美國信安金融集團 (PFG) 2002 Q4 法說會逐字稿

Good morning. My name is Jeff and I will be your conference facilitator today. At this time I would like to welcome everyone to the Principal Financial Group 4th quarter conference call. There will be a question and answer period after the speaker's remarks. If you would like to ask a question, simply press star and the number one on your telephone keypad. I would now like to turn the conference over to Tom Graph, Senior Vice President of Investor Relations.

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 the reading of the safe harbor position, Barry Griswell and Mike Gersie will have some prepared remarks. Open for Q & A are John Aschenbrenner, Michael Daley, responsible for marketing and sales, and Larry Zuppleman, responsible for the asset accumulation businesses. Julia Waller will also be available for questions.

Some of the comments made during this conference may contain forward looking statements. There are a number of risks and uncertainties that cause actual results to differ materially than those expressed or implied. Results are discussed in the company's report ended December 30, 2001. And on form 10Q, filed by the company with the Securities and Exchange Commission.

Barry?

Thanks, Tom. And good morning. Let me also extend a very personal welcome to everyone on the call. At this time I'll provide a very brief overview of our results, focusing most of my comments on key accomplishments, progress in executing our strategies during the 4th quarter and for the year. Mike will follow my comments with a detailed overview of financial results.

We're pleased with our 4th quarter results. We continue to deliver strong earnings per share growth, in spite of a weak economy and falling interest rates. 4th quarter results contributed solidly for the year. Our fourth year in record earnings. EPS would have increased 9%. This performance is very good, particularly in light of the difficult environment during the year. We want to benefit from our diverse, well-managed business. Our international asset management and accumulation each delivered double-digit operating earnings growth. Equity market declines can strengthen growth -- proved 5% for the year. Off segment earnings, this primarily affects earnings for global investors.

Due to employee costs, these increased costs primarily reflect higher compensation, due to improved investor performance for the year, investors delivered 3% in earnings. Asset management, Principal global investors played a key role in this growth with asset management increasing $11 million. The acquisition of SPECT occurred in October of 2001. For the quarter we also made some real headway in terms of improved investment performance. 55% of our domestic and international equity funds are in the top two MorningStar percentiles at year end, compared to 25% just a year ago. On Monday, Barons just released their fun family rankings and Principal mutual funds were ranked 10th out of 81 families for the performance period ending December 31, 2002. We describe our primary areas of focus. Accelerating growth in the US business, thriving international growth and profitability, proof of performance, operational excellence, effective use of capital and building value for our shareholders.

If you look back at our results, these key areas I've characterized 2002 as a year marked by very strong execution. 4th quarter was a continuation of our strong sales momentum, primarily reflecting changes to our distribution model in 2001 to encourage and reward these sales. Global service accumulation sales, 2.2 billion for the quarter, an increase of 141%. 6 billion for the year, up 8% over 2001. Reflecting outstanding sales over the last couple quarters. We're experiencing strong deposits and strong cashflows. Deposits are up 32%. Net cashflow for that business increased 950 million or 48% to 2.9 billion which equates to 6.8% of beginning of the year account value. More than double our average. We're also continuing to see strong demand in the marketplace for our other key retirement products. Individual annuity sales increased 7% to 1.1 billion. And we achieved record mutual fund sales for the year, 1.4 billion, an increase of 34%.

In 2002, we did a tremendous job in making previously announced distributional alliances work. In 4th quarter our alliance partners sold 400 million in our retirement and investment products, bringing the total for the year to more than $1.1 billion. Sales of Principal advantage which we launched in 2001, improved sharply in 2002, 850 million, up $10 million from 2001. In addition, new relationships in the bank channel and our fixed annuities both positive cashflow from individual annuity sales, $455 million in 2002, compared to $96 million in 2001.

Also we saw some industry consolidation in 2002, a promising trend as we continued to see growth in our U.S. fine contribution business. Our sponsored endorsement agreement with Key Corp has been very successful. Compared to our average new sale, we experienced stronger close ratios, and a higher average case size, in terms of asset management and participants. We expect to report additional sales and deposits in the second quarter 2003, as we close out our committed sales. We continue to seek summer arrangement and opportunities under asset management. Importantly, as this consolidation continues, Principal is well positioned to capitalize on opportunities. Our scalable platform, our strong national distribution strength, uniquely enables us to successfully execute this type of arrangement. Our reputation for quality is unmatched, and our experience and leadership in meeting the needs of small and medium sized businesses is unrivaled.

Expanding on this last point, we added a number of new products during the year offered through the small and medium size business work site. We entered into a strategic alliance agreement with Alliance Capital to offer Principal College Bound funds. A section 529 college savings plan, where employees save for college through payroll deductions. We introduced and achieved good early success with our Principal Security Builder Retirement program, for the underserved small business 401K markets, selling more than 250 plans in only 8 months. We launched innovative group benefit solutions to provide growing businesses a lower cost options for quality employee health care coverage.

