美國信安金融集團 (PFG) 2002 Q3 法說會逐字稿

Good morning, ladies and gentlemen, and welcome to the Principal Financial Group third quarter 2002 results conference call. All lines have been placed on mute to prevent any background noise and after the remarks will be a question and answer period. If you would like to ask a question during this time, simply press star and the number 1 on the telephone keypad. At this time I will turn the call over to Mr. Tom Graf, Senior Vice President. Mr. Graf, you may begin, sir.

Thank you. Good morning and welcome to the Principal Financial Group's third quarter conference call. If you don't already have a copy, our earnings release and financial supplement can be found on our website at www.principal.com/investor under financial overview. 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 marks. Then we'll open up for questions. Available for the Q&A are: John Aschenbrenner, Executive Vice President responsible for life and health insurance and mortgage banking statements; Mike Daley, Executive Vice President responsible for marketing and sales; Jim McCaughan, Executive Vice President and global head of asset management; Larry Zimpleman, Executive Vice President responsible for the U.S. asset accumulation businesses; and Julia Lawler, Senior Vice President and Chief Investment Officer.

Some of the comments made during this conference 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 to 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 June 30, 2002, filed by the company with the Securities and Exchange Commission.

Barry?

Thanks, Tom.

Once again let me also extend a personal welcome to each of you on the call this morning. I'll provide a brief overview of third quarter results, accomplishments and our progress in executing our strategies. Mike Gersie will follow my comments with a detailed overview of financial results.

Certainly we are extremely pleased with third quarter results. First and foremost we delivered record operating earnings, as all segments performed well in what was arguabley the most difficult quarter in decades with a weak economy, declining equity markets, and falling interest rates. Mortgage banking had an exceptional quarter driven by continued strong mortgage refinancing activity. Another key accomplishment for the third quarter was record net cash flow from our pension accumulation business. Strong sale success over the past few quarters is driving strong deposits and strong net flow. Pension accumulation deposits are up 29% over the same quarter a year ago and net cash flow from that business is up 37% over a year ago. This increasing cash flow along with expense controls allowed us to deliver solid third quarter earnings and 11% increase for full service accumulation compared to a year ago in a time of unprecedented equity market declines.

Our sales momentum and retirement businesses was particularly strong in the third quarter. New full service accumulation sales were a record 1.4 billion, up 70% over a year ago. This will contribute to continuing growth in deposits and net cash flow in future quarters. Compared to the same quarter a year ago, sales of individual annuities were up 54% and sales of mutual funds up 57%. All in all strong marketplace demand for our key retirement products.

We continue to focus on and experience very solid results from previously announced distribution alliances. For the third quarter we had $329 million sold and committed from alliance partners, bringing our year-to-date total to over $1 billion. In addition, new relationships in the bank channel and strong demand for our fixed annuities drove positive net cash flow of nearly $100 million from individual annuity sales.

We are also experiencing ongoing success in asset retain. During the quarter we retained 52% of at-risk assets within the full service business, demonstrating continued success in this critical area. Consolidation of the defined contribution business in the U.S. is accelerating. This is a promising trend as we continue to focus on accelerating growth in our U.S. defined contribution business.

In providing an update with our agreement with Key Corp, let me start by saying that based on our results to date, we are viewing this as a very significant success and will definitely be in the marketplace again. That said, we are not going to project an overall conversion rate for plans or assets under management. This information will be a competitive advantage to the principle in bidding and negotiations for potential future blocks of business. What I can tell you is this: Our national distribution foot print uniquely positions us to execute this type of sponsored endorsement agreement, enabling us to add sales volume within our existing sales infrastructure. Our buying decisions are taking longer than expected. For whose who have made a decision, we are very pleased with the closed ratio. We are successful running cases in the middle and larger end of the SND market with plans that are significantly larger than our average new sale in terms of assets under management and participants.

Importantly we had a noteworthy third quarter in terms of investing performance for funding managed by Principal global investors. For the 12 domestic and international equity funds in our array of pension suffered accounts, half are in the top for the quarter and the trailing twelve months. Of these funds 75% are now in the top half for the trailing twelve months compared to 50% only a quarter ago. In terms of our three-year performance we now have 42% in the top half compared to 17% as of the second quarter 2002.

In addition, Spectrum Asset Management, our preferred securities subsidiary, had another outstanding quarter. [INAUDIBLE] Adjustments selected Spectrum as the sub-advisor for a second closed end fund. Spectrum's assets under management are now $4.2 million, up more than 300% since we acquired the firm in October 2001.

As you know at the end of August we announced that we reached a definitive agreement to sell substantially all of BT Financial Group to Westback. While it was a very difficult decision, it was the right decision for us. That transaction closed October 31. Mike Gersie will discuss that in more detail. In view of this sale, I would like to take a moment to re-emphasize that our international growth strategy going forth remains intact. We remain committed and well positioned for international retirement services growth.

First International which continues to make excellent progress in terms of growing earnings, assets under management, and customer base, demonstrates we can be successful in capitalizing on asset accumulation opportunities on an international basis. A great example is our second quarter acquisition of Zurich Zipora pension business in Mexico, which is making a meaningful contribution to results. We'll continue to make strategic acquisitions as we work to appeal and to position our operations in Latin America and Asia for future success.

