美國信安金融集團 (PFG) 2003 Q3 法說會逐字稿

Good morning and welcome to the Principal Financial Group third quarter 2003 conference call. (OPERATOR INSTRUCTIONS) I would now like to turn the conference over to Tom Graf, Senior Vice President of Investor Relations.

Good morning. Welcome to the Principal Financial Group's third quarter conference call.

If you don't already have a copy, our earnings release and financial supplement can be found on the investor relations section of our website 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 financial measures are not meant as a substitute for GAAP measures. Therefore, we have also posted on the IR section of the website a reconciliation of each non-GAAP financial measure 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 remarks. 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 June 30, 2003, filed by the Company with the Securities and Exchange Commission.

Barry?

Thanks, Tom, and welcome to everybody on the call this morning.

Before I get started let me again acknowledge the error (technical difficulty) about the principal. Hopefully this did not cause investors any inconvenience.

Moving on, this morning I will provide some very brief comments on our results, as well as an update on recent accomplishments. Mike Gersie will follow my remarks with a detailed overview of our results for the third quarter.

We were very pleased with the third quarter results following the record earnings per share in the second quarter. Operating earnings for the third quarter were very strong. Compared to the year ago quarter, operating earnings per diluted share increased 9 percent to 63 cents and year-to-date we have achieved 20 percent EPS growth. US Asset Management and Accumulation had a second consecutive quarter of record earnings and was the key growth driver, improving 30 percent compared to a year ago. It is also worth noting that during the third quarter our US Asset Accumulation Businesses exceeded $100 million in operating earnings for the first time ever.

Importantly, as equity markets improve and interest rates rise, we're seeing earnings emerge as we had anticipated. In the third quarter 2003, operating earnings for our US and International Retirement Businesses grew to 58 percent of total company earnings, which compares to 44 percent in the year ago quarter. As previously guided, this shift is a result of strong earnings from US Asset Management and Accumulation, more normal earnings in the Life and Health segment and earnings from Mortgage Banking pulling back from record results associated with the refinance boom.

I will focus my remaining comments on a number of key accomplishments during the third quarter, as well as year-to-date. Including this broader period provides a more complete picture of the earnings power of our Retirement Services Businesses and our success in executing our growth strategy.

As you know, accelerating US retirement services growth is a critical element of our strategy. Let me start by discussing pension full-service accumulation and some important improvements in the key leading indicators of growth.

Compared to a year ago, full-service accumulation account values have increased 28 percent or $11 billion to 51 billion. This measure demonstrates just how strong a growth engine full-service accumulation can be when the two components of growth, investment performance and net cash flow are working together.

The S&P daily average was nearly 12 percent higher than the year ago quarter, driving a significant improvement in credited investment performance, which contributed 5.7 billion of the growth in full-service accumulation account values. The remaining improvement from a year ago reflects 5.2 billion in positive net cash flow. At 3.5 billion, full-service accumulation net cash flow is up 177 percent compared to the nine months ended September 30, 2002. This year-to-date total equates to more than 8 percent of beginning year account value, well above our long-term expectation of 6 percent of beginning year account value per year for full-service accumulation. The improvement in net cash flow is largely due to higher deposits, which reflects increased contributions from existing customers and strong sales. It also reflects reduced withdrawals.

Full-service accumulation deposits are up 1.8 billion, or 25 percent year-to-date, to 9.2 billion. Attributions from existing customers made up nearly 7 billion of that total and account for 1.4 billion or 78 percent of the improvement. Full-service accumulation sales are up approximately 820 million to date or 22 percent. Third quarter sales were very solid at 1.2 billion, but down 16 percent from the year ago sales, which were aided by Key Corp conversions. Importantly, though, full-service accumulation sales are trending back positive, up 26 percent from the second quarter, as we continue to work hard to achieve sales at the high-end of our 1 to $1.5 billion quarterly target.

I would add that alliance sales, a key component of sales growth, continues to be outstanding. In the third quarter alliance partners deliver 450 million in full-service accumulation sales. Year-to-date alliance sales have improved 78 percent, or more than 500 million, exceeding 1.2 billion for the nine-month period.

Year-to-date withdrawals have improved by 8 percent, or approximately $0.5 billion. Withdrawals during the third quarter were 2 billion, up from the relatively low levels in the year ago quarter. However, we viewed the third quarter withdrawals as very reasonable relative to average withdrawals for the trailing twelve-month period of 1.95 billion per quarter and as a percentage of beginning of period account values.

Our plan level retention remains among the best in the industry. We also continue to make excellent progress in retaining plan participants.

Our rollover asset retention rate remained outstanding, again exceeding 55 percent, including 58 percent for the month of September, making us an industry leader in retention.

Our ability to grow also reflects continuous refinement and improvement of our product and service platform across each of our segments. During the third quarter we launched a number of new products and product enhancements -- our new executive non-qualified defined benefit plan; our new UL product, Principal Universal Life 3; and principal annuity legacy, a unique insurance investment and estate planning tool for the affluent market. We were also selected to run the Iowa Workplace College Savings Plan, the first 529 plan in the nation developed to be sold exclusively through employers.

In terms of accelerating international growth and profitability, principal international had another outstanding quarter. Mike will discuss the financial results, but I would point out some notable accomplishments. Assets under management reached 6.9 billion, up 64 percent from a year ago and up 40 percent excluding acquisitions, record retirement sales in Brazil during the quarter, and continued strong ROE progression exceeding 5 percent for the trailing twelve-month and improving 24 basis points sequentially and 270 basis points compared to a year ago.

