yeah, it is a pretty broad one.
Let me start with what we think we've got. I think I mentioned in my opening remarks.
You did.
We've got on balance sheet between $3.5 billion and $4 billion of capital capacity. We've said before, that's first for business growth, perhaps second for acquisitions, and third to buffer us against bad things that happen to good people.
Let's say you don't do any acquisitions by the end of the year, would that be the time to start seriously considering share repurchase? Could you repurchase shares at that time?
Andrew, this is John. Let me respond to that in so far as to that how long will you give it or how soon will you know type of a question. Our thinking on this is more driven by a change in opportunity set than it is driven by an arbitrary point in time. Meaning if we think the prospect or likelihood of putting the money to work has diminished because the opportunity set has contracted, we'll be considering giving it back in terms of the capital. By opportunity set contracting, what I'm really referring to is things we would be interested in pursuing that are done away from us. So far, that hasn't happened, meaning the things that have been announced were not things we aspire to do. To us, our opportunity set has not changed.
In some respects, we've taken transaction capacity out of the market by virtue of other people committing themselves to other ideas. In terms of thinking about this, it's hard to put it in a context of a fixed number. I think of it more in terms of a fixed timeline. I think it more in terms of a significant change in the opportunity set. We like our prospects for investing in the business, and in terms of M&A, as we talked about it before, it's opportunistic. It's not a strategic necessity, and we want to be positioned to take advantage of those opportunities. If those opportunities are not proving out, that's when we consider giving it back as we have thought about and as we backed to the pond in the past. More about the conceptual framework, less about a specific point in time.
John, in a nutshell, you feel like there are opportunities out there from an M&A standpoint right now?
Yeah, we continue to think there are opportunities out there, it's very hard to predict the certainty of whether they happen. We think we're in a desirable position in terms of our ability to pursue them and whether that translates into outcomes or not is too early to call.
Okay. Then just in terms of liquidity, you mentioned that you have. Where are you going with that capital and what yields are you seeing right now as you invest some of that liquidity?
Let me address the liquidity point. We have $2 billion of cash at the holding company. $1 billion of that is our cash cushion, then $1 billion of that is excess liquidity. We've also got proceeds from the Wachovia sale, the JV sale, that are still sitting inside of PICA. I want to just make one thing clear on this. The $2 billion of the net $3.7 billion in proceeds is really funding the investment that PICA had. PICA is going to take that money, keep that money, and invest it in long-term assets inside the general account. It'll be between 4.5% long term. The remainder of that is excess liquidity in PICA
That will need to be deployed at some point, it's probably a little better than $1.7 billion. As far as the rates go, let me let Mark make some comments about where the investment portfolio, if he
Well, if we look at the core sort of fixed rate investments that we make, thinking of maturities in the, let's say, three to seven-year neighborhood centered around five years, we're in the same markets that everybody else is in, the rates that we are able to earn would be in the neighborhood of 4.8%-5%.
Just lastly, real quickly on commercial real estate. Hearing that mortgage rates are coming down pretty sharply, does that change your view of what you're going to hold in terms of commercial real estate or whether you're going to make more loans? Just what are you seeing in the environment, does it change your strategy given the improvement in values?
Andrew Kligerman, it's Bernard Winograd. Let me try to take a stab at that. I think we see the real estate environment unfolding as we've been talking about it, which is valuations probably reached their bottom, depending upon whether you're talking about the transaction market in the second half of last year or the appraisal series, which is probably in the first half of this year. With a lag effect, excuse me, that translates into an environment that will improve for mortgage investing, in the sense that the portfolio you have is better positioned, less likely to experience problems. As I said, on Investor Day, we feel like, by the end of the year, we got to the point where our reserves on that front are perfectly adequate. We are happy to be a real estate lender at this point.
Because, in general, we feel good about the upside opportunity for valuations relative to the downside risk. We have been in the enviable position of being able to be somewhat selective in the sense of we're able to stick to our investment disciplines around what kind of credit we are typically interested in. Which is and remains the very high end of the market, largely in income-producing properties that are stabilized.
Excellent. Thanks much.
