美國信安金融集團 (PFG) 2003 Q2 法說會逐字稿

Good morning, and welcome to the Principal Financial Group second quarter 2003 conference call. There will be a question and answer period after the speakers have completed their remarks. If you would like to ask a question at that time, simply press star, and the number one on your telephone key pad. I would now like to turn the conference over to Tom Graph, senior vice president of Investor Relations.

Thank you. Good morning and welcome to the Principal Financial Group's second quarter conference call. If you don't already have a copy, our earnings release and financial supplement can be found on the Investor Relations section of our web site at www.Principal.com/investor.

Please note in the earnings release and during this call, we discuss certain non-GAAP financial measures that management believes are important in evaluating the company's normal ongoing business operations. These non-GAAP measures are not meant as a substitute for GAAP measures. Therefore, we've also posted on the IR section of our web site a reconciliation of each non-GAAP measure used to the comparable GAAP measure. 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 will open up for questions. Others available for the Q&A are executive vice presidents John Aschenbrenner, responsible for the life and health insurance and mortgage banking segments, Mike Daley, responsible for marketing and sales, Jim McCaughan global head of asset management and Larry Zimpleman, responsible for our asset accumulation businesses.

Julia Lawler, senior vice president and chief investment officer, will also be available for questions. Some of the comments made during this conference call may contain forward-looking statements within the meaning of the private securities litigation reform act. There are a number of risks and uncertainties that could cause actual results to differ materially from those expressed or implied.

Factors that could cause actual results to differ materially are discussed in the company's annual report on form 10-K for the year ended December 31, 2002, and in the company's quarterly report on form 10-Q for the quarter ended March 31, 2003, filed by the company with the Securities and Exchange Commission. Barry?

Thanks, Tom. And welcome to everyone on the call. This morning I will provide some very brief comments on our results, then an update on recent accomplishments, as we continue to execute our growth strategy. Operating earnings for the second quarter 2003 were outstanding. As we continued to benefit from our diversified business mix. Compared to a year ago quarter, operating earnings per diluted share increased 29% to a record 67 cents. Mortgage banking was again a key driver with earnings improving 82% compared to a year ago but our other three operating segments, U.S. asset and accumulation, international asset and accumulation and life and health insurance each delivered record earnings for the quarter.

While we were very pleased with the second quarter financials, we continue to focus on the future. The challenges and opportunities ahead, and the ongoing strategic investments necessary to ensure sustainable profitable growth for for our shareholders. Mike Gersie will follow my comments with a detailed overview of results from the second quarter and also provide additional color on some of our challenges and discuss the investments we expect to make in the second half of the year.

As you know, a key element of our strategy is to accelerate U.S. retirement services growth. Reflecting the strength of our sales over the last several quarters, we continue to experience strong deposits. In the second quarter we delivered 4.9 billion in deposits, from our U.S. asset accumulation businesses. This includes full service accumulation deposits of 2.9 billion, up 26% from a year ago. Employer level lapse rates have declined to more normal levels in 2003 as we move beyond the demutualization effect prevalent in 2002.

This is reflected in a 20% decline in full service accumulation withdrawals year to date. We continue to make excellent progress in retaining participants as well. Our rollover asset retention rate improved 13% over the same period last year, to a record 55.5%. Full service accumulation net cash flow during the quarter of 932 million transports to 2% of beginning year account value.

This is well above our long term expectations for full service accumulation of 1 and 1/2% of beginning year account value per quarter and at 1.7 billion year to date, this equates to more than 93% of our net cash flows for all of 2002. The 928 million, pension full service accumulation sales were solid. But slightly below the expectations we communicated last quarter. As previously discussed, much of our efforts in the first quarter were focused on wrapping up Key Corp. cases and maximizing our close ratios.

Which reduced somewhat our pipeline building activities. We also experienced some delay in planned sponsor buying decisions during the second quarter reflecting poor equity market and economic conditions, during the first quarter, as well as uncertainty around the war in Iraq. Importantly, though, full service sales are up more than a billion dollars year to date. Close rates remain strong, and the pipeline going into the second half of the year is strong. We are as bullish as ever on our long-term growth opportunities for our defined contribution pension business and we are as confident as ever in our value proposition, the strength of our franchise, of small and medium businesses, and our ability to deliver outstanding growth and sales, account values and earnings.

Our ability to grow also reflects our ability to meet customer needs and exceed their expectations. We have a highly competitive product and service platform, one we keep competitive through continuous refinement and improvement. During the second quarter we launched a number of new products and product enhancements. Perhaps the most important of which is the Principal rollover choice IRA.

Which simplifies IRA rollovers for retirees and job changers. This introduction is a good example of our focus on delivering comprehensive retirement solutions, a commitment that was once again recognized during the second quarter. The Principal has named defined contribution news provider of the year for supporting the American worker and small to medium sized plan sponsors. And we received the 2003 insurance innovators award for use of the Internet to improve customer relations. In terms of accelerating international growth and profitability, Principal international had another outstanding growth quarter. Mike will discuss the strong financial result, but I point to other notable accomplishments.

