美國信安金融集團 (PFG) 2002 Q2 法說會逐字稿

Good morning. My name is David and I will be your conference facilitator today.

At this time, I would like to welcome everyone to the Principal Financial second quarter earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers remarks there will be a question-and-answer period. If you would like to ask a question during this time, simply press star, then the number one, on your telephone keypad. If you would like to withdraw your question, press the pound key.

Thank you.

Mr. John Effrein, you may begin your conference.

Thank you.

Good morning and welcome to the Principal Financial Group second quarter conference call.

If you don't already have a copy, our earnings release and financial supplement can be found on our Web site at www.principal.com. Following a reading of the safe harbor provision, Chairman, President and CEO, Barry Griswell, and Executive Vice President and CFO, Mike Gersie, will deliver some prepared remarks. Then we'll open the call for questions.

Others available for the Q&A portion of the call include , Executive Vice President responsible for the Life and Health Insurance and Mortgage Banking segments; , Executive Vice President responsible for marketing and sales; , Executive Vice President and of asset management; and , Executive Vice President responsible for the U.S. asset accumulation businesses.

Some of the comments made during this conference call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act. There are a number of risks and uncertainties that could cause actual results to differ materially from those expressed or implied. Factors that could cause actual results to differ materially are discussed in the company's annual report on form 10-K for the year ended December 31, 2001 and in the company's quarterly report on form 10-Q for the quarter ended March 31, 2002 filed with the SEC.

With that, I'll hand the call over to Barry.

Thanks, John. Let me also extend a very personal welcome to each of you on the call.

This morning, I'll focus my comments on second quarter results overall, key accomplishments and progress in executing our strategies. Mike Gersie will follow my comments with a detailed overview of financial results.

Certainly, we were very, very pleased with our second quarter results. We delivered near-record operating earnings, double-digit revenue growth and record gross new pension deposits. This during a quarter where the S&P declined nearly 14 percent. In U.S. asset management and accumulation, the segment we view as our long-term driver of growth, earnings advanced 16 percent; a very, very strong quarter indeed.

I'd like to take a moment now to discuss some very important recognition for The Principal. First, we were very pleased with our addition to the S&P 500 effective July 22nd. And during the second quarter, we received top honors in best Web site for participants, and we were selected as one of Computer World's top 50 places to work. And, finally, we were profiled in Money Magazine, one of just four companies cited, active business model and future growth prospects.

We believe each of these reaffirms our leadership, builds our recognition in the marketplace and strengthens our franchise.

In addition to strong results, the quarter was marked by a number of key accomplishments, our business agreement with Key Corp is another example of our efforts to accelerate growth in our U.S. retirement business and leverage our leading position in the 401K market.

Key Corp, which had approximately 1400 DC clients and eight billion in assets under management is transitioning out of the bundled DC business and recommending the principle to his full service clients. While we're fairly early in the process of meeting with employers, we've been well received to date. For competitive reasons, we don't believe it would be appropriate to project a conversion rate for plans or assets under management at this time; however, we do expect the conversion activity will begin having a very positive impact on deposits and assets under management in subsequent quarters.

We also created the principle security builder of retirement program to make it easier for businesses with five to 100 employees to offer a 401K plan. Designed to be sold by agents, brokers, registered reps and TPAs, this new offering provides growing businesses affordable access to key 401K services, cutting edge technology, online support, and record keeping, electronic reporting, a multi-manager investment approach and a world class participant servicing package.

Enhancements to our distribution system in early 2001, also continue to drive strong results. New full service retirement sales exceeded $1.1 billion, up 94 percent over the second quarter of 2001, and up 53 percent year over year on a six-month basis. This again, reflects a continuation of strong trends from last year's restructuring and strong demand for our offering. These sales will also contribute to growth of deposits and assets under management in subsequent quarters.

We continue to focus on and to experience very solid results from previously announced distribution alliances. For the second quarter, we had $434 sold and committed from alliance partners. In addition, new relationships in the bank channel and strong demand for our fixed annuities drove a 99 percent increase in individual annuity sales, and positive net cash flow of $131 million for the period.

We've also experienced ongoing success in asset retention in this business. During the quarter, we retained 49 percent of at-risk assets in our defined contribution plans, demonstrating continued success in this critical area.

Moving to asset management, Spectrum Asset Management, our preferred security subsidiary was higher during the quarter by to sub advise its $965 million closed-end preferred securities fund. Spectrum's assets under management are $2.6 billion, up more than 150 percent since we acquired them in October of 2001.

We were also engaged by to manage $100 million real estate mandate. These were two very important wins, reflecting continued recognition in the marketplace of our strengths and capabilities as an asset manager.

In terms of driving international growth and profitability, Principal International achieved a number of important milestones during the quarter. This includes its sixth straight profitable quarter, break even for operations in Hong Kong and Mexico , ahead of expectations, and reaching $4 billion of assets under management and $3 million covered lives. results were mixed. had another outstanding quarter with net flows of nearly $1 billion Australian bring to assets under management of 6.4 billion Australian. also had several key corporate wins during the quarter including , and . These successes indicate again the financial advisors are still supportive of and areas not impacted by adverse investment performance. This gives us confidence that improving investment performance will be followed over time by better business results.

However, as did many other global money managers, suffered the impact of declining global equity markets. The Morgan Stanley Capital International Index declined 9.5 percent in the quarter and is down 16.3 percent for the trailing 12 months. As we expected, assets under management declined again, in turn impacting fee based revenues. While June and July redemption slowed, we expect that will experience negative fund flows through year end and into early 2003.