Moving to our efforts to create a successful asset management organization, we've acquired an interest in MW Post, a premier asset management firm specializing in high yield fixed income. We plan to increase that ownership position to a majority interest in January. The acquisition allows us to broaden our product offerings and provide attractive yield enhancements and diversification benefits to clients.

During the quarter we continued to build momentum with third party institutional clients, particularly in real estate and fixed income. This includes a number of very important new mandates, including $100 million wins with the Florida State Board of Administration, Nord Capital and Golden Rule Insurance and a 550 million real estate mandate with Cal Sterns (ph).

Non-affiliated assets under management are up 89 percent compared to a year ago to nearly 22 billion, and we now manage assets for 7 of the 25 largest US pension funds.

While absolute investment performance in equities continue to improve, Principal Global Investors experienced a decline during the quarter in terms of Morningstar relative investment performance. We will continue to work hard to bring our relative performance back to recent to strong levels, and we're confident we can deliver high-quality investment results over the long haul.

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 priorities in 2003 -- we continued to repurchase shares. In the third quarter we bought back 2.4 million shares for $78 million at an average price per share of $32.83 from the $300 million program authorized by the Board in May 2003. We will continue to opportunistically utilize share repurchases as one of the options in our effort to effectively utilize capital to achieve our earnings and ROE targets.

As you know, in late October the Board of Directors declared an annual dividend of 45 cents per share, payable on December 8th to shareholders of record as of November 7th. We were very pleased to be able to increase the shareholder dividend by 80 percent from a year ago. We believe this increase reflects our continued strong earnings growth, as well as our commitment to deploying capital to create long-term value for our shareholders.

Before providing guidance, I will briefly mention some recent and imported third party recognitions. As you may recall, in the first quarter we were named as one of Fortune's "100 Best Companies to Work For". We added to that honor with "Best Place to Work" awards from Working Mother Magazine, AARP, InformationWeek Magazine, Latino Style Magazine and Chile-based Capital Magazine. We firmly believe that attracting, retaining and motivating employees is a key factor in delivering strong financial performance and we're very proud that our commitment is being recognized.

Moving now to guidance, we expect the fourth quarter 2003 operating earnings to range from 60 cents to 63 cents per diluted share. Our operating earnings estimates are based on certain assumptions, including domestic equity market performance improvement from September 30, 2003 levels of roughly 2 percent for the remainder of 2003. We're also revising guidance for losses from fixed maturity security impairments and impaired sales to $120 million for the full year 2003, down from the previous guidance of 130 million for the full year. Mike will discuss credit losses in more detail, but I would like to say we are again very pleased with the improvement in credit market conditions overall and our own continued improvement in credit losses during the third quarter.

I will provide some preliminary guidance on our outlook for 2004 earnings as well. We expect operating earnings per diluted share to range from $2.65 cents to $2.75. This estimate is also based on certain assumptions, including domestic equity market performance improvement of roughly 2 percent per quarter throughout 2004. We expect to refine this range throughout 2004.

Earlier in my remarks I mentioned that an increasing portion of our earnings is coming from our higher multiple businesses. We expect that trend to continue, with most of our earnings growth in 2004 coming from our retirement and asset management businesses.

I will close with a comment on our operating return on equity. For the trailing twelve-months our ROE has declined to 13.1 percent from 11.8 percent a year ago. We're very pleased to have exceeded our year-end target of 12.5 percent, and will continue working hard to deliver on our promises to drive growth and build value for our shareholders.

Mike?

This morning I will spend a few minutes providing additional highlights for the quarter and financial details for each of our operating segments. I'll close with some brief comments on the quality of our general account portfolio.

As Barry indicated, we're very pleased with our overall results for third quarter. We delivered outstanding growth, particularly in the light of higher security benefit costs of $14 million after-tax, or 4 cents per share, compared to third quarter 2002.

There are several things I would like to highlight at the segment level, starting with US Asset Management and Accumulation. Assets under management are up $25 billion, or 29 percent compared to a year ago, driving total company assets under management to a record $135 billion. Segment earnings increased 30 percent to a record $111 million compared to $85 million in the year ago quarter.

Pension was the main contributor to improved segment earnings, increasing 24 percent to a record $87 million. Each of our pension businesses delivered double-digit growth. The segment increase also reflects triple digit earnings growth for mutual funds, individual annuities and double-digit growth from Principal Global Investors.

I will discuss full-service accumulation earnings in more detail because of its importance to our growth story and share some information on items impacting comparability between periods.

Full-service accumulation earnings improved 13 percent compared to a year ago. Lower DAC amortization expense in the current quarter was offset by additional costs to unwind a subsidiary long-term incentive plan. However, the current quarter had higher security benefit costs of $3 million after-tax. Excluding this item, earnings would have improved by 21 percent, which is more consistent with the 22 percent in growth in mean full-service accumulation account value over the same period.

Within our international asset management accumulation segment, Principal International's earnings improved 40 percent from a year ago to $8 million. This increase primarily reflects improved earnings in our Brazilian joint venture. Year-to-date Principal International's earnings are up 115 percent to $27 million. The improvement reflects strong growth in our pension business in Mexico, aided by our two recent Afore acquisitions and growth in assets under management in Brazil and Chile.