As we've previously discussed, I'd also like to touch upon two other areas of focus in the organization. Our operational excellence program continues to focus on process improvement, performance management, contract negotiations and employment cost management efforts. Here in, head count was down over 1,300, operational excellence initiatives overall grew $30 million for 2002. We are continuing to work hard to identify a sustainable way to improve the efficiency and effectiveness of the organization, meeting our target goal again in 2003. Effective use of capital. During the quarter we announced two acquisitions, PCI group and Tempe. PCI answers our defined benefit capabilities, allowing us to continue to respond to the increasing demand for complete retirement solution. Tempe will compliment our Zurich acquisition made last year. The acquisition strengthened our position in Mexico, while freeing our market share to 11%, establishing us as a key player in the market.

In addition to utilizing capital for strategic acquisitions and to fund organic growth, our top two priorities in 2003, will continue to opportunistically purchase shares. In 2002 we completed the first of three board authorized repurchase programs, buying back 27 million shares for $750 million at an average price per share of $26.99. The Board has also authorized a 300 million program in November of last year. And in 2003, we began repurchasing shares under that program. This new program, through January 31, bought back 2 million shares at 59.9 million at an average price per share, $29.78.

Before I move to guidance, I'd like to mention in 2002, we continue to be recognized for our leadership in the marketplace. Receiving some very important third party recognition. From CFO magazine affirming our position as the 401K leader, overall and in the small and medium-sized business segment. From Boston Research Group, Dowbar, and Plan Sponsor affirming our leadership in meeting customer retirement service needs. From Information Week, affirming our committment to innovation. And from ARP, Latino Style, the National Association of Female Executives, and the Wellness Councils of America, as well as Computer World and Money Magazine affirming our status as one of the best places to work. More recently, in January, we were named to the Fortune 100 best places to work. A recognition we're very proud of.

Moving to operating earnings guidance. We expect the first quarter of 2003 to range from 53 cents to 56 cents per diluted share. And full year operating earnings from 2.25 to $2.40. 2003 estimates reflect an estimated additional 4 cents per share, for stock option expense and employee stock purchase plan expenses, and an additional 11 cents related to our pension benefit expense. Earnings estimates are based on certain assumptions, including domestic equity market performance improvements, from December 31, 2002 levels, of roughly 2% per quarter. However, given current market levels, and the absence of a quick recovery, we would expect we would be at the lower end of this range. In 2002, we accomplished a great deal, including a 26% return to shareholders. There is still so of more for us to achieve.

Handing it over to Mike, I'd like to add that we will work hard to deliver growth and build value to our shareholders. Through our efforts, we are effectively positioning the organization for recovery in the equity markets. We are very confident that with modest equity market recovery, we'll be able to achieve our ROE target, of 12 1/2 percent by year end. Thank you. Mike?

Thanks, Barry. I'm assuming everyone has had the opportunity to review the earnings release and the financial supplement. I'll spend a few moments providing some commentary will be helpful in understanding the drivers of our results and our outlook for 2003 and beyond. As Barry mentioned, we view our results for the quarter and the year as very solid. There are several things we're highlighting at the segment level. U.S. asset management and accumulation earnings declined in the 4th quarter compared to a year ago. But we're up 5% for the year, despite a 23% decline in the SMP. The fundamentals of this segment continue to be very good. Cash flows were very strong, new sales were excellent, and the expense picture shows good control.

We define new full service accumulation sales as expected annual deposits, and assets transferred to us, and view them as a leading indicator. As Barry indicated, pension delivered a 141% increase in new full service accumulation sales for the quarter. Demonstrating again the strength of our product offering. Nearly 70% of our wins in 2002 have been take overs for existing plans. We also view net cashflow as a leading indicator. Full service accumulation delivered a record $1.7 billion in net cashflow for the 4th quarter, and $2.9 billion for the year. Strong sales over the past several quarters drove an 81% increase in full accumulation deposit compared to 4th quarter 2001. And a 32% increase for the full year. As we have said in prior calls, you won't see a direct correlation between year-over-year sales growth and deposit growth. There's a lag between the time that sales occur and the time deposits arrive, and sales make up only one component of deposits.

As Barry indicated the U.S. asset accumulation earnings were down compared to the 4th quarter a year ago. We view the full-year segment earnings as very solid. We faced a very challenging environment. Compared to 2001, pension had lower investment income due to declining average asset yield. Our assets and liabilities are well matched, and we have been able to maintain our price experience. C growth was constrained by equity market performance. Looking back full service accumulation accounts were down for the majority of the year compared to the beginning of the year balance. We have aggressively managed expenses to maintain pricing margins. Despite difficult conditions, we continue to grow overall reflecting strong cash flow and the benefit of our diverse business mix of B spread and risk based products. While equity market declines negatively impacted account balances, segment assets under management still increased 12% compared to a year ago.

