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Last week, Fitch Ratings affirmed the issuer default rating (“IDR”) of ‘A-‘ of the U.S. life insurer Prudential Financial Inc.’s (PRU - Analyst Report). Concurrently, the rating agency affirmed the insurer financial strength (“IFS”) ratings at ‘A+’ of the subsidiaries.

Prudential’s operating results, debt servicing capability, capital strength as well as reliance on both short and long-term external debt were all taken into account by the rating agency for the rating action.

Fitch noted that strong operating performance at Financial Services Business was led by better results of its high growth international, asset management and other segments. The rating agency is also positive on the company’s acquisition of Star/Edison and expects that the deal to provide strong earnings growth over time.

As far as dependence on external debt is concerned, Fitch acknowledged that Prudential has commercial paper borrowing of 4% of total debt as of September 30, 2012, unchanged relative to December 31, 2011.  The company’s short-term debt level lies within the rating agency’s cut-off limit of 10%.

On the flip side, Prudential’s high financial leverage ratio of 35% continues to be a cause of concern for the rating agency. It was also concerned with the company’s Total Financing and Commitments ratio of 1.4x, which was above its peer group average due to high use of debt within the insurer’s capital structure.

Nevertheless, Prudential’s robust statutory capitalization of 475% as of September 30, 2012, gives the rating agency adequate confidence in the company. Its Japanese operations also hold statutory capital, way above the minimum required levels.

The rating agency has considerable confidence in Prudential, which is attested by the stable outlook accompanying the ratings. A stable outlook reflects that Prudential is experiencing stable financial and market trends, and therefore a rating change in the near term is unlikely.

However, Prudential may face near-term downgrades, if financial leverage ratio breaches the 35% mark; commercial paper holding increases above 10% of the total debt; interest coverage ratio falls below 5%; total financing and commitments ratio increases above 1.5x; NAIC RBC falls below 400% and Japanese solvency margin ratio falls below 600%.

A rating upgrade can be accompanied by a reduction in Commercial paper holdings, bringing down the leverage ratio to mid 20% and total leverage to below 40%, maintaining interest coverage ratio at 8x to10x range and holding NAIC statutory capital near the current level, and Japanese subsidiaries’ risk-based capital above 700%.
We believe Prudential is well poised for solid earnings growth and improved return on equities (ROE) led by its superior brand value, an aging American population, strong Japanese operations and a growing international business.

Peer MetLife Inc. (MET - Analyst Report) carries an IFS of “AA-” and IDR of “A-” from Fitch. Prudential’s stock retains a Zacks #3 Rank, which translates into a short-term Hold rating. We also maintain our Neutral recommendation on the company.

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