Moving to life and health, earnings were down $3 million compared to a year ago. The decline in segment earnings primarily reflects lower individual life sales during the quarter. As communicated last quarter, we continue to expect normalized earnings to be in the mid $50 million range for the segment.

We continue to focus on key growth markets and opportunities in order to generate sustainable, profitable growth for the segment. Importantly, we're already seeing some signs of improvement. In the third quarter new sale covered members increased for group insured medical and dental/vision sequentially and compared to a year ago. Further, the decline in covered members for group insured medical and group dental/vision has slowed to a trickle. Dental covered members actually increased, but the growth was offset by vision losses. This progress gives us confidence that our initiatives will drive growth in 2004.

Moving to Mortgage Banking, the natural hedge of production and servicing continued to work in the third quarter. The result was another very solid quarter with segment earnings of $29 million, which contributed to a 30 percent return on average equity for the trailing twelve-months. In the light of rising interest rates, I will spend a couple minutes discussing how earnings emerged in the third quarter and how we expect earnings to emerge over coming quarters.

Production earnings declined $40 million from 134 million for the second quarter. While loan production volume reached a record $18 billion, reflecting a sizable pipeline of loans going into the third quarter, production earnings declined due to decreased gains on sale of mortgage loans. This decline reflected rising interest rates and greater pricing competition for new loan applications. Thought expected in this rising interest rate environment, fourth quarter long production earnings will continue to decline, reflecting even lower margins, as well as much lower volume.

On the servicing side losses improved significantly from $89 million in the second quarter to $11 million in the third quarter.

To provide some additional color I will break the $11 million servicing loss into its three components -- $20 million after-tax loss from refinements to our valuation model; a $3 million gain after-tax in hedging for mortgage servicing rights valuation adjustment; and $6 million in earnings from servicing operations. What you're seeing as we transition from a production to a servicing environment is lower losses from valuation model assumption changes, highly correlated hedges and earnings from servicing operations that are still being muted by high amortization.

In the fourth quarter, while we expect amortization expense to be relatively high, it should decrease from third quarter levels, resulting in higher earnings from servicing operations. Assuming interest rates stabilize at higher rates, we would expect amortization expense to decline even further in 2004, further increasing earnings from servicing operations.

I will briefly share a couple of additional points on our Mortgage Banking business. At the end of the third quarter the weighted average interest rate for our portfolio was 6.01 percent. Nearly 75 percent or $88 billion of our servicing portfolio has an interest rate at or below 6.5 percent. In light of higher interest rates, we have a larger, more valuable asset, one that will continue to grow in value as interest rates continue to rise.

I also want to provide a quick update on our loan warehousing facility used for non-recourse financing of residential mortgage loans. We early adopted the new rules under FASB interpretation 46 -- "Consolidation of Variable Interest Entities". Under these rules our warehousing facility no longer qualifies for off-balance sheet treatment.

We're now consolidating the facility, which means an increase of approximately $3.6 billion in assets and liabilities on the balance sheet with a very immaterial impact on operating earnings. There is no economic impact of the change. We have discussed this matter with the rating agencies and expect no rating issues associated with this change in reporting presentation.

I'd like to briefly discuss credit quality in our fixed maturity securities portfolio. After-tax net realized capital gains of $2 million for the quarter reflect $19 million in losses from impairments and impaired sales of our fixed maturities. This is a 70 percent decline in losses from third quarter 2002, and marks our fourth consecutive quarter with strong improvement in net realized capital losses.

At $179 million gross unrealized losses have also improved, down 9 percent compared to second quarter 2003. Gross unrealized losses equate to only five-tenths of a percent of our fixed maturity portfolio and only three-tenths of a percent of total invested assets and cash. Only $35 million -- less than one-tenth of a percent -- of our fixed maturity portfolio has declined and remained below amortized cost by 20 percent or more for six months or longer. The watch list has also continued to improve, down $360 million from a year ago or 2.6 percent of our fixed maturity portfolio to 1.3 percent at quarter end.

We continue to aggressively monitor each investment and actively manage problem or potential problem loans. Based on our watch list at quarter end, we revised downward our previously communicated expectations. As Barry mentioned, we now expect credit capital losses of $120 million after-tax for full-year 2003.

Before moving to questions I will offer a couple of final thoughts. Earnings continue to emerge as expected and we continue working hard to provide meaningful guidance in this area. With improvement in equity markets, we're again seeing real growth potential for our retirement services business. We recognize the importance of delivering strong current earnings, as well as the need to continue to invest in being the premier provider of employee benefits to small and medium-size businesses. This will enable us to deliver sustainable, profitable growth into the future.

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

(OPERATOR INSTRUCTIONS) Andrew Kligerman, UBS.

Quick questions. One, on mortgage loan production, you have mentioned that the margins were coming down. Could you give us a sense of what exactly the margins are and where they could go in the next year or two?

Secondly, on your FSA sales at $1.2 million, they were down (technical difficulty) year ago. I know you have the Key Corp transaction that you (indiscernible) a little bit into the quarter a year ago, but where do you think FSA sales could go over the long-term? What kind of growth would you like to see and how are you going to get it?