Within our international asset management accumulation segment, Principal's international earnings improved by $8 million in the 4th quarter to $16 million for the year. The increase primarily reflects increased earnings in our Mexico pension business and the Chilian operations. Over the quarter and the year respectively, 800,000 and 4.6 million in improvements, relates to the non-amortization portion of implementing FAS 142. As a result of the sale of substantially all of BT, we recorded an estimated after tax loss of $197 million in 2002. Pursuant to FAS 144, accounting for the impairment or disposal of long-lived assets, while revenues and expenses including corporate overhead, allocated to the discontinued segment, they're reported as discontinued operations. Therefore, operating earnings for BT reflect only allocated corporate overhead expenses and all historical results for BT were restated. The required discontinued operations treatment reduced full-year operating earnings by $12 million, which in effect reduced diluted earnings per share from $2.17 to $2.14. While Principal international revenues were down $151 million in 2002, $125 million represent the sale of a large single premium group annuity case by Mexico Seguiros in the third quarter of 2001. Importantly Principal's international assets under management are up 19% or $700 million compared to a year ago.

Moving to life and health, segment earnings were strong again in the fourth quarter, up 24% compared to a year ago and contributing to 16% improvement for the year. Earnings growth during the quarter and the year, was driven primarily by improved loss ratios. For group life, and group medical, and dental and vision [INAUDIBLE]-- segment return on equity reached an all-time high at 13.7%, significantly improved compared to the 11.6% at December 31, 2001. As Barry mentioned, mortgage banking delivered double digit earnings growth in 2002. $143 million for the year, which is a 13.5% return on equity for the trailing twelve months.

While earnings for the quarter were down slightly from a year ago, the fourth quarter is an excellent example of the macro business hedge at work. Because we compete in both origination and servicing, the heavy refinancing activities that resulted in impairment of the services portfolio, also produced exceptional loan production earnings. Our $29 million in earnings in the 4th quarter consists of record production earnings of $120 million, which was partially offset by a servicing loss of $91 million. The servicing loss reflects an after-tax loss from mortgage servicing rights evaluation adjustments after hedging of $82 million.

I'll explain the difference between this quarter and the 3rd quarter, where we offset 94% of our mortgage servicing rights evaluation rights with hedge gains. We continually review and when appropriate, adjust the assumptions in our valuation models. In continually updating our model, we've avoided large valuation shocks that have surprised some mortgage services. During the fourth quarter refined the repayment and cost assumptions, resulting in approximately half of the $82 million valuation adjustments, and in an increased amortization expense. We believe our updated model reflects the current business environment and places a very realistic value on servicing rights. The other half of the valuation adjustments, resulted from declining mortgage rates during the quarter, while interest rates on hedging instruments stayed flat, or even increased slightly. This conditioned caused higher prepayment expectations, thus lowered MSR values, which were not offset by increasing values on hedges. In other words, we were impacted by basis risks and as you know, it is very difficult to eliminate this risk. While the financial hedge did not work as efficiently as in prior quarters, the natural or macro hedge of production did work very efficiently, resulting in a solid quarter of earnings for mortgage banking.

That said, I'd like to summarize the key accomplishments for the mortgage banking segment in 2002. Record operating earnings of $143 million, up 13% from our record 2001. 52% or $400 million increase in operating revenue, to a record $1.2 billion. Record loan production, nearly $17 billion in the 4th quarter, $47 billion for the year. A 34% increase in the servicing portfolio, reaching $108 billion at year end. As we announced late last month, we made the decision to focus the retail consumer loan business origination business within the Principal residential mortgage direct operation, which originates loans across the nation via phone and online. Just this morning, American Home Mortgage announced they would acquire a retail mortgage branch network which includes assuming lease and equipment obligations, the opportunity to retain our employees. Going-forward, we have a significantly larger base of servicing business, a strong production pipeline, and our resources directed to higher growth, variable cost distribution channels.

Before moving to questions, I'd like to briefly discuss net income. First net income for the fourth quarter was positively impacted by a favorable resolution with an IRS audit issue. We also had after tax net, realized and unrealized capital losses of $90 million, which compares favorably to the net realized and unrealized capital losses of $168 million a year ago. The improvement primarily reflects lower losses from permanent impairments, $71 million decline on credit loss on fixed maturity securities compared to 2001. We've been very rigorous and aggressive in recognizing accounting for problem assets. It's clearly still a very difficult equity and credit market. We do, however, have a very high quality, very diversified investment portfolio. We aggressively monitor each investment, continual access our exposure to troubled sectors and credit, and actively manage problem or potential problem loans. Based on our watch list at year end, we expect net realized credit capital losses for 2003, of approximately $170 million after tax, weighted toward the first half of the year.

In closing, let's reiterate a couple of key points. Strong deposit growth and asset retention throughout the year helped offset the impact of equity market declines. Our aggressive and ongoing efforts to sell new business, retain assets, and manage expenses clearly delivered real results. However, as previously indicated, our ability to continue to meet earnings growth expectations depends on a number of factors, including the resumption of more normal growth in the equity markets. This concludes our prepared remarks, I would now ask the conference call operator to open the call to questions.