Assets under management, which are up 38% from last year, are quickly approaching 6 billion dollars. Covered lives now exceed 5 million. Return on equity for the trailing 12 months is nearing 5%. Further, from a sales perspective, we launched our VGBL retirement product in Brazil and sales are growing rapidly. And in chile, where we are number one in annuity sales, we achieved record volumes.

We also continue to build scale through acquisition, signing an agreement to acquire Hanara, mutual fund company in Mexico, strengthening our position in the long-term investment and retirement markets. Moving to our efforts to create a successful asset management organization, we continue to build momentum with third party institutional clients. At mid year we have already won 32% more mandates than we won in all of 2002. And we now manage assets for six of the 25 largest U.S. pension funds. Nonaffiliated assets under management are up 136%, compared to a year ago. To $21 billion.

Spectrum Asset Management has been a key contributor. Since our acquisition, in the fourth quarter of 2001, spectrum's assets under management have increased from $1 billion to more than $10 billion. Principal global investors had mixed results in terms of our morning star investment performance during the quarter with a three-month top half number slipping from March 31, 2003.

However, we showed continual improvement in our longer term investment performance. Where the domestic and international equity funds and our pension separate accounts, 83% are in the top half of the trailing 12-month period. Compared to 75% at the end of the first quarter. Our ability to deliver strong financial performance, also reflects our focus on effectively utilizing capital. In addition to funding organic growth and strategic acquisitions, our top two priorties in 2003, we continue to repurchase shares.

In the second quarter, we bought back 3.8 million shares for 116 million dollars at an average price per share of $30.83. Completing the program authorized by the board in November, 2002. During the quarter, the board also authorized a new $300 million share repurchase program. We will continue to opportunistically utilize share repurchases as one option in our effort to effectively utilize capital and to achieve our earnings and our OE targets. With a hang in the tax law and given investor sentiment senior management and the board are also taking a hard look at our dividend policy. Clearly we must look at each of the days we deploy capital.

Including dividends. And determine what best supports the creation of long-term value for our shareholders. Consistent with the timing established in 2002, we expect to announce a board-authorized shareholder dividend in the fourth quarter of 2003. Moving to guidance, we expect the third quarter, 2003, operating earnings to range from 59 cents to 62 cents per diluted share. We are revising upward our previous full year 2003 operating earnings guidance of $2.25 to $2.40 per share to the new guidance of $2.45 to $2.50 per share. Our revision reflects our strong results here to date.

Compared to 2002, full year 2003 year guidance, reflects an estimated additional 5 cents a share expense for stock options and employee stock purchase plans and an estimated additional 11 cents a share related to our pension benefit expense. These operating earnings estimates are based on certain assumptions, including domestic equity market performance improvements, from June 30, 2003 levels, of roughly 2% per quarter, throughout the remainder of 2003. In his segment discussion, Mike will provide a little more detail on how we arrived at this guidance.

Mike will also discuss credit losses in more detail. But I would like to say that we are very pleased with the improvement in credit market conditions overall. And our strong improvement in credit losses during the second quarter. We're cautiously optimistic that we will continue to experience more normalized levels for the remainder of the year. As such, we are also revising guidance for net realized capital losses to 10 million for the full year, down from previous guidance of 170 million for the full year. Now, let me close with a comment on our operating return on equity.

With the trailing 12 months, our ROE has climbed to 12.8% from 11.1% a year ago. We are very pleased to have exceeded our year-end target of 12.5%. We will continue working hard to deliver on our promises. Drive growth. And build value for our shareholders. Mike?

Thanks, Barry. This morning I will spend a few minutes providing additional highlights for the quarter and the financial detail for each of our operating segments. I will also provide some commentary I believe will be helpful in understanding our outlook for the remainder of the year. I will close with some brief comments on the quality of our general account portfolio, and our expectations for credit losses. As Barry indicated, we're very pleased with our overall results for the second quarter. A strong earnings across each of our operating segments.

We delivered outstanding growth despite carrying additional pension benefit costs, and stock option expense during the second quarter of $13 million after tax, or 4 cents a share. There are several things I would like to highlight at the segment level, starting with US asset management and accumulation. Segment earnings increased 6% to 108 million dollars, compared to our previous record of $102 million in the year-ago quarter. The current quarter result, includes $2 million from the sale of Principal Bank's credit card portfolio. Excluding the sale, segment earnings would have improved 4%.

Pension was the main contributor to improved segment earnings, increasing 7% to a record 84 million dollars. Pensions increase is primarily due to improvements in the full service payout business, reflecting strengthening of reserves in the second quarter, 2002. This segment also benefited from improved earnings in pension investment only, mutual funds, and individual annuities. We were pleased with the strong run-up in the equity marks. At June 30, 2003, the S&P 500 had almost rebounded back to the June 30, 2002 levels, down just 1 1/2%.

But it's worth noting that the S&P 500 daily average for the second quarter of 2003 was actually 12% lower than the average for the year-ago quarter. So while the markets were moving in the right direction, pension account values and therefore earnings were again muted by the lingering effect of the equity market declines in prior quarters. Even in the absence of absolute growth in equity markets between the two periods, mean account values for pensions pension funds and individual annuities grew 9% in the aggregate compared to the year ago quarter. Operating earnings grew 10% over the same period for these three businesses. Our account value growth and earnings growth reflects strong sales over the past several quarters. The benefit of ongoing 401(k) contribution, and excellent retention.

