保德信金融集團 (PRU) 2007 Q3 法說會逐字稿

Welcome to Prudential's third-quarter 2007 earnings conference call. Now, at this point and during management's prepared remarks, we do have all of your phone lines muted or in a listen-only mode. However, later there will be opportunities for your questions and we invite you to queue up at any time during the call. (OPERATOR INSTRUCTIONS). As a reminder, today's call is being recorded. So with that being said, let's get right to this third-quarter agenda. Here with our opening remarks is Prudential's Head of Investor Relations, Mr. Eric Durant. Good morning, sir and please go ahead.

Good morning, Brett. Thank you very much and thanks to all of you for joining us today and belated happy Halloween. We have a lot to share with you today and we also look forward to entertaining your questions. So let me get first into our forward-looking statement.

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 third quarter of 2007, 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 will 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 third 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. Our first speaker is Art Ryan. Art?

Thank you. Good morning and welcome. Our earnings for the third quarter of 2007 were Prudential's strongest ever. They reflect solid performance across our portfolio of businesses. Based on adjusted operating income, earnings per share increased 15% compared to the third quarter of last year and are up 29% for the year to date.

As you know, we consider return on equity be to be the single best measure of Prudential Financial performance. Last year, our return on equity was 14.6% and we introduced a goal for the 2007 to 2009 period to expand return on equity within the 15% to 17% range. We are on target. Our ROE through September is 16.5% based on adjusted operating income. Excluding the impact of unusual or potentially nonrecurring items, our return on equity for the year to date would still be nearly 16%.

Our growth and increased financial returns reflect underlying improvement in the capabilities and performance of each of our businesses. Our risk management and asset management skills coupled with disciplined capital management and expanding distribution support our improving returns and strong strategic positioning.

Because unsettled market conditions, especially in credit markets, characterized the third quarter, risk management is a subject I will turn to again. Dislocations in financial markets are, of course, a fact of life for financial institutions. As we discuss earnings, you will hear how our earnings have been affected by a variety of financial market developments. Our results are very good. We are managing effectively in this environment.

At Prudential, risk management begins with quality business models and diversification of risk. Prudential has a portfolio of businesses that I believe is unusually diverse. Our businesses serve both individual and institutional clients. We operate in the United States and abroad and we manage a broad set of insurance and market risks that, to a great extent, are uncorrelated. We select the particular risks we take carefully based on our proven skill sets. For example, management of credit risk is a long-standing demonstrated core competency of ours. On the other hand, our appetite for interest rate risk is modest as outguessing the market on interest rate movements is not one of our core competencies.

Annuities are a case in point of how market conditions also create opportunities for us. Since the early 2000s, demand for risk management features and guarantees has driven sales of variable annuities. Companies with the skill sets and the capital strength to meet this demand have flourished. Those lacking them have exited the business or fallen behind.

Prudential's Lifetime Five products have been at the cutting edge of living benefits innovation. These products have won excellent market acceptance. They are a major reason for our take rate for living benefit options is around 80%.

Just as importantly, we believe that the product design features and our hedging programs have kept the risk to Prudential within appropriate bounds. We include the breakage between our hedging results and the mark to market of our product guarantees within adjusted operating income. This quarterly breakage has consistently been single-digit millions of dollars since we launched our first Lifetime Five product in early 2005.

Another example of our ability to respond effectively to demand for risk management features and guarantees is our retirement business new Income Flex product. This product, essentially an institutional version of Lifetime Five that is designed to provide a lifetime stream of income to participants in defined contribution plans, addresses a deeply felt need of participants nearing retirement. We view Income Flex as a significant addition to our quiver that leverages our scales and product design and risk management. Change comes slowly in the retirement business. We do not expect Income Flex to garner significant sales in the near term, but we believe it holds great promise for us over time.

Other opportunities are bound to come and our strong capital position will allow us to pursue them. We estimate that excess capital, which includes untapped capital, as well as hybrid securities and equity on the books, is in the range of $7 billion to $8 billion.

This year, we have repurchased $2.25 billion of common stock through September, in line with our Board authorization to repurchase up to $3 billion in the full year. As I said at our last investor day, as a base case, we expect annual repurchases of $3 billion through at least 2009.

Finally, I will update earnings guidance for the full year. Our businesses continued to perform well. We are raising our guidance for Prudential's 2007 common stock earnings per share to a range of $7.45 to $7.60 based on adjusted operating income. This represents an increase from our earlier guidance of $7.20 to $7.40. As usual, this guidance reflects our consideration of a wide range of circumstances, including seasonal patterns and lumpy expenses. In addition, our guidance assumes stable equity markets over the balance of the year.

Now I will ask Rich Carbone, John Strangfeld and Mark Grier to review the quarter for you. After that, we look forward to hearing your questions. Rich?

Thank you, Art. I will begin with an overview of third-quarter adjusted operating income for the financial services business. As you have seen from yesterday's release, we reported common stock earnings per share for the financial services business of $1.97 for the third quarter compared to $1.72 for the year-ago quarter. This amounts to a 15% increase in earnings per share.

