美國信安金融集團 (PFG) 2007 Q3 法說會逐字稿

Good morning and welcome to the Principal Financial Group's third quarter 2007 conference call. There will be a question-and-answer period after the speakers have completed their remarks. (OPERATOR INSTRUCTIONS). I would now like to turn the conference over to Tom Graf, Senior Vice President of Investor Relations.

Thank you. Good morning and welcome to the Principal Financial Group's quarterly conference call. A brief announcement before moving on. Yesterday invitations were distributed by e-mail to our inaugural investor day, which will take place on December 6, 2007 at the St. Regis Hotel in New York City. If you would like to attend but did not receive an invitation, please contact me. Our investor day will also be accessible through Webcast and teleconference. Details will be publicly announced about a week in advance of the event.

Moving back to our third-quarter call. As always, if you don't already have a copy, our earnings release and financial supplement can be found on our Web site, at www.Principal.com/investor. Following a reading of the Safe Harbor provision, Chief Executive Officer Barry Griswell, Chief Operating Officer Larry Zimpleman, and Chief Financial Officer Mike Gersie will deliver some prepared remarks. Then we will open up for questions. Others available for the Q&A are division presidents John Aschenbrenner, responsible for the Life and Health Insurance segment, and Jim McCaughan, responsible for Global Asset Management, and Julia Lawler, Chief Investment Officer.

Some of the comments made during this conference call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act. The Company does not revise or update them to reflect new information, subsequent events or changes in strategy. Risks and uncertainties that could cause actual results to differ materially from those expressed or implied are discussed in the Company's most recent annual report on Form 10-K and most recent quarterly report on Form 10-Q filed by the Company with the Securities and Exchange Commission. Barry?

Thanks, Tom, and welcome to everyone on the call. This morning, I'll comment briefly on our performance for the quarter and through nine months. Mike Gersie will then provide a detailed review of our financial results. Larry Zimpleman will follow Mike with an operational overview.

With all-time highs for total company operating earnings, earnings per share and assets under management, results for the third quarter 2007 were outstanding, as our core Asset Management and Accumulation businesses continued to demonstrate strong momentum and significant underlying growth.

Total company highlights include a record $306 billion of assets under management, an increase of 42% from a year ago, record operating earnings and record earnings per diluted share in the quarter, with 23% growth in earnings driving a 24% growth in EPS, and 120 basis points improvement in return on equity from a year ago.

Clearly, there were a number of items benefiting third-quarter results and impacting comparability, which Mike will discuss. Even excluding those items, total company earnings improved 15% from a year ago, a very strong result in light of market volatility, which included a 1% drop in S&P 500 daily weighted average during the quarter.

The US and International Asset Management and Accumulation segments continued to achieve significant growth in assets under management, propelling total company AUM up $91 billion over the trailing 12 months. This increase includes $19 billion of net cash flow, as well as approximately $44 billion from strategic acquisitions.

AUM growth in turn is driving significant earnings growth. Combined earnings for these segments, excluding items impacting comparability, are up more than 20% year-to-date. The Life and Health segment continues to show meaningful progress in a number of key areas -- 19% earnings growth from Specialty Benefits division compared to a year ago, 7% underlying earnings growth in the Individual Life division, excluding, again, items impacting comparability, and solid earnings improvement over the first two quarters for the Health division.

Specialty Benefits and Individual Life also delivered strong growth in premiums, deposits and fees. We surpassed a number of key milestones in the third quarter. $100 billion of account values for full-service accumulation, doubling in just four years. $150 billion of account values for our four US accumulation businesses. And again, $300 billion of total assets under management. These milestones reflect continued strong demand for our product and service solutions, the power of our multi-channel distribution network, and momentum of our alliance strategy, and strength of our proprietary investment performance.

Total Retirement Suite and strong Alliance sales drove us to our first $3 billion sales quarter for full-service accumulation. Increased penetration across multiple independent channels, and the successful launch of new fixed deferred annuity products late in the second quarter, drove us to our first $1 billion sales quarter for individual annuities business. And continued strong investment performance resulted in a number of important new institutional mandates, driving Principal Global Investors' net cash flows to a record $4.8 billion in the quarter.

In closing my remarks, let me emphasize our commitment to having a portfolio of businesses that creates long-term value for our shareholders. Our risk businesses add to the strength of our small-to-medium business franchise, provide earnings diversification, and contribute to the organization's long-term profitable growth. Our US and International Asset Management and Accumulation segments continue to build market leadership, exhibit tremendous momentum and achieve extraordinary growth. Additionally, as a result of our ongoing strategic investments in our higher multiple businesses, these two segments account for 81% of total company earnings through nine months. This compares to 74% for the full year 2006.

Mike?

Thanks, Barry. This morning I will spend a few minutes providing financial detail for each of our operating segments, including additional highlights for the three and nine-month periods.