Thank you. Our next question comes from the line of Suneet Kamath from Sanford Bernstein. Your line is open.
Great. Thank you. My first question is on the full service accumulation business, I think, John, you referenced, as did your press release, 10 quarters of positive net flows in a row. My question is, what do you attribute that success to? If we think about, let's say, Principal, another big player in this business, they've had results that were a lot more choppy. They've also talked about, at certain points in time, some aggressive pricing by life companies in this business. I guess my question is, why do you think you're succeeding, and any comments on the pricing or competitive environment in the business? Then I'll have a separate question.
Suneet, let me let Bernard take that.
I think actually there's probably two or three things at work here. Without commenting specifically on others, we are focused on the middle market, not the very largest plans and not the very smallest plans. That part of the market has behaved somewhat differently than the small business market in this downturn. I think secondly, and probably at least as important, there was a period of time there where we clearly have benefited from the flight to quality phenomenon. Finally, we like, and that probably from my point of view, the most important, we like our positioning in this marketplace as the provider of solutions that are focused on getting good retirement results for beneficiaries. That we're not focused on being necessarily the lowest cost provider.
We are therefore the beneficiaries of a macroeconomic trend, if you will, or a macro trend in the industry of as corporate America focuses more on the defined contribution vehicle as the way in which they provide retirement benefits, we pick up interest and therefore market share from others who are more focused on being the lowest cost provider.
Okay. Thank you. My second question's on the variable annuity business. I think at Investor Day last year, you talked about the ROE on that business at around 6% for the first nine months of the year. Can you talk about where you are in terms of the ROE in that business today? If you keep adding new business at $2-plus billion in terms of flows per quarter. Over a 12-month period, how much of a lift, assuming stable markets, could that give to that consolidated ROE for the variable or for the annuity business? Thanks.
Suneet, it's Bernard Winograd again. Let me try that one. The ROE has somewhat improved, obviously, relative to what we were talking about that you referred to, just because markets have improved more rapidly than the assumption we had made of 2% a quarter improvement. The ROE has been stronger than what you're referring to.
Roughly around the 10% level. The question as to how it affects the long-term trajectory is an interesting one, because the short-term impact of adding the business is actually not necessarily positive in the year in which you add it. We do have certain acquisition costs that are not capitalized, not subject to DAC. Therefore, there's kind of a lag effect to the benefit to return on equity to when you get to the second year. I think what you'll begin to see that over the longer, medium term time horizon for us, which is as we add this business at higher and higher ROEs, the real benefit of it comes in the second, third, and fourth years that those cohorts are in our portfolio rather than in the first year.
Okay, great. Thank you.
Thank you. Our next question comes from the line of Nigel Dally with Morgan Stanley. Your line is open.
Great. Thank you. First question, just to follow up on the variable annuity business. Great sales employed again this quarter. At some point, if that momentum continues, do you get concerned that the annuity exposure could grow too large? Second, with asset management. We still have a little drag from commercial mortgages this quarter. Based on your comments regarding the commercial real estate outlook, is it fair to expect that drag to diminish looking forward? Thanks.
Well, Nigel, this is John. Why don't I take the first question first. In terms of can the variable annuities become too large? I think our view on this is materially affected by our success with our product line. Meaning that had we had our old book, that would be probably of a greater concern. Given the design of our new book of business and the increasing percentage of the total that represents, we're very comfortable with where we stand, and we're very comfortable with the outlook. We also expect to see that a number of our other businesses are growing around it as well, particularly those who are market sensitive in particular. As they come back, that also helps achieve and maintain the balance.
Also keep in mind that the capital intensity of the new business is not nearly as great as the old business as well. There's a lot of very good forces going on there, which means that we'll clearly watch that factor closely, but we don't see a problem, particularly because of the product design and our balance of our overall mix of businesses. Bernard, do you want to take the second piece?
Nigel, the answer to the second question is yes. That is, as the real estate markets improve, the adverse or drag on the asset management business that results from that should diminish.
That's great. Thank you.
Thank you. Our next question comes from the line of Tom Gallagher with Credit Suisse. Your line is open.