Our core earnings performance was strong in the current quarter despite volatile conditions in financial markets. Third-quarter results also reflected a net benefit of around $0.06 per share for several items that are of an unusual or nonrecurring nature. I will go through these items individually now.

Our individual life, individual annuity and group insurance businesses completed their annual reviews of experience and actuarial assumptions in the third quarter. This resulted in favorable unlockings of DAC and other amortization items along with reserve refinements for a total contribution of about $0.18 per share.

Our individual life business received compensation based on multiyear profitability of certain third-party products distributed by our agents contributing another $0.08 per share and results for our International Investment segment included income from the sale of an interest in an operating JV, mark-to-market income on securities related to exchange memberships and a benefit from a recovery on a former investment for a total of about $0.12 per share.

Now we also had a few items going the other way during the quarter. Our retirement business recorded a pretax charge of $81 million or about $0.12 per share reflecting payments made to clients who authorized us to proceed on their behalf to seek recovery of losses on several investment funds managed by State Street Global Advisors.

Additionally, several of our businesses recorded mark-to-market losses within adjusted operating income amounting to $78 million pretax or $0.12 per share on externally managed fixed income investments in the European market. These investments contributed to our portfolio of diversification since the underlying assets are mainly European corporate bonds and asset-backed securities. About 90% of the underlying assets are investment grade and there are no investments in the US subprime mortgage paper.

Structures are used to swap the underlying cash flows to currencies that are a good match for Japanese and US insurance liabilities. Our accounting treatment is based on the investment structure and the negative mark to market in the current quarter reflects spread widening in the European credit markets rather than defaults or impairments.

And lastly, in our asset management business, realized and unrealized losses due to the widening credit spreads during the third quarter resulted in a $42 million loss from the commercial mortgage securitization operation. Comparison of this loss to average results for this operation in recent quarters results in a negative swing of about $0.08 per share.

As I mentioned earlier, the sum of these unusual or nonrecurring items is a net positive of about $0.06 per share to the current quarter's results. Our results a year ago also benefited from favorable unlockings and other items of a nonrecurring nature with an estimated contribution of about $0.27 per share that we identified then. Taking these items out of both the current year results quarters, our EPS would be 26% -- up 26%. John and Mark will speak to our detailed business results underlying this growth in a moment.

I will close now with corporate and other. Corporate and other operations reported a loss of $5 million for the current quarter compared to adjusted operating income of $4 million a year ago. The contribution from our real estate and relocation business, which is included in corporate and other results, was down $15 million from a year ago reflecting a less favorable real estate market.

Now John Strangfeld and Mark Grier will review our business results for the quarter and I will turn it over to John for the domestic businesses. John?

Thank you, Rich. I will start with the Insurance division. Adjusted operating income for our individual life insurance business was $247 million for the current quarter compared to $183 million a year ago. Current quarter results benefited from two items that Rich mentioned earlier -- the DAC unlocking, which came mainly from updating our actuarial assumptions to give effect to mortality experience over a five-year period contributed $78 million and compensation we receive based on multiyear profitability of third-party products distributed by our agents contributed another $57 million.

Results for the year-ago quarter included similar benefits -- $46 million from a favorable unlocking and $25 million from compensation related to our distribution of third-party products. Stripping out these items from the results, individual life's adjusted operating income was unchanged from a year ago.

Mortality experience was within the range of our current expectations, but less favorable than the year-ago third quarter and this offset higher fees from growth in separate account values.

Sales, excluding COLI, amounted to $113 million in the current quarter, up $19 million or 20% from a year ago. The sales increase came mainly from our term insurance products, which are up more than 50% from a year ago. We are continuing to benefit from development of third-party distribution relationships, including direct response agents who specialize in term insurance, as well as national and regional brokerage organizations.

In addition, we improved our competitive position with the fine-tuning of our term insurance pricing earlier this year, lowering the rates for term insurance cases of $1 million or more in selected underwriting categories while raising rates for some smaller face amount policies.

Sales of Universal Life also increased from a year ago, but are below the level of the past several quarters. We are maintaining our vigilance to screen out stranger-owned life insurance cases, especially in this market.

Our Prudential agent and third-party distribution channels each registered sales increases of roughly 20% for the quarter compared to a year ago. The Prudential agent count stood at about 2550 at the end of the third quarter, down about 260 from a year ago and essentially unchanged over the past three quarters.

In order to maintain cost effectiveness in this channel, we are continuing to hire selectively and we hold agents to minimum production standards on a calendar year basis typically resulting in attrition of lower producers during the fourth quarter.

Our annuity business reported adjusted operating income of $203 million in the third quarter compared to $192 million a year ago. Current quarter results benefited $30 million from the unlocking, which came mainly from favorable performance at the investments underlying our variable annuity account values. Results for the year-ago quarter also benefited from the favorable unlocking, which amounted to $37 million. Stripping out the unlockings from the comparison, results were up $18 million from a year ago. The third quarter of last year was our first full quarter of reporting the variable annuity business we acquired from Allstate, so the quarters are now comparable. The $18 million increase came mainly from higher asset-based fees driven by market appreciation together with strong net sales of variable annuities, which amounted to $1.8 billion over the last year.