We've previously discussed our efforts to enhance operations and we're continuing our aggressive focus on improving investment performance and managing cost. Rest assured, we understand the importance of effecting a turnaround at . We're up our resources as we intensify our efforts to drive improvement. Since appointment in April as global head of asset management, we've made some real progress in more closely aligning our asset management businesses to ensure better coordination and more effective use of resources and in creating a seamless global research platform to support the construction and monitoring of better performing investment portfolios.

As we've previously discussed, I'd like to touch upon two key areas of focus for the organization, operational excellence and capital management. We continue to identify sustainable ways to costs out of our operations through process improvement, rigorous performance management and negotiation of lower vendor contracts.

Another important aspect of operational excellent program is our intense focus on managing employment costs. Through attrition management and other employment cost management efforts head count is down by nearly 1,000, more than 5 percent from year end 2001. This effort alone shall allow us to achieve our targeted 25 million expense reduction for 2002.

In terms of effective use of capital, we continued to repurchase shares during the quarter under the $450 million repurchase program authorized by our board in February of this year. Through August 2nd we've repurchased approximately 14.6 million shares at a cost of $410 million or an average price per share of $28.15. We'll continue to actively and opportunistically utilize share repurchases as an important option in our efforts to effectively manage capital. As you may have noticed, we expanded our financial supplement disclosure in the second quarter providing enhanced account roll forwards and additional income statement detail for our pension operation.

As described in our release, Mike Gersie and I intend to certify our recent financial disclosures and most recent proxy statement, our most recent annual report on From 10-K for the year ended December 31, 2001, and our quarterly report on Form 10-Q for the periods ending June 30, 2002, and March 31, 2002. The Principal Financial Group is absolutely committed to providing investors clear and accurate and timely disclosure and we support the SEC in its efforts to improve investor confidence and ensure quality disclosure.

As additional evidence of our commitment, I'd like to announce our decision to expense stock options. We will change our method of accounting for employee stock options this year, recognizing compensation expense for options granted in arriving at our earnings. We estimate that earnings per share impact of this accounting change will be two to three cents per share for 2002.

Like others, we are hopeful that FASB will quickly create a standard approach to calculating the expense level for options. In the meantime, we believe this is an appropriate move for the Principal Financial Group. We're all aware of the investor confidence problems pervading the marketplace, and as I hope you've come to expect that Principal will continue to do its part to be part of the solution.

I'd now like to provide some guidance on our outlook for 2002 operating earnings. We expect the third quarter to range from 51 to 53 cents per diluted share and full-year 2002 to range from $2.08 to $2.16 per diluted share. These estimates do include the impact of expensing employee stock options. The estimates also incorporate certain assumptions, including domestic equity market improvement of roughly one-half percent per quarter for the second half of the year from current levels.

I'd also like to add that we're continuing to work hard to grow earnings and effectively utilize equity. We're confident that through those efforts, we'll be able to achieve our ROE target of twelve-and-a-half percent by the end of 2003. This assumes a minimal market recovery in 2002 and modest equity market growth in 2003.

In handing it over to Mike, I'd just like to stress again our commitment to shareholders - a commitment that is reflected in the execution of our strategy and in our efforts to help investors better understand the drivers of our business. Mike?

Thanks, Barry.

I'm assuming everyone's had the opportunity to review the earnings release and financial supplement. I'll spend a few minutes covering current results and providing some commentary I believe will be helpful in understanding our outlook for 2002 and beyond. As Barry mentioned, we are pleased with our results for the quarter. There are several things worth highlighting at the segment level.

U.S. Asset Management and Accumulation earnings were up 16 percent for the second quarter 2002 compared to the same period last year. The fundamentals of the segment continue to be very good. Cash flows were strong, new sales were excellent, and the expense picture shows good control. Within the segment, pension earnings improved 10 percent, reflecting strong operating results from the full-service sales as a leading indicator of the strength of our product offering.

Strong new sales helped drive a 21 percent increase in full service accumulation deposits. It's important to remember you will not see a direct correlation between year-over-year sales growth and deposit growth due to the fact that sales make up only one component of deposits and there is a slight lag between the time sales occur and when sales convert to deposits.

Within our international asset management accumulation segment Principal earnings improved nearly $4 million. The increase primarily reflects increased earnings from our Mexico , Mexico and Chile. $1.3 million of the improvement is related to the non-amortization portion of the new FAS 142 rules for goodwill and intangibles.

At $3 million in the second quarter of 2002, earnings improved $3.2 million over the second quarter of 2001. However, this improvement wholly reflects implementation of the new FAS 142 rules. Excluding the beneficial effect of FAS 142, earnings would have been $5 million in the prior year quarter.

International segment revenues were down $28 million. About half of the decline reflects a decrease in fee revenues due to lower assets under management. The other half is a reduction in pay-out annuity premiums in Mexico and Chile due to temporarily reduced flows of business in these markets.

Segment expenses were down $41 million, which related to ongoing aggressive expense management and discontinuation of amortization expense. assets under management decreased $2 during the quarter. Declining markets contributed to decline in assets, as well as to outflows. As Barry indicated, we are highly focused on this issue and we continue work very hard on turnaround.

Moving to our Life and Health segment, earnings were up 27 percent. Return on equity improved 13 percent for the trailing 12 months, compared to nine percent at June 30, 2001. This earnings increase reflects continued pricing discipline in the group medical business and better-than-assumed loss experience.

