Prudential: A Prudent Choice For A Recession, But Not Today (NYSE:PRU)

Since 1875, Prudential Insurance (NYSE:PRU) has provided individual and group insurance policies. Along the way, Prudential has tried a variety of businesses, including a Wall St. brokerage. Today, PRU provides a healthy mix of investment management, retirement services and insurance products, but how does an insurance company work? What are its risks and advantages? Let’s dive into this company’s “old bones”.

Life Insurance Companies – A Primer

Please skip to the next section if you are already familiar with how these companies are built.

Life insurers like PRU are basically inverted banks. What do we mean by that? Banks take in deposits to lend them out or invest in other assets, but depositors have access to their funds whenever they want. Insurance companies sell life policies where the insurer collects premiums over time and only pays out when the policyholder either surrenders the policy (turns it in) with an equity value or passes away, triggering the full benefit payment to the beneficiaries.

Bank deposits and life insurance policies are liabilities with very different characteristics. You can have a run on a bank’s liquidity but that’s much harder with a life insurance company. On the other hand, bank depositors only get back what they deposited whereas a life insurance policy pays out the insured amount no matter how much was paid in (assuming no other investment products are attached to the policy).

A bank knows whether it made a good spread against deposits whereas the insurance company may not know for decades, which helped give rise to actuarial sciences that predict these future claims with unsettling accuracy.

Life insurance is a subset of the overall insurance industry that includes sectors like Property & Casualty (P&C), Liability, Health and Reinsurance. Each has its own rhythm and cycle. We like Life Insurance because it is generally more predictable and has a strong asset management component that makes these more comparable to modern banks, but with other interesting behaviors in a recession.

Investment Thesis

We are heading into a recession. The Fed is likely to overshoot and cause a harder landing. Not because The Fed is bad, but rather this is what happens most of the time when fighting through the fog-of-war. We see The Fed Funds Rate topping around 4.5% and holding until core inflation retreats below 4%. Then we expect the Fed will lower rates while maintaining real interest rates (short term rates above the core inflation rate) as a necessary restocking of monetary policy tools.

Prudential Insurance appears to be well-positioned to meet this climate and prosper as we come off the worst hit to life expectancy in 100 years. As we get better at healing COVID-19 patients and society finds its new normal, life expectancies should recover their pre-pandemic rates. Of course, we assume the current threats from Polio, Monkeypox and the Omicron COVID-19 strain remain relatively well controlled.

PRU doesn’t look good at first blush when we compare it to all its peers, but then we looked deeper. Some life insurers are far more dependent on asset management fees while others like PRU are more insurance policy and annuity focused. Those insurance policies and annuities recognize their revenues over the life of the contract, which can run decades. That’s an important difference because asset management fees are mostly earned when they are paid.

We conclude that as COVID-19 deaths have receded, PRU’s huge policy/annuity position will increase profitability along with revenue stability. More asset management focused insurers, however, will experience greater earnings volatility in a recession where asset values fall and investors retreat from the stock market.

We rate PRU a Hold today with a Buy target at $85 per share.

Under The Hood

Let’s breakdown PRU’s businesses and how it works together from their Q2 Investor Presentation:

PRU’s three revenue drivers are:

1. PGIM – the global asset management group. They manage investments on behalf of PRU clients and its own book.
2. The U.S. Businesses – primarily insurance policies, retirement services and annuities (you give PRU money upfront and they pay out over time at a fixed or variable rate).
3. The International Businesses – international version of the US businesses.

How each of these behaves has big implications for PRU’s performance. But let’s not view these in a vacuum, let’s compare to other similar insurers for a contextual valuation: Manulife Financial (MFC), Sun Life Financial (SLF), Principal Financial (PFG), MetLife ( MET), and Lincoln National (LNC) as insurers with significant retirement, life and asset management components with strong North American businesses.

Ticker	Yield (‘FWD’)	Price/ Cash Flow (‘TTM’)	Price/ Book (‘TTM’)	EBITDA Margin	Leverage* LT+ST Debt/ Debt+Equity	Return On Total Capital
PRU	5.08%	3.43x	1.25x	6.19%	41%	2.81%
MFC	5.81	2.04	.83	34.93	30	8.04
SLF	4.85	83.43	1.30	22.19	24	8.89
PFG	3.31	6.60	1.75	32.69	30	18.03
MET	3.02	3.47	1.42	7.95	67	1.95
LNC	3.61	2.70	1.42	7.24	45	3.76
Average**	4.23%	4.05x	1.22x	17.52%	36.5%	5.9%

Click to enlarge

Source: SA

*Excludes insurance policy liabilities which are match funded by investment assets.