I'll start with US Asset Management and Accumulation. Segment assets under management are up $81 billion, or 45%, from a year ago. Segment earnings increased 35% from a year ago to $212 million in the third quarter. We continue to see strong performance from our US Accumulation businesses, which were up 44% in total on a reported business, up 17% after adjusting for items impacting comparability.

At a record $111 million, full-service accumulation earnings improved 51% on a reported basis, approximately 13% after adjusting for items. As communicated in our release, we had a net after-tax earnings benefits of $28 million in third quarter 2007, $30 million benefit from unlocking deferred revenue and expense assumptions, partially offset by a $2 million tax refinement charge.

During the third quarter we completed an in-depth assumption study updating our best estimate of gross profits and other related assumptions. As a result of the assumption refinements, the Company recognized approximately $100 million of previously deferred revenues, and approximately $120 million of previously deferred policy acquisition costs. The Company also wrote up the deferred policy acquisition cost asset by approximately $65 million, primarily due to the extension of the amortization period, reflecting better retention. The net impact, $30 million of higher earnings after tax from unlocking.

Moving to Principal funds, at a record $13 million, earnings nearly doubled from a year ago, as our mutual funds business continues to achieve solid organic growth and good post-merger performance. At $16 million, individual annuities earnings were down 9% from a year ago on a 21% increase in mean account values. During the third quarter we had deferred policy acquisition cost unlocking that reduced earnings by about $3 million after-tax, as well as some higher expenses to support recent growth. Over the long-term, we continue to expect individual annuities earnings to grow in line with account value growth.

At $25 million, Principal Global Investors' operating earnings improved 6% from a year ago, in spite of commercial mortgage-backed securitization spread widening and increased spread hedging costs. We view this as an outstanding result, with a shift to the joint venture with US Bank minimizing the negative impact of adverse credit conditions. I would also point out that Principal Global Investors earnings are up 15% year-to-date, reflecting continued strong fee revenue growth, which is up 32% through nine months.

Investment-only and full-service payout earnings were both up more than 20% compared to the year-ago quarter. Investment-only earnings benefited from higher asset yields, an 8% increase in account values, and nearly $2 million after-tax from higher prepayment fee income. Full-service payout earnings benefited from a 4% increase in account values, $1 million from higher asset yields, and nearly $1 million after-tax from higher prepayment fee income.

Moving to International Asset Management and Accumulation, third-quarter earnings were a record $39 million, up 69% from a year ago. The increase in earnings reflects growth in assets under management from each of our international operations, including particularly strong growth in Brazil and China. Third quarter 2007 earnings also reflect a $9 million unlocking benefit due to regulatory fee change in Mexico, as well as $5 million experience benefit, reflecting the impact of unusually high inflation on asset yields in Chile. As you may recall, third quarter 2006 included a net benefit of $5 million for tax refinements in Mexico. Excluding items from both periods, earnings were up 38% from a year ago.

Moving to the Life and Health segment, at $73 million, third-quarter earnings were down $9 million from a year ago. On a comparable basis, earnings improved $5 million, or 7%. This excludes previously communicated items, which benefited third quarter 2006 earnings by $12 million and the impact of Individual Life's fourth quarter 2006 return of capital to corporate. Specialty Benefits delivered record earnings of $27 million during the third quarter, 19% improvement from a year ago, growing premiums by 12% while holding down growth in operating expenses to less than 4%.

Individual Life earnings were $27 million in the third quarter, compared to $31 million a year ago. As you may recall, the prior-year quarter included a $4.5 million earnings benefit from deferred policy acquisition cost unlocking, as well as about a $1.5 million of investment earnings due to a higher capital base. Excluding those items, division earnings increased $2 million, or 7%, from a year ago.

Reflecting higher loss ratios and additional member declines, Health division earnings were $19 million, down from $28 million in the year-ago quarter, which included a $4.4 million after-tax reserve refinement benefit. Year-to-date, division earnings are $44 million. As previously communicated, we continue to expect negligible earnings for the Health division in fourth quarter due to seasonality of claims and high deductible health plans. Reflecting the $15 million impact in the first quarter from unfavorable reserve developments and 2006 claims, this translates into an earnings run rate of approximately $60 million for 2007, and a run rate return on equity of about 12%.

Let me now comment briefly on the $59 million of realized and unrealized capital losses that we have recognized during the third quarter. These were primarily unrealized losses for net hedging activities and mark-to-market on credit default swaps, which we viewed as very reasonable given credit conditions.

Let me wrap up my remarks with a couple of final comments. At quarter-end, we continue to be in a very strong capital position, with about $500 million of excess capital between the holding company and the life company, and about $400 million of debt capacity. Organic growth and strategic acquisitions remain our top two priorities for use of capital.

We also continue to return capital to shareholders through share repurchases. In the third quarter we bought back 3.8 million shares for $212 million, bringing repurchases through nine months to $430 million. We completed the remaining $70 million of the Board's May 2007 authorization during October, buying back an additional 1.1 million shares.