The Life businesses also continued to make solid, steady contribution to improving segment results. Mortgage banking also had another strong quarter with $25 million in operating earnings. And segment earnings declined $20 million from second quarter 2001. I'd like to take a moment to explain why we characterize the quarter as very strong.

Second quarter 2001 operating earnings were somewhat of an aberration. As we have previously discussed, origination and servicing tend to act as a natural hedge against each other. Servicing impairments, net of hedging, typically offset higher origination earnings during low interest rate, high production volume periods. However, earnings in the second quarter of 2001 benefited from high origination volume and higher origination pricing margins than in the second quarter of 2002 without the benefit of servicing impairments.

Mortgage loan production during the second quarter of 2002 remains strong at $9.1 billion, compared to $10.5 billion in the year earlier period. We also saw a little softening in mortgage loan origination margins during the second quarter, and we have seen some strengthening of these margins in recent weeks.

The servicing portfolio, at $96.5 billion as of June 30, 2002, also continued to grow at solid pace during the quarter, up $7.4 billion from March 31, 2002 and up $32 billion, compared to June 30, 2001. As described in our earnings release, the growth in our servicing portfolio increased servicing earnings, as did a gain on the sale of a package of non-performing loans. However, this gain was offset by impairment of our servicing asset.

In the corporate and other segment, we saw a $14 million decline in earnings. This decline primarily reflects lower reinvestment yields, including a lower reinvestment yield and our conventry sale proceeds.

In addition, as we've' discussed in prior calls, there is some volatility, because of the nature of the segment's activities, particularly property development, which produces income unevenly as we sell properties.

Moving to operating revenues, second quarter increased $295 million or 13 percent to nearly 2.5 billion. We had strong revenue increases in pension, from record single premium group annuity sales, and in the mortgage banking segment.

Assets under management were down only slightly from first quarter at 119.6 billion as of June 30, 2002. Run sales activity helped offset the impact of equity market declines. As we previously indicated, our ability to meet 2002 earnings expectations depends on a number of factors, including resumption of more normal growth in equity markets.

Only though, our aggressive and ongoing efforts to sell new business, retain assets and manage expenses have delivered real results as we continue to combat challenging equity market conditions.

I'd also like to take a minute to discussions net income. Net realized capital losses for the quarter were $70 million. This includes after-tax losses of $11 million on the sale of WorldCom bonds, and 30 million on WorldCom due to permanent impairments. This is a very difficult equity and credit market environment, however we have a high quality investment portfolio. We aggressively monitor our portfolio and continually assess our exposure to troubled sectors and credits.

This concludes our prepared remarks and I would ask the conference call operator to open the call to questions.

At this time I would like to remind everyone in order to ask a question, please press star, then the number one on your telephone keypad. If you would like to withdraw your question, press star, then the number two.

We'll pause for just a moment to compile the Q&A roster.

Your first question comes from of Bank of America.

Thank you. Couple questions. First, could you give us again your earnings sensitivity with respect to a one percent change in the S&P? The second question I had with regard to 401K sales, are you seeing a shift from separate account to fixed account? And could you also again remind us what percentage of assets are in general versus separate in the pension roll forward? And the third question, can you just break out share repurchase for us? How much did you repurchase in the second quarter and so far how much in the third quarter? Thank you.

Hello , good to hear from you. Let me ask Mike Gersie to handle probably the first and the last, and then I'll ask to cover the couple in the middle, so the first one about market sensitivity, Mike and then share repurchase?

Hi .

Hi there.

When we went on the road and we talked to investors, we use the rule of thumb of 10 percent change in the equity markets, resulting in about a four percent change in income. One of the things we've done subsequently, is really focused on, I'll say dynamic budget process, to really get expenses in line with revenue and so to some extent, we've been able to offset, mitigate, some of the market declines due to good old fashioned expense control. So I think the rule still stands, but the, it's modified by the fact that we're doing everything we can to react to declining equity markets by adjusting expenses and looking for operational excellence activities.

And also , the share repurchase.

Oh, share repurchase. Jason, I think the number that we gave was . . .

410 out of . . .

410 and that was the most recent number. I don't know if I had the number at the end of second quarter.

Yeah, we don't have the split but we do know it's -- at the end of the second quarter it was -- it's 410 out of the 450. So we're substantially through the 450 repurchase of authority. Larry.

Jason, hi, this is . You're -- you had two questions I think about some of our 401(k) business. The first one had to do with the direction of new monies into 401(k)'s, the split between fixed income and equity. There has been some very small shift, modest shift away from equities towards fix income. Our latest numbers would indicate that we've moved from the first quarter where about 46 percent of the inflows were in equities, into the second quarter we're about 43 percent of those inflows are in equities.

I think your second question had to do with how the present account values are split within the 401(k) block. That's where it is approximately 50/50. It might be slightly higher toward the general account but basically is about a 50/50 allocation between the two.

Thank you and just one follow-up with regard to share repurchase. I assume you'll go back and try to get another authorization?

Well, Jason, as we've always said, share repurchase is an important tool in managing our equity and it will continue to be that way.

Great. Thank you very much.

You're welcome.

Your next question comes from of .

Good morning, gentlemen. Can you hear me OK?

Yes, Kim. How are you?

Doing well. how are you? Just wondered if you could give us a little bit of an overview on current trend in the mortgage business I guess addressing the likelihood of interest rates going down further, refi activity and perhaps the of the refinance ways that folks are pointing to.