Good morning. First one is just also related to variable annuities. I guess, Mark, you've commented on prior calls about the macro hedge. Can you comment on both the macro hedge and your regular economic hedge for the variable annuities? How much of that expense is actually flowing through what you define as core earnings? Are you counting that against core earnings, or is that below the line? That's question number 1. I'll stop there, and then I'll wait for a follow-up.
The macro hedge is in core earnings. Just to refresh your memory on that, it's an outright short. We're very comfortable with where we are there, but we continue to evaluate other alternatives. As of right now, we're sort of pursuing the course that we have. We'll let you know if that changes. The answer is that's in core earnings.
It is. Okay. Is that a hedge put out through year-end 2010, or is it longer than that?
It's longer than 2010, but it also could be taken off anytime.
Got it. Okay. Let's see. The other question is for Bernard on PMCC, I guess related to Nigel's question. I think you had a $26 million loss this quarter. That compared to a $100 million last quarter. I believe the portfolio dynamics are a $237 million reserve against a $1.6 billion portfolio. Kind of wrapping all that up with your comment before, are we looking at this going to break even or even profitable potentially over the next several quarters, or how should we think about the timing on that?
Tom, that's hard to answer definitively with regard to the timing. The trend is very clear, which is to the extent markets improve, that the need to add reserves will ultimately diminish. We feel like we have the reserves at roughly the right level. We've also begun to have, in this most recent quarter, the somewhat encouraging experience that we have sold some foreclosed properties for more than our marks, which leads us to believe that we have it adequately marked for that reason. As the exact timing of all that and when it stops adversely affecting the bottom line and when gains on sale are larger than incremental reserves, that's very hard to pin down.
Okay. Then if I could sneak in one follow-up for Rich. I just didn't fully get all the comments you made about cash redeployment with the Wells put and any other cash that you think is in PICA. Can you just tell me, just the sheer magnitude, total cash you think gets redeployed into longer-term investments?
It's about $3 billion. A billion is at the holding company today. $2 billion is sitting in PICA, and that today is earning money market rates.
Over what period of time do you think that gets redeployed?
I think we're going to look at that opportunistically.
Okay, thanks.
Thank you. Our next question comes from the line of John Nadel from Sterne Agee. Your line is open.
Hey, good morning, everybody. I have two questions. One, I guess we're sort of all getting around this issue of VA, but let me think about it a little bit broader on your retirement segment. The attributed equity there grew about 8% quarter-over-quarter if I think first quarter versus year end. If I think about this business continuing to grow at about a similar pace, good strong net flows in VA, continuing positive net flows in FSA. Asset management improving but not really a capital-intensive business. Should we expect a similar level of incremental capital allocated to this segment over the next few quarters? Or was there anything underlying change in allocated equity or something else formulaic?
I just want to clarify the question. When you say the retirement segment, you're including annuities and-
Yeah, I'm sorry. I'm taking retirement annuities and asset management together.
Okay. All of those together.
Yeah.
There was a few things that happened in the first quarter that were outside of business growth.
Okay.
We converted some short-term debt into long-term debt in the asset management business, particularly around PMCC, and that got reclassified as capital as opposed to operating.
Okay.
We set up some additional statutory reserves at year end due to the interest rate environment. They call them AAT reserves, and that drew in a bunch of capital in the quarter, because we didn't calculate that until we filed the blank.
Okay.
The rest of it was sort of made up of cats and dogs.
Is it fair to sort of characterize it as, I don't know, half business growth, half other stuff, or is that a reasonable estimate, or is it something different?
I'm hesitant to throw a ratio out there. I can tell you, though, that more than half in this quarter came from other stuff other than business growth.
That's helpful. The second question I have for you is just on the tax rate. This quarter higher than I believe what you guys had laid out as an expectation at your investor day for 2010. Is there something sort of from a regulatory or legislative perspective there, or is that just a function of higher pre-tax earnings?
It's just higher pre-tax earnings.
Thank you.
I believe that rate will persist for the year.
Understood.
In your models, you need to use the first quarter's rate.
Okay, driven by an expectation that pre-tax earnings are higher.
Right.
Thank you.
Thank you.