Compared to record earnings of $46 million a year ago, pension full service accumulation earnings declined. However, we still view current quarter earnings of nearly $43 million as strong. Second quarter 2002 DAC amortization expense was lower due to a change in the sales compensation structure during that quarter. Which aided operating earnings by $2 million. On the other hand, second quarter 2003 operating earnings reflect additional costs for employee stock options and security benefits. As well as an accrual for long-term performance-based compensation. Excluding these items, earnings would have improved 12%.

Due to equity market appreciation, full service accumulation, deferred acquisition cost amortization was actually lower than it would have been in the current quarter by $4.7 million after tax. However, we reset the mean reversion period during the quarter to better match up with equity market cycle. This change resulted in negative unlocking of deferred acquisition costs, reducing second quarter 2003 full service accumulation earnings, by 4.2 million dollars after tax, substantially offsetting the lower DAC amortization related to equity market improvement.

As Barry mentioned, segment fundamentals continue to be very good during the quarter with strong net cash flows and solid new sales. We've continued to aggressively manage expenses to maintain pricing margins. And because our assets and liabilities are well matched, we have been able to maintain pricing spreads in spite of lower average asset yields than a year ago.

Within our international asset management accumulation segment, Principal international earnings grew to $12 million, up 7.5 million, or 165% compared to a year ago, in spite of the negative impact of foreign currency movements over the past 12 months. The increase primarily reflects improved earnings in our Mexican pension business, driven by strong results from our two recent afore acquisitions. Principal international earnings [INAUDIBLE] also benefited by approximately $2 million from higher nominal yields due to higher inflation in Chile and Brazil. Principal international continues to deliver steady growth and assets under management up 38% from a year ago reflects growth in net cash flows, investment performance and strategic acquisitions.

Looking to the remainder of the year, we expect Principal international earnings to range from 8 to 9 million dollars per quarter. We anticipate higher expenses in the second half. As we continue working to build market share. And to invest in additional infrastructure to support continued growth. Moving to life and health, earnings were strong again in the second quarter of 2% compared to a year ago. Earnings growth was driven primarily by improved loss ratios in group medical and dental vision businesses. Segment return on equity remained near its all time high at 13.7%.

Up from 13% June 30, 2002. This was another great quarter for the segment. But well above normalized earnings expectations of $55 million per quarter, in an unsustainable result in the near term. We don't expect the continuation of favorable loss ratios that have supported earnings growth over the past couple of quarters, particularly in group medical, and dental vision businesses. We've also made the decision, going into the second half of the year, to redouble our efforts in order to generate sustainable profitable growth for the segment.

This means higher expenditures in the second half of the year, as we invest in our key growth markets and make enhancements in our distribution and our product offers. Moving to mortgage banking, this segment was again a key driver of second quarter earnings growth. Segment earnings increased 82% from a year ago. To 45 million dollars. Which translates into a 38.8% return on equity for the trailing 12 months. Second quarter was another excellent example of the macro business hedge at work. The heavy refinancing activity that resulted in impairment of the servicing portfolio in an $89 million servicing loss, also generated exceptional loan production earnings of $134 million.

I would like to provide some additional color by breaking the $89 million servicing loss into its components. The first component is a $49 million after-tax loss from refinements to our valuation model. Second component is a $59 million loss after tax and hedging, from other impairments of mortgage servicing rights. Hedge gains offset more than 70% of impairments associated with interest rate movements. Our financial hedges worked well, and as expected. In the third component, is $19 million in earnings from servicing operation, including $7 million from the sale of servicing.

We've experienced a period of declining interest rates, which generated record production earnings, reduced earnings from servicing operations, and created losses from parents. Since the end of the second quarter we have seen interest rates increase about approximately 100 basis points. If rates remain at current levels or increase further we would expect production volume and production margins to decrease. However we would also expect earnings from servicing operations to begin moving back to a more normalized 25 to 30 million dollars per quarter. One other change occurred with mortgage banking during the second quarter We determined there was little chance to recover a portion of the servicing valuation allowance so we reclassified a portion of the allowance from temporary impairment to permanent write-down.

At June 30, 2003, servicing valuation allowance was $341 million. Down from $658 million at March 31, 2003. Since the temporary impairment had already been run through operating earnings there was no impact from this reclassification on operating earnings or net income during the second quarter. Before moving to questions, I would like to briefly discuss credit quality and our fixed maturity securities portfolio. Our net realized capital losses of $15 million after tax for the quarter reflects $24 million in losses from impairment and impaired sales of our fixed maturities. This is a 79% decline in losses from the second quarter of 2002, and marks our third consecutive quarter of strong improvement in net realized capital losses.

Importantly, the decline in realized capital losses is accompanied by a 45% decline in our gross unrealized capital losses from the first quarter, to a June 30 amount of 196 million dollars. This $196 million unrealized capital loss equates to only .6/10 of a percent of our fixed maturity portfolio and only 4/10 of a percent in our total invested assets in cash. Further 33 million dollar or one-tenth of a percent of our fixed maturity portfolio has declined and remains below amortized cost by 20% or more for six months or longer.