As we previously discussed, I'd like to touch upon two other key areas of focus within the organization. Through our operational excellence program, we continue to identify sustainable ways to improve the efficiency and effectiveness of the organization. Through process improvements, performance management, contract negotiations, and employment cost management efforts, we've already achieved in excess of our targeted $25 million expense reduction for 2002, and we are committed to doing so again in 2003.

In terms of effective use of capital, during the quarter we completed the $450 million repurchase program authorized by the board in February of this year purchasing approximately 15.9 million shares at an average cost of $28.22. We also began to repurchase shares under a new $300 million program authorized by the board in August. Through November 1, we've repurchased 9 million in shares in the new program at a cost of $243 million for an average price per share of $26.84. In addition to utilizing capital fund organic growth and strategic acquisitions, we will continue to opportunistically utilize share repurchase as an option in our efforts to effectively manage capital.

Before I provide guidance, I'd like to make a few comments about our investment portfolio. While market conditions remain difficult, our investment portfolio is of high quality, well-diversified by industry, geography, property type, and individual credit. We continually and aggressively monitor our portfolio and take appropriate action to minimize the impact of this difficult environment. We believe this has enabled us to be relatively less effected than many market participants.

Moving to guidance, we expect the fourth quarter 2002 operating earnings to range from 51 cents to 54 cents per diluted share. I'd also like to provide some guidance on our outlook for 2003 operating earnings, which we expect to range from $2.25 to $2.40. This is a fairly wide range, but one we will be refining throughout 2003. These estimates include the impact of expensing employee stock options, which we began in the third quarter. 2003 estimates do reflect an estimated 4 cents a share for stock option expense and 12 cents a share related to our pension benefit expense. The estimates also incorporate certain assumptions. Domestic equity market performance improvement from September 30, 2002, levels of 2% for the remainder of 2002, and roughly 2% per quarter equity market growth throughout 2003.

In handing it over to Mike, I'd like to add that we'll continue working hard to grow earnings and effectively utilize capital. We are confident that through our efforts and equity in market recovery we'll be able to achieve our ROE target of 12.5% in 2003. Mike?

Thanks, Barry.

Before I get started, I want to discuss the topic of communicating corporate performance. October marked the end of our first year as a public company. Through our actions we demonstrated a real commitment to providing investors the information they need to make investment decisions. Our commitment is reflected in the financial supplement, which we've been told is the most comprehensive in the industry. It's also been reflected in our disclosure practice. We provide guidance each quarter. We were the first of our peers to decide to expense stock options, and we were only one of a few companies that publicly released information regarding exposure to Enron and Worldcom. We proactively established a pattern of behavior to let investors know that if there is material news, we'll share it with the world. Given our history, we were frustrated about speculations several weeks ago, with the problems besetting one of our mortgage banking competitors applied to us as well. We hope that at the end of the day the investment community will come to recognize that Principal is an organization committed to full and fair disclosure.

I'm assuming everyone had the opportunity to review the earnings release and financial supplement. I'll spend a few minutes covering current results and providing some commentary that will be helpful in understanding our outlook for the remainder of the year and beyond. As Larry mentioned, we were very pleased with results for the quarter. There are several things worth highlighting in the segment model. US Asset Management and accumulation earnings up 3% for third quarter 2002 compared to the same quarter last year, while the S&P has declined 22% over the trailing twelve months. Fundamentals of the segment continue to be very good. Cash flows were strong. New sales were excellent, and expense picture shows good control.

As Barry indicated, pension delivered a 70% increase in new full service retirement sales for the quarter. Nearly 68% of the cases year to date have been takeovers of existing plans. We define new full service sales as annualized deposits and assets transferred to us, and view them as a leading indicator of the strength of our product offering.

We also view net cash flow as a leading indicator, and full service accumulation delivered a record $929 million for the quarter. Strong new sales during the year helped drive a 29% increase in full service accumulation deposits compared to third quarter 2001. You won't see a direct correlation between year-over-over sales growth and deposit growth. Sales only make up one component of deposits, and a lag from when sales occur and the time deposits arrive.

Pension earnings also improved slightly compared to third quarter last year in spite of higher amortization expense in the third quarter. While U.S. Asset Management accumulation earnings were down compared to second quarter, we view third quarter earnings as very solid. Second quarter 2002 benefited from strong securitization earnings within Principal Global investors. Compared to the second quarter, full service accumulation has lowered investment income due to declining average asset yield. It also experienced a decline in fees as account values dropped 1.8 billion in the quarter due to equity market performance. We also experienced a decline in investment only, reflecting a true up related to our foreign currency dominated agreements. We continuing to grow even though equity markets sustained growth in asset-based fee revenues. This reflects strong cash flow and the benefit of managing a diversified investment portfolio. Despite equity market declines, segment assets under management increased 12% from a year ago.