Our gross variable annuity sales for the quarter were $2.8 billion, up 22% from a year ago. Our sales are continuing to benefit from expanded distribution, including the new distribution that came to us with the acquisition of the Allstate business and from our innovative living benefit features, which are highly valued in the market and that is increasingly focused on retirement income solutions.

Our overall take rate for living benefits in the quarter was more than 80% and account values with our highest daily or HD Lifetime Five feature that we introduced last November reached $2.6 billion at the end of the third quarter. This feature was recently cited by Boomer Market Advisor, a leading publication serving insurance, financial and benefit market professionals, as the living benefit that best addresses the income and longevity needs the clients face.

Gross variable annuity sales in our largest channel, independent financial planners, were $1.9 billion this quarter, up 15% from a year ago. Sales by insurance agents were over $600 million for the quarter, up 30% from a year ago with the increase driven by the success of our products in Allstate's proprietary channel.

Sales in the wirehouse channel, including the relationships that came to us with the Allstate business, are up roughly $100 million or 39% from a year ago.

The group insurance business reported adjusted operating income of $97 million in the current quarter compared to $90 million a year ago. Current quarter results included a $13 million benefit from group disability reserve refinements based on our annual review, while results for the year-ago quarter included a similar benefit of $19 million. Stripping out the reserve refinements from the comparison, results were up $13 million from a year ago mainly due to improved life claims experienced in the current quarter.

Group insurance sales were $54 million in the current quarter compared to $127 million a year ago. Most of our group insurance sales are registered in the first quarter based on effective dates of the business sold, but sales for the year-ago quarter reflected several large new cases with third-quarter effective dates, including one national account with about $50 million of group life annualized premiums.

Our main focus in group insurance is on returns rather than sales or revenue growth and we have seen fewer attractive large case opportunities in the current market as compared to last year.

Turning to the Investment division, the Retirement segment reported adjusted operating income of $53 million for the current quarter compared to $109 million a year ago. Current quarter results include an $81 million charge reflecting payments to be made to Prudential retirement clients who authorize us to proceed on their behalf to recover losses on several investment funds managed by State Street Global Advisors. We believe this action to protect our clients and their plan participants from adverse impact in their retirement accounts while we pursue remedies under their behalf is appropriate under these highly unusual circumstances. Excluding this charge, results were up $25 million from a year ago mainly as a result of higher fees due to the growth of full-service account balances, which increased $12 billion or 13% over the past year and more favorable case experience on traditional group annuity products.

The Retirement segment recorded $12 million of mark-to-market losses on externally managed investments in the European market that Rich mentioned. This largely offset an increase in investment income net of interest costs reflecting the growth of balances for institutional investment products.

Gross deposits and sales of our full-service retirement business were $3.2 billion for the current quarter compared to $2.9 billion a year ago. We continued to enjoy excellent plan persistency at the 97% level for the first nine months of the year. However, with our gross sales still below our targeted levels, net full-service flows for the quarter were a modest negative. Our main focus is on the mid to large case market and we remain confident in our long-term prospects to cultivate large case sales while continuing our strong track record of keeping business on the books.

Last week, the Department of Labor announced final rules under the Pension Protection Act for qualified default investment alternatives or QDIAs under 401(k) plans. QDIAs provide a safe harbor for plan sponsors investing the funds of participants who don't select their own investments, including those who are auto-enrolled in 401(k) plans.

Under these rules, the QDIAs include lifecycle funds, balanced funds and other diversified funds that include stocks, as well as variable annuities and managed accounts. Prudential already offers a wide variety of retirement products that are consistent with the new safe harbors for default investments and we believe that products with income features such as Income Flex will qualify under the new rules expanding our opportunities in the retirement income area.

The final rule does not include stable value products among the default alternatives, but we believe these products will continue to be attractive to plan participants who select their own investments. The Department of Labor rules also grandfather funds already invested in stable value products meaning that there is no requirement to move these funds to new QDIAs.

The Asset Management segment had adjusted operating income of $119 million in the current quarter, up $19 million from a year ago. The increase reflected greater performance-based fees mainly related to real estate investment management and growth in asset management fees. These increases were partially offset by the current quarter loss of $42 million from our commercial mortgage securitization operations that Rich already mentioned. This compares to a contribution to adjusted operating income of $5 million a year ago and average adjusted operating income of $11 million per quarter for the year 2006. The current quarter loss came from realized and unrealized losses due to widening spreads, which we would regard as an unusual market swing.

The Financial Advisory segment had adjusted operating income of $85 million this quarter compared to $51 million a year ago. The $34 million increase came mainly from $24 million greater income from our share of the retail brokerage joint venture with Wachovia, which benefited from growth in fees and commissions.