As you can see, we continue to be very rigorous in recognizing and accounting for problem assets. While we're encouraged by these improvements, credit conditions remain strained in certain industries. However, we have a very high quality, very diversified investment portfolio. We will continue to aggressively monitor each investment. And actively manage problem or potential problem loans.

Based on our watch list at quarter end, we are revising downward our previously communicated expectations. As Barry mentioned, we now expect realized credit, capital losses of $130 million after tax for the year. This concludes our prepared remarks and I would now ask the conference call operator to open the call for questions.

At this time, would like to remind everyone to ask a question, press star, and then the number one on your telephone key pad. Please limit your questions to one question and one follow-up. We'll pause for just a moment to compile the Q&A roster. Your first question comes from Joan Seathe from Goldman Sachs.

Good morning.

Good morning, Joan.

Oh, my God I only have one question. I have to decide which one I'm going to ask. All right. I guess what I'd like to ask is about capital. All right?

To go into this a little bit more. Can you just repeat again how much excess capital you think you have? How are the -- are you seeing any change in rating agency view of capital requirements in the life insurance industry, given the fact that credit has gotten better? And you know, does that give you a little bit more flexibility? And I guess you know, the question is, from the buy-back standpoint, do you think that this is going to be sort of less of a driver, going forward, because of, you know, of other opportunities, you know, particularly acquisitions, and things like that, that we should be expecting? So I know it is a long question, but it is just one sort of about --

Sure Joan, good to hear from you. We will certainly answer it. I will take a quick shot at it and let Mike fill in some of the details. I guess I would say that we are in a very, very good capital situation.

We have been, relative to our peers but it is a moving target and there is no doubt that the rating agencies continue to scrutinize capital requirements and make changes on the margins, and we certainly have to pay attention to that. Our ratings are very important to us. We have always, I think, had a interest in moving away from share repurchase and looking at using capital for other types of growth. The issue is, we've not found ways to deploy that capital.

So we continue to be committed to looking at strategic acquisition, funding our organic growth and then to the extent we don't need the capital in those areas, we would continue to look at share repurchase, even though I would say it would probably be more muted than it has been in the past, rating agency concerns, would be the primary driver. So Mike, do you want to fill in there?

Yeah, Joan. Good morning.

Thanks.

Let me start off by just a little color on rating agencies. And I know that at least some analysts have noted that -- at least some of the rating agencies are really increasing some of their capital factors. Sort of reacting to losses, capital losses that have occurred over the past few years. And so as they're strengthening their capital models, that is putting I think a little pressure on all companies, in terms of capital adequacy.

I would say I would view our capital, excess capital to be roughly in the half a billion dollar range, taking that future conservative viewpoint, rating agency viewpoint into account. That capital pretty much resides outside of the life company, in the holding companies, above the life company, currently we are not contemplating any dividends from the life company, to the holding company. During calendar year 2003. That obviously could change as we get into further discussions with rating agencies. But we're taking pretty conservative viewpoint, so we do have excess capital, it is a available, as Barry said, for share repurchase, for acquisitions, and for dividends. So we are exploring all options.

I guess as my follow-up, do you have any comments on Cigna block? Would that be one of your type of strategic acquisition that you would be looking at?

We certainly wouldn't comment on any speculation in the market. Obviously, we're interested in growing our core business in a variety of ways but we certainly wouldn't comment on a specific situation like that.

Okay. Thank you.

Thank you.

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

Good morning. The service accumulation sales and deposits were weaker than hi expected and I appreciate the commentary about the key core comparisons, but I was wondering if you can elaborate a little bit more on the, you know, current environment, in this, you know, what I would consider to be a fairly unpenetrated market? And can you give us some guidelines for what you're expecting in terms of sales and deposit growth in this area for the second half of the year? And I don't think we had the sales numbers for the second half of '02. Would you be able to provide that as well? Thank you.

Good to hear from you Michelle. Let me ask Mikedaley who is here with us to give you the answer to that.

Hi, Michelle. Good morning.

Good morning.

In terms of the environment out there, as Barry noted in his comments, we certainly came across a hesitancy in the market in the first and the second quarter due to a number of factors, including the war that was taking place at the time and so that most certainly had an impact on our pipeline generation activities. Coupled with the fact that we took our field force and pushed them hard to focus in on a non-pipeline generating activity. Which is closing business.

And that was around the key block. Because it was in our best interest to close out as quickly as possible. And so the good news, in July, we started to see the market coming back. In terms of this fire decision gridlock that was taking place there, so pipeline for the second half of the year continues now to ramp up. We are sticking with the commentary we've provided last call of 1 to 1.5 billion in sales per quarter. And last year's numbers were consistent with that in the second half, where for instance, in the third quarter of '02, we had roughly 1.2 and a half billion in sales taking for full service accumulation.

Given that this market is so underpenetrated why wouldn't you see better sales growth than what you had in the second half of last year?

Right, in terms of the underpenetration, by that I presume you're meaning that 401(k) plans are not highly visible in a number of small to mid sized companies, out there, is that what you're referring to?

Yes.