Within our international asset management accumulation segment, principal international's earnings improved by over $3 million quarter over quarter. The increase primarily reflects increased earnings from our Mexico pensions business. 1.2 million of the improvement relates for nonamortization portion of implementing FAS 142. As a result of the sale of substantially all of BT, we recorded an estimated after-tax loss of $201 million in the third quarter. The loss which is smaller than the estimate originally provided reflects higher than expected hedge gains and tax benefits and overall conservatism in our original estimate. Pursuant to FAS 144, accounting for impairment or disposal of long-lived assets, all revenues and expenses excluding corporate overhead allocated to the discontinued segments were reported as discontinued operations. Therefore third quarter operating earnings for BT reflect allocated corporate overhead expenses.

While Principal International's revenues were down $141 million, $125 million represents the sale of a large single premium group annuitity case by Mexico in the third quarter of 2001. Principal International assets under management are up a billion or 31% compared to third quarter 2001. Excluding the exchange rate of impacts, assets under management would be up 1.5 billion or 47% for the same period.

Moving to life and health, revenues grew $17 million. The increase occurred despite $11 million in premium seeding during the third quarter related to the group medical re-insurance agreement effective January of 2002. At $56 million, we view third quarter segment operating earnings as very solid. While earnings were down $5 million compared to a year ago, the decline reflects a return to more normal loss ratios for medical and dental compared to the unusually low loss ratios experienced in the third quarter 2001.

Return on equity for the twelve months remains near an all-time high at 12.8% significantly improved compared to 9.4% in September 30, 2001. As Barry mentioned, Mortgage Banking hit another outstanding quarter. Operating revenues increased 51% to $313 million. Production during the third quarter 2002 remained strong at $11.1 billion compared to $10.5 billion in the year earlier period and $9.1 billion in the second quarter. The record $63 million in operating earnings was driven by strong loan organizations, reflecting increased loan closing volume. The record also reflects an increase in margins on loans originated as mortgage lenders are approaching maximum capacity due to high volumes throughout the industry. The servicing portfolio had $102 billion as of September 30, 2002, and also continued to grow at a solid pace during the quarter, up 5.5 billion from June 30, 2002, and up 30 billion compared to September 30, 2001.

As you may have noticed, we have provided two new tables in our financial supplement, a mortgage servicing rights role forward and the impact of mortgage servicing rights hedging that guidance. As we've discussed, it's impossible to perfectly manage hedges to risks; however, as you can see, we continue to effectively utilize hedging to deal with the impact of interest rate movements on the value of our mortgage servicing rights.

Total company assets under management were down slightly from second quarter at $117.4 billion as of September 30, 2002. Sales activity throughout the year helped to offset the impact of equity impact declines. As we previously indicated, our ability to continue to meet earnings growth expectations depends on a number of factors including resumption of more normal growth in the equity markets. Clearly our aggressive and ongoing efforts to sell new business, to attain assets, and manage expenses have delivered real results as we continue to combat challenging equity market conditions.

Before moving to questions, I'd like to discuss our net loss for the quarter. It reflects the previously mentioned estimated loss of $201 million related to the sale of substantially all of BT, which falls under nonrecurring items. It also reflects after tax net realized and unrealized capital losses during the quarter of $147 million, which compares to net realized and unrealized capital losses of $45 million a year ago. 50 million of the increase relates to unrealized losses of mark to market adjustments under investments and government sponsored mutual funds. It also reflects higher losses for impairments. Approximately $28 million higher for fixed securities and $19 million for equity securities. Clearly this is a very difficulty equity and credit market environment. We have a very high quality, very diversified investment portfolio. We aggressively monitor each investment and continually assess our exposure to troubled sectors of credit. While we expect to see additional capital losses in the fourth as well as the first half of 2003; we expect the losses in the second half of 2003 will be much improved. This concludes our prepared remarks.

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 and then the number 1 on the keypad. We'll pause just a moment to compile the Q&A roster. Your first question comes from Collin Divine from Salomon Smith Barney.

Good morning gentlemen and congratulations on the exceptionally strong quarter. A couple of quick ones. First, can we talk about the investment portfolio a bit more? Frankly, the losses were somewhat surprisingly high and more than I would have expected. And then if we could also do an update on where you view your capital position is. Obviously several of your competitors such as Hancock appear to have capital and rating agency problems and just where you stand and sort of future share repurchase levels we should expect.

Hi, Collin. How are you doing? This is Barry. Let me give you a quick comment on each of these, and then turn it over to a couple of my colleagues to give it more detail. On the capital losses, I don't know if you have all the details there, but when you cut through all of it we really had 147 million, I think, realized and unrealized. When you get that down to what I would call the true capital losses, it was really about $70 million. We had $50 million that was really related to money we have and seed money in mutual funds, which was an accounting change, kind of a mark to market, if you will, and we had a similar kind of thing in the equity securities of $20 million. So if you really get it down to the actual capital gains and losses, it was only about $70 million, and that compared favorably. It was down from where we had been. I'll ask Julia Lawler maybe just to amplify if I gotten those facts right, Julia, or anything else to add.

Hi, Collin. Yes, Barry got that just right. And I'm not sure what you were comparing it to, but if you look at credit losses related to fixed income, securities were actually less than we projected last quarter for this quarter. And so I'm guessing what your --

What was the gross number again for your losses?

$147 million.

Gross. Okay.

That was the gross excluding the nonrecurring. That's after tax. And 50 million of that was related to the seed money as I mentioned and another $19 million was the equity.

Yeah. I think the biggest piece of the increase is related to the equity securities as opposed to fixed income.