Sure, Kim, we'll be glad to. I think I'll ask or maybe to make some comments on that and we'll fill in as we need.

Yeah, I don't know how to predict what interest rates are going to do and that's going to be the key of really what happens in the mortgage banking business but it continues to go strong. Currently about 54 percent of our pipeline is refinance and the remainder is new mortgages. So the flow seems to be continuing and it will be dependent on what happens on interest rates in the future.

As I recall, , our pipeline's about 7 billion . . .

Yes.

Right now. So that's a very, very strong pipeline. Pretty high for us given where its been more recently. So things look very good right now, Kim.

Are you seeing any more competition in that business or any existing players competing more in the markets where you all play?

No, I don't think so. I mean we actually saw a shrinking of the margins in the second quarter. Toward the end of the second quarter, beginning of the third quarter, the margins are spreading out a little bit. So not only are we seeing good volume but we're seeing very strong margins as well.

Thanks very much.

And I would just point out, we continue to manage that business very, very well and we have a great outlook for that business.

Your next question comes from Ed Spehar of Merrill Lynch and Company.

Good morning everyone.

Hi, Ed.

I have a few questions. I was wondering, Mike - you mentioned in the prepared remarks the benefit of a commercial mortgage-backed securitization at Principal Capital Management. And looking at the - and we know that that's recurring but lumpy. But then also in the line, the Property Development earnings are also recurring but lumpy and they look to have been maybe light this quarter. Is there any way to give us a sense of, if you net out sort of the two and compare that to what a normal quarter is, what that was - what that means?

And also, when you talk about the appreciation assumption, I think you said a half a percent per quarter in the market. Was that going from the current level or was that from the June 30 level?

And finally, if we look at your Pension earnings - this was a strong performance, I mean, given the - given the market. And I'm wondering was there anything unusual in that number or is that kind of a good, sustainable number. Thanks.

Multi-part - I'm having trouble just keeping all this straight, Ed, so I'll try to go through these as I remember them.

CMBS - the commercial mortgage-backed - we look at commercial mortgage-backed securitization and property development obviously as two separate activities, so I'm not sure in a way netting them out makes sense. But I can speak to each of them.

CMBS probably - maybe a couple of million dollars of extra gain in the second quarter due to I'll say very beneficial market conditions. Principal Development Investors is the real estate development arm, and I suppose maybe rather than speak to that, maybe speak to income in the Corporate Business unit - so, the Corporate Operating segment. That income probably will run around zero for the next few quarters. Remember that segment has all of our corporate debt in it. Some of the debt is denominated in dollars. The Aussie dollar is strengthening, so some of our debt cost is going up. In terms of property sales, we would anticipate a modest amount of property sales over the next few quarters. So I think we're really talking about a kind of a wash and getting pretty close to a zero - maybe even a little bit to the negative side, somewhat in line with what we were showing this quarter, but hopefully maybe a little better.

In terms of the half a percent increase in the market, that was from current equity - well, equity levels as of about a week a go let's say, so basically current equity levels, in the pretty severe market declines in July.

In terms of Pension, I'll turn that over to .

Hi, Ed. This is .

Your question in regards to Pension earnings, I would say that this was a very, very solid quarter. As Mike noted, there was nothing particularly unusual or out of pattern. I think the earnings, you know, do reflect two elements that Mike commented on - first, you know, very solid cash flows which help us offset the impact of equity market declines, and second I think very, very good expense management where we're very, very focused on watching our headcounts and our - and our expenses and trying to keep those very much in line with our revenue picture. So, a very, very solid quarter right down the middle.

OK, thank you very much.

Thanks, Ed.

Your next question comes from Thomas Gallagher of Dresdner Kleinwort Wasserstein.

Good morning.

First, just a quick follow-up to the comment on pension earnings. Can you just comment on where your spreads are running for the general account side of that business? Have they been unusually high recently, or is that asset fairly normal.

Larry, you want to...

Hi, Thomas, this is Larry.

I would say they're right in pattern in line with what they've been in the past. Not an aberration one way or the other.

OK. And then also related to the pension business, can you just comment, , just in terms of the way I guess the net flows have been trending, especially in your full service pension accumulation business? ; shipped 100 million this quarter. remain fairly high.

Can you just talk a bit about what your expectations would be? Would they be at a going forward, as you see sales momentum? Or, you know, is that going to continue to be fairly low as a function of competition in the market?

One other thing to note there. Your case count - or rather number of plans - actually went down in all of the various sizes of the cases. Can you just comment on what's happening there? Because I know that most of them went up from 4Q to 1Q, but then they went back down again in the second quarter.

OK, sure. I'll be happy to comment on it.

In terms of just the general picture with regard to flows there, as you can clearly see from the material that we've made available, the inflows are continuing to be very strong. And that does reflect the cumulative effect of strong sales growth over the last few quarters. And, once again, the second quarter was very strong, so we see that the inflows should continue to be quite robust into the full service accumulation business.

As you note, there is a slight uptick in outflows. Those are both at the employer level, where we are seeing a very slight increase in employer terminations, primarily as a result of financial restructuring. And there's also a very slight increase in member level withdrawals.

But, again, I would say that we saw experience last year a little below the long-term norm, and while it's a little above the long-term norm today, we do see that perhaps trending back down as we go forward. So I think we'll see our net flows expand a little bit over the coming quarters.

And then, finally, you asked about case counts. The numbers of factors driving that case count, one of them I mentioned was that we are seeing some financial restructuring, and so that's driving that case count down a bit. There was also a little bit of what we're calling a of fact in the first and second quarter, where there were a number of employers who received the benefit of their compensation and knew that was coming and then had already made the decision about leaving.

