Prudential's Accounting Books Hides $500 Million in Losses

By Gavin Magor
TheStreet.com
October 30, 2008


Prudential Financial (PRU) shares were trading sharply down this afternoon after the insurer held its earnings call to explain the $166 million loss for the third quarter.

Prudential's shares had opened at $35.25 in early trading on Thursday, and rose 7% in early trading. Shares then went as low as $26.11 before closing at $28.87, losing 18% for the day. It is not clear what drove the sudden drop, but clearly the market was unsettled by the lack of advice about future earnings, together with a reluctance of management to provide details about any excess capital reserves.

Perhaps the market would have reacted stronger if it had heard the matter-of-fact way that CFO Richard Carbone announced to the listening analysts that Prudential was changing its accounting practices, with immediate effect, to follow SEC guidelines more closely and that $500 million in fixed-income securities that would previously have been reported as an impairment other than temporary will be recorded instead as an unrealized loss, as it considers the securities "good cash." In other words. "We are changing the way we account for assets partway through the year, because we don't want this loss to show up."

Factoring in this "loss," the comparable figures would indicate a quarterly loss of $666 million; a significantly different story from the one told by the profit-and-loss statement. Naturally, the quarterly report included a significant loss on investments of $1.1 billion, and the consolidated loss of $166 million was down $1 billion from the same quarter in the prior year and a massive $2.3 billion year to date.

 Carbone said that the "losses reflect a change we feel is necessary at this time." Hardly surprising, as the news release indicates a loss of 23 cents per common share, and this would have been closer to $1.29 per share had the same accounting practices been followed. Analysts had been expecting a profit of 78 cents per share. Prudential did meet the range for the pre-announcement of operating income earnings per share at 74 cents per common share, excluding the life insurance business closed to new policies that lost $58 million for the quarter.

The insurance division recorded $32 million in operating income, down $524 million on the comparable quarter of the prior year with annuity income down $512 million, recording a $307 million loss. The investment division recorded a loss of $92 million, down $403 million, with retirement being a rare positive area, up $68 million to $133 million. The only division to at least punch its weight in this difficult economic climate was the international insurance and investments division, which recorded a $497 million profit, down just $40 million.

Assets under management and administration decreased to $714.4 billion, down $53.9 billion.

In the call, analysts were told by Chairman and CEO John Strangfeld that "the underlying performance of our business is solid." He went on to say that sales and cash flows remain positive despite the market conditions, and indeed premiums are up $125 million to $2,798 million compared with the prior-year quarter and up on the year to date. The problem is that investment income is half of the revenue, and this has been severely affected by the serious decline in asset values, including one-time losses of $300 million on investments in Lehman Brothers and American International Group (AIG) in the third quarter.

Unrealized losses now total $5.9 billion, up $2 billion in the quarter, representing those assets that Prudential believes will ultimately hold value, including the previously mentioned $500 million in impaired fixed securities. Prudential believes that it faces a potential $550 million loss over a five-year period.

Prudential refused to quantify the excess of capital that it believes it holds but is not reported on the balance sheet. One analyst pointed out that it was always discussed, so why not now? The response from Carbone was that "we are reluctant to spit out numbers that may not be accurate." He went on to say, "in this environment, we would be very cautious about applying assumptions that we might have done one year ago."

Even when it was pointed out that Hartford (HIG) stock prices were down significantly because it had been evasive over capital discussions, the response was that on the basis of an S&P 500 at 900, Prudential anticipates risk-based capital coverage of 350 to 400; currently it is about 350. The S&P closed today at 954.

Prudential, like most insurance companies, operates a securities lending program, and at the quarter end it amounted to $6.9 billion, a quarter of which is in Treasuries. It says that it has an additional $10 billion in assets that could be pledged to the program, but as this is not "mission critical," it is not worried about the continued pressure on the underlying asset values. Strangfeld, referring to liquidity, said "we have sufficient to meet our needs at the parent company and subsidiaries."

When asked by analysts about the credit rating, and whether it would be concerned about a possible downgrade, Prudential did not seem bothered, responding that when it originally went public it was rated A, could cope and, if necessary, had the resources to move capital to subsidiaries.

In addition to the capital discussion, the focus was on the realization of a put option held on a joint venture brokerage with Wachovia (WB) that is expected to realize around $5 billion, netting $3.7 to $4 billion when exercised in January 2009 and payable to Prudential in January 2010.

Despite this positive note, it was recognized that the capital position of Prudential might well drop further, with possibly $1 billion being required to maintain the 350% risk-based capital ratio.

The company withdrew all guidance for the remainder of 2008 "in view of the current market volatility and extraordinary events and developments affecting financial markets generally."

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