On the capital position, I'll ask Mike to chime in. We are actually sitting in a good position. Mike, you want to respond?

We are sitting in reasonably good situation, Collin. Remember we were extracting capital from the BT operation, so we can dump that in the capital available for investment bucket up at the holding company. We have not had any real pressure from the rating agencies about our capital position because risk-based capital is still showing up very well. Remember, we talked about a target under the old risk-based capital somewhere around between 240 and 260, translating into under the new risk-based capital around 375, and we think that we'll be in excess of 375 at the end of the year even with asset impairments at the life company.

If I could just interject for a second, Mike. That's ending off last year, I believe. You were at 448 under the old.

I believe that's right, Collin, yes. So it will come down some, partly because we divided money out of the life company. We also had capital losses taking in the life company, but still we'll be in excess of the target that we've set for us, and that seems to at least in our discussions with the rating agencies be satisfactory to the rating agencies. Can't speak to where they'll go in the future, but at least as of today we don't see real capital crunch coming.

So there's no need to -- you know, you're not suspending your share repurchase program unlike Met, Lincoln, or Hancock?

Obviously we'll be taking a look at it. We've got the 300 million program that's authorized, and I think we, in our press release, we announced that we have completed roughly 250 million of that program. Hope to, I suppose it's forward-looking, but get that done by the end of the year. And up to the board to decide whether we'll have another program subsequent to that. Certainly we'll have capital available if we chose to implement a program.

Okay. And the other issue on the rating agency situation, it was my perception that for whatever reason, justified or not, they were concerned with the mortgage banking unit. And, you know, the volatility that it might cause to the parent, the potential risk it might represent to the parent. Is that now diminished with what were totally very strong results for the third quarter, or is this still on an ongoing source of discussion?

Collin, I'll let John Aschenbrenner chime in. We are just announcing our results today so we haven't been in contact to agencies relative the third quarter. But there is no doubt it will be an issue with them. It will continue to be an issue. Quite frankly, many times I don't think the rating agencies understand this business. They don't find this business in many of our peers. It's an education. It's back and forth between the agencies. No doubt it's a lower-rated business so we'll continue to have pressure. We continually try to convince them we manage it extraordinarily well; we have a great pattern of managing it, and I think we are have a good dialogue and I think they are starting to understand the business, but no doubt it will be an issue over time.

Thanks, very much, Barry.

Your next question comes -- your next question comes from Ed Spehar of Merrill Lynch.

Hi, Ed.

I had a couple of questions. I guess, could you talk a little bit about -- when you think about BT, the amount of capital now that you've freed up from this, can you remind us how much you're thinking that is today, and has that changed at all from when you announced the sale? And related to that, the BT thing didn't work out like everyone had hoped. But I'm wondering how do you sort of think about the long-term growth rate for the company now? I think that BT had been expected to be a pretty nice contributor at the margin if you look forward over a number of years. I'm wondering has this changed at all, your expectation about long-term earnings growth for principal? Thanks.

Sure Ed. Let me answer the last and let Mike give you a quick recap for the capital for BT. I don't think it has changed our long-term growth expectations. We had BT in the model as ramping up growth, but it was going to take a number of years for that to become a reality. We are very, very pleased with the growth in our other international operations, particularly in Mexico where we made the Zurich acquisition. Frankly, we are getting much more optimistic about growth within the United States as we talked about consolidation of the DC business here, the Key Corp kinds of activities. If you just look at our normal growth, when you think of an equity market returning to normalized rates, I think you're going to see us right in there with the growth expectations that we communicated on the road show, and I really don't -- and later comments as well. And I really don't see the BT acquisition significantly changing our growth outlook at all. In terms of BT Capital, it's actually -- we're going to have realized more capital than we thought because we have got some hedge unwinding that is actually a little bit of positive. Maybe Mike can give you a quick overview of that. Mike?

I'll try. I'm roughing out some numbers on the back of an envelope here just trying to give you the best number I can come up with. I think the capital it will free up will about somewhere if you talk about not only the capital extracted from BT but also some gains on the hedges and the tax benefits that we're able to achieve out of BT. That will free up somewhere I believe between -- around $700 million of capital. So I think that speaks to the fact we've got a fair amount of dollars that we can redeploy in the business. Any follow-on to that?

Yes. That's perfect. Thanks. I wanted to ask, Barry, when you talk about getting more optimistic about growth in the U.S., it's a very interesting comment given that I think most asset accumulaters would probably be heading in the other direction in terms of their outlook. What is really -- could you kind of go through, maybe, a couple of things that you're seeing now that is really driving the consolidation in the D.C. market? Is it largely the regional bank issue? Is there something else going on that could add color? Thanks.

Sure, Ed. I think -- and Larry Zimpleman may want to join in here and make a few comments. But I think the equity market decline that we've seen over the last year or two is putting enormous pressure on competitors who are -- for whom this is not the core business, and that does include regional banks and money center banks, it includes smaller insurance companies. Look at the fact that Hancock and Met and others have outsourced administration. So it's putting pressure on a lot of folks for whom this is not their core business. This is our core business, so we would expect to be a net winner in this kind of consolidation. If you look at our sales numbers, 70%, 1.4 billion for the quarter. If you look at our alliances, we just feel strongly we have a business model that works, and we can sustain a lot of growth with our current infrastructure, and that gives us a very positive outlook. While equity markets may not go back to the robust levels they were over the last decade, we believe they will go back to the more normalized 8-12%, which will give us good growth. So, Larry, you want to chime in?