At this time, I would like to remind everyone that in order to ask a question, please press star then the number one on your telephone keypad. We'll pause for just a moment to compile the Q & A roster. Your first question comes from Colin Devine of Salomon Smith Barney.

Good morning, gentlemen, congratulations on a solid quarter. I have a couple questions for you, though. You're not going to get off that easy on investment, generally losses were higher than expected. And while I appreciate getting the net numbers, frankly, from my perspective, that's largely irrelevant. I was wondering if you could focus in on the gross impairments for the year, how those compared to 2001 and what you're projecting for 2003. That would be question number one. Question number two, if you could provide us more details on your pension assumptions, what they've been changed to, and what led to the increase. Third, with respect to the mortgage business, we take out the MSR adjustment, the servicing side of the house is still losing money. How is that going to change if originations slow? And then lastly for Barry. Interestingly enough, one of your competitors at Nationwide used the President's proposed savings account forms as a negative for the industry and a source of considerable concern. Another competitor, will the CFO at Manual Life Financial on his call yesterday basically said it's the greatest thing since sliced bread. I'm curious as to where you fit in to all this.

Ok, Colin. Its good to hear from you. I'm glad that you're not at a loss for questions for us, this morning.

I do my best.

On the investment portfolio, Julia is with us, I'll ask her to cover that quickly.

Good morning, Colin. First of all, I think you asked what 2002's gross losses were compared to 2001. Gross losses were just under 300 million, compared to gross losses for 2001 of $225 million. They're up slightly. These are all after tax numbers I'm giving you. That compared to the number that Mike gave, $170 million from 2003.

Hold on, on the -- did Mike give the gross number for 2003? I specifically recall him saying the net number?

Colin, when we do our projections, we're not including any opportunistic sales, and so when we talk about anticipated capital losses for next year, we really are looking at credit losses.

So apples to apples, it's 225, 300, 175.

Correct.

Okay. Thank you.

Those are assumptions, which were made back in October.

In October. And remember, I believe we may have talked about this in October. All of our assumptions setting is basically, I'll say processed or formula driven, so there's very little manage discretion that we use, and we set assumptions, I believe our discount rates came down from 7 1/2% in 2001 to 6 1/2%. As we struck the valuation in October of 2002, our asset earning assumptions came down from 9% to 8 1/2% year over year. So we did drop assumptions going from 2001 to 2002. Also remember, Colin, the stock market decreased and so our asset values were down. All of those things in sum drove pension costs up by roughly $54 million -- gap accounting pension costs, we have to be specific on that, $54 million year-over-year. After tax, it's roughly $35 million. That's where you get to around 11 cents a share.

Okay.

And the third question had to do with the mortgage business, the servicing, and the run rates and so forth?

Yes.

John Aschenbrenner is here and he'll answer that for you.

You made the point that, we're losing in the servicing area, $9 million this quarter, even without the impairment change. That comes about because of the increase in amortization. And so if interest rates go up, and the production of new mortgages slows down, the amortization will go back down and we should be back to normal levels of earnings in the servicing line.

And what would you view as normal?

20 to 25 million per quarter.

Thank you.

I guess that leaves me for the last one, Colin?

That's the $64,000 one.

And I don't know that I really have a great answer for you. I think the fact that you're getting different answers from two different people is probably indicative of this. We certainly think that any proposals to encourage savings is a good thing. I think in the President's proposal there are at least three new savings accounts proposed, and I think one of them. I think it's called the employer savings account -- I don't know the exact name. The one that's directed to suplifying all of the qualifying plans. Its called the Employer Retirement Savings Account, would really supplify 401K's, 403 B's, 457's, bring them under common criteria, common rules. I think that would be a huge positive for us. I think we would be ideally suited to taking advantage of that with our work place marketing, our leading position with 401 K, with our Principal Pensions Inc. operation, I think that would be a huge positive. The other two, I think I'm less positive about, they basically would impact more, I think, the traditional annuity business, maybe that's why you're getting maybe nationwide, you said not seeing as a positive. I think the traditional annuity business is going to have a difficult time with both the savings account proposal, but also the dividend exclusion from tax proposal. And I think really none of those have a negative impact on our core retirement services business, 401 K. One of them as I said, will be very positive if it gets enacted.

With respect to dividends, have you given any thought to changing your current rate?

We're in the middle of evaluating that, Colin, as you would well know, just based on where we came out in stock price to maintain the same payout ratio. We'd be looking at an increase. We're certainly evaluating that, and I think you'll be hearing from us sometime very soon.

Thanks, Barry.

Thank you, Colin.