Let me ask John Aschenbrenner to take the margins on the mortgage. Let me just say in general, and I'm sure you're aware of this, that in a low interest rate environment where you have a lot of capacity you're able to get much higher margins. And obviously when interest rates go up, everybody's competing for loans and you do have margin compression. Maybe John can give you a little more of a sense as to what that looks like.

We don't have a specific margin number, and part of the reason for that is it is changing so quickly and it varies very much by the outlet.

I think it is coming down to where we still have margin, so we would still expect production earnings, but those production earnings are going to fall off significantly as the servicing earnings begin to pick up. I think of the key to remember is that we did sell our retail brick and mortar block earlier this year, so we do not have the fixed costs drag of a brick and mortar retail operation that would drag the margins down even further if we still had that.

Will it get to a point where it pierces below double-digit ROE? Do you see that happening?

No. Again, the key is really the macro-hedge that as interest rates stay at this level or go higher, the amortization on the servicing side should go down; the servicing earnings will go up as the production earnings go down. So we still think a reasonable expectation is in the 25 to $30 million per quarter, which is still a very strong ROE for the line.

On the ROE over the last -- I think I have a chart on this -- over the last seven years I think we've averaged over 20 percent ROE and we had one year when it was below 15 and that was at 14.9. So this has been a very strong ROE business.

Let me ask Mike Daley to answer your question about FSA sales and maybe a little bit about the outlook going forward.

Just to clarify one point, sales were actually down 16 percent at the 1.2 billion level from the year ago quarter, though up 26 percent from last quarter, as we talked about in the press release.

With regards to the future of sales, I just want to put this in context for you. When we talked about this company during the road show, we talked about 25 percent plus sales growth on the full-service accumulation side. That was coming off of a $2 billion sales base in the year 2000. We're now delivering, as you know, last year roughly 6 billion and right now year-to-date we're at 4.1 billion. So we have exceeded that 25 percent sales growth on CAGR basis right now. And if you take the our range and apply it to the fourth quarter -- the range Barry refers to of 1 billion to 1.5 billion -- we will come in anywhere between 40 and 44 percent roughly if we fall within that range on a three-year CAGR basis from a sales standpoint.

Going forward from that, we can't anticipate 25 percent growth on top of that large of a base because of our extreme success early on here, and so we will probably be starting to bring that number down towards a 15 percent sales growth level as we look out over the next three years.

Thank you.

Nigel Dally, Morgan Stanley.

You took another negative model refinement charge; I think it's the fourth in a row. Why shouldn't we be concerned that this is a sign that you have been aggressive in capitalizing your mortgage servicing rights? And what assurance can you provide us that we will not see further charges in upcoming quarters?

And (indiscernible) statutory earnings, do you have details on your statutory earnings this quarter and estimates on your (indiscernible) capital ratios and how much excess capital you have?

Let me ask John to comment on the first question and then we'll turn to Mike on the second.

On the first question on mortgage banking, we did take a $32 million model change which was one small tranche of our servicing where we did some correction in the prepayment model.

Again, we constantly stay on top of that. We are very comfortable that we're on top of it. All of our checks against outside entities -- and we have an outside entity that does a valuation for us -- we're within their range. So we're very comfortable that we are managing the servicing very closely. We will stay on top of it. If it needs changes, we will make changes. But we've made all the changes that we believe are necessary and appropriate at this time.

I think it's actually a positive that we're making these changes as we go along. I think it would be much more concerning if you didn't make the changes when you find them, and then you would be creating perhaps a situation that is not sustainable. But we do make them and we feel this is fairly valued now.

I guess just a follow-up -- in a rising rate environment would you expect these model refinements to go away? Is it mostly just a function of the interest rate environment?

I think that is generally so. I think as we have talked before, I think in the prior environment we've been in I think we were unprecedented refinancing. We talked a little bit about the media effect when interest rates go down. And I think largely those things go away in a rising interest rate. But I think in any model you always have things that you can see that is going to emerge differently than you originally projected. But my guess is there's fewer of those in a rising interest rate.

John, would you agree that?

I would agree with that. I think the other thing that we will find is the OAS model that we use and the approach that we use should be slower moving up than what you will see at a lot of other companies.

Then you asked about stat earnings, risk-based capital and access capital, so we will kick it over to Mike for a quick update.

That is unfair because that's about three questions combined into one. But I'll do my best.

I don't have stat earnings right in front of make, but generally our stat and GAAP earnings are very similar. I would not expect any significant difference in GAAP and stat earnings, especially as we dividend some of our principal residential mortgage income up to the life company. We do that on a periodic basis. So I think those two are, again, pretty similar.

Risk-based capital, I believe will still be right around the 400 percent level. I don't have that calculation in front of me either. But there's no significant changes in our mix of business or risk.

Available capital today is somewhere around $500 million. Remember we have a shareholder dividend that we will pay later this quarter. That will bring that amount down some by the end of the year. The offset to that is that we're an organization that generates a lot of free cash, and basically a lot of capital that's not needed to support our business.

The one wildcard that we have interacting with the rating agencies is that obviously rating agencies still have a concern about capital. They're still looking at adjusting some of their risk-based capital factors as they do their calculations at the end of the year. So we're being a little bit cautious in terms of how much available capital we think we think we have and how quickly we will be able to extract capital from the life company to get up to the holding company. We hope to work through those issues in the next couple of quarters and should have a little better read about where we will be in 2004 and going forward.

That is great. Thank you.

Michelle Giordano, JP Morgan.