And the other thing that's probably as hard for you to see, but actually the recent tax reform legislation , now made it no longer necessary for employers to have two plans - as single employer to have two plans - in order to gain a higher contribution limit. So we've had about 60 employers that have actually combined what was formerly two programs into one program because now there's no longer the need to do so under the Pension Reform legislation. So that's the primary explanation.

OK. So there hasn't really been a change in the competitive environment then? A lot of this stuff sounds like this is more related to the and timing. And also, in some case, a combination of plans. But you don't see the level of withdrawals as problematic here?

In fact, you know, just a follow-up question, would you see those going down and when do you think those will start abating a bit, after you get through some of this noise?

Yes, I do think the withdrawals may mitigate a bit. Again, our pension, , continues to grow. You can see it's up five percent from a year ago. So I think we will see that, I think we will see those withdrawals trend down over the next quarter or two. Maybe I'll let Mike comment just a little bit about the competitive environment, .

Sure, hey , in terms of the competition, we are not really witnessed any sort of heightened impact out there over the last 12 months, not to mention over the last three months or six months. So I would tell you that based on who we're competing against today, who we're winning business from, we also track where those cases leave, what competitors we go to, the mix is identical to what it was a year ago, and there's nothing out there that is surprising us or is losing it's head at this point.

And I will point out, we actually had about a 10 percent increase in the number new plans sold this quarter over quarter last year, so we're actually starting to see more cases. So the trend is actually going the other way.

OK, good, and then just one follow-up. Can you just comment on what your, I know you gave the net investment losses. Can you just comment on what gross investment losses were for the quarter?

Well, you take, I guess the way to answer that is to take the 70 million that's investment loss divided by .65. That gets you up to a gross number, but imbedded in that number are some gains in sales of assets, some losses on sales of asset without getting into impairments or through investment losses. So I think that's about the number.

Well I guess what I really wanted to get at was what were the amount of gains you harvested in the quarter to offset, if you can give us an idea of the magnitude?

They're passing me a sheet right now that's, the gains were about $83 million gain on sale of bonds.

OK, now is pre-tax?

Pre-tax.

OK. Thanks.

Yes.

Thank you .

Your next question comes from of Goldman Sachs and Company.

Thank you. Good morning.

Hi .

Just have a few questions. My first relates to Australia. You talked about assets now as having an outflow to maybe even the beginning of next year. Do you think we should anticipate that you might have to review the goodwill recoverability again in the second half of this year, if those assets continue to leave. That's my first question.

My second question is, could you talk to the, your expectations of investment performance, not only in your fixed income securities, but also in your mortgage portfolio? Do you think that we have to be prepared for maybe some erosion going forward in the commercial mortgage portfolio?

And then lastly, just anything about the mortgage servicing rights, again, any pressure to bring that down, maybe in the second half as a percentage of your servicing portfolio?

OK, , we'll try to answer those. I'll call on people as needed. Let me just talk about Australia quickly. Clearly there's two things going on there. We had expected outflows to be fairly significant and as I said in my remarks, there's actually abated a little bit in June and July, but I think one of the issues we're facing is global equity markets in general are becoming very depressed and not only, you know, in the past we would have argued that much of our problem was related to our own investment performance and I would say now we're seeing some effects of global equity markets. So people are starting to get out of international equities as an asset class and so we are getting kind of a double effect there and while we have worked hard to improve our own investment performances, obviously nothing we can do about the macro, you know, equity market, particularly the international.

In terms of the goodwill write down, we'll make that determination at the end of the year. You know, I'll be very honest and I think anybody that has a large asset management business that has been purchased, if equity markets continue to be depressed like they are, you know, your assumptions are built on future equity markets and so, you know, that will be a factor no question but right now we feel comfortable, we'll review it at the end of the, you know, at the end of the year like everybody else and make that determination but as I said in my remarks, we're absolutely committed to turning that business around and to putting a lot of resources to do so.

Investment performance, fixed income and mortgages, maybe I'll look to to make a comment and then maybe Mike to chime in as well.

On the investment performance and fixed income in particular, over the three month period 68 percent of our funds and 78 percent of our assets under management were above median. This is pointing to the fact that we can through an extremely difficult and extraordinarily difficult with some credit impairment within our portfolios. This is in the corporate sector but with less than most of our competitors did and I think that's a pretty healthy results and it reflects the high quality and the large effort we have in credit research.

On the mortgage investment, clearly we're seeing some quite good things happen in the mortgage in terms of performance. We see very little evidence of impairment yet in that part of the portfolios. Obviously we're monitoring it but, you know, mortgages are a prior charge and we see very little evidence that there's to much going on in the mortgage part of the portfolio.

I think you were asking also maybe about mortgage credit and what . . .

Quality.

Quality, yeah.

Right.

Joe, I think we're -- basically we've seen very few problems in the commercial mortgage portfolio. That's holding up very well and so looking out through the end of the year, for example, we are not expecting any significant amount of impairment in the commercial mortgage portfolio.

Looking at the fixed income portfolio, we're anticipating to see impairments roughly equivalent to what we've seen in the first half of the year. So I think our projection would be maybe another couple hundred million dollars of impairment over the third and the fourth quarter on a pre-tax basis. Obviously part of that depends on what happens in the economy and what happens with additional credit or to the credits but we're somewhat subdued in our thinking that the markets are going to return to anything to a normal condition.