In addition, the segment's expenses for retained obligations in the current quarter were $10 million lower than a year ago. Wachovia completed its acquisition of A.G. Edwards on October 1 and has indicated that they expect to combine A.G. Edwards with Wachovia Securities in early 2008. As a result, we will continue to record a 38% interest in the JV for the fourth quarter. Our ownership percentage after the combination will be determined based on a process that is now underway.

Now, I will turn it over to Mark for the international business.

Thanks, John and hello, everyone. The International Insurance segment reported adjusted operating income of $366 million for the current quarter compared to $397 million a year ago. The segment's results include adjusted operating income of $153 million from Gibraltar Life in the current quarter compared to $149 million a year ago. The increase in Gibraltar Life came mainly from improved investment income margins and lower expenses. Sales from Gibraltar Life based on annualized premiums in constant dollars were $100 million for the current quarter compared to $98 million a year ago. Sales of our US dollar fixed annuity product through Gibraltar's bank channel contributed just $5 million to current quarter sales compared to $20 million a year ago when we benefited from initial demand following the product introduction in that channel.

Life advisor sales were $95 million in the current quarter, up 22% from a year ago. In this channel, sales of our US dollar fixed annuity tend to rise when the yen strengthens in relation to the dollar as the product is perceived as more attractive by life advisor customers.

During the third quarter, the yen did strengthen and greater US dollar fixed annuity sales contributed about half of the sales increase in our life advisor channel. The remainder of the increase came from sales of traditional Japanese yen-based products.

Gibraltar's life advisor count stood at about 5940 at the end of the third quarter, largely unchanged over the past few quarters. We hold our life advisers to minimum production standards based on semiannual evaluation periods and we experienced some attrition of lower producers over the course of the year thus far. At the same time, we continue to focus on quality of the field force and earlier this year, we reinforced our selection standards in hiring based on our observations about critical success factors.

Our Life Planner business, the international insurance operations other than Gibraltar Life, reported adjusted operating income of $213 million for the current quarter compared to $248 million a year ago. Current quarter results include $53 million of the mark-to-market losses on externally managed investments in the European market that Rich mentioned. These investments can be tailored to support our long-dated Japanese yen-denominated policy obligations and have performed well over five years of ownership in our international insurance businesses.

Excluding these mark-to-market losses, adjusted operating income for the Life Planner business increased $18 million from a year ago. The increase came mainly from continued business growth. In addition, our Life Planner results benefited $8 million for more favorable foreign currency translation mainly related to our Korean operation.

The foreign currency exchange impact was more than offset by a less favorable level of policy benefits and expenses and compared to the year-ago quarter. Sales from our Life Planner operations based on annualized premiums in constant dollars were $185 million in the current quarter compared to $182 million a year ago. Sales in Japan are $115 million for the current quarter compared to $125 million a year ago.

Sales for the year-ago quarter included $16 million of an increasing term product that was popular in the business market in Japan. This product was attractive for use with retirement funding arrangements because premiums are tax deductible and there is no taxable income upon surrender when the proceeds are used for retirement funding purposes.

During the current quarter, Prudential of Japan essentially stopped sales of this product because of an anticipated tax law change that would eliminate the tax advantages. We are in the process of developing alternative products for this market. Absent the effect of this product, constant dollar sales for Prudential of Japan would have increased about 5% from the year-ago quarter.

Our Life Planner count in Japan was 3030 at the end of the third quarter, up 3% from a year ago. We transferred about 70 Life Planners or about 2% of the Life Planner force this year mostly during the third quarter to Gibraltar's home office staff where they will contribute to the expansion of Gibraltar's bank distribution channel as we prepare to participate in the anticipated expansion of bank assurance in Japan.

For our operations outside of Japan, sales were $70 million in the current quarter, up $13 million from a year ago. The increase came mainly from current quarter sales in Taiwan in advance of an expected regulation change. Sales in Korea were also up modestly in the quarter.

The Life Planner count in Korea stood at just over 1600 at the end of the third quarter, just above the level of a year ago. The count declined through most of last year as we experienced difficult competitive conditions and poaching of Life Planners. While it is early to declare victory, the Life Planner count has stabilized over the last few quarters following our implementation of some fine-tuning of our compensation structure in Korea, including features to encourage sales of life insurance to new customers.

The International Investment segment reported adjusted operating income of $114 million for the current quarter compared to $31 million a year ago. Current quarter results included income from the sale of an interest in an operating joint venture amounting to $37 million, mark-to-market income on securities related to trading exchange memberships of $22 million and a $17 million benefit from recoveries on a former investment of our Korean asset management operation. Excluding these items, current quarter results in international investments were up $7 million from a year ago mainly due to more favorable results from our Asset Management business in Korea. Now I will turn it back to Rich.

I am now going to comment on net income and the investment portfolio. Net income for the Financial Services business was $860 million for the third quarter compared to $1.2 billion a year ago. Current quarter results include pretax realized net investment losses of $109 million net of related charges and adjustments. This compares to realized gains of $221 million a year ago. The current quarter realized losses include $11 million of impairments on asset-backed securities collateralized by subprime mortgages. Credit related losses and impairments in total were $44 million in the quarter.