Good morning. First on the real estate sales gains, can you tell us what the magnitude was in the quarter and what's embedded in your '04 guidance? And secondly, in the FSA market, I was hoping that you could comment on current customer sentiment and the competitive environment? And have you gotten any takeover business from CIGNA?

Let me ask Mike Gersie to give you a little flavor on the real estate gain and then Mike will answer the second.

Real estate gain really came from some joint venture properties and also some prepayments of mortgages. So that's what boosted the earnings dab (ph) in corporate business units.

And she asked about embedded in the guidance for '04.

In '04, I think you could still say that, just as we have said in the past, we don't see any real change from -5 to -10 million dollars, although that amount, there's going to be some lumpiness. So there will be times when we might exceed it by a little bit and there will be times when we might beat it by a little bit.

Mike Daley, do you want to talk a little bit about FSA and customer sentiment and competition?

As we've talked to year earlier in one of these conference calls, there was certainly a malaise that swept through the marketplace in the first and second quarter tied to the convergence of the war and the soft economy continuing and also before the equity markets picked up midyear.

So we have seen that malaise start to lift. So customers are back into a buying mode in the marketplace. It hasn't fully evaporated, but it certainly has lifted a bit. And we're starting to see that shape up in the form of stronger pipeline right now.

With regard to CIGNA specifically, I can tell you that yes, our pipeline that is tied to CIGNA transfer deals is probably double what it was prior to them going public with their announcement around potentially selling their business. So that certainly has had an effect out in the marketplace.

Just the general competitive environment?

General competitive environment I think remains the same for us. The bigger issue was the overall environmental factors, not competition. So at least ton this point in time, we continue to view that competitive environment as relatively stable and equal to what it was earlier in the year and last year.

Thank you.

Tom Gallagher, CSFB.

Good morning. Two related questions; first is related to the sales outlook. Mike, you had had talked about pipeline is firming. Does that also relate to -- because you had talked at the beginning of 3Q that the pipeline had firmed and looked strong. Is it now stronger than it was in 2Q? I guess does that assume or pretend that we're going to get better sales results in 4Q in all likelihood? That would be the first question and then I have a follow.

In terms of the pipeline, yes, it continues to firm. So as we talked last quarter call, we had a pipeline starting to rebuild from what it was early in the year. It continues to improve, that situation. So pipeline is stronger today than it was a quarter ago. And we continue to be optimistic that if the markets continue along the path that they are on that we will see an increase in that level over time.

Perhaps at the upper end of that 1 to 1.5 range, where the current quarter was more in the middle or a little on the lower end of that range -- billion.

Thanks. And then just a follow up on retention. Barry, I know you have talked pretty positively about what your net retention has been, but I just wanted to look at it kind of a different way. If you look at your overall case count, it's been steadily declining and dropped somewhat dramatically this quarter. And I know the key thing to look at here is assets, and not necessarily cases. But can you comment on why we're seeing the decline in case count, number one? Number two, if you did look at it on an asset basis, what would be the net wins versus losses that you're seeing in terms of transfer business right now?

Let me actually let Larry Zimpleman answer that. I think he's got the numbers handy here.

Let me just make a couple of comment relative to the issues on case count that you had mentioned. Again, in the supplement you can see that compared to a year ago our case count is down about 730, 735 plans. And as we pointed out in that supplement, about 640 of those are actually a result of some specific actions that we took to clean up what were essentially some old and rather inactive contracts. So there was a relatively nominal amount of account value that was in each one of those. And that has been cleaned up, primarily by moving it to some other, more appropriate arrangement.

If you look at from a year ago, if you look at the plan counts in everything above 100 live (ph) you'll see that the plan counts are up about 7 percent. I think that's a very healthy sign. If you look at plan members in those areas, they're all up. That's a healthy sign. Most importantly, as you commented, the real driver here is account value. And that is a 28 percent overall for full-service accumulation. That reflects great retention, both at the member level, as well as at the employer level.

You asked about wins versus losses; I'm not sure exactly what you might mean there. But certainly each year -- I think year-to-date we brought in about 1,800 case counts. And so if you ignore the cleanup efforts that we talked about, you would see a very strong gain between the wins and losses, if you get rid of those 640 that really reflect the onetime cleanup.

One very last comment, our lapse rate at the employer level is about 4.5 percent and that's about 20 percent better than it was a year ago. I hope all those stats will help you understand what's going on.

I think, Tom, you might have also asked about takeover business versus startup. I'm not sure if you did or not. But I think we're still running about two-thirds of our business is takeover.

Thanks. And then just one follow. And Larry, what I was referring to in terms of assets, in terms of wins versus losses, in speaking to at least one competitor of yours what they said is they win about five times the amount of assets that they lose. Have you look at any comparable ratios, just in terms of transfer business?

Yes we do, Tom. We look at who we lose business to and who we gain business from. As we have said before, we track that very closely. There is no significant top tier competitor that we are in a negative situation on. And we're actually in a very positive situation relative to most of the middle tier players, and the banks and the vast majority of those 300 or so competitors in the 401(k) space. So I would challenge anybody who says they're writing five-time the amount that they would lose to us.

And just clarify, I'm not referring to you; I'm talking, this is a broad comment about they were winning five times more versus competitors broadly speaking than they're losing.

And that would probably be pretty comparable to our situation. Ours would be very comparable to that. And it comes from those middle tier and second-tier competitors I was describing before.