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

I have two questions for you. On the 401K business, what kind of efforts are you making to try to increase the number of employees per plan. And could you talk about that in a little more detail? I mean, I understand that the whole game here is to basically grow assets. But doesn't make some cost sense for you to try to get the sales people to also increase -- secondly, I know disabilities are a very small business for you. We did see a spike up in the loss ratios on the group side, and on the individual disability side from the last two quarters. So if you can address that issue as well.

Good to hear from you. Let me ask Mike Daily to talk to you about the size case and what impact it has on the employees within the plans, and then John will follow-up on the DI question.

Good morning, Michelle. Actually it those two tend to move in tandem for the most part. There are anomalies out there where you have extremely high average assets per employee that don't follow that rule. But for the most part, as we move up market and take on a larger asset per plan average, we're also taking on higher employees per plan. So both of those are coming our way through the activity that we're doing today.

Mike, do you remember where we're probably in excess of 100 employees per plan, average book.

The average book is about 65 employees and about $1.2 million in assets, our sales activity has us closer to the 100 mark, and $2.1 million in assets for transfer cases from our wholesaler arm.

So we are certainly moving that way in larger cases?

John, on the GI ratios.

If I could follow-up on that, when would we see it moving to that basically what we're seeing is 63 average employees per plan in 2000, moving up to 66 at this point. I mean, does this take, you know, several years, when does this actually transfer through? And then my thought is, once you've actually taken over the plan, what initiatives are there to get more people in the plan to participate? So I understand you're getting bigger plans where there's more participants, but how about increasing the number of participants in each plan? If there's 200 employees at a company, what's the efforts to actually get more than, say, 65 people participating in the plan?

I think there's two questions there. With regards to your first one, how long will it take. You do have to understand our book of business is rather sizable here. We have over 30,000 defined contribution plans, we bring about 2 to a year in terms of new sales plan. That's why you're seeing it creep along the way you're doing it. That's why we'll continue to point out new sales and what the average is, how that compares to the book. With regards to what are we doing to try to enhance participation levels within the plans that we adopt, we aggressively go after that number. And we are at about industry average right now, around the 70 -- low 70% participation rate level at the plans that are on our book of business, with efforts across our national service foot trend to try to move that number north. So there's a concerted effort throughout our service model aimed at that very issue.

Patient rates and deferral rates are two key drivers we're working very, very hard on getting them up all the time. And they are going up. John, do you want to cover the DI.

Yeah, the lift up on loss ratios on disability are just a normal fluctuation within the normal range. I think the third quarter probably was a little bit low. And the fourth quarter a little high. But the loss ratio you're seeing for the year is, I think, the reasonable loss ratio.

And do these higher claims relate -- are they -- you know, related to certain occupation classes? Or can you give us a little more color on what was driving that in the quarter?

There really isn't any -- there's no pattern. It really is just a normal blip.

Thank you.

Thank you, Michelle.

Your next question comes from Eric Berg, with Lehman Brothers.

Good morning. I had one follow-up to Michelle's in the 401K area and one question in life and health. With respect to just sort of thinking about the size of your business, it would seem from your financial supplement that the number of plans is basically unchanged. And I realize you have been effecting this transition in favor of larger employers, and as you mentioned, the average is basically number of employees per plan is also unchanged. It would seem from the data that the number of participants has not really changed in the last two years. And that the growth, therefore, has come from existing -- from ongoing contributions. Growth and account values has come from ongoing contributions from existing participants. My question, is that the right way to think about this? Or, in fact, do you have more people as 401K customers today than you did two years ago.

Good to hear from you. Let me ask Larry to respond to that.

Good morning, Eric. How are you?

Good morning.

There is, indeed growth in the participant count around our 401K business. We're running in the range today, I think, of about 2.2 million defined contribution members. And so what you're seeing is, as Mike Daley described just a minute ago, you're seeing us write larger plans, you are seeing a movement of some very small plans away, either into SEP-IRAs or into similar arrangements. And as Mike described, we're working to increase deferral rate in existing plans. And we've had quite a bit of success in that in the current year, because of the surface model that we provide, and that is certainly provided growth for us.

Thank you. My question on life and health is generally this. I'm certainly -- I certainly heard you and listened to you when you talked about the earnings growth, but -- and ultimately my question will be the same. My thinking -- am I thinking about the business correctly or incorrectly. When we look at the numbers in the supplemental data, and we look at things like the number of people covered by principal dental plan, vision plan, health plan. Earned premium and individual life insurance. Premiums and equivalents on a full-year basis in group life. The number of people are sort of top lined. It looks like these businesses for the most part, with some exceptions are either not growing or in some cases shrinking. Am I thinking about this incorrectly? Is there an issue here or not?

Let me -- I'll ask John Aschenbrenner to address that, but I would say at a very high level, I would keep in mind we continue to do some things, in these lines of business which will affect those numbers. For example, we continue to exit states.

Okay.

We continue to get outlines of business, and the group life, we're actually seeing some very competitive marketplace environment in the large case market and we're not willing to write business for a loss, so there really are some things that I think are very explainable and I would expect you'll see those numbers turn as we stabilize the business. Let me ask John to give you a little more color.