Also included in the $109 million of net realized losses were $67 million of losses on sales of subprime paper from roughly $650 million of book value sold. These losses were a function of widening credit spreads in that market rather than losses or downgrades.

There has been no material change in our estimate of the potential credit losses that we mentioned in our second-quarter earnings conference call of $150 million after tax on subprime holdings in stress scenarios. The scenarios assumed a 40% decline in the housing prices underlying these securities.

Our gross unrealized losses on fixed maturities in our general account stood at $1.5 billion at the end of the third quarter. Of this amount, roughly $300 million relates to subprime holdings, which amounted to $8 billion in total at September 30. 99% of our subprime holdings were priced as of quarter-end using third-party pricing services. These underwrite realized losses essentially reflect widening of credit spreads.

These holdings are substantially all investment grade with roughly 90% AAA and AA. We experienced very limited ratings downgrades in our positions from July 1 through the beginning of this week. Downgrades affected $47 million, a par value, of our $8 billion of holdings and about half of the $8 billion are in a portfolio that we use to invest proceeds from securities lending, repurchase activities and cash management funds and are essentially short-term investments.

We have reviewed all our portfolios with subprime exposures and continue to be comfortable with the level of risk. The remainder of the $1.5 billion of gross unrealized losses relates primarily to interest rate movements on other investment-grade securities. Non-investment grade fixed income maturities comprised 6.5% of the Financial Services business fixed maturity portfolio at the end of the third quarter, essentially unchanged over the past year.

And now briefly I will make some comments 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 $7 million for the current quarter compared to $53 million a year ago. Net realized investment gains were $113 million in the current quarter, down $37 million from the comparable quarter of the prior year. We measure results for the closed block business only based on GAAP.

Now to sum up, I will turn back to the Financial Services business and take a look at where we stand for the first nine months of this year. Each of our divisions registered double-digit percentage increases in adjusted operating income compared to a year ago. Insurance division is benefiting from continued growth of our Annuity business and our domestic Protection businesses. Individual life and group insurance are also performing well.

In the Investment division, our Asset Management business benefited from higher performance-based fees and growth in assets under management and financial advisor results benefited from lower retained costs and higher earnings from our retail brokerage joint venture with Wachovia.

Our International businesses are benefiting from continued business growth in our Life Planner operations, increased investment income margins at Gibraltar and an uptick in results from our International Investments business.

Our annualized return on equity based on after-tax adjusted operating income for the first nine months of the year was 16.5%, well in line with our objectives. And thank you for your interest in Prudential and now we look forward to hearing any of your questions.

(OPERATOR INSTRUCTIONS). Nigel Dally, Morgan Stanley.

Great, thank you and good morning. With your mortgage conduit operation, have conditions for that group now stabilized or are there further potential losses for mortgages you have in warehouse that we could be essentially facing in the fourth quarter?

Second with the retirement, seems to be taking longer till the sales and flows ramp up. Can you discuss what gives you the confidence that you are still on track for improved performance there looking forward? Thanks.

Nigel, this is John Strangfeld. Let me take them in reverse order if I can. So first with regard to the Retirement business, here is our perspective. Our first order of priority with the CIGNA integration was to integrate and stabilize. We have clearly done that. We have done that well and the 97% plan participant persistency gives you a good feel for that.

Our second order issue, which has now become our first order issue, is achieving sales momentum. Similar to Q2, Q3 was softer than we would like and we are clearly not content with it, but we don't see anything systemic here that causes us concern. In a sense, the multiyear pattern is what we expected. The slope of the line is not as steep as we would like. What I mean by that is we had negative flows in '05, breakeven in '06, year to date are modestly positive and we expect to do much better and we will.

So in sum, we are getting the persistency that we are seeking. We intend to achieve the sales and flows and we are confident that we will and we are quite confident that we are on track to do that. So that is on the retirement piece.

On the mortgage conduit side, just to keep in mind, roughly half of the losses that we -- that arose from this spread widening were realized losses on securitization and the other half were the mark to markets on the hedging instruments and on the associated loans.

I think this is still a marketplace that is undergoing change in terms of activity levels, so we really don't want to speculate about where the market is going to go from here.

Having said that, I would say though that, in our case, we have both the mortgage conduit on the one hand and a very proactive general account origination on the other and what we have seen is a lot of activity going back to the traditional lending activity as a consequence of what has gone on in the mortgage market.

That's great. Thank you.

Tom Gallagher, Credit Suisse.

One quick follow-up on Nigel's, then I have a couple of others. Can you comment on how big the warehouse facility is for CMBS?

Right now?

As of September 30?

Right now, there is $300 million of loans and there is about $750 million of commitments and rate locks. So call it $1.1 billion, some of which is hedged.

Okay, thanks. And did that number change materially from last quarter?

No.

Okay. The other question I had was on I guess the market value adjustment in Japan of $53 million. Can you explain a little bit further what exactly those investments are and how big that portfolio is that is subject to market value investments that I guess would flow through net investment income?