Thanks a lot.

Jeff Hopson, AG Edwards.

A question generally on USAMA. And now that we've got strong asset growth, how would you expect that to play out in terms of earnings leverage? I assume you'll still be spending money to bring in new business, but can you talk about earnings leverage in general and any plans in terms of expanding the alliance partners?

Let me start with Mike Daley on the alliance front and then will shift back to Larry on how the earnings might emerge.

With regards to the alliance partners, as you know, that's been a very successful program for us and has been one of the engines of sales growth. We absolutely intend to continue to broaden and deepen those relationships on a go forward basis. They are contributing about 25 percent year-to-date today of new sales that we're bringing in. So we have struck upon a rather rich gold mine here and we will continue to go after it.

Larry, on the earnings?

In terms of the operating earnings, I'm not sure you want to talk about the asset accumulation businesses generally or the full-service accumulated business.

Overall USAMA I guess.

In terms of overall USAMA I think the general metrics that we've provided still look like they hold true, and that basically is to look at three components of operating earnings growth. The first would be investment performance, which broadly for USAMA we categorize as somewhere in the 7 to 10 percent range. The second one would be net cash flow, which again we ballpark at around 3 percent, although we've been actually exceeding that for most of the quarters. And then the final one would be an operational efficiency, or kind of margin expansion component, which again we ballpark as 1 to 2 percent, but again we've been exceeding that in the last few years. Generally speaking, I think that would get you to the high-end of the 11 to 13 percent growth in earnings that we've been trying to communicate. We expect to be at the higher end of that range for the USAMA businesses.

Thank you.

Beth Malone, Advest.

I have two questions. First, with regard to the return on equity and the goals the Company has, is it going to be more challenging as the mortgage banking operation contributes less in the future as it transitions from origination to servicing for you all to achieve the returns on equity, since that is such a high return on equity business?

Obviously, if mortgage banking could continue to grow as it had been with the kind of ROE, then obviously it would have been a great add. I think the converse of that is that now that USAMA is really the growth engine, it's a much larger part of our business and it earns it earns 17 to 18 percent. So I think when you factor those two in, and you think about the kind of growth rate that we're going to get from USAMA, we are actually in a better position on ROE basis going forward.

Whether we debate that or not, I will say that we continue to be committed to increasing our ROE about 50 basis points per year. We're still committed to get to 15 percent. As I noted in my remarks, we're already at 13.1; up over the 12.5 we communicated for this year. So we feel very good about our ability to continue to drive ROE improvement.

I think there's one other aspect that I ought to mention, and I think it is true for us and others. As I mentioned earlier, rating agencies and the potential level of capital that they require organizations to hold for a given rating level could come into play here. And so that could be perhaps a bigger impediment to increasing return on equity than anything. Not so much the numerator, but the denominator may have an impact.

A follow-up on the life and health business. That has been a very strong sector of your operations over the last couple of years, as you have been able to keep ahead of medical inflation in your rates in the products that you're marketing. With the modest decline we saw in the third quarter, is the dynamic in that business changing? Or is the medical inflation just catching up to where you have been able to price?

I think you have to look back, particularly at the second quarter, and say that that was abnormally high earnings because of spectacular medical experience. Right now in the third quarter, I think we're back to about where we should be in terms of the medical experience. The earnings are, I would say, understated a little bit this quarter, maybe by 3 to $4 million because of some unusual one shot things that happened during the quarter. So I think as you look forward, as we have said in the past, I think on mid-50s is a reasonable expectation for the rest of this year and next year. And then I think after next year you ought to start seeing high single digit growth in the earnings from the life and health segment.

Thank you.

Ed Spehar, Merrill Lynch.

Good morning. A couple questions. I am going to try to pull the multi-part thing here too in each question.

In full-service accumulation, Mike, I was wondering if you could go into a little bit more detail about what was driving results this quarter. And I guess specifically when I look at the sequential comparisons, your fees were essentially flat -- actually down just a little bit -- on a sequential basis despite it looks like seven percent growth in average assets. So I am wondering if you could talk about why we're not seeing a follow-through from asset growth to fees this quarter. And expense side, the DAC amortization was less than half of what you had in the second quarter. I'm wondering, are you suggesting that all of that -- that you had an unusual comp expense that was like 8 or $9 million this quarter? It just doesn't seem like it was that high. And you had taxes for the first time also, I think, versus credits. So that's the first question.

Let us answer that three-part question. I'll let Larry take first two and maybe Mike can take the one on taxes.

In terms of the fees sequentially in the full-service accum segment, the fees from separate accounts actually were up about 4.5 million as a result of the higher account values in AUM that occurred as a result of the market. You didn't see it flow-through as a 4.5 million increase in the income statement primarily because there was a little bit of other onetime noise in there associated with both prepayment fees and also the way we handle capital gains and losses due to defined benefit clients who cash out. But what I can tell you is that there was a $4.4 million increase in fees that is embedded in the income statement from higher AUM in Q3.

In terms of the DAC amortization, there was noise going both ways. There were some higher onetime expenses for security benefits, for some incentive compensation, as well as for our acquisition of benefit consultants on the 1st of January. So all three of those drove some expenses higher. There was a DAC amortization unlocking that was associated with a redo because of better lapse assumptions, better lapse rate and lower lapse assumptions, as well as some operating margin improvement that we expect to see as a result of operating off a much higher AUM base.