As you may have seen, yesterday we announced that our Board of Directors declared an annual dividend to common shareholders of $0.90 per share. This represents a 12.5% increase over a year ago, our fifth consecutive year of double-digit increases and a 260% increase from our first dividend as a public company. As always, we will continue to focus on effective use of capital to build value for our shareholders.

Larry?

Thanks, Mike. As indicated, I'll provide a brief operational overview covering our ongoing focus on three areas -- continuing growth in our Asset Accumulation businesses, leveraging our global asset management expertise, and profitably growing our Life and Health Insurance businesses.

Let me start with Life and Health. We continue to view the underlying operations of the Specialty Benefits and Individual Life divisions as solid and improving. Specialty Benefits premium and fees are up 12% year-to-date, and operating expenses as a percent of premium and fees have improved more than 200 basis points through nine months.

In the Individual Life division, claims have returned to normal levels year-to-date, and we continue to build sales momentum across a broad spectrum of our retail products, reflecting continued good performance from our career channel and strong momentum with independent distribution. Through nine months, total premium and deposits are up 14% for the division, with strong growth in first year and single premiums and deposits.

In the Health division, our top priority remains stabilizing earnings. One key to this is controlling claims costs, and we're making meaningful progress with a number of key initiatives, including network contract management, claims processing, and integration of wellness and disease management. In August we announced a new exclusive business relationship with a local PPO network in Oklahoma, making competitive discounts available to our fully-insured and self-funded customers in that state. We continue to work hard to negotiate this type of arrangement across our selected markets to improve the competitiveness of our offerings.

Another key is diligent expense management. Even with the decline in covered members, we were able to improve operating expenses as a percent of premium and fees, at 40 basis points from the year-ago quarter for insured medical, and 800 basis points for the fee-for-service business.

As expected, we are continuing to experience a decline in Health division covered members. We are seeing some early retention benefits in the fee-for-service business from our network discount arrangement with Aetna Signature administrators. Membership growth, particularly in the insured medical business, will be a slower turnaround.

In closing the Health discussion, we remain confident the actions we are undertaking will help stabilize earnings and enable the division to achieve sustainable 15% returns over time. There are a number of meaningful longer-term opportunities for the division, opportunities created by increasing market interest in consumer-driven healthcare, health savings accounts and preventive care programs. We continue to believe we have the expertise to capitalize on these trends in both our insured medical and fee-for-service businesses.

Let me now comment on our US retirement businesses. I will start with full-service accumulation, where key measures continue to reflect the business' underlying strength. At quarter-end, full-service accumulation account values reached a record $103 billion, an increase of $18 billion, or 21%, from a year ago, which compares to a 14% increase in the S&P 500. That strong increase reflects good growth in deposits from existing retirement plan investors, strong plan and participant-level retention, and outstanding sales.

After achieving $1.6 billion of net cash flows for the first half of the year, full-service accumulation delivered a record $2.1 billion in the third quarter. Results to date highlight the ongoing unevenness of this measure, and why we focus on net cash flows over multiple quarters as opposed to a single quarter. Net cash flows of $3.7 billion through nine months translate into 4% of beginning-of-year account values, which puts us on track to achieve our 5% net cash flow target for the full year. We continue to believe that in any given year, full-service accumulation net cash flows could come in as high as 6% and as low as 4% of beginning-of-year account values. Again, this reflects the natural unevenness caused by sales and termination effective dates and associated timing of asset transfers, as well as the impact of market performance fluctuations.

Increasingly, we're focused on account value and operating earnings growth of our three largest accumulation businesses on a combined basis. This view captures our success retaining a large and growing pool of at-risk member-level assets, as well as our success tapping into the broader market of individual investors.

On a combined basis, earnings for full-service accumulation, principal funds and individual entities are up 30% year-to-date, account values up 44% from a year ago, and sales up 60% through nine months to more than $16 billion. While the WM Advisors acquisition and items benefiting third quarter 2007 earnings are impacting comparability, directionally it's clear; we have built, bought and integrated a portfolio of offerings to meet investor needs across the accumulation-to-pay-out continuum. These investments are paying off with significant growth.

A couple of additional comments on full-service accumulation. At $3.4 billion, we achieved our best sales quarter on record, improving more than $2 billion, or 148%, from the prior-year quarter. At $7.1 billion, nine-month sales nearly match our full year 2006 result. Alliances are an increasingly important element of our sales growth, making up 40% of sales year-to-date and improving 84% to $2.8 billion through nine months.

Total Retirement Suite remains a key driver as well, at 60% of sales year-to-date, based on assets. Employer securities within Total Retirement Suite account for about $1 billion of sales in the third quarter, and approximately $1.8 billion year-to-date. While employer securities generate a lower return on assets than historical returns for the block, there are a couple of key points to remember. These ESOP assets are accompanied by defined benefit, defined contribution and/or nonqualified assets, plans we're often winning because of the integrated ESOP capability. ESOP account values contribute to further return on equity expansion, and ESOPs present a longer-term retail retention opportunity as participants cash out of the plan.