Sure. Yes, Tom, it's Mark. I am going to make a couple of comments and then turn it over to Rich because I think you are also interested in why the accounting treatment is what it is for that. The portfolio is a good fit for what we do in Japan because we can adjust the maturity and the currency structure to fit our liabilities.

We also like the diversification into the European markets and from the perspective of the business, the underlying investment is a credit-related portfolio that looks a lot like the same thing we do in the US. It happens to be in Europe and it is the way in which it gets turned into a yen-denominated asset that creates the accounting treatment and I'm going to let Rich talk about the dynamic of that and why it is an AOI.

We hold, as Mark said, we hold a $1.8 billion basket of European credits in a structure that includes a note with a fixed coupon and an embedded derivative. The embedded derivative is essentially a total return swap on the basket. We record the coupon on the note as interest income. The mark to market on the swap is included in AOI as other revenue immediately if it is in a loss.

If the derivative is in a cumulative gain, the gain is amortized into AOI as other revenue over the remaining life of the note, essentially a yield adjustment. As spreads widened and rates rose, the swap lost value and we charged the loss to AOI in the period. And that affected several of our businesses as I had mentioned earlier.

So Tom, this is Art. It is $1.8 billion. We have had this investment for about five years. As Mark mentioned, it is a very, very good match to our liabilities and the spread widening is a well-known fact, of course, what has happened in the past quarter, but we believe it is a very valuable investment.

Okay. That's helpful. And just average credit rating of that basket and I guess the imputed yield on a normalized basis, is this kind of a below investment grade type exposure or is that not necessarily the case?

No. 90% is investment grade now and there is a heavier weight on BBB than AAA, but 90% is investment grade.

And you would want to think about the yield as you would an investment grade private. That is the typical yield on average in the basket.

Okay. So bottom line is spreads blew out, there was a negative mark on it and that is really why we are seeing what we are.

The structure of the deal is why it is the unusual accounting treatment for this particular instrument and yes, but to answer your question, your summary is a good one.

Okay. And then just one last question if I could. Just on the Retirement business and potential exposure to this issue of the DOL ruling on moving away from stable value as a default option, can you just talk a little bit about how important the stable value option is to Pru within the Retirement business? Earnings percentage that would be coming from stable value AUM in that area and how you think that affects you going forward?

Sure. Just a macro comment on that. In our stable value -- in our retirement services book, stable value represents roughly a third of our assets and it is very attractive and it's chosen by a lot of the clients because of the stability and their comfort level with that kind of an instrument. We don't see the demand of that being driven by the default option. This is what clients have historically selected and we think will continue to select going forward when they are proactively doing it. So the presence or absence of the default option we don't think is a big factor, vis-a-vis the plan participant interest in this option.

Actually, Tom, of $32 billion of stable value balances, only about $2 billion were defaulted into, but you are quite right, in the aggregate, the earnings on the $32 billion of stable value balances, which represents about 30% of the entire portfolio, would rough justice account for about twice the proportion of the earnings in the business.

Yes, in fact -- this is Art -- in fact, the demographics would suggest that stable value will always be attractive in that the default option tended to be used much more frequently by younger and newer entrants into a plan and I think the Labor Department was driven on the fact of a need for a more balanced approach if you will, a long stock market and the like for younger employees to default into and there, we are well-positioned as well as we have those products in addition to the stable value ones.

Thanks a lot.

Suneet Kamath, Sanford Bernstein.

Thanks. I just wanted to follow up again on Nigel's full-service accumulation question. John, I can appreciate that you are confident that you're going to see the sales and the flows improve going forward. I guess what I would like to hear more is why. In other words, you are obviously not generating the sales that you need to turn the flows positive, so there must be something that is going to change in terms of your strategy and I was wondering if it is price, is it service, is it a better investment lineup? I mean something has to sort of cause that delta for the sales to recover and I am just wondering what that is?

Well, I guess part of it is, Suneet, that there is a cycle time to this and so what we are seeing in -- what we saw in Q2 and what we're seeing in Q3 is a product of our activity levels six months ago or so. And we had a lower hit rate than we thought we should and we made a series of adjustments, not so much pricing-related, but a variety of more tactical things that had given us confidence that the activity levels we can anticipate going forward are considerably stronger than what they were from that time period. It is a broader macro notion, but I want to make sure I'm conveying confidence in our prospects going forward because genuinely the feeling is there.

Okay. Thanks.

Andrew Kligerman, UBS.

Great. Three questions. Just quickly following up on that, I am still not convinced that a cycle, so business will naturally come to you in the retirement area because time is sort of running its course. What competitive advantage do you bring to the table versus the others out there?

The second question would be around the subprime bonds that you sold or that exposure where you took the $67 million net realized loss. If I understand correctly, you sold bonds worth $650 million and you got that net loss of $67 million, so about a 10%, 15% loss. And yet Rich, you were talking about $150 million in losses I think over a five-year period relating to subprime. Why the rush to sell such a big block and why such a big loss? I just can't quite reconcile that differential right there and then just maybe a little color around what those agents in the Japanese banks are going to do. That sounds very exciting.