Let me ask to comment on those -- the question relative to mortgage servicing rights.

Yeah, I think the question was, do we anticipate any pressure to bring down the value of the mortgage servicing rights in the second half of the year and that, of course, will be dependent upon what happens to interest rates and pre-payments on the mortgages in the second half of the year. We stay on top of that by the minute really and so at the end of the first half of the year we had the mortgage valued appropriately where they ought to be. We're also very heavily hedged now, so that - we've got financial hedges, so if we need to write them down, the financial hedges should work well to cover a significant portion of that. And the environment that would cause us to have to take more impairments on mortgage servicing rights would also be a positive on the originations, so we should have strong earnings on the originations side.

Just a follow-up - you did talk about the sensitivity to the equity markets. What if interest rates - what if the whole yield curve shifted down and interest rates dropped another 70 - 75 basis points, what - you know, what's the impact on the company if that were to happen?

Joan, from a - the major impact would be in the residential mortgage area. That would have an impact on service - the value of the servicing, as just described.

In terms of the - what would happen in the, I'll say, general account guaranteed area, really we're pretty well immunized. We do pay a lot of attention to matching assets and liabilities. So when look at interest rate shifts, it matters, but it matters very little. So, I can't give you a number, but it's, you know - a percent change in interest rates might mean, in terms of cents per share, maybe a penny or two or three a share.

OK.

So, interest rate changes do not have a major impact on the organization.

Great.

And in the Mortgage business, we are hedged, so, I mean, you know, that would - some of that would no doubt flow through, but a large part of it would be hedged.

Great. Thank you so much.

Thank you, Joan.

Your next question comes from Michelle Giordano of J. P. Morgan.

Thank you. Good morning. I have a couple of ...

Hi, Michelle.

Hi, there. Couple of questions - one, would you care to comment on 2003 EPS guidance?

Secondly, based on your recent discussions with the rating agencies, would anything have come out of that that would suggest you might slow down some of your share buybacks in the second half of the year?

And then third, could you just review with us how much you accelerated expenses in the quarter and what your methodology is and what kind of assumptions you have built in?

Thanks, Michelle. Let me ask Mike to cover those three.

Thanks for throwing that to me, Barry.

OK, I can take - I can take EPS. going to comment today on 2003.

We're looking at projections for 2003, and obviously, projections for 2003 are heavily dependent upon what the equity markets do and what investment conditions are in the second half of 2002. So we're unprepared, although I guess you could say we're somewhat muted in our view of 2003 just given the way the markets are acting today.

In terms of - let's see, another question was ...

Rating agencies.

... rating agencies. We have not had any real pressure from the rating agencies that would cause us to take a different view on share repurchase. We do have - if you look at our risk-based capital ratios, if you look at capital adequacy, if you look at liquidity, we're really sitting very, very well from a - I'll say a rating agency perspective.

And the third question ...

I'm going to throw to .

.

Yes, Michelle. Hi, this is . You asked about some of our methods and assumptions. I'll try to cover that real briefly.

I would, however, just start by saying that our products don't have a significant amount of , particularly the pension products do not because they do not have a lot of high acquisition expenses. So I think that's important to keep in mind.

In terms of our methodology, we use a methodology around our . We began that in 2001. The basic assumptions we have built into that is an equity return in the vicinity of eight to nine percent, which implies a total market return that's around 10 to 12 percent.

We use basically a 10-year period for our amortization. So that's the sort of the high levels around our methodology.

Thanks.

But it's been a fairly small percent of - I mean we have a asset compared to our competitors. And, of that, a fairly small percentage is equity related. So...

Yes. Which goes back, again, to the fact that our products don't have a lot of high acquisition expense built into them.

And due to using the version, we did not accelerate any amortization .

And how much - you know the reason why I was asking about the '03 earnings guidance is because you reaffirmed your target to hit the 12.5 percent by the end of next year, which sort of imply that you'd probably get your earnings. So what would have to happen in the operating market to cause you maybe not to hit that 12.5 percent by the end of next year?

Well as I said in giving the guidance, I talked about there being a, you know, 1.5 or a half percent each of the next quarters. And then we talked next year about a very modest improvement in the operating markets the rest of this year, which I just said. And then returning to somewhat normal.

So you know I think, as said, we're probably looking at somewhere in the five, six, seven, eight percent equity market return next year. Off of what it would normally be, but if we can hit those kind of equity market returns, we're still confident of hitting the 12.5 percent .

I think another element that would be implied there would also be very aggressive management of our capital base as well. So if you think about levers we can pull, you can pull on the operating income lever and you can pull a little bit on the utilization of equity lever. And we would hope to pull on both levers to get to that 12.5 percent.

Great, thank you.

Your next question comes from Len Savage of Fox-Pitt Kelton.

Good morning. And, first, I just wanted to thank you for the additional disclosure. That's really helpful.

Just back to the redemption rate, , if you can talk about it, I'm getting a sort of annualized rate this quarter of 24 percent compared to about 15 percent a year ago. Is the year ago more in line with what your expectations are? And if you could break it down for us, you mentioned member level redemptions and then employer level redemptions. What percentage of the redemptions come from each of those two buckets?

I'll try to give you a little more information on that. Intuitively, it feels to me like 24 percent versus 15 percent is a much sharper increase than what is really going on in the business in my own personal view. In terms of - let me break it into two pieces.