Okay. Part of the issue with that is again something that happened with the equity markets down, and the war, and the economic uncertainty, don't have a lot of plan formation taking place among those small to mid-sized companies. Who are eager then to put into that environment a new 401(k) plan in place. And so I think your point is that there is still upside for us, because this is an underpenetrated market with a better environment, we should see more plan formations starting to take place, and expect that to happen if the markets continue to do their positive thing.

Okay. Thanks very much.

You're welcome.

Thanks, Michelle.

The next question comes from Eric Berg with Lehman Brothers.

Thanks and good morning. Actually, Tracy and I have, Tracy Jackson and Sarah and I, were going to have a conversation privately but maybe we can do it on this call, regarding the hedge accounting, and the question that Tom Graph and I were sort of batting around last night is this.

Given the size of the I guess the net earnings loss from MSR adjustment, that is to say the write down of the MSR net of the hedging gain, and in particular given the fact that the hedge seems to be relatively ineffective I think it worked out to you said 70% effective or to put it differently 30% ineffective, is there a risk here that your auditors will not give you hedge accounting treatment and that in a rising rate environment, as you start losing money on your derivatives, you will not be able to write your MSR up to market? I know that's quite technical but I hope I was clear in my question. And I have one follow-up, thank you.

Were you clear, Eric. And we appreciate you're giving us a heads up on asking that question last night so we did a fair amount of research on it, we feel very comfortable on our position on it and I will let John Aschenbrenner fill in the details. The bottom line is we see no risk in losing the hedge accounting treatment but John you want to fill in the details a little bit.

Sure. We don't see any risk as Barry said of losing hedge accounting treatment and the way that test works is you segment the entire portfolio into much smaller segments, and then within each segment, you decide whether you're going to hedge or not hedge, and each of those small segments that we decide to hedge, we would hedge 100%, and what you're hedging, you have to define it very specifically, and what we are hedging is a parallel shift in interest rates.

We're not hedging any other aspect. And so the correlation that we have to have there to get hedge account something very, very strong. Because it is segment by segment, and it is based on only a parallel shift in interest rates.

So if were you to get a nonparallel shift in interest rates, for example, a -- I guess steepening of the yield curve like we're having here what would happen from an accounting perspective?

From an accounting perspective, you may have -- you may miss somewhat as far as your hedge is covering your complete change in value, but from a correlation to test whether you can hedge accounting, that nonparalleled shift aspect of it does not enter into the factor. Does not enter in at all.

Okay that was great. My follow-up questions relates to your core 401(k) business and it is, does it matter to you that the -- I mean in the end of the day, I suppose what matters is the money coming in the door, not how many plan participants, not how many employers have you under, you know, under -- as customers. But I still would like to ask the question, does it matter to you that the number of employers is basically remaining constant with whom do you business? Planned sponsors according to your financial supplement, I think 36,000 area.

Sure, sure, Eric. It matters a great deal. And maybe I will ask Larry to fill in a little color but we do track this, with a little noise in the system, but it matters greatly and Larry why don't you film in some details.

Good morning, Eric. This is Larry.

As Barry indicated we are very focused on wanting to grow all aspects of our retirement business so that would include our plan count our participant accounts and ultimately our account values, as we said to you in the past the account values are really the primary drivers around operating earnings but if I was to going to keep my eye on one single ball, that would be the ball.

Under Mike Daley's leadership we refocused retirement sales people to be a little bit more active in the upper end of small and the mid-sized cases and we're finding new channels, we're trying to grow the lower end, the new startup plans, the retirement sales reps still work there but we're also looking at new channels including TPAs and so forth. So I'm confident, Eric, you will see the plan counts continue to grow. They've kind of bottomed out as a result of demutualization, we discussed that in prior calls.

Thank you.

And Eric, if you went back and looked at same quarter 2002 versus this quart if you looked at the plans above 100 lives, everything but the small, we had a 10% increase and that was spread throughout the block so we have very strong growth. Where we're missing it is in the micro market where we intentionally did some things to change the focus, we've introduced new products, we got new channels going after it so my guess is over the next few years you will see the whole block grow, it will just have some variability from quarter to quarter.

I saw that in the numbers and I thank you.

Thank you, Eric.

The next question comes from Collin Divine with Smith Barney.

Good morning, gentlemen. Barry, in some ways I agree with you a solid quarter across most of your business lines except perhaps for one and I was wondering if I would might talk about the disability insurance line. Looking at the return on equities and frankly I find this hard to believe but you're still earning a worse return than even provident today. I appreciate this, this is not the biggest line, but I guess the basic question is, why the heck are you still in, it is clear Principal doesn't have the scale. [INAUDIBLE] has no synergistic value with your 401(k) business and as far as I can tell, it is just depressing your ROE.

How do you really feel about that Collin?

If you sold it, I would feel a lot better.

I appreciate that.

So will your shareholders.

I will let John get into a little detail but a couple high level. We are in both the individual DI and long term disability, LTD, STD, so we think those are fairly important products when dealing with a small to medium business market they are complimentary to group life to group health and if I think if you decide you want to provide financial services to that market segment you at least have to look at whether it makes sense to manufacture those producting and we look at it and being in the fact we are in both sides of it have complimentary skills we think it makes sense and actually the LTD has been a pretty good source of growth and we think we have done some things in the individual DI to right the ship.