Moving to Principal funds, post-merger earnings are ahead of plan for our mutual funds business, as are account values, which are up 10% from year-end 2006 to a record $40.8 billion. Mutual fund sales are up nearly 140% for the quarter and year-to-date, with our new third-party distribution contributing about 85% of that gain over both comparison periods. And our existing channel is contributing about 15%.

In terms of Principal funds cash flows, similar to second quarter 2007, we experienced some outflows from the WM Advisors block. As previously communicated, these outflows were expected, related to a decision prior to our acquisition to change advisor compensation related to the strategic asset management, or SAM, portfolios. An issue unrelated to the WM Advisor block more onetime in nature contributed to negative third-quarter flows. With the District of Columbia Court of Appeals elimination of fee-based brokerage accounts for broker/dealers, our career agents were heavily focused in the third quarter on retaining a $1.6 billion block of business to other Principal funds offerings. They did an excellent job, but we lost about $200 million of the account values in the process. As a related impact, the heavy focus on retention reduced the time our agents could spend on new sales, dampening deposits as well. Even with these redemptions, our lapses as a percent of beginning-of-period account values were in line with published industry rates.

Importantly, we continue to make progress positioning the mutual funds business for future growth, recently filling a number of open wholesaler slots, launching new offerings like our global real estate investment trust, creating new materials to support our marketing efforts, and completing our transfer agent conversion. We expect mutual fund net cash flows to improve next quarter as we build additional sales momentum, and expect 2008 flows to improve from levels achieved prior to the acquisition.

Moving to Global Asset Management, Principal Global Investors continues to leverage and expand its expertise. Compared to a year ago, Principal Global Investors AUM is up $73 billion, or 46%, to a record $233 billion. This includes a record $83 billion of third-party assets, an increase of 70% from a year ago, and an increase of 31% on an organic basis. At a record $4.8 billion in the third quarter, and nearly $15 billion over the trailing 12 months, we remain extremely pleased with Principal Global Investors' net cash flows.

Reflecting increasing strength in our sales pipeline, third quarter included $2.8 billion of institutional flows and, in October, we funded an additional $2.5 billion of institutional mandates. Investment performance remains strong as well, with 51% of PGI's retirement plan separate accounts in the top two Morningstar quartiles for the one-year period, 85% for the three-year period, and 84% for the five-year period. That track record includes continued strong equity investment performance, which has driven equity assets under management up 90% from a year ago to more than $70 billion. The increase in third-party assets under management also includes about $14 billion from our acquisition of a majority interest in Morley Financial Services, a leading stable value asset manager, which closed during the third quarter. The acquisition enhances an investment option, we believe, baby boomers will increasingly demand as they move toward retirement and seek to preserve capital and generate income.

In terms of accelerating international growth and profitability, Principal International continues to make excellent progress as well. Segment assets under management are up 51% from a year ago to a record $27 billion, up 39% excluding M&A. This growth includes net cash flows of $2.7 billion over the trailing 12 months, which translates into 15% of beginning-of-period assets. With just over $1 billion of net cash flows over that period, Brazil has been the key contributor to organic growth in assets under management, as well as to earnings growth. But I would also point to solid net cash flows and earnings growth in each of our operations, and to China in particular.

Reported assets under management does not include assets under management in China, which have increased from $600 million a year ago to $5.6 billion at the end of the third quarter. This significant growth in assets under management brought China to profitability last quarter, more than a year earlier than planned. Based on normalized earnings, segment return on equity is approximately 7.7%, and Principal International remains on track to achieve sustainable ROE of 10% by 2010.

Principal International continues to do a tremendous job transitioning to more fee-based businesses. Beginning this quarter, we began disclosing in our financial supplement a breakdown of premiums, fee revenues and assets under management for our equity method or unconsolidated subsidiaries. On a GAAP basis, fee revenues are up $13 million year-to-date, or 15%. However, including our equity method subsidiaries, fee revenues are up $110 million year-to-date, or 67%.

In closing, we remain sharply focused on executing our growth strategy. As always, we will continue working hard to extend our leadership in the industry, to meet the needs of growing businesses and their employees, and to deliver superior long-term results for our shareholders.

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

(OPERATOR INSTRUCTIONS). Steven Schwartz, Raymond James.

Congratulations on a great quarter. The question I wanted to ask was a much more general one. In particular -- well, actually, I have a very quick question. Could you give us the date on when Morley was acquired? I've been trying to find that everywhere. And then, with regards to that, and maybe stable value in general, the Department of Labor, I guess, has come out and made the final decision that stable value products and offerings won't be a default. Could you talk about how that might affect your business and Morley?

Thanks for the comment on the quarter. I think we closed Morley on August 31st of this year. I'll ask Larry maybe to talk a little bit about the stable value. But I will make one comment. We were actually in favor of having lifecycle or life stage funds be the default option. We didn't think that stable value was really the appropriate default option, and we understood what we were doing when we had that position because we owned Morley. But we also are a leading provider of lifecycle life stage funds. So, we believe that's a more appropriate default, and we certainly anticipated that when we made the Morley acquisition. I guess I probably answered the question for you, Larry.