And I will let Mike Gersie comment on the tax issue.

The primary driver of the increased taxes really dividend received deduction, if you go back and compare to year ago -- a year ago, besides the benefit of dividend received deduction, we also released a little bit of our tax contingency reserve for dividend received, as we got some additional interaction with the IRS and got a little more assurance of some of the positions that we were taking.

One thing to remember about dividend received deduction is to some extent it's a fixed amount, and so if you think about an increased income it will have less of a relative impact as income rises. So if you think in terms of if our income were to magically double, we'd still have roughly the same amount of dividend received deduction and our relevant tax rate would rise.

Just one follow-up. The life earnings were down more than -- if I look at the third quarter level of life earnings it was more than 20 percent below the first quarter. And when I'm thinking about life insurance earnings, you don't typically see that kind of a decline in a couple of quarters, given the stability of the business. And I think someone made the comment about maybe some unusual items in the quarter. I'm wondering if that's in the life side and if you could talk about that a little bit.

The unusual one shot things were not part of the life segment. Primarily what's happening in the life segment right now is that the sales are not high enough. And because the sales are not high enough we have some significant fixed expenses, and those fixed expenses are not getting charged off and are not getting DACed because of the cap we have on our DAC.

The other thing that is going on in life, you're aware that we've had some very significant increases in pension costs for the year. Much of that is from the agents' benefit plan, so a lot of that ends up hitting the individual life coverages. So we've made some significant decreases in expenses, but we've not been able to cover completely the increase in pension costs on the individual life side.

But I guess that would be a year-over-year issue, right? That's been a factor in each quarter, I would assume. Is that correct?

That's right. The bigger piece this quarter is really on the DACing and the lower sales.

Thank you.

Colin Devine, Smith Barney.

Good morning. I was wondering with respect to the 401(k) business if you could just give us an update on your thoughts about what's going on in Washington. It is my understanding I guess they're looking at finally getting legislation passed that would let a 401(k) administrator like yourself actual to start providing direct financial planning advice to plan participants. And if that's the case, what you think that might mean for your company going forward.

I'll let Larry answer the advice one. I'll just say more broadly in Washington things have actually been pretty positive for the pension side. There's been, you know, Portman-Cardin passed last year, year before a piece of legislation that really enhanced that business. They have another piece of legislation pending now, I think it's HR 1776, which really has a lot of things in that that would benefit our industry, including a deduction or an exclusion for annuitization and some other things. Let me turn to Larry on the specific question about advice.

Yes, investment advice has been a big issue within the industry, certainly I think coming out of the negative equity markets. We know from being out in the marketplace every day that there is a need for some level of investment advice to plan participants.

We had in place, of course, an independent advice capability for about three years that we do through financial engines, which is either a Web-base or phone-based service. But the reality is, as we have said in other calls, that's a little bit clunky. That's our technical term for that. So the legislation that you're describing would actually make the provision of that advice a much easier and much more seamless process.

We're looking at that. We're encouraging that. We're also looking at the potential through managed account type structures as well to try to bring investment advice down to the planned participant level. And we, like I am sure other top tier 401(k) competitors, are actively working on that project and talking to a number of firms about that. And I think you could expect us to hopefully do something in 2004 in that area.

Does your approach, Larry, as a full-service provider really give you a leg versus some of the others like the Manulifes or Nationwides still in transition where they're using PPAs?

We think it does, and we know from competitive studies that the fully bundled model continues to be the preferred model. It just has fewer moving parts and pieces, and our ability to provide that really seamless entire point of service, focused around Principal Financial Group, coming to you with a wide array of retirement solutions really does resonate. And our clients and our customers have a very strong preference for that. So we feel very confident and comfortable with our competitive position. And the fully bundled model is certainly going to be the way we are going to go.

Joan Zief, Goldman Sachs.

Good morning. I just want to go back to the ROE issue, and that is do you think that there's a risk that possibly your capital is going to start to build, kind of retarding your ROE improvement, particularly if you can't do anything with a closed block and if life and pension sales are not as great as they were in the past? And so, I guess my question is how do you start shedding that excess capital effectively so that that ROE does continue to move up? Do you have any plans? Is it really just a buyback issue? Is it that you are going to do something with the closed block? Is it that you're going to be more aggressive looking for acquisitions?

Good question. I would say that our story is much as it has been in the past, that we see that we have a couple of options in terms of effectively managing our capital, keeping in mind what Mike said that what the capital base is still a little bit in flux in terms of what the rating agencies are going to allow us to do.

But setting that aside, we continue to look at organic growth as our key driver and we would love to put more of our capital to use in organic growth. But as you know, that is somewhat difficult.

We will continue to look at acquisitions. I would say that we are likely to stay in the mode that we have said we're in, which is more modest, small to medium-sized kind of acquisitions, particularly like you have seen us do with MW Post, like you have seen us do with the acquisitions in Mexico. We think that's a good way to deploy capital and we will continue to do those kinds of acquisitions. We will opportunistically look at larger acquisitions as they come along. And if it makes sense from a shareholder value perspective, we will certainly pursue them.

And lastly, we continue to look at dividends and we look a share repurchase as very important ways (technical difficulty) are creating value and we will continue to use all three of those. We're very much focused on ROE and the effective use of capital and will deploy whatever techniques that we need to do to accomplish that within the bounds set by the rating agencies.