No doubt we have some prior sins that are showing up in the financials. We've repriced. We think the outlook actually looks pretty good. I can assure you we are going to manage this business appropriately. And if it doesn't make sense we won't be in it but right now we think it does make sense and very complimentary, it is strategic and I have probably stollen most of John's answer but let me see if I he's got anything to add.

Not a whole lot more to add. I guess the two things I would add is on the individual disability we do have an older block that while it is profitable, is never going to move to a high ROE basis and so we've got that weight. On the group disability, we did just reprice our LTD in November of last year. We added significant margin into our product. But we changed the product and made it much more flexible so that employers can Taylor it to their needs. And so we saw both an increase in -- significant increase in our margin and a significant increase in production because of the product changes. It will take 18 months to two years for that full margin to flow through as we reprice existing blocks. But over that time period, the group disability ROE should move pretty dramatically.

I guess two quick follow-ups. I mean I got to tell you, it is still very hard for me to believe that I'm ever going to see this thing north of 10% and so I again I come back to why it is there. But also if I go back to my notes from the demutualization maybe I took this down wrong and perhaps you can clarify (inaudible) but I thought the number of cases are overlap -- in terms of customers between your 401(k) and certainly your group disability business was negligible. Is that incorrect?

No, I think that is correct. We -- it is not incorrect that it is a strategy to continue to look for cross selling opportunities. We have done a number of things in terms of integrating DI and LTD. Where that is a natural integration. When you go into a business, and some executives need an individual product, the rang are rank and file need a group product.

So there is more overlap there. I wasn't trying to suggest that it is, you know, a very closely correlated cross sale but it is one that is a very good product to have in your portfolio when you go in to talk to a small business owner, sometimes it leads to other sales, sometimes it is a cross sale. Collin, I will agree with you this is not a core business and as I say we will manage it over time. We think it makes sense to be in it. It we think there is strategic rationale but if it turns out there is not we will take appropriate action.

Thanks, Barry.

Your next question comes from the Jeff Hopson from A.G. Edwards.

Hi, good morning. Just to hit the whole life insurance business, or the insurance business, really, I think you pointed to the fact that you're trying to accelerate the growth there, can you give us an update on both the challenges and the opportunities to spur the growth in that business?

Sure. Sure. Good to hear from you, Jeff. I assume you're talking about I assume you're talking about the individual life, the group medical, group life and those products, in which case I will have John Aschenbrenner provide some color.

Yeah, you mentioned life first so I will maybe kind of focus my answer on that and if you want to go further, we can. But on the life side, I think the challenge -- one of the big challenges is the individual life industry is growing very slowly.

And so I think we've got to overcome that. I think the opportunity for us is we are very focused and we have been shifting our focus to the SMB market. One of our key growth areas is using life insurance to fund nonqualified excess retirement plans, and so the big opportunity that we are starting to really take advantage of is to connect the marketing of those products with the marketing of our 401(k) products. And we think that is a huge opportunity for us going forward.

Okay. If I could follow-up, what about attacking the individual business owners for life insurance outside of plans?

Yeah, the focus for us is on the entire small to medium size business. So we've got the enterprise solutions that I just talked solutions that I just talked about, which would be things like the nonqualified excess plan, in addition, we are marketing to the personal needs of the business owners and the key executives, and we are starting an effort to build an ability to market to the employee base of the small to medium-sized business. So as all those pieces come together we think there is a strong opportunity to really capitalize our presence in the small to medium-sized business.

Okay. And in terms of when you would expect that to start to show up in the numbers, is this 12 months event?

Yeah, I think on the enterprise side, and on the business owner side, it will be faster. I think it will be slower on the general employee base.

We would expect by year end actually going into the first quarter of next year that we are very optimistic are you going to see some sales growth that will be a leading indicator of this strategy working.

Okay. Thank you.

Your next question comes from the Tom Gallagher from CSFB.

Good morning. The first question for Barry, can you just update us on your thoughts on M&A? If I remember correctly after you sold BT your comment was you would be focused more on smaller sized deals on a go forward basis. Now, I don't want to put words in your mouth but I would just be curious if I'm thinking about that the right way and you know, how are you looking at the M&A environment right now?

Sure, Tom, I will be glad to address that. Fundamentally, we are migrating I guess a little bit toward saying that we are only going to do shawl tuck in acquisitions to one at least be open to what's in the environment and I think that is only appropriate. You know, we have made a number of I think very important smaller type acquisitions, particularly in the international area where we've made two of our acquisitions in Mexico which are pending out quite well we made a small acquisition of an ESOP administration company here in the States which is working out well. The spectrum asset of management [INAUDIBLE] we did a few years ago has been splendid has been the not-for-profit acquisition we made. So those are the kinds of things that we would envision doing but I would say the environment, you know, there is a lot of chat about consolidation and might what might happen, there is a lot of, you know, interest in which company, you know, like the Key Corp. may ultimately not be in the defined contribution area so I would just say we are in a strong position from a capital perspective, we have a good valuation and so I think our options are open, we have flexibility. But I can assure you, whatever we do, will be done judiciously and be done with the right valuation and I'm not signaling anything other than the environment may be changing, and we just need to be open to that. I'm more comfortable with modest sized acquisitions that we can handle that fit with our core business and that's most likely to see -- what you see out of us.