The first piece would be employer level withdrawals, again because of financial reorganization, et cetera. And basically, as we've said in the past, kind of the long-term historical lapse right there has been about six to 6.5 percent. And today, Len, that's running a little bit - if you take the first two quarters, it's running a little closer to eight percent.

So, again, there's a little bit of a tick up there, but it's not that significant. And, again, we do see that perhaps coming back down over the next couple of quarters, because some of that is a result of this lingering that we saw from '01 into '02.

In terms of member level withdrawals, the long-term experience that we've seen is that we see a lapse rate in account values because the member withdrawals were approximately nine percent. And, today, that number, if you annualize it, is running approximately 10 percent. So again, it's up a little bit, but not up in a very significant way and that is very closely tied to how the economy will do on a going forward basis. So I hope that's helpful.

Yes, that's very helpful and just one last question. If someone can comment on, I know you don't want to give us a dollar amount for the Key Corp, but can you give us some timing? When should we start seeing those sales impact your flows and how long will that last? How many quarters will it take to get that book moved over?

Sure, let me, I'm going to ask to answer that. Let me add one comment to your prior question, just make sure that we understand the demutualization effect. We're basically saying that we have some bunching of lapses in the first quarter. It probably should have been prior to demutualization, so what's happened is when people understood they had a payment, they obviously kept their plans, beyond which they normally would have and then after the payment, so I would say we probably got a little lower results last year and a little higher this year and it's probably the right number somewhere in between.

OK, that's helpful.

Back to on your new question.

Sure, hey .

Hi.

We anticipate most of the action taking place over the course of the next two quarters. We are, we spent the month of July, obviously announcing this and moving into the setting up of meetings with the prospects or the current Key Corp customers. And those meetings are starting to unfold right now, in addition to some additional meetings are being set up, but you'll start to see some of those decisions being made over the course of the next quarter or two and then the ultimate impact of those assets starting to unfold in the first half of 2003.

OK, thanks very much.

You're welcome.

Thanks.

Your next question comes from of Bear Stearns.

Morning. I have three questions. First, on the attack issue, $10 million increase in amortization in , could you give us a sense of, you know, was there actually an impact over there?

Then moving over to group life and disability. It looks like the benefit ratio came down nicely, sequentially, as you had mentioned in your press release, could you give us a sense of what the morbidity ratios comparables would be for the disability product?

And then thirdly, could you talk about the performance over, say the last three months and the last year at BT Australia, and what the pumps would be versus their competitors?

, I think that last question got cut off just a little bit. You were asking about investor performance at BT?

Yes, the last three and 12 months versus the competition at BT Australia.

OK, good. Let me ask to take the first one on , and then we'll get to come in on group and life and health, and ask to take the BT.

Hi , this is . In regard to amortization, the, I described earlier in answer to a question, kind of the basic methodology that we use around our amortization. So that gives you the basic outline of it. What I can say is that the model itself basically would perhaps offset about half of the impact that the market would otherwise have on our amortizations. So that's, so there is an impact caused by the market in terms of the financial results, which you see for the second quarter. And I think the impact, if you netted everything out, was somewhere around five million on a pre-tax basis for the basic U.S. asset accumulation businesses.

And when you were actually answering the question for , did I understand it correctly that you assumed initially eight to nine percent and then the reversion to the mean is somewhere between 10 and 12 percent over the next 10 years. You mentioned the word total return but I wasn't totally clear on that. Is that the reversion to the mean?

Oh I'm sorry, Andrew. Yeah, I appreciate the chance to clarify. What I was saying there was that the assumptions that we use is an 8 to 9 percent equity return in our mean reversion methodology and then in addition to that there's typically a 2 to 3 percent dividend return that you get each year on the S&P if you look at it historically. So an 8 to 9 percent equity return implies in the vicinity of a 10 to 12 percent total return for the S&P 500. So that -- does that explanation help?

It does clarify it and then is there some to the mean, meaning like, you know, as some of the other companies had 8 to 9 percent equity market returns but there equity market reversion to the mean was somewhere in the 13 to 15 percent range because the market had gone down so much. Are you anywhere near there or have you just recently set you standard? I know you had made a big revision recently.

Yeah. We did adopt the in 2001, Andrew, so we're fairly new into this and the going forward returns that we would need over the remaining period is still in the sort of middle, double digits range. So it's still very much within the range of reasonableness and we don't feel that we need to do anything at this point relative to the . We do have caps in place. we do work with our auditors and we do have caps in place so that if that were to become an unreasonable future assumption, we would have to take some action in regards to the but we're not in any position to be nearer to that point at this present time.

OK. Great. Thanks.

I think some question about .

Yeah, Andrew, could you repeat your question on the disability? I wasn't quite sure what you were looking for.

Well I just was looking at the group life and disability and I saw the benefits ratio came down, you know, a good $8 million sequentially, about 20 million over the year ago quarter and the press release mentioned that, I think it did anyway, it was so much reading but -- that you saw some improvement in your . Could you give us a sense of your loss ratios in that area and what kind of improvement you've been seeing in the disability line?

Sure. On the group disability, our loss ratio for the second quarter this year was 82.3 and that's down from first quarter of 93.3.

Anything going on there or just really gotten your claims management under control? What was the ?

It was a combination of three things. One, it is claims management, much more attention to the claims management aspect of it. Another piece is just better this quarter and the third piece is some price increases.

OK. Great.

And then your -- I think your last question had to do with BT investment performance over the last three months and the 12 months.

Right, versus the peers.

