美國信安金融集團 (PFG) 2008 Q2 法說會逐字稿

Good morning, and welcome to The Principal Financial Group's Second Quarter 2008 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 Mr. Tom Graf, Senior Vice President of Investor Relations.

Thank you. Good morning, and welcome to The Principal Financial Group's Quarterly Conference Call. If you don't already have a copy, the earnings release, financial supplement and additional information on the company's investment portfolio can be found on our web site at www.principal.com/investor.

Following a reading of the Safe Harbor Provision, Chief Executive 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 Chief Investment Officer, Julia Lawler, and our three division presidents, John Aschenbrenner, responsible for the life and health insurance segment; Dan Houston, responsible for the US Asset Accumulation segment; and Jim McCaughan, responsible for Global Asset Management.

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 quarterly report on Form 10-Q filed by the company with the Securities and Exchange Commission.

Larry?

Thanks, Tom, and welcome to everyone on the call. This morning, I'll focus my comments on execution of our growth strategy, including performance and progress of our three key growth engines, US Asset Accumulation, Principal Global Investors and Principal International. Mike Gersie will follow my remarks with a brief overview of financial results and a discussion of our investment portfolio and capital position.

Before I begin, though, I wanted to express my sincere thanks to Mike, who, as you know, is retiring after 38 years with the company. His leadership, dedication and hard work have helped position this organization to capitalize on its opportunities and face the challenges ahead. As you also know, Mike's successor has been named. Terry Lillis brings 26 years of experience in key financial and leadership roles at The Principal. His most recent role, CFO of the US Asset Accumulation segment since 2000, makes him uniquely qualified for this critical position. Terry will join us at the third quarter earnings call.

Let me also welcome Dan Houston to his first earnings call. Dan's promotion to President of the US Asset Accumulation segment was announced in the first quarter as part of our planned succession process. Dan is also a seasoned veteran with nearly 25 years with The Principal, all dedicated to our retirement businesses.

Let me start with a couple comments on the current operating environment. Equity markets continued to decline in the second quarter, including a 3% drop in the S&P 500, driving that index down 16% since September 30, 2007. In light of the environment, I'd characterize our results for the quarter and through midyear as very solid, reflecting strong underlying growth, the benefit of earnings diversification, ongoing strategic investment and discipline around expenses.

Highlights for second quarter include nearly $3 billion of net cash flows for US Asset Accumulation and $6 billion through midyear, substantially offsetting the impact of poor equity market performance, a 32% increase in Principal Global Investors third-party assets under management, 19% growth in assets under management for Principal International driving its second-best earnings quarter on record, and double-digit earnings growth in the Life and Health segment driven by record results for the specialty benefits division.

Once again, we're very pleased with a number of key growth indicators, measures we believe demonstrate our competitive advantages in asset management and accumulation and strong day-to-day execution on our growth strategy.

Starting with the US Asset Accumulation segment, full-service accumulation delivered sales of $1.4 billion in the second quarter, bringing six-month sales to $4.9 billion, an increase of 34% compared to the same period a year ago. Two key factors are driving our continued sales success - the advantage that we have in the marketplace with Total Retirement Suite, and strong momentum with distribution alliances.

Though midyear, Total Retirement Suite made up 57% of sales based on assets, and alliance sales are up more than $750 million or 40%. Looking forward, pipeline remains strong and we continue to expect to meet or exceed our 10% to 12% sales growth target for the year.

As a reminder, down markets pressure sales in a couple of different ways - the plans we sell have lower assets, and you do tend to see more aggressive pricing from some competitors. Strong sales coupled with strong plan-level retention drove full-service accumulation net cash flows to more than $4 billion through six months, an improvement of 160%. For the trailing 12 months, full-service accumulation net cash flows are more than $7 billion. This translates into 7.3% of beginning-of-period account values, significantly ahead of our long-term target of 4% to 6%.

As you know, we also continue to work in cooperation with advisors to retain participant assets at risk due to retirement or a job change. Through six months, we've retained more than $1 billion of participant assets into our mutual fund, individual annuity and bank products, demonstrating both the strength of our asset retention capabilities and the depth and breadth of our retail rollover solutions.

With record earnings, sales and net cash flows, this was a truly outstanding quarter for the individual annuities business. On a year-to-date basis, sales are up 118%, reflecting increased penetration across multiple distribution channels, and continued success with the fixed deferred annuity product we launched in mid 2007. Withdrawals have remained stable in absolute terms, but have declined as a percent of beginning-of-year account values to 5.2% for the first six months of 2008 from 6.4% from the same period a year ago.

Moving to principal funds, sales and net cash flows have improved $240 million and $100 million respectively from the year-ago quarter. We view this as a very solid result in light of market conditions, reflecting continued solid progress in the wire house and independent broker-dealer channels, where sales are up 36% from second quarter 2007 and 27% year-to-date. As some additional context, industry flows are down nearly $300 billion or 97% comparing second quarter 2008 to first quarter 2008. By comparison, our flows were up $40 million or 50% over the same period, albeit on a relatively small base.

For Global Asset Management, the second quarter was a period of continued strong investment performance. 64%, 71%, and 75% of the retirement plan separate accounts managed by Principal Global Investors ranked in the top two Morningstar quartiles for the one, three and five-year periods respectively at quarter end. Reflecting that strong performance, Principal Global Investors has been awarded more than $13 billion of unaffiliated assets through midyear.

First-half net cash flows were $4 billion, contributing to more than $10 billion of unaffiliated net cash flows over the trailing 12 months, which translates into 16% of beginning-of-period assets. Investment choices managed by PGI continued to be attractive both to sponsors and participants within full-service accumulation, accounting for 60% of both assets and flows. This and the non-affiliate flows contributed to total net cash flows for PGI of $7.3 billion in the first half, up from $6.5 billion in the first half of 2007.

Principal Global Investors' fee mandate business continued to perform well with 27% growth in unaffiliated management fees, offsetting the impact on revenues of equity market declines and a slow down in the real estate markets. As an update on the spread and securitization business, our first quarter efforts to reduce loan inventory in the CMBS joint venture were highly effective, and the business broke even in the second quarter.

We continue to minimize the risk of additional mark-to-market losses reducing loan inventory from $540 million at the end of April to less than $200 million at the end of July. Recent sales validated our valuation of the loan inventory at March 31st, and throughout the quarter. As such, we continue to believe the spread and securitization business will come in at or near break-even in the second half of the year.

Demonstrating, again, the value of earnings diversification, Principal International delivered its second-best earnings quarter, improving 19% from a year ago. The life and health segment delivered 11% earnings growth. Principal International's earnings growth reflects significant growth in assets under management, which are up $4.7 billion or 19% from a year ago. More than half of the increase in assets under management is from net cash flows, which at $2.5 billion over the trailing 12 months were 10% of beginning-of-period assets.

I'd also like to comment on two exciting recent global developments. Starting in October, we'll begin participating in a new employer-sponsored 401K-like market