Okay. Why don't we -- let's take them in reverse order. I'll let Mark talk about the agents and the changes going on in Japan in terms of bank assurance.

Yes, I'm glad you said it sounds very exciting because I think it is. These agents will be seconded to the bank channel through a range of banking relationship that we have, including very large, as well as regional banks and they will be selling life insurance when it becomes approved by the regulators and we anticipate that before too long.

So this will be a big opportunity for us, and I think we are in a great spot with Gibraltar and POJ, because we can do things in Gibraltar that don't conflict with our Life Planner business in third-party channel initiatives, and I'm very optimistic about where this opportunity may go.

I am going to ask Rich to answer your question on subprime.

We exercise judgment in managing all of our portfolios. We saw more value in other subprime issues than the ones we had. So we sold about 650 of the ones we felt were overvalued and bought positions we felt had upside. The $150 million estimate of potential after-tax losses on subprime -- and those are potential after-tax credit losses -- was not a measure of market value changes during our ownership period.

The estimate of $150 million has not changed, and again our sales during the quarter reflected widening of credit spreads on these securities rather than downgrades or defaults. So said another way, we sold into an illiquid market and realized losses as we replaced selected securities with higher-quality subprime positions.

John, do you want to answer the question on retirement? I think you ought to sell more retirement so we don't get as many questions on that one.

I am noticing a recurring theme. And Andrew, I didn't mean to give the impression that simply the passing of time was what caused the optimism. I think we have competitive product, competitive capabilities. We have management very, very focused on this. We obviously have all the integration things behind us. And my comment about time was that, you know, the things we're working on now are the things that show up in six months' time in sales results. And just based on activity levels and the focus of our management, it gives me confidence about the future.

So stuff like that Lifetime Five like product that you were mentioning earlier, that should have more impact down the road?

Yes.

Got more wholesalers there, I mean that sort of stuff?

We have more marketing capabilities. The product development piece on Income Flex, you know, is an added feature that we think will be perceived as being attractive, and we are just very, very focused on this now. So I am not surprised by the questions and I express confidence about our ability to deliver.

Thank you.

Jimmy Bhullar, JPMorgan.

Hi, thank you. The first one's for, I guess, Art. When do you expect to disclose and what is the timing of disclosing who the next CEO is? Is that Investor Day or is it sometime next year, and when would the new person take over?

The second question is for Mark. On Life Planner growth, I think this quarter it was 5% if you add back the people who were transferred, then it is -- or 3% reported, 5% with the transferred planners. In the past, I think you have aspired to do close to 10%. You haven't done 10% since the third quarter of '05.

The question is, is it realistic to assume that you will be able to grow your Life Planner force in Japan by close to 10%? And if you don't, then would the sales growth be coming down versus where it has been in the past?

This is Art. The succession timeframe is the same as I have been saying for the last year and a half. The Board has been looking at this issue. I think they are quite confident. I would expect that an announcement will be around the end of the year, not later than January.

The timing is not yet determined, and that will be done simultaneously with the announcement on the succession. So it is still on track. Nothing has really changed.

On the Life Planner question, our aspiration to grow at 10% is still in place. As you pointed out, we don't always get there, but we have historically been pretty close and we have historically maintained the relationship between Life Planner growth and sales pretty well if you look over time. Things bounce around quarter to quarter. And I don't see any reason to change that aspirational objective or the expectation that over time we will get pretty close to it.

We mentioned earlier that we came into this year with fewer sales managers in Japan than we desired. That reflects the fact that becoming a sales manager relative to a Life Planner is not always a decision that our Life Planners want to make. So we are doing some things to shore up the pipeline into sales manager positions.

With that will come the strength that we need in terms of numbers of people to boost our Life Planner recruiting and maintain our Life Planner retention. So we have initiatives underway in several aspects of what we do around both sales managers and Life Planner recruiting that I believe will move us a lot closer to on track over the next two quarters.

Nothing is going on in this business that is leading me to reconsider the longer-term metrics that we have talked about in terms of earnings growth and returns driven by the basic fundamentals of the Life Planner system.

And could you briefly comment on what is going on in Korea? Has the poaching -- is that over? Has the business turned the corner in terms of recruiting, if you could just briefly comment on that?

Well, the poaching has slowed down. And as I said in my prepared comments and we discussed last quarter, we have made some changes in our compensation plans, which have been attractive to our Life Planners and we have seen more stability there. We actually saw a small decrease this quarter because we appointed sales managers, again the same kind of need in the business to have sales managers. We appointed sales managers during the third quarter.

So I think the phrase I used was it is probably early to declare victory, but we are seeing at least stability and some positive indications around both market conditions, as well as the impact of our management actions. So I believe Korea will continue to be a more challenging market because it is more dynamic, but we are getting ourselves on track.

Thank you.

Eric Berg, Lehman Brothers.