My other question, since that wasn't too much of a (multiple speakers) question, relates to the mortgage banking business. I just wanted to try and understand better why your production earnings came down so much from the last few quarters relative to other mortgage banking companies that have reported their third quarter already, where they were able to have record levels of production earnings.

I think the primary issue there -- and it gets a little bit complicated -- we have a warehousing facility that we sell our mortgages into and that tends to cause us to recognize the gained at the time we do that. And many of our competitors have their own warehouse or they accumulate the loans on their own balance sheet, and then they don't recognize the gain until they actually securitize them and sell them off. So it is largely around a timing issue. We took more of those gains in the second quarter; some of our competitors were able to take some of those gains in the third quarter.

Mike or John, maybe you can opine as to whether that's the appropriate --

I think that's the big part of it, is when you take the gains on your pipeline.

So then let me just make sure I understand. So it wasn't that margins on these securitizations are down so dramatically from what they were in the past; it's just that the timing of when you reported it versus the production levels that is a little bit off?

What I would say is that the margins on loans that we'd originated in the second quarter, that we locked into in the second quarter, were still high. But most of that margin was taken in the second quarter. The margins now on loans that we are locking in to and committing to in the third quarter are significantly lower than the second quarter loans were.

And that will show up in the fourth quarter?

Well, it is showing up in the third quarter and will continue to show up in the fourth quarter.

And it should show up in our competitors as well.

So I make sure I understand this, the fact that you're putting your warehousing thing on the balance sheet, does that impact this timing issue?

No.

Thank you.

(multiple speakers) actually it does impact the timing issue for a piece of it, not the biggest piece. A small piece it will impact.

Thanks.

Eric Berg, Lehman Brothers.

A couple of numbers questions. One, why are the company's overall operating expenses -- a line itemized presumed to mean overhead -- rising so much more rapidly through the first nine months than revenues? That's my first question. The rate of growth of overhead would seem to greatly exceed the rate of growth of revenues.

And second, as I dig into the numbers underlying the full-service accumulation pension earnings, it looks to me like the earnings growth was driven heavily, or certainly importantly, by spread expansion or (indiscernible) margin expansion, and in turn seemed to be driven by your ability to lower crediting rates on the general account of 401(k), at least that's how it seems. So my question is, am I right about that analysis? And if so, what is your ability to continue to get earnings gains from widening spreads?

Let me ask Mike Gersie to take the first and then Larry Zimpleman the second.

I'll answer this just from a very high-level. If we had about an half an hour I could probably drill down into a lot more detail.

Part of the expense increase comes from changes in accounting presentation. For example, our medical reinsurance is now treated as expense, whereas in the prior year it was treated as the difference between premiums ceded and benefits recovered from ceding companies. Some of the PGI expenses for offshore were embedded in our BT discontinued operations last year and so wouldn't have shown up as expenses last year but have shown up this year. Some of the acquisitions that we've made has increased total organization expense. For example, the BCI acquisition that we made early in the year now shows up as pension expense, where we didn't have that in the expense line last year. Defined benefit pension cost is up by about $54 million pre-tax. It will be up for the year. That's our estimate of a change due to change in pension benefit plan assumptions. So that's showing up. There were a bunch of onetime expenses that we don't think will be repeated and I could go into them in innumerable detail, but I won't.

So I think there's a whole bunch of noise that's in the expenses. What I tend to do is strip that all out, Eric. So if I strip out some of the DACing, if I strip out some of the impact of mortgage servicing -- and sometimes we look at expenses all-in in terms of with mortgage servicing lumped into operating expenses -- you strip that all out and you strip out some of the one timers, our actual expense increase is under 5 percent -- somewhere between 2.5 and 5. So we think that that's a very manageable increased in operating expenses. But there's a lot of noise in the numbers and difficult to get your arms around. (multiple speakers) That's one thing we analyze in great detail.

Eric, real quickly on your questions around full-service accum earnings, spread expansion is one component, but frankly not the major component that is driving full-service accum earnings because there's not that much spread business that's embedded into the full-service accum. There's a little bit of that in the guaranteed interest accounts.

But the other two components beyond that which are more significant, there is fee expansion. Again, as I commented in an earlier question, you can't quite see it as dramatically. For example, in Q3 there was about 4.4 million of additional fees coming through the separate accounts because of the account value growth.

And there's also an expense reduction component going on. We've commented on this previously. For example, just a little bit over the last year or so we've actually taken out over 500 full-time equivalents out of basically the full-service accum portion of our business. We have gone from about 4000 employees to about 3500.

So that kind of operational efficiency also drives through. It's masked a bit by the retirement increases, but BCI acquisitions and so forth that Mike Gersie commented on. But that deficiency is real and it is embedded and it is driving the increases in FSA earnings.

Thank you.

I think that's our last call. Let me just make a closing comment here. We appreciate very much you all joining us today. We appreciate your interest in the Principal Financial Group. I can assure you that this is a management team that continues to be committed to creating shareholder value and dealing with investors and analysts on a transparent basis. We hope you all have a great day and a great week.

Thank you for participating in today's conference call. This call will be available for replay beginning at approximately 1 PM Eastern time until end of day November 11, 2003. 3101314 is the access code for the replay. The number to dial for the replay is 800-642-1687 or 706-645-9291.