Just a couple of quick comments. I think the Department of Labor regs came out, as Barry said, very much in line with what we expected and anticipated. We don't see it as having any significant impact on Morley, or our ability to drive growth and earnings out of Morley. One of the opportunities that we see as it relates to Morley and stable value is really as much in the end retirement period as it is in the accumulation period. So we think there is a lot of opportunity to kind of bring some more innovative solutions to the retirement marketplace, and use stable value as a more effective payout vehicle during retirement than has been done in the past. We think there still remains good opportunity in that business.

Suneet Kamath, Sanford Bernstein.

Quick question on the full-service accumulation business. I think if you take out the onetime benefit in the quarter, I think even Mike said the operating earnings were up about 13%. But the account values were up over 20%. My understanding is that in the past you've talked about earnings actually growing faster than account values. So, maybe what happened in the quarter, and should we expect some positive operating leverage going forward?

I'll take that question. The overall account value for full-service accum, we're up about 21% from a year ago. There's, as Mike commented, a bit of noise in there. So I'll try to kind of walk through those relatively quickly. We had about 30 million of the DAC. We also had about 2.5 to 3 million of the tax adjustment that goes the other way. We had about -- the effective tax rate increased about 6 percentage points from a year ago. That's worth about $8 million from a tax impact. And finally, there is the shift that's going on that we commented about from, basically, general account, which has a more robust return on assets but a lower ROE, to the employer securities, which has the higher ROE but the lower return on assets. And that had about a $2.5 million effect. So if you net all that out, the 111 that you see for full-service accum would probably look like about 95 on a normalized basis, and that would compare to about 73.5 a year ago. So that would be about a 29% increase in operating earnings on a 21% increase in account value. So we don't see that there is negative leverage going on; we think there continues to be positive leverage, but you do have to take into account kind of the shift from general account to employer securities. I hope that helps.

Very helpful.

Eric Berg, Lehman Brothers.

I think you acknowledged earlier -- it sounded to me that you were acknowledging that in what was otherwise just a broadly-based very, very successful quarter, there continued to be some issues in the health area, at least with respect to enrollment and profitability. My one question is this. I don't think I'm being unduly harsh when I say that you've been working at this health business for quite a while. The numbers are not going in the right direction in terms of enrollment. The business has been shrinking pretty much all year, indeed for several years. You've developed this concept of a target market, and the target market has been shrinking. Why not call it quits, sell the business, let someone else provide the health insurance that you feel is a necessary part of your product suite? You have so much to be proud of with respect to the remainder of your business; it doesn't seem to be working here. Why not move on and focus on the retirement business?

We appreciate your comments. Just a clarification, I would argue that since becoming a publicly traded company, our group medical business has added enormous value, had very high ROEs. And while over that entire period it may have been shrinking, in more recent years it has actually been growing. We're in a situation right now where we hit a bad spot, where we had some problems with high deductibles, claims on high deductible health plans where we had some underpricing, and we're correcting those things. I think it's -- I don't think it would be a fair characterization that this has been a troubled business for that entire period of time; it's only been in recent times.

But I would also argue that we manage our businesses appropriately. We've taken appropriate action when necessary. We either fix businesses or we get out of businesses. We believe we can fix this business. We have a plan to fix it. It's a very, very important strategic fit for us. It helps small-to-medium businesses. We appreciate the concern about it. We have a very good plan to get back on track. It's a relatively small part of our business right now, probably less than 15% of our earnings. It's still -- even with the current situation, it's normalized at about a 12 to 13% return on equity. So we have a lot of expertise in this. But I guess I'll say to you what I say to people continuously, and that's my long-term commitment that we will manage and operate our businesses successfully and profitably. And if we get to a point where we can't do that, we'll take appropriate action.

That's complete and helpful. Thank you very much.

Nigel Dally, Morgan Stanley.

Two quick ones. First on capital management. Giving your excess capital position, do you expect to ask the Board to authorize a new repurchase program before year-end? And secondly, if you can just discuss the pipeline of sales in full-service accumulation and PGI.

I'm sorry; would you repeat that last one?

Just the pipeline, what you're seeing in terms of sales in full-service accumulation and Principal Global Investors.

On the share repurchase, I guess our standard answer is that's a board decision, and our board does meet in November. We don't necessarily have a view of what the Board might do, but I guess you could look at history and say that we have been good stewards of our capital. And you might be talking about a timing issue. We look at our capital as a great asset for strategic acquisition, for organic growth. And to the extent we don't need it for those two, we have a very strong tendency to return to shareholders. So that should give you some indication. Again, what the Board does or doesn't do at our next meeting has not been decided. Again, over the long haul we'll do the right thing, I can assure you. Full-service accumulation pipeline, Larry?