I just had a couple of comments. I think Barry covered it well, Ed. There are today 250 to 300 competitors in the full service contribution or 401(k) market, and that's just a bigger number than I think any of us believed can be sustained. So, that speaks to our comments, I think, consistently over the last 12 months or so about consolidation. So I think when you put that together with the scalable business models that Barry spoke to, that's really why we are optimistic about our ability to grow our revenue and earnings from that part of the business.

I'm sorry. Not to take up too much time, but just one final thing. Is there any reason for you to want to acquire any of those companies or is it just better to sort of have the type of agreements we are seeing with Key?

I'll comment quickly, Ed. This is Larry. We really prefer the endorsed sponsorship kind of arrangement we executed with Key Corp. And, by the way, it's the same approach we executed with the two prior deals as well. Both Wilmington Trust and Life of America. Because the reality is that we have really no interest in record-keeping platforms or other infrastructure from these other providers when they exit the business. What we really want is the business, because we have scalable platforms, and that's how we get the biggest bang for the buck.

Thank you.

Your next question comes from the line of Michelle Giordano of JP Morgan.

Good morning. I was hoping that you could comment a little bit more about the significant improvement in withdrawals in the full-service accumulation business. Was it anything in particular that you were doing in terms of active efforts or just that there's less potential players to go to? Secondly, I was hoping that you could give us some more details on where you expect the realized losses to come from in the fourth quarter by specific asset classes or industries? And, third, could you talk about our your gig spreads are holding up and what you think the outlook is for these spreads going into next year?

Hi, Michelle. Good to hear from you. Let me ask Larry to take both the first and the the third, the full service and then gig spreads. And then we'll ask Judy to come in and answer your question on the losses from the fourth quarter. Larry?

Michelle, good morning. In terms of lapses under the full service segment, you know it's a great observation. The lapse rates have been coming down. We felt that they would be coming down. They're actually under the normal sort of assumptions that we've seen historically from that business. The driver there, and I think again we commented on this in prior calls, the driver really was a slight bubble up as a result of the demutualization activity. So in the first and second quarter this year, there was a slight bump up in those lapses as those employers hung around to wait for their demutualization credits. They'd already made the decision, but they hung around and left after they received that. In terms of the gig spreads, Michelle, certainly while the yields continue to come down, we work very hard to maintain the spreads, and so far all of our work is paying off. While there's pressure there, we are not seeing diminishment at this point.

And can you remind me what the gig spreads are?

It would be in the range of 60-70 basis points.

And we'll ask Julia to comment on expectation for losses in the fourth quarter.

Hi, Michelle. Yeah, I think what you asked was where do we think that will come from. The asset class class that we're probably watching more closely continues to be public bonds. While we have a very thorough process to look at a lot of industries and a lot of names, you have to say that the dominant industry that we are watching for fourth quarter would be energy utility.

And could you tell us what your exposure is to each of those sectors?

Total exposure to utility and pipeline industry is 3.3 billion, but the benefit of that particular industry is made of -- covered in 87 different names. We are very well diversified in that particular industry. So when we say we are exposed, we have that level of exposure, we are probably looking at a much smaller group of names we would consider in more trouble.

Great, thank you.

Thanks, Michelle.

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

Good morning. I have a couple of questions on mortgage banking. In the press release you cited that you had some increased revenue from pooling and selling mortgages. I wonder if you could give us that number?

Do you have a different part of that question? We'll try to find that while we're talking.

Sure. I guess the second question on that, again on the mortgage servicing right, you wrote it down. It's still roughly 150 basis points, which seems higher than some peers at sort of 75-90-ish. I was hoping you'd give us color as to what's different in your portfolio compared to peers that the MSR rate will be higher.

We really do think that there are a couple of fundamental numbers that makes that a good number for us. First as we are doing agency mortgages. The servicing fee coming off of those is higher than many of our competitors that do nonconforming. You are getting basis points up in the 40-45-50 points. That makes a huge difference. The fact we have a very low coupon pool makes a huge difference. It's less sensitive to interest rate drops. Those are the two big, and I think the third would be that it's a fairly new portfolio which relates to the last comment. You factor all that in, you would expect to have this number be higher for us because of the nature of our business, and it's always been that way, and explained it numerous times, but those are some of the facts. On your comment about the pooling, quite frankly we're not sure what that number is. We will absolutely get it to you if you want to call Tom Graf following the call. I think it's a fairly obscure number, and we did mention it, but I don't think it's a significant number. We'll get it to you.

Okay. That's helpful. And just one more follow-up, if I could, on the guidance for 2003. If you look at this quarter and normalize the mortgage banking at $25-27 million, you're at 47 cents run rate. If you annualize that, you're at $1.90-ish or so. Your guidance is $2.25 - $2.40, that's up 18% to 25% from that normalized annual number, and you cited the option expenses or the pension expenses. Can you give us some sort of color? Where are you going to make up that kind of growth? Is there some higher expense savings that we should expect or just talk about how you get that growth off the run rate?