Right. OK. let the index benchmarks are more important in retail funds in Australia than in most countries. On the index benchmark last quarter was slightly below than it was third against the peer group. Talking both the year to date in the last 12 months we are -- we're basically close to benchmarks and either second or third group depending on which fund you look at.

The residual negative comments in Australia on investment performance mostly relates to 2000 and over the last 18 to 24 months we've been basically in the middle of a . Given that we've got somewhat of a gross biased, we regard that as actually a reasonable out turn. Against the more competitors in the Australian market we actually show up pretty well.

Given your strong brand name, does help you get a decent level of inflows?

Our brand.

Given your strong brand - given the sort of ratings - or performance rather - is that good enough to get decent inflows?

Not right now in Australia. And the big feature right now is something Barry mentioned earlier which is that the very poor absolute returns of international equities from an Australian base have induced people to allocate assets away from international equities. And remember, we have a particularly high market share in international equities among the Australian funds groups. So it's really these macro factors that are putting us under pressure rather than our own performance.

And, you know, bear in mind that the Australian equity market has been one of the best performers in the world. So, you know, they have - or at least in the developed world. They have felt that the international equities have done them no favors, and people are allocating away from that. And that's really the issue that's causing our outflows rather than any relative performance in the last few months.

Great. Thanks so much.

Your next question comes from Elizabeth Malone of Advest.

Good morning.

Good morning.

Yes, could you give us a little more color on the opportunities of a KeyCorp-type acquisitions in the future? I mean do you see this as a - as an area where there is going to be a lot more opportunity for you and where there is opportunity for - can we assume that there's going to be growth coming from these types of transactions in the future for Principal?

Well, , I certainly think so. I mean I think we've probably spoken about this to others. We really see the KeyCorp move is maybe at the front end of a trend. You know, we've actually been involved with others of these. We were involved with a . We took over - , - is that the right ...

Yes, that's correct.

We took their business over. The - , we've taken over their business. So we really do see this as an early trend. And, yes, I believe it will benefit our growth because we're obviously the market leader and we're going to be there at the table when these things happen. So we see it as a very, very positive trend from our perspective.

What factors in the marketplace do you see driving companies to make a decision like that to decide to get out of this business and also to choose Principal to help them do that?

Yes, I mean I think there are a lot of things going on and you really have to almost look sector by sector, and I'm not an expert on the banking industry. But clearly you've seen a lot of banks start to get back to their core businesses and getting out of some of the periphery businesses. There's no doubt that being in the full-service defined contribution business requires an awful lot of heavy investment and technology administration. And it's my belief that providers are just having to make a decision to invest heavily in the business or to get out of the business. And it's not a place that you can dabble. And I think many, many organizations, you know, are looking .

Why would they select us? Well, I think lots of reasons - you know, our great competency in this business. But I think at the end of the day, they need somebody that they can rely on that can take over the business, can provide professional service, has the name recognition. And it would seem to me that people will increasingly go to the market leader when they want to provide the best for their clients when they're getting out of a market like that.

OK, thank you.

Your final question comes from Jeff Hopson of A.G. Edwards.

Hi, Jeff.

Excuse me. Good morning.

Can you give us a little more information on the business? I know you're making progress there, but it's still relatively small in terms of the contribution to earnings, but can you give us a little more details on the progress? And on the individual life business, you're making progress there in terms of sales, et cetera. Can you give us a few more details in particular? The - any increased penetration of the small, medium-sized business market?

OK. Let me ask to cover the super , where we stand there, and maybe make a comment on as well, because it's kind of closely aligned.

OK. Hi, , this is .

In terms of corporate super , as you know, we've had a real strategic priority around that business since the time of the acquisition. And just to take you back to where we were then, we had a market share in that business that was just a little bit under one percent. And where we're at today is our market share is right around the three percent level.

So we have certainly been gaining ground in that. And, as Barry commented in his remarks, we continue to have some nice wins in that area of the business because it does offer a more open architecture investment platform, so it's not tied as exclusively to proprietary investment performance.

In terms of the profitability of that business, because we've had to make some investments over the last couple of years, it's in about a breakeven situation this year. We expect we will come to about breakeven by the end of the year, and we do expect it to contribute to profitability for and the enterprise in 2003.

And in terms of , obviously that's been a very, very strong business for . Again, Barry commented on that, and it will be a strong driver both of growth and profitability actually beginning this year and continuing on into next year as well.

, you want to make a few comments about individual life sales?

Sure.

As you mentioned, we are seeing improvement in individual life sales. And much of that growth and future growth will come in the small and medium-sized business market. A lot of the growth this year, and really a prime driver this year, is coming through our EBS, Executive Benefit Services subsidiary that we purchased last year that is marketing non-qualified 401K plans funded with life insurance. So that is driving a lot of our current and future growth going forward.

OK, thank you.

Ladies and gentlemen, we have reached the end of the allotted time for questions and answers. We will now go back to Mr. Barry Griswell for today's closing remarks.

Well I just want to thank everyone for joining us today and taking the time. We hope that the information we gave you was helpful. We look forward to communicating with you often during the coming months.

And I'll turn it back to the moderator, .

Thank you for participating in today's Principal Financial second quarter earnings call. This call will be available for replay beginning at 1:00 PM Eastern Standard Time today through 5:00 PM Eastern Standard Time on August 13, 2002. The conference ID number for the replay is 4766888. Again, the conference ID number for the replay is 4766888.

The number to dial for the replay is 1-800-642-1687. And for international calls, area code 706-645-9291.

Thank you again for participating. You may now disconnect.