** Excludes high and low values from peer group.

What a mess! Numbers are all over the place on EBITDA margin and Return on Total Capital even after adjusting out the extreme values. How can we account for this difference?

Revenue Mix

The answer is found in the revenue/product mix. Both PRU and MET derive the bulk of their revenues from policy premiums and annuities which are typically long-tailed earnings (they can only recognize the profits over time). PFG, SLF and MFC are far more deeply involved running mutual and other funds as well as asset management which recognize their fees mostly as they are received. LNC is just a smaller player in a massive market who does not have PFG, SLF or MFC’s scale.

How revenue is measured and credited differs widely between writing an insurance policy/annuity and realizing fees from asset management. Both are very complex businesses which I will simplify. If you wish to dive face first into all the variations, PRU’s 10-K accounting notes are incredibly detailed, befitting a giant complex business.

When a PRU writes a policy, it recognizes revenues as follows: “Premiums from individual life products (other than universal and variable life contracts), as well as health insurance and long-term care products are recognized when due. When premiums are due over a significantly shorter period than the period over which benefits are provided, any gross premium in excess of the net premium is generally deferred and recognized into revenue in a constant relationship to insurance in force. Benefits are recorded as an expense when they are incurred. A liability for future policy benefits is recorded when premiums are recognized using the net level premium valuation methodology.” The revenue treatment is very similar for annuities – they can only recognize the profits over time.

On the other hand, the asset management business recognizes revenues far faster: “Asset management and service fees principally includes asset-based asset management fees, which are recognized in the period in which the services are performed. In certain asset management fee arrangements, the Company is entitled to receive performance-based incentive fees when the return on assets under management exceeds certain benchmark returns or other performance targets.”

Product Mix Effect

Let’s take a look at policies/annuities liabilities on the balance sheets:

Ticker	Policy/Annuity Liabilities ($Millions)	Total Liabilities ($Millions)	Percent of Total Liabilities
PRU	398,214	666,681	59.73%
MFC	281,596	594,061	47.40
SLF	104,885	223,453	46.94
PFG	88,372	281873	31.35
MET	350352	625526	56.01
LNC	144692	326581	44.31

Click to enlarge

Source: SA

Both PRU and MET are more focused on policies and annuities which shows up as more slowly recognized profits than our other four peer companies. That also means, all other things being equal, that PRU and MET should produce more steady returns over time.

But all things were not equal the past two years. Life insurance claims soared high enough from COVID-19 deaths that US life expectancy decreased for two years in a row. That hasn’t happened since the Spanish Flu more than 100 years ago and accelerated payouts drove down profitability for insurers.

There is a silver lining. HCA reported in its 2022 Q2 Earnings call that COVID-19 admission fell 70% from the 1st Quarter and the CDC reports COVID-19 related deaths have plummeted in the Omicron era. We are doing much better at preventing COVID-19 related deaths and if we make headway on opioids, those numbers will more than reverse, increasing PRU and MET’s policy profits.

Annuities are also tied to life expectancy, but in the reverse fashion. The sooner the annuity beneficiary passes, the more profitable to the insurer. The big swing for annuities is how well the insurer has invested the upfront annuity payment to meet the annuity payments (match funding). That can get very tricky. An up or down market is not as important to managing these as volatility. Higher volatility makes annuity hedging more expensive and reduces profits.

Finally, asset management experiences more volatile cash flows that are related to the economy and the stock market. When markets are rising, profits increase and vice versa. Many asset managers experienced losses in Q2, presumably related to annuity hedging and asset outflows.

The revenue mix for our companies broadly falls into two categories: immediate revenue recognition and deferred revenues. If you think the world is revving up, a more asset manager oriented insurer should outperform. Rolling into a recession, however, deferred revenues under contracts we know are in force is a preferred risk exposure.

Valuation Conclusions

Now that we’ve discovered how product mix influences valuation, let’s draw some conclusions.

PRU offers the highest yield while its valuation measures of Price/Cash Flow Multiple and Price/Book Value give a very close but mixed result. When we see that, we believe it reflects PRU being fairly valued against its peers today.

What about tomorrow given our predicted difficult economy and PRU’s advantages? Both PRU and MET appear best positioned to benefit from a rebound in US life expectancy whereas asset management is likely to struggle through rising interest rates and a recession. Is that enough to make it a Buy today?

No. There is further to fall. Not in step with the market, but more dragged a bit behind, in our opinion.

We rate PRU a Hold today and a Buy at $85 per share.