Sure. I'll let Mike jump in. We're at $1.61 right now, and our guidance is 51-54 for the fourth quarter. So, if you do the math and add the percentages. I think that is pretty consistent of where we have talked about being in terms of percentage increases. We are looking to manage our equity. So that's a portion of the equation. Mike, you want to add color, too?

I might quibble with where you put the run rate. Because I think we would put the run rate a little higher than that, Len. I would say we would view the run rate being more like between 50-52. We could easily get to a normalized for the third quarter at 52. There's other noise in some of the other segments as well. If you backed out some of the things in the mortgage banking segment, you might have to add in a little bit in the USAMA segment. For example, we took impairment of some DAC in the USAMA segment. We wouldn't view that as being normal. And so while it was a very modest amount, it didn't probably depress our earnings by a couple of cents.

Okay. So you think the run rate we've used in the past for mortgage banking is actually -- should be higher now given with what's going on with the financing?

Well certainly we're working off bigger volumes. A more normalized rate, you have to bump that rate up a little to reflect the higher volumes of servicing that we are seeing.

Remember, we went over the $100 billion mark, and that's a significant increase from the last couple of years.

Okay. Thanks very much.

Your next question comes from Joanne Smith from UBS Warburg.

Good morning. I have a couple of questions. Just on the MSR, since don't want to beat a dead horse, but if I look at the income you generated in the mortgage banking segment in the quarter, it was far, far above what we would have expected, and obviously was the source of the big upside surprise. I was wondering if there was a reason why you didn't take the MSR asset down more so it's closer to where the peer group is given the strength in the origination volume and the hedging gain. The other is a follow-up to Michelle's question in terms of the spread of the outlook for '03. I don't think that was answered. And then lastly with the run rate on the life and health, should we look at the $56 million that you reported in the quarter as more of the run rate on a go-forward basis given your comments concerning more normalized levels of loss ratios? Thank you.

I think I'll call on a couple of my associates. John Aschenbrenner will take probably the first and the last. And your middle question, Michelle, was that relative to spreads on gigs for next year?

Yes, it was in response to Michelle's earlier question about the outlook of gig spreads going forward.

And would you repeat your third question? 56 million on the medical. Go ahead.

The third question was really related to the run rate on life and health at 56 million; should we look at that as the true run rate going forward?

If we start with mortgage banking and go to the theory of valuing the servicing portfolio. The theory is we ought to provide our best estimate of the value, not to play games with trying to put in a conservative value when we have the chance to do so. This really is our best estimate. We had it verified by an outside independent valuation firm and by our auditors that this is the best estimate of the value of the servicing portfolio. I would go back to Barry's comment that we don't believe that we are out of line with our peers when you common-size the value with the differences of our portfolio. When you look at our higher servicing strip, when you look at the lower coupon rate and lower average age and higher preponderance of fixed rate mortgages, we feel we are in the middle of the pack as far as the servicing valuation. As far as run rate on the life and health segment, I guess the only comment I would make there is there was a slight decrease from the second quarter to the third quarter, which was primarily a result of the second quarter probably being understated -- or excuse me, overstated slightly because of lower claims in the second quarter but greater leg in claims carrying over to the third quarter. If you look at the run rate between the second and third, I would say it is slightly higher than the 56 you are seeing in the third quarter.

Certainly in the ballpark.

Very much, so.

And Larry will pick up the gig spread outlook.

Good morning, Joanne. In relation to the gig spread just to make a couple of points about that. This is a business we've been in for 20 years. We have some very knowledgeable and expert investment professionals that run an immunized portfolio in there. We do not see the gig spreads or the outlook is not for any negative effect going on there. We fully expect to maintain our gig spreads in '03.

Thank you.

Your next question comes from Caitlin Long from CSFB.

Good morning, everyone. Could you just comment a little bit, just to drill down further on the guidance range? You said that you expected roughly 2% per quarter of equity market appreciation, and yet given you didn't give a range on the equity market appreciation, I'm surprised that the range of the guidance is so wide. Can you provide more color on that?

Well, good morning. I think we are being a little bit cautious here to try to understand all of the variables that are going on. Nobody would look back and say that this year has been anything but unprecedented. We are just a little bit cautious moving forward. As I said in my opening remarks, we did give a broader range than we would normally give. We do have the mortgage business, and we do not quite understand if the refinance boom is going to continue. That's a bit of a variable. So I guess that would be the primary color I would give. We feel very comfortable that it is $2.25 to $2.40, and we'll refine that guidance as we get into the end of the year and as we go through the year we'll certainly nail it down as we see some of the external factors starting to appear in the forecast.

And just to follow-up on Len's question earlier where you talked about the sources of growth. If I look at the numbers in '02, a big source of the delta year over year came from the mortgage bank. Obviously, that was true in this quarter especially versus expectations. Next year is it fair to assume that your expectation is that the biggest driver of the growth is going to be coming from the core USAMA businesses?

That would certainly be our expectation. As I said, if we get modest -- I mean if you think about the drop and the equity markets over the last year and the fact we actually increased earnings in that environment, if you think about a more modest return in the equity markets and our continual focus on expense management and growing the sales volume, I'm absolutely convinced we'll have most of our growth coming from the core business.