Okay that's great and just one follow-up. Can you just comment, I guess this is for Mike D., the full service pension earnings, why they were flat versus 1 [INAUDIBLE]. Was there any spread compression going on there?

No there was no spread compression going on. One of the things that you have to consider as you look at full service pension earnings is the fact that we were carrying some additional benefit cost expenses, also I believe there were some DAC adjustments in the -- looking back, at the year-ago quarter, which gave us a little bit of a boost over the year-ago -- in the year-ago quarter, so I think if you wash out some of those factors, I believe, as I mentioned in my prepared remarks, I think the increase was somewhere around 12%. If you back out all of the -- I will say the noise that are in both of those numbers.

Mike, if I can just interject, I was referring to versus last quarter, the first quarter of '03.

Last quarter?

Yeah and the fact that the market was up pretty strong, and whether there was anything unusual going on that would have either depressed earnings this quarter or give a boost to earnings last quarter.

Okay. Well, I'll turn it over to Larry. He is anxious to answer this one.

Well, Tom, as we said in our comments, in the second quarter, while the equity market run-up, we took the opportunity to reset the mean reversion period and I think as Mike said in his comments, that the effect of that was about I think 4 1/2 million after tax which was completely associated with the full service accumulation business. In Q2, it's not in Q1.

So all else being equal there was a depressing effect of 4 1/2 million after taxes in 2 Q?

Correct. And the good news is, that's been reset now so we have a much more realist equity growth expectation and that should bode well for the future earnings.

Okay. Thanks.

Your next question comes from the Liz Warner from Sadler O'Neill.

Good morning. I guess my first question is just in thinking about sales and your outlook for sales, can you just remind me, you know, how much sales growth do you really need to maintain that -- say 11-13% growth in U.S. asset, particularly full service accumulation, because I would assume, and if you would just remind me how much growth is in inherent in your business just from continued inflows of existing plans, and obviously the 2% equity market appreciation.

Sure, Liz, good to hear from you I will Larry jump in with the details on that.

Good morning, Liz. As we have I think very consistently talked about for our U.S. retirement businesses, we see three components to operating earnings growth. The first one is of course market performance itself. And we've sort of ballparked that at 7-10% over any particular 12-month period. The next big driver as we've said is the next cash flow of the business or our ability to grow our deposits faster than any benefit payments or withdrawals.

And for the entire segment, that is about two to three percent of beginning account value. It is actually a little more than that for the full service accumulation business as Barry noted in his comment, more 1 1/2 to 202% but close to flat for the gig segment and the third component which grows our earnings about 1-2% a year which is operational efficiency which is simply the scale of the business.

So really, where sales come in, liz, is their in that element around net cash flow. So the faster we grow our sales, the more we will be able to trend above that 2-3% of net cash flow. And as you've seen from the very recent quarters, we've actually been running something closer to 6-8% net cash flow numbers, and that is really the result of those robust sales. So if we can keep that going, then you will see those numbers continue to be much higher than our long term expectations and we will grow our operating [INAUDIBLE].

Okay. Great and I guess I got a follow-up, I think.

Yeah, sure.

Sure for you liz, you can follow-up.

I just want to know, just briefly, your outlook for some of the spread based deposits going forward. I know that funding agreements tend to bounce around a bit. But is there anything -- has your view changed at all in the outlook for spread-based deposits? You know, given the current interest rate environment and competition that is out there?

I will take a crack at that, Liz. This is Larry. In terms of our spread-based deposits, I think about three general opportunities there. One is the GIC a business, it's investment only where as you say we are doing some medium term notes and other products there, we continue to be a product innovator, we're looking at some retail programs and other ways to grow that business, so we remain pretty optimistic there.

The other one, that is a spread business is our fixed annuity business, our retail annuity business, we've grown that business pretty substantially over the last few quarters. Primarily as we've moved into additional bank distribution, and we think that has still got some room to go and that's still got legs and then the last piece of our spread business would be our single premium group annuity.

And because of both equity market conditions and interest rate, unfortunately that business has been on its back. But we're starting to actually see some signs of life, in our sales pipeline there, and we're actually hopeful that with the equity market rebound some of these defined benefit plan sponsors who have been sitting on the sidelines kind of waiting for the opportunity to be able to terminate their defined benefit plan, they will be able to begin thinking about that later this year and on into next year and so that business should start to grow as well.

Okay, great, thank you very much.

Thanks, Liz.

Your next question comes from Suneet Kamath from Sanford Bernstein.

(inaudible) operations. I think you said earlier that your ROE there was 5% and I'm just wondering I see the capital attributed to that segment has gone up. Certainly from last June. I'm just wondering if you can give us a sense of where you see that ROE trending not for the second half of the year but more over the next couple of years.

Good morning, I think you broke up a little bit when you first started asking your question but I assume it was around Principal international based on the follow-up part of that question. Let me ask Larry to address that.

Good morning, SUNEET. In terms of where we see that going, as was said, in the opening comment, the ROE for our international businesses is now approaching 5% ROE, and we think we will have the ability to continue to grow our operating earnings about 20%.