Just a quick comment on that. I would say that the full-service accumulation pipeline remains very strong. As you know, we talk in terms of a 10 to 12% growth in sales. And what I can say is that our full-service accumulation pipeline is more than sufficient to continue to give us that 10 to 12% growth in sales. So as long as our close rates hold, we remain confident we can hit that mark. I'll let Jim comment on PGI.

Over the last year and a half we've added a lot of sales and relationship management people in the institutional and sub-advisory business of PGI. Roundabout half of our sales and relationship management people have joined us during that time. And they're now getting to the point where they've got maximum traction in the market, and are getting to their -- getting to their target productivity. For that reason -- and we've done that in order to exploit the strong track records we've built serving investors both in the US and abroad. So, all of this means that we are targeting an increased pipeline. Larry mentioned the 2.5 billion of institutional assets funded in October, which we are particularly pleased with. I would say that the level of activity right now is the highest we've ever seen, and we remain optimistic about the future. So I don't believe that the 4.8 billion cash inflow in the third quarter was in any way an outlier. So we feel pretty optimistic.

Ed Spehar, Merrill Lynch.

Just two quick ones. First I want to clarify, is it your expectation that still, given the shift in mix that you're seeing in FSA, that the asset growth and earnings growth should track pretty closely?

Larry, you want to take that?

We do expect the earnings growth to track closely or to slightly exceed account value growth. Again, we're at a point where there is a shift going on from general account to employer securities, but we don't see that as necessarily saying that the leverage is going to reverse at all. So we do expect those two to grow in line with each other.

The second one was can we assume that all of the sequential decline in the net investment income line of PGI reflects the challenges we had in the quarter for the securitization business?

No, not exactly. Let me get Jim to clarify.

There's two things going on there. One is the move to the joint venture, and the withdrawal of 500 million of capital from that business, which you will recall was executed late last year. So if you're comparing it with a year ago, there was quite a lot of capital in the business (multiple speakers)

I'm comparing it sequentially.

Sequentially to the previous quarter, yes. Going into -- just to give you a flavor for that, going into the quarter, we expected the spread businesses of PGI, which is primarily the commercial mortgage securitization, to make around about 6 million net. It actually broke even. And that's the impact of the very severe adverse credit conditions during the quarter. I think that's really the answer you're looking for.

I guess that would be the bulk of the decline then. So that's 6 million after-tax?

That's correct. The commercial mortgage securitization business actually continued to trade very effectively during the quarter. We made issuance which was actually higher than in the previous year quarter; I think the number was 1.4 billion of issuance that we made. But the reason it broke even was the profits on that issuance were offset by the mark-to-market losses on inventory within the joint venture.

Thank you.

I was going to say, Ed, the fact that we stayed in the market, I think, bodes very well for this business in the future.

We are optimistic about the future of the credit market's return to whatever a more normal position is.

Jimmy Bhullar, JPMorgan.

I don't think I pressed for a question, but I'll ask one regardless. Could you just discuss your pipeline in the FSA business? I think the sales were very strong, but if there was any benefit from large case sales. I think in the past when you have had sales this strong, there have been some large cases. But if you can just discuss what drove the momentum for sales this quarter, and just your outlook.

I think Larry kind of commented a little bit on the outlook. Give a little color on what was in the third quarter, and maybe talk again about the outlook for the fourth quarter, and maybe even early next year, Larry.

Good morning. In terms of Q3, maybe we'll start there, I think we have generally tended to sort of define larger cases as maybe those that were over 100 million. And there were, I think, seven clients in the third-quarter numbers that were $100 million and over. And so that certainly contributed to the very, very strong result.

But having said that, we do expect to have -- on a regular basis we expect to have plans of 100 million and over. Now, I can't sit here and promise you we'll have seven every quarter. But I think last year, for example, we had 10 plans the entire year that were 100 million or over, and we hope to certainly exceed that this year.

In terms of going forward, again, it's always somewhat difficult to predict. Our close rates have remained very solid this year. They have generally stayed in a 12 or 13% close rate range. We're not seeing anything that indicates any deterioration. Our pipeline remains very strong. It has double-digit increases. And I would say, very, very importantly, this sales increase is not being driven by just large cases. If you look at our emerging, if you look at our -- which is less than 5 million -- if you look at dynamic, which is the middle market, or institutional, they're all up. And institutional is up a little bit more. But dynamic, for example, is up 22%. So it is broad across-the-board growth; it's not being driven just exclusively by a few large cases.

Tom Gallagher, Credit Suisse.

Just wanted to circle back on your comments on the target date or lifecycle funds. Can you talk about what your AUM are in those funds right now? And also, when you're selling those products within the 401(k) plans, is that predominantly just Principal brand funds, or are you selling third-party lifecycle funds?

Very good. We appreciate it. Let me ask Larry to comment on that.

In terms of the amount of lifecycle funds, I think that number is somewhere in the 25 to $30 billion range today. So again, at this point in time, we believe, we are the fifth-largest manager of lifecycle funds in the United States. So we think we have a very, very strong competitive position in that.