Thanks very much. One of my questions was answered regarding the Life Planners just now, but I did have one question regarding life sales for John Strangfeld. I think you were saying that you continue to be vigilant in screening out, my words not yours, but I hope I am being faithful to your position, screening out stranger-owned life insurance and you ended by saying something along the lines of especially in the current market. What is it about what is going on right now in the market that leads you to want to be especially vigilant?

I was recently -- this is Art -- I was recently at an ACLI meeting and maybe I can add some color to that. There are a number of states where various lobbying groups are looking to adjust insurable interest laws and that is another codeword for stranger-owned life insurance. So in an environment where there are groups that are proactively attempting to provide a rationale for this particular product, I think that is where I have added and spoken with John and our agency system about extra diligence around stranger-owned life insurance. I don't necessarily see a particular uptick in volume, but I do see more activity at the state level by those who are interested in changing insurable interest laws.

That answers it. Thank you, Art.

Tamara Kravec, Banc of America Securities.

Thank you. Good morning. Can you talk about where you think you still have work to do on distribution in the annuities area and what the potential may be for more block acquisitions in the future?

Okay, Tamara this is John. A couple of thoughts on that. One is we think we have more potential in a couple of different areas. First, with regard to the wirehouse channel, we see broadly speaking more opportunity there. We have relationships with these new wirehouses, but we are still in varying degrees of development with regard to their -- relative to their potential.

We also see more opportunity in the Allstate channel, both vis-a-vis their agents, as well as vis-a-vis the bank activities -- the bank channels that they are focused on also. So I think we are seeing considerable additional potential, vis-a-vis our distribution opportunities. Second part?

Acquisition of blocks.

Oh, acquisition of blocks. Well, as you think about this, the business, the cost of being in this business from a skill set point of view is going up as they are increasing orientation towards these lifetime benefits, whether it is the hedging costs and the technology and the like. And in our mind what that is going to mean is players that have relatively modest books of business are going to conclude that it is not something they can effectively do or afford to do in a way that has the right risk management practices. So we think this is going to create other opportunities for blocks of business, not unlike the situation with Allstate.

Okay. And the Universal Life sales, they have been declining sequentially now for a couple of quarters. Can you just update us on your thoughts on the environment and what sales trends should be in the near term?

Tamara, this is Eric. Universal Life is actually the market that I think John was referring to. I am going back to Eric's question. There is a lot of premium finance going on now. We think that is facilitating business that we don't want to be a part of.

More broadly what you see here in Universal Life, a lot of it is sold through third parties and a lot of our third-party business tends to be relatively big-ticket stuff and the big-ticket stuff tends to be inherently volatile. So you have got a lot of noise from quarter to quarter here simply as a function of whether we write big-ticket items that quarter or not.

Okay. That's helpful. Thank you.

Joan Zief, Goldman Sachs.

Thank you very much. I have one basic question and that is that given your high ROE and your ability to continue to generate enormous amounts of excess capital, do you think that Pru is really shifting more towards an asset management type of business where things are driven by fee income and returns on investment opportunities? And then sort of as a follow-up, when you think about the retirement areas, the asset management, your variable annuity, how much of the asset management is actually managed by Pru through proprietary asset management structures and how much is managed by outside third-party managers?

In terms of the first, no, I think it does reflect the diversification we have and where the activity is. I mean there is no question that unit-linked activities have been more the flavor over the past four years, but we certainly are quite large as a global life insurer that is not unit-linked. Certainly most of our business in Asia is not related to that, so we like the balance between being a significant asset manager, fee-driven while also having large exposure if you will in terms of mortality, growing exposure in longevity risk.

So if I look across the board at market rate, interest rate, mortality and longevity, I like the balance because, as we all know, markets do change and we certainly don't want to be linked if you will to only one type of activity and I think our business mix allows us that enormous flexibility to do that.

In terms of the assets under management, I think our total assets under management are just over $600 billion, of which a bit over $400 billion are managed by Prudential entities. Maybe it's a little bit higher than that.

About 80% is managed.

Yes, about 80% is managed by Prudential entities and the others is outside and that is predominantly in our International Investment business in terms of where we have some money being managed. Also, Rich, do you know where the other areas are?

Annuity separate accounts.

Annuity separate accounts. The separate accounts of the Annuity business.

Retirements of DC plans.

But about 80% of our total assets under management are managed by Prudential entities.

Great. Thank you.

With that, Mr. Ryan and our host panel, I will turn the call back you for any closing remarks.

I want to thank everyone for taking the time to listen in and for those who asked the questions, thank you very, very much and we look forward to seeing you at our next quarterly call in a few months. Have a good day.

Ladies and gentlemen, Mr. Ryan is making today's call available for digitized replay for one full week starting at 2:30 p.m. Eastern daylight Time November 1 all the way through 11:59 p.m. Eastern standard Time November 8. To access AT&T's executive replay service, please dial 800-475-6701 and at the voice prompt, enter today's conference ID 860620. Internationally, please dial 320-365-3844 again with the conference ID 860620. And that does conclude our earnings release for this third quarter. Thank you for your participation, as well as for using AT&T's executive teleconference service. You may now disconnect.