Hey, this is Eric Tremain. Sometimes we're divided by a common language, I want to come back to Gallagher's question. I think Pru is unusual in that we include in what we call adjusted operating income for the annuities business, all DAC unlockings, all unlockings of GMDB and GMIB reserves, and all hedge breakage, including the impact of the capital hedge. The $90 million number, which is the sum of all these things, includes a mark-to-market loss in the first quarter of $54 million on the capital hedge. When we talk about the underlying earnings of $145 million, that net gain, if you will, of $90 million is reduced from the reported number to get you to that 145. Just wanted to be sure that that was clear.
Thank you. Next, we'll go to the line of Ed Spehar with Bank of America, Merrill Lynch, your line is open.
Thank you. Good morning. Two questions. First, I think if we adjust out the noise in the annuity line, the pre-tax ROA was around 67 basis points, which I think if you do the same analysis from the fourth quarter, it was 58 basis points. I just was wondering if you could give us some sense of how sustainable you think that type of ROA is here in the near term. Also, if we look out a few years, considering the margins on the new business you're writing, what do we think the margin on that business can get to? I'm going to have one follow-up.
Well, it's Bernard Winograd. ROA is, I have to say, from a management point of view, not a measure that we focus a great deal on. I don't want to contradict your calculation, but I'm focused on it enough to know whether it's right or it's wrong. From our perspective, we are looking at the returns on equity here and finding the returns on equity to be On the business we're writing in the high teens at this point. We believe that the portfolio's ROE, therefore, in a rising stock market, will trend up towards that number.
Could you give us some sense of the relative capital levels? I'm assuming the new business is less capital intensive than what we would look at as your in-force.
Yes, it's considerably less. I don't know if a ratio is easy to state, but you can get at that by simply looking at the amount of capital that we're deploying to the business relative to the increase in sales, and you'll see it's relatively modest compared to what it would have been under the old regime, if you will, of pre-HD products.
Okay, the final question is on statutory earnings. I think if you look at your last 5 years, you've had pretty volatile stat operating earnings at PICA, but I'm thinking that maybe last year was more indicative of a normal year. I'm wondering if you can help me out here. Is a $400 million-$600 million after-tax statutory operating gain sort of a normal quarter for PICA?
I think it's Rich, Ed. I'm hesitant to tell you what normal earnings are on a statutory basis with the way assumptions whack around and the way realized gains and losses come in and out. You got the AVR and the IMR. There's too many moving parts.
No, I'm talking just about net operating gain. I'm not talking about realized gains, losses.
Yeah, I'm still hesitant because of the reserve movements.
Well, let me ask you this then. In the $2.4 billion you reported for 2009 at PICA stat operating earnings, how much of a benefit was there in that number from any sort of reserve releases related to the improvement in the equity market?
That I don't have off the top of my head.
I'll follow up. Thanks.
Thank you. We have time for one final question, and that'll be from the line of Darin Arita with Deutsche Bank. Your line is open.
Thank you. Just had two questions. One was on the variable annuity business. Can you talk about how often you review the product to test the pricing and the risk in the product?
Well, Darin, it's Bernard Winograd. I could say daily. I wouldn't be terribly misleading in the sense that there is a continuous process of evaluating how we're doing against the market, and against the various costs that go into the product. We are looking at it literally daily because we're always thinking about whether the hedging needs to be adjusted in light of the market environment and the pricing.
Client behavior, I'd add to that.
Yes.
There's a lot of work that's done on this, as Bernard said, every day and every week.
Okay. Then as we're looking at your sales, the take-up rate on these living benefits are very high. I was wondering if we look at your retirement business, the IncomeFlex product, how much traction are we getting there?
The IncomeFlex product continues to grow. We're over a quarter of a billion dollars now, it grows each quarter. There is positive momentum there. It's fair to say that it hasn't exploded yet, that part of the reason for that is that to this point, all the sales that we have made have been to clients where we are the record keeper. For that bit, that has somewhat limited the marketplace. We are at the point where we have agreements with third-party record keepers to allow us to sell IncomeFlex to people other than our own platform, whose records are kept by others. We continue to feel good about the upward trajectory, therefore, that we're looking at in that product.
All right. Thanks very much.
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