In that part of our business. Which should translate into somewhere between 75 to 100 basis points per year. Improvement on ROE. So remain pretty comfortable with the general guidelines or parameters of being in the 7-8% range by 2007 and being in certainly the double digit range by 2010.

Great. And hopefully you can hear me now. In terms of follow-up, and this is just a small item. I think you talked about 55 a million quarterly run rate in the insurance segment. I'm just wondering if that already includes some of the additional expenses that you are going to incur related to business growth or should we be thinking about that as a baseline and then adjusting it for some additional expenses. Thanks.

I think that includes some of the expenditures that we would be making in the second half of the year. So no adjustment from that normalized run rate.

Okay. Thank you.

Thanks SUNEET.

Again, to ask a question, please press star one. Your next question comes from the Ed Cejar from Merrill Lynch.

Thank you. Good morning, everyone. Hi a question about the earnings outlook in the second half of the year. Or I think specifically you laid out a number for the third quarter. Michael Gersie, if you look at the numbers that I think you talked about in terms of normalizing earnings if I wrote this down correctly it was life health, maybe 55 million, and then international, maybe assuming 8 to 9 million a quarter. If I make those adjustments, that would take out about 4 cents, from operating earnings. And you reported 67 cents in the second quarter.

So I'm wondering if you can go into maybe a little more detail about what else we're seeing. Is it the mortgage banking business primarily? Is it on the spread side? Because your spread-based earnings did look pretty strong in an investment only this quarter, for example. So I'm wondering if you can talk a little bit more at least conceptually about where you might see some sequential weakness. Thanks.

Sure. I think Ed, you hit it right on the head. You have to look at Principal residential the mortgage. There we've talked about normalized earnings somewhere around 25 to 30 million dollars on the servicing side. Seeing interest rates spike up a little bit, I would say that originations are going to be, production side of the business, will be somewhat weak in the second half of the year.

So you can knock off maybe 15 million dollars or about a nickel a share. In terms of -- I will say unsustainable or unusual, maybe a better way of putting it, unusual earnings in the second quarter. So when you make those adjustments, the way I look at it, in terms of normalized earnings per second quarter, if you take off about 15 million dollars for PRMI, about five million dollars or so for life and health, another 5 million or so for PI, that gets you down to a 25 million decrease, that's roughly 8 cents a share, so you subtract off 8 cents from the 67, and it gets you to about 59 cents a share which would have been at the top end of our range.

Okay. And if I could follow-up, again, on the spread-related question. The investment-only earnings looked particularly strong this quarter. Is that a sustainable number? Or do you think there could be something unusual in that number? Thanks.

Ed, hi, this is Larry. I will just make a quick comment on that. As you observed, it has been -- our spread businesses, excuse me, continue to perform very well, and we have continuing expectations that's going to occur.

I think the reasons for that, relative to some of our other competitors again speak to the broad investment capables that we have, particularly around areas like commercial real estate, preferred securities, with spectrum asset management, are also an issue in that, and frankly, our ability to make the kind of pricing concessions and liability redeterminations when necessary, is also a factor in that. So we feel pretty confident about our ability to maintain our long-term spreads in those businesses.

Thank you.

Thank you, Ed.

Your next question comes from the Beth Malone from ADVEST.

Beth, you're not coming through. I don't know if there is a problem with the phone or what.

Ms. Malone if are you on a speaker phone could you please pick up your hand set?

Well, operator, maybe rather than trying to fix that, maybe we can just close the call here. I actually would like to give Julia Lawler, our chief investment officer a few minutes to talk about our investment performance particularly since it was so good, and we get so many question, so let me ask Julia to do that and then I will close the call out.

Well we continue, thank you, Barry, we continue to feel very good about our investment portfolio. It is diversification and its credit quality. And in both, Mike and Barry mentioned in their presentation, that we are revising our forecast for the year. For after tax losses, for the fixed maturity portfolio. From 170 million down to 130 million. Which has to do with not only the credit markets improving but our portfolio being strong and our profits being rigorous and aggressive in taking past losses so we continue to feel very good about our portfolio. As mentioned, we are cautious. And we're certainly cautiously optimistic. So -- and as far as our commercial mortgage portfolio, while vacancy rates continue to rise, and our expectation is that delinquencies might continue to rise, and by delinquencies, I mean only those things that are 60 days past due in their payment, we do not expect our losses to increase over our expectations. And that's largely due to the quality of our portfolio. As well as the -- quality of our portfolio as well as the low loan to value.

Thank you, Julia. Well, let me just thank you all for joining us on the call today. It has been a good time with you. We remain focused as a management team on creating long-term shareholder value, doing the right things, operating this company with transparency, so we look forward to our relationship continuing with each of you over the coming months and I look forward to being out with you at conferences and road shows and other things, so thank you all very much for being on the call today and I will turn it back over to the operater.

Thank you for participating in today's conference call. This call will be available for replay beginning at approximately 1:00 p.m. eastern time until the end of today August 12, 2003. 1449098 is the access code for the replay. The number to dial for the replay is 800-642-1687. From the U.S. And Canada. Or 706-645-9291 for international callers. Thank you. This concludes today's conference call. You may now disconnect.