Yeah, I think Barry, you did a good job of covering it for me, but the businesses have been fairly flat. We have based some significant changes in our individual distribution that we think will help some of the individual product takeoff and build some momentum. As Barry mentioned, we've been exiting states in the medical, that growth is starting to turn around, once the states that we exited fall off. So it's important to us to continue and to build that momentum of growth in those businesses.

Thank you very much.

I think 2003 will be an important year to see those numbers change, and I think you will see them change.

Thank you. Good luck.

your next question comes from Jason Zucker with Bank of America securities.

A couple questions. One, I was hoping you could compare for us 2001 and 2002 and tell us the percentage of assets that are managed in-house, and how that may or may not change in 2003. And then Mike also mentioned earlier how sales growth is a leading indicator of deposit growth. Very good deposit growth for the quarter. Very good sales growth for the whole year. Does that mean that I can think about strong deposit growth looking forward quarter by quarter in 2003?

Good to hear from you, Jason. Actually, I'll have Larry Zuppleman answer both of those.

Today we have, and this has actually been fairly consistent over the course of the last four quarters. We've got about 89% of our full service of fine contribution assets in what we call our proprietary investment options. Those would be either our PGI managed or subadvised investment options. That's remained fairly steady. We hope overtime, to try to drive it a little further. I may be over-optimistic, because as we add to that subadvice platform, Barry said, we have improved PGI investment performance. As it relates to deposit growth, I think your analysis is absolutely on the mark. The strong sales growth in our full service business is translating into deposit growth as that business ultimately transitions over to our platform. I would expect you'll see substantial growth in deposits for the next few quarters.

Terrific. Thank you.

Thank you, Jason.

Your next question comes from Andrew Cleagurman with Bear Stearns.

Good morning. Let me ask a question to make about the mortgage banking unit. I didn't clearly understand your description of the hedging instruments. It sounded to me like half of the writedown was due to a decline in interest rates, yet your hedging instruments had the macro effect of flat interest rates. So you didn't get the benefits on the hedging. Is that the correct interpretation much what you said?

I think that's correct. Remember, Andrew, I mentioned the change in basis, and --

What did you mean by that.

Well, what I really meant is, the mortgage rates and the way the servicing performed, did not really match the way our hedges performed. And so our hedges basically performed in a flat interest rate environment whereas mortgage rates were coming down during the quarter so that compressed the basis. We expect some additional prepayments coming out of the mortgage servicing portfolio, but the hedges did not -- we did not get the offsetting lift in hedges just because the interest rates on hedges stayed right about the same.

I guess that would bring me to the question of why didn't your hedges reflect the environment in which your mortgages were seeing declining rates.

Again, because there are two -- in a way, in effect --

They should be matched, right?

Matched as best we can, but remember, Andrew, what we're really trying to do is -- because we're using derivatives, we're using one to proxy another, and those proxies don't always move in sync.

All right.

But Andrew, when they don't move in singe like that, that's usually because mortgage rates have fallen very quickly. You typically, in that environment get an extraordinary origination, and that's exactly -- what we call that the macro hedge, and that's exactly what happen in the quarter, we got probably more than we would have expected from orge nations. So at the end of the day, we still mate made the $26 million or whatever, because the macro hedge really picked up in the hedging. The macro hedge worked very well, the financial hedge left a little to be desired in the last quarter.

That's sounds fair enough. The other question is on the -- USAMI unit. I apologize for slowing a little detail at you, but I want to try to get a little clarity on it. Your assets were 63 1/2 billion in the 4th quarter and lower in the 3rd quarter at 60 1/2 and lower in the 4th quarter in 61. 4th quarter in the prior year at 64.1. Now I look at operating earnings in the 4th quarter, and I come in at 83.7, and yet earnings were higher at in the 3rd quarter, a year ago they were 94.4 million. The decline in income, you know, you mentioned in the press release and the call that it was compensation. The first part of the question is -- who is getting the fund managers, the distributors? The second question, is your return on equity coming down? And actually, what is the return on equity expectation for that unit? The third and last of this long question is, I was looking at the full service payout earnings on one of the back details of the supplement, and full service payout earnings were 17 1/2 million in the year ago quarter versus $10.9 million in this quarter. So I thought that had something to do with it.

Good questions, Andrew. I'll ask a couple people to jump in, I think you were right on in your analysis. The compensation change is really causing that distortion. Let me ask Jim McCaughan to address that.