I think your second question had to do with whether we're selling only our proprietary lifecycle funds, or whether there is some third-party. The vast, vast majority, I will say 90%, of that is proprietary lifecycle, either the risk-based funds, which are the strategic asset management portfolios, or the time-based funds, which are what we call the lifetime funds. Almost all of that is proprietary. There can on occasion be some third-party -- for example, a Russell LifePoints -- option in there in certain limited distribution situations. But it is mostly proprietary.

We have sub-advisors underneath in those funds? I believe we do, Larry. So that would (multiple speakers) not all proprietary asset management.

In the lifetime funds, it's currently split about 70 to 75% PGI proprietary across a range of managers, and it's about 25 to 30% an array of outside sub-advisors. So that's within the lifetime series.

Just a follow-up on that. Is it fair to say, if this is like the fastest growing pool of funds within your 401(k) business, that we may see a shift back toward proprietary managed funds? Because I think the direction, if you look over the last three years, had been more towards third-party.

Yes, Tom. I agree with that. Again, what actually influences that kind of percentage that ends up being proprietary is really in many cases guided as much by whether the sales -- at the margin whether the sales are coming more in the institutional block, as compared to the dynamic block, as compared to the emerging block. So you'll see a few ebbs and flows from quarter to quarter just depending on kind of which of the sales areas are weighting in more heavily in a given quarter.

Colin Devine, Citigroup.

I'm wondering if we could go back, Larry, to the Department of Labor ruling. I appreciated you answered the question with respect to Morley, but my area of interest is really with respect to your whole 401(k) business. Specifically, if we look at how much of those FSA assets are sitting in the default option today, what -- then how is that going to shift -- how could that impact the economics? Recognizing it's always been my impression you make a lot of money off the stable value product that you're managing for yourselves right now. And of course that's going to have some capital implications if that money is rolling into lifecycle funds. If you could elaborate on that as well. Thanks.

Today there's about -- in rough terms there's about $9 billion that are in -- kind of general in our full-service accumulation; they're sort of general account guaranteed interest-type assets. And that number has actually trended slightly downward over the last few quarters. And I think -- who knows? I think it would be reasonable to assume that it will continue to trend down to some degree. Again, we look at that as, generally speaking, a healthy shift. Because again, what's generally going on is it's moving from the guaranteed interest-type option to more of the lifetime or lifecycle funds that, I think, we would all agree is a more appropriate choice for default investors.

So again, as we've commented earlier, it will have some ROE implications and some ROA implications. But we don't see it rising to the level that it would change the leverage, the relationship between OE growth and account value growth. So it's just the normal, natural shift that's going on; very able to shift with that and still protect earnings.

But to be very clear for a minute, let's just cut to this. Are you saying it's positive for FSA's ROE, negative for its ROA, which means net net it's negative for its operating earnings?

No. I wouldn't necessarily agree with that. It is going to be positive for return on equity. It is going to have some diminishment in return on account values. But it will also end up in higher free capital. At the end of the day, it will end up in higher free capital. So in other words, we'll need less capital to support the ongoing organic growth. Again, we still see -- as we model forward, we still see our ability -- through just the size of the book of business and operational efficiencies, we still see us able to maintain the relationship between OE growth and account value growth.

How fast do you expect this to unfold, and where should we see, then, the assets moving within your reporting structure? If 9 [billion] of assets is shifting over into lifecycle funds, I just want to make sure I understand where they're coming out of, and is this going to be over the next several quarters. How fast do you expect this will unfold?

I would say that based on the way the Department of Labor -- and again, I think they did a very credible job, Colin -- I think essentially there would be no reason to expect that there would be sort of a wholesale movement of these guaranteed interest accounts out of where they are. You have to remember, in many cases, the participants -- these are -- these still have two, three, four, five years remaining on a guaranteed interest period. There would be -- it would be very unusual, and I would be very surprised, if any employer ever would move those prior to the maturity. So you'll see that to the extent it gets smaller it will happen on sort of a very phased basis, over a longer-term basis, three years, five years, seven years. So it will be nothing dramatic; it will simply happen over time, as it has been going on to this point. And again, I think, we've demonstrated our ability to control this and still have OE growth in line with account value.

Tamara Kravec, Banc of America Securities.

On the mutual fund segment, you had some outflows that you talked about in terms of changing advisor compensation. How long is that going to run through? In other words, would you expect continued net outflows for a period of time, or do you think this is more you change the compensation and it has more of a near-term impact? My second question is, on the Life and Health area, particularly Individual Life, you had some operating expense improvements. I'm wondering how much room do you think you have to continue to see improvement in there, and how much of a lever you think that really is. Thanks.

Larry, you want to jump in and take the first part of that?

Good morning. The change that we referenced earlier was actually a change that was made in March of 2006, prior to the time we did the acquisition. We certainly modeled that -- our best estimate of that particular impact. And again, I would emphasize that our modeling and our acquisition plan is very, very much in line with the experience that we have seen on the block. Again, the outflow is something that will, generally speaking, take place over time. We don't view it as a big problem.