That's great. And finally on the mortgage servicing rights, the hedge gain was almost 100% offset, the writedown. What portion of the MSRs are you hedging on a go-forward basis?

We target a 75-90% as kind of the range, and that will vary depending on the environment and a number of factors. But we are very highly hedged, and obviously in an environment we've been in recently we try to stay close to the 90%.

Okay. That's great. Thank you.

Your next question comes from Andrew Kliggerman of Bear Stearns.

Good morning. Three questions. Barry, at one point during the initial commentary you are ahead of the 25 million in '02 anticipated expense saves, and that you expect the same next year. Does that mean we can expect another 25 next year? Second question on excess capital or free capital. A lot of numbers were thrown around with regard to BT, 700 million capital there raised. You've spent money on buyback. Where do you stand today on excess capital? And then finally back to the mortgage banking segment. The 7% and below coupon was certainly very meaningful last year upon the IPO. But now it seems like 6% and below would be a more meaningful indicator. Could you give us that figure in terms of percent of your mortgage loans?

Let me respond first to expense savings. We absolutely do anticipate as we said in the road show a $25 million savings per year for three or four years. We achieved it this year and we fully expect to achieve it in the next couple of years. We're doing a number of things there. I mean the head count would be significant one. I think we are down about 1,000 people in head count. We really have a number of things going on to collaborate across the business and use technology, so I'm very comfortable with that number. I'll let Mike talk a little bit about excess Capital and then I'll come back around to John on your question on the mortgage. Mike, on excess capital?

Yeah, I think in the past, Andrew, we've talked about having roughly a billion of excess capital, and that would include also some future earnings that we generate over the next few quarters. I think we are roughly in that ballpark although you've got to remember that some of the capital might be trapped at the life company, and so while its excess could be used for acquisitions, but probably not for share repurchase. If you're trying to calibrate how much share repressure could you factor in to some of the calculations, it would be a lesser amount than the full billion. Obviously we are not ear marking any specific amount for share repurchase. That's kind of opportunistic.

Okay. So within the next couple of months if you needed a billion in capital for an acquisition and some degree lesser for buyback, then that is the number. Okay.

We'd have to strain to fully deploy that full billion in the next couple of months. Remember, we do have the closed block and insurance or securitization in the closed block as an additional source of capital.

Okay.

John?

On the mortgage banking, I don't have at my finger tips as far as the percentage below 6%, but we can get that. But as long as we are talking about mortgage banking, if I can slip back to Len's question earlier, I think I understand that now. The statement talked about the increase in production earnings and where those came from. A small piece of that came because of production increasing. But that really is small because we are talking about 11.1 billion of production versus 10.5 billion of production, so that's not a huge piece of the increase. The rest of the increase is coming from an increase in margins on those loans that we do produce, and the comment about secondary marketing revenues is really referring to that increase in margin on the mortgage loans we've produced in the quarter. And that's where this big bulk of the increase in earnings is coming from.

Sorry to take part of your time answering Len's question.

With the MSR, can you just maybe talk a little bit further about how you determine the $600-plus million dollar write-down of that asset? Was it discretionary? Was there a formula? What went into that?

Let me let John come back and give you details.

Sure. It was a very rigorous, sophisticated, complex model that we use. We actual look at our actual experience in terms of prepayments and other aspects, and it gets plugged into a model that comes out with total value. That total value then is compared with market if there is a market, and there really is not a market for servicing today, so it is almost entirely based on the complex model. But it's also compared against multiple models, so we have an outside, independent organization that helps to value mortgage banking that performs multiple valuations to check our model, and very much -- our results very much fell within their models as well.

Thanks.

It is not heavily discretionary.

Thank you.

Your next question comes from Joan Zeef of Goldman Sachs.

Thank you, good morning. My first question is, when do you think we're going to see the trough in book value and start to see book value growth going forward? That's my first question. I guess that will depend on, right, the level of MSR write-downs and credit losses, but I'm just curious to what your timetable is on that. My second question has to do with the hedging in the mortgage banking business. Is there a risk that at some inflection point in interest rates you might have an MSR write-down plus prepayments are pushed into one more quarter because of the backlog? At the same time interest rates move up, which make your hedges less effective. And how do you deal with your hedging when we're close to potentially an inflection point on interest rates?

Thanks, Joan. Let me ask Mike to comment first on the book value and the John Aschenbrenner to comment on the hedging question.

You asked a very good question, Joan. Obviously the whole point of what we're trying to do as the management team is grow the organization. That is reflected in book value. Think about what we've gone through in the first nine months of the year, first with the impairment of BT and then the writedown on sale, and then you throw on top of that capital losses that we had during the -- especially impairments during the first nine months. We are all dead in the water for the year in terms of growing book value. What we hope to do is we see, and really the main determinant will be the impairment situation. If we can get to the point where asset impairments drop off, we have a good engine that grows operating earnings, and I think as we indicated earlier probably subdued growth in growth book value in the fourth because we still expect capital losses in the fourth quarter, although certainly not to the extent we saw in the third quarter, and then continuing capital losses is off setting some of that operating earnings the first two quarters of the year. Muted growth for the next I'd say nine months or less, I guess, because we are halfway through the fourth quarter, and then some significant pickup in book value going out in the future.

John?

On the mortgage banking, I'm not sure I exactly understood your scenario. But there is a risk that the prepayment will not exactly match your hedging. You can't match that exactly, and there is a risk, I think, maybe as you were talking about that the timing may not match exactly within the same quarter. But we believe that we really are on top of it, that we have the expertise that allows us to keep our hedging right on top of the market, and that we can adapt quickly, and that any misses in timing are not going to be catastrophic or major.

Okay. I have this one last question. And that has to do on the pension area. You talk about consolidation and how that's a great opportunity and you've had the Key Corp, et cetera. Are you in discussions right now with a series of of 401(k) writers, or is basically your focus on consolidation just something that you expect to happen in the future?

I guess I would argue, Joan, that if you look at the last six months or so, or maybe even year or 18 months, there is good evidence that this is happening. We are certainly trying to position our organization to be a major player as it unfolds. We believe that it will pick up significantly in the coming months and years, and we're trying to position organization from a number of perspectives. That's why we did the Life of America, the Key Corp, the Wilmington Trust, because we want good experience. We want to understand exactly how you go about doing this on a profitable basis. So we are very proactive. We would expect to be in the market any time. Any movement in terms of consolidation.

Okay. Thank you.

Your next question comes from Sunit Kuma of Sanford and Bernstein and Company.

Yeah, just a few quick questions. You mentioned the closed block of securitization. I was wondering if you could let us know about how much capital you think you could free up from the individual life and health business. Question two i,s when is your next board meeting? Thanks.

Sounds like a pointed last question. Mike, the closed block was 700 million total. And what we can expect to free up?

If we wanted to extract all of the value that we think could extract, 700 million. Obviously you could do it in pieces either or through re-insurance or securitization, but that would be about the total we could tap into.

We have quarterly board meetings. I think our next is toward the end of February. Oh, I'm sorry, that's next year. We got one in three weeks at the end of November. So prepared for that one, I was going on to February. But we have one at the end of November.

Thank you.

Your next question comes from Jeff Hobson of A.G. Edwards.

Hi. If you could address a couple things. I was curious about the full service accumulation business. I guess given your own situation with higher pension costs, is that what is driving the increased activity overall? And then secondly on the individual side, mutual funds and annuities are both up. Is that coming from you own retail or is there something else contributing to that?

Good question, Jeff. Let me ask Mike Daley to jump in and respond.

Be it the sales is a function of both proprietary work salesforce driving it as well as some of these new alliance arrangements, including one with your shop, obviously, that Barry had mentioned. So, we actually have both of those engines running hard and fast for us right now.

Yeah. Your question about the pension costs, I assume you're talking about primarily defined benefit costs are going up because of assumptions and plans, if that's what your question is.

Right. Is that helping your accumulation business?

It's really not related. I mean I guess there'd be a little effect from our DB business, but by the vast majority our increases are coming in the DC business and its distribution related. It's the new alliances. It also picks up the mutual fund business, which is up, I think, over 50% of the annuity business, or well over 50%. So, it's somewhat unrelated to the pension costs going on. Again, Jeff, remember that pension costs that we report and that other companies will report, that's an accounting issued, not necessarily a funding issue. It may not effect their funding all that materially other than asset values are probably down, which maybe kicks up funding a little bit.

Okay. Thank you.

Your next question comes from Eric Berg of Lehman Brothers.

Thank you. Good morning. Would Larry comment on what's happening with margins in the full service accumulation business? Consultants tell us that revenues have been under pressure for some time on a unit basis and that basically the trend has been for basically employers that for ever richer features on their 401(k) plans, and they don't want to pay for them. You, obviously, are very bullish about the outlook for 401(k). I'd love to get Larry's view in the profitability at the plan level. Thank you.

Thanks Eric. Sure, Larry, go ahead.

Eric, good morning. How are you.? There's no doubt that the full service business is a scale business. If I could just quickly refer you to kind of what our trend lines are looking like at the moment. If you take the three quarters year to date versus three quarters a year ago, our earnings out of the full service business are up 25%. That again is in an era of fairly difficult revenue for the reason that you mentioned. We really do focus on the scalable business platforms that I mentioned before. For example, in the Key Corp transaction, the only net increase in staff as a result of that transaction were the approximately 15 relationship managers that we brought on board. Other than there were no staff additions associated with that Key Corp transaction. That's our business model and it seems to be working very well. If,on the other hand, you have a business model that is more intensive as it relates to staff. If you haven't used technology and invested in technology, then it is a difficult environment. We are feeling a piece of that, but our results stack up well and we are optimistic for the future.

Thank you.

Ladies and gentlemen, we have reached the end of the allotted time for questions and answers. Mr. Graf, are there any closing remarks, sir?

This is Barry, let me just thank all the participants for joining us today. Let me thank you for your continued interest in our company. We are committed to performing against the expectations that we have established with you. I'll be on the road the next few months. I look forward to seeing some of you out there, and I wish you all a very happy Thanksgiving. Thanks again for joining us.

This concludes this morning's conference call. Thank you for participating. You may now disconnect.