Thank you very much. The, um, compensation, number that depressed the 4th quarter earnings for global investors was the quarterly fluctuation due to the truing up the year end of the annually based incentive compensation base accruals. To get a better understanding of the underlining quarterly profitability ticking up, you should really look at the operating earnings on the year for PGI of $39.1 million. We made only $2.4 million in the 4th quarter. There's a number of moving parts in this. But for retention and motivation of the investment professionals, mainly the portfolio managers, we base incentive compensation on revenue growth, asset growth and investment performance. All three of those contribute greatly to the earnings of the organization going-forward. But the incentive compensation pays part of that contribution back to the people who make it happen. And over time, that will true up, but in this particular quarter, we recognized a large part of what we paid for that strong performance. So I think that's basically the answer. I point out that for the year as a whole, for principal global investors, this is a mix of affiliate and non-affilliated assets, the assets up from 85.7 billion to 92.3 on the financial supplement showing the earnings power of PGI is rising very nicely over time.

I think I'll ask Larry to cover the ROE section next question, and I'll cover the payout.

Good morning, Andrew. In terms of the ROE, the USAMA segment is mostly made up by our U.S. asset accumulation businesses. And in looking at the return equity for those businesses over the last four quarters, it's actually moved up slightly from around 17% a year ago, to something between about 18.4% in the current quarter. We feel very good about that, and again, I think as Jim was just suggesting, it speaks well for the earnings potential if and when the equity markets improve. And your question about full service payout, again, your observation was that the earnings in that segment of our business were down in the 4th quarter from a year ago, that is indeed correct. The primary reason there are really just some experienced adjustments. The primary business there is our single premium group annuity. We do make periodic experienced studies and adjustments there, that was really the reason it was depressing our Q-4 earnings. I would expect a kind of normalized run rate between those two numbers, Andrew. About 13 million per quarter.

Thanks for the detailed answers.

You're welcome.

Your next question comes from Tom Gallagher with Leg Mason.

Could you comment on what the level of excess capital remaining is from the BT sale?

Sure, Mike. Do you want to jump in?

Well, there's really two questions there. I think the level of excess capital that we're -- available capital that we have for investment, for organic growth, for acquisitions, for stock repurchases is still somewhere in the billion dollar range, that's roughly the same number we talked about in the 3rd quarter. We haven't made significant acquisitions, we haven't done significant stock repurchases since our last earnings call. So that number still remains about there. The number that I think we used in terms of cash that has come in from BT, net-net after tax is somewhere around the three quarters of a billion dollar mark.

Okay. And just looking ahead, looking at how strong your growth could be, you know, using the net flow number that you had in the quarter, assuming maybe it trends down from there, are you going to be using up more capital even without acquisitions than you would have previously thought?

I think or capital plan is roughly right in line. Growth assumptions are -- haven't really changed much since 3rd quarter. Stock assumption purchases haven't changed much since 3rd quarter. We're at a run rate about the same as the 3rd quarter.

A lot of the good growth is not really driving capital usage, it's products do not require a lot of capital.

Okay. And then just -- can you just comment on outlook for your GIC business? I know that slowed. Is the expectation that that's going to remain fairly level from an asset based standpoint, or is that going to potentially grow?

Tom, good morning, this is Larry. You should expect to see it stay relatively flat. Again, as we've said, we have a cap on our GIC business, and we are staying very, very close to that cap. We're actually slightly under it at the end of the 4th quarter. But we would anticipate staying very close to that cap and trying to get as many sales early in the year as we can to maximize the operating earnings out of that part of the business.

And the last question is, can you just comment, you now break out different asset classes within USAMA. Can you just comment on what % of that total is actually general account again?

We're taking a quick look to find that number. Rather than hold it up, we'll get the number and I'll tell you somewhere along the call before we get off, I'll trying to get it to you.

Great, thanks.

Thank you, Tom.

Your next question comes from Nigel Daily with Morgan Stanley.

A couple questions, first, just looking at mortgage prepayments, you have one of the largest allocations to mortgages in your investment portfolio, I would have thought this would have benefited you, discuss the mortgage income in the current quarter. Second, going back to the investment portfolio, hoping we can get more details on where these losses are coming from, your net losses rose dramatically, while it seems like everyone else's are coming down, I'm just trying to understand that. Third, international, in the 4th quarter, are there any one-time items in there which we should think about when looking at a run rate going-forward.

Okay. Good, Nigel, appreciate it. Mike, you want to hit the prepayments?

We look at prepayments -- I don't have the breakdown between securities, Nigel and commercial mortgages, but our prepayment fees have been running between 4 and $6 million per quarter after tax for the year. And so if you think about the impact on fees, somewhere in the 4th quarter it was around $4 million.

Okay. Let me ask Julia to talk a little bit about the net losses again and what's going on with the last part of the year.

Good morning, Nigel. I'll start by saying our 4th quarter impairments and losses were pretty much on quarter for what we projected, so it wasn't higher than our expectation. It's coming from several different places, just like our investment portfolio, which is extremely diversified, the losses are coming from several different names. There isn't one name I could point to and say that's all the losses for the quarter.

Any industry group like energy or utilities or anything like that?

Yeah, I would say energy certainly was, if you looked at the number of names, energy was the bulk of it. If you looked at our industry cap classification.

Okay. And is much of that now behind you, or is that why you expect other losses in the first half of this year to also remain quite high?