In terms of the overall net cash flows, we would expect to be roughly neutral. We're about 200 million negative in this quarter. That was primarily the result of the Court of Appeals decision around fee-based brokerage accounts that we alluded to earlier in the call. Obviously, that shouldn't be much of an impact in fourth quarter. And then we believe we'll be back to positive flows starting in the first quarter of 2008. I'll let John comment on the Individual Life question.

On the Individual Life, we measure our expenses as a percentage of expense revenue, the pricing revenue. And that improved about 960 basis points year-over-year in the last -- the first three quarters of the year. The expenses we are incurring now are actually lower than our pricing expenses. So, while we have some great improvement this year, we've got a little bit of room for improvement going forward, you're not going to see the dramatic type of improvement going forward, I don't think, in Individual Life that you saw.

Quickly, just on the other two pieces of the Life and Health segment, we mentioned the improvement on the Health side. That, I think, you're going to see us pretty much holding our own now. As the membership continues to fall off a little bit, we will, I think, be able to keep our expenses going down to match the membership fall-off, but you're not going to see dramatic improvement in the cost ratios for Health in the next couple of years. Once we get the membership stabilized, I think, there is room for some further improvement there.

Specialty Benefits, we had over a 200 basis point improvement in the expense ratios there. We should be able to continue to see some slight improvement in Specialty Benefits as we continue to see growth in premiums and deposits that should outpace the growth in expenses. So, a very, very good expense picture.

Just a quick follow-up. On the loss ratios here that -- anything that you're seeing this quarter -- I understand the fourth quarter is still going to be seasonally lower just on higher claims -- but looking into 2008, is there anything you've seen in this quarter to make you more or less optimistic about a run rate for 2008?

Are you talking the Health business?

Yes.

I think what we are seeing is very much a stabilization in the loss ratios for Health, and a stabilization that really puts us in a position that we were at pretty much a 12% return on equity run rate in the business. We think that will continue into 2008, and we should start seeing even some slight improvement in that going forward. As you mentioned, the high deductible, though, will cause a very significant increase in the loss ratio in the fourth quarter. But that -- we're expecting that, and that's built into the 12% run rate return on equity that we're talking about.

Joan Zief, Goldman Sachs.

Thank you very much. You've talked about how successful your retention is. You've talked about how you're now thinking about the business from the FSA and the mutual funds and the individual entities. Can you give us an idea of what trends you are seeing with the asset flows of the 401(k)? The piece of the business that you're not retaining, where is that going? What percentage of the business that you retain actually stays in the 401(k) when an individual leaves there work? How much actually flows into your individual annuities? Are there any trends that are shifting it to sort of mutual funds and broker accounts? Can you give us an idea of what you're seeing?

Joan, was that one question?

That's one question that encompasses everything.

Good morning. I'll do my best here. They'll probably be kind of quick hits as we go. I think you asked the question around flows. And again, we're seeing very strong flows into the lifecycle-type funds, which if you then think about where the lifecycle funds kind of disperse them, you are seeing a little faster growth in sort of the equity area, both US and international. But again, it's really through the operation of the lifetime funds. So again, it's moving away from money market; it's moving away from stable value; it's moving away from guaranteed interest, generally speaking, into a more broadly diversified strategy using lifecycle funds. Again, we view all that as positive.

In terms of where does the money flow, there's not really any big changes going on there. The assets we retain, in rough terms, half of that stays in what we call a personal retirement account. That's sort of your own personal account within the retirement plan. So you retain your own existing investment options, and we deal with you as an individual. The other half goes into a variety of choices, banking products, individual annuities and regular retail mutual funds.

Finally, I think, you asked about, in terms of the money that leaves us, is there any particular place that seems to be winning the day. And what I would say is that there doesn't seem to be. I will tell you we track that very, very closely, literally by name as to other institutions. It is very, very broadly diversified. At the end of the day, it seems it really comes down to who their advisor is. If they had -- most of the time the money that would leave would have some advisor, not somebody who originally brought the plan to Principal; they have their own retail advisor, and that's going to be the influencer as to where the money goes.

Let me wrap the call up now, maybe just a quick summary comment. We are very, very pleased with the quarter and results year-to-date. In addition to the results themselves, we're just very pleased with the acceptance we have in the marketplace, the products and solutions, our extended distribution, our leadership in the small-to-medium business market, and our ability to grow our asset accumulation and asset management businesses. And I think, very importantly, this momentum positioned us very well to continue our commitment and our goals of delivering 11 to 13% EPS growth over the long haul, and improving our return on equity 50 basis points per year. And we believe by doing that we create excellent shareholder value, and that is, of course, our goal. We again thank you for your support and your interest, and we look forward to seeing you all at our first investors day in a few weeks in early December. Thank you all very much.

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 8, 2007. 16893229 is the access code for the replay. The number to dial for the replay is 800-642-1687 for US and Canadian callers, or 706-645-9291 for international callers. This concludes today's conference call. You may now disconnect.