When we look at our watch list and how we set our forecast for 2003, the names on there, again, very well diversified, but many of the names on there continue to be energy. So we would expect that if things don't continue to improve, some of that will still come from energy related industry.

Okay. Great.

Nigel, I think we've been pretty straight up in taking losses and not trying to offset them with gains, and so maybe what you're seeing in some other places is some offsets, but we really haven't been doing that. Larry, you want to fake the principal international and where -- take the principal international and where the earnings growth is coming from?

Yes, there were two questions, earnings growth, and earnings growth around our principal international businesses are coming out of two places, one is Mexico foray, or pension business, a mandatory assigned contribution there, our tem pay acquisition we think will further add to that growth potential. Our Chilean business is also an area of potential growth for us going-forward. You also asked about the Principal international run rate, whether there were any peculiar items in Q4, there were some in there, about $2 million in there, I would say one-time item, so you would be correct to be cautious in using Q4 to estimate the run rate.

Okay. That's great. Thank you.

Your next question comes from Joan Dee of Goldman Sachs.

I have a few questions. Could you talk to how close to your expectations has the Key Bank sponsored conversions been going? I know it's successful and additive, but has it been actually, as you have expected, a little bit light, a little bit more? And what sort of probability would you put on another announcement similar to that in the first half? My second question relates to the group health, and how sustainable is the earnings of that health business, particularly given the macro environment of rising health care costs, et cetera. The last question I have is why do you stay in the disability business at all when it really is so insignificant to your earnings? Why take the underwriting risk and the potential for volatility.

Thank you, Joan, as I recall in your reports this morning, you had 13 questions, we're only getting three of them.

That's right, well, I didn't want to take up more than my share.

Hopefully we answered some of the others.

Not many, but --

Oh. [ Laughter ] On the key corps I'll ask Mike Daley to talk about that. We're not going to be able to give you a great amount of specifics because of competitive reasons, but we'll give you a flavor. Mike?

John. Joan, we did meet expectations on that transaction. We would not be ten the to pursue others like that at all. We would be extremely interested in that, and, in fact, are pursuing those type of activities. Just to give you a little color around it, as Barry mentioned in his comments, we had experienced higher close rates and also experienced a larger average case size in that key transaction. And to give an example of that we closed nearly a dozen cases north of $25 million in define contribution assets with that block of business, and so that proves our ability to deliver that best in class service that we are so famous for at the small end of the market into the middle market space which helps us on the growth front. Secondly, it displayed the sales as we were able to glom on to that and not miss a step. We will go after additional loans, I can't share with you the probability of that, but we are in the market talking to people.

Two questions in the health segment, one on sustainability of health earnings, then I'm going to ask Larry to get back to Tom's question and close up with that. John?

On the group health side, this year was an exceptionally good year from an earnings standpoint on group health. So it's going to be very difficult to maintain as high a level of earnings in group health going-forward, but we really think we've got the discipline and we've been able to maintain our pricing, so we don't expect to see a significant falloff at all. Why in the disability business? I think I should probably start off by saying we are not wedded to the disability business, we continue to look at the businesses we're in and whether they make sense as stable businesses going-forward. A key advantage for us being in the disability business right now is distribution. It has -- brings us a lot of distribution relationships that are very valuable in the small to medium-sized business, and in developing other products going-forward.

The defining label --

Rest assured if we scant manage it properly going-forward, it won't stick around.

Couldn't you do it private label and not give up the distribution. Wouldn't you want to do that with?

I think it's very important to us to have a product that we control, we control the service, we control the claims, it's our reputation, we're selling it, we want to do what we can to maintain as much control. If we can do it profitably, we think we can.

Let me go back to just a little bit about the group health, you have mentioned that this year was an unusual earnings year, it might be difficult to maintain this earnings level. I mean, what type of environment are you looking for in 2003? What type of earnings pressure do you think we should be thinking about?

Yeah, I don't think the environment is going to be that much different in 2003? So the key for us in 2003 is to grow the business, and that's what's really going to drive earnings up going-forward.

Thank you.

Let me close out with first, I'll let Larry answer the previous question we didn't answer, then I'll just have a few brief closing comments.

In answer to your question around the proportion of USAMA, that is, general account type assets, the answer is about 40% of the USAMA assets are invested in the general account and the remainder would be unaffiliated through PGI, a separate account or other sort of separate account, mutual fund-type assets. I'll turn it back to Barry.

Thanks for joining us, we appreciate your good questions and the dialogue. We're again very pleased with the year we've had, we're very optimistic in future. I look very forward to seeing you out on the road in the next couple months. Thanks again for joining us.

Thank you for participating in today's conference call. This call will be available for replay beginning at 1:00 p.m. eastern time today, through midnight. On Wednesday, February 12, 2003. 7417819 is the conference ID for the replay. The number to dial for the replay, 1-800-642-1687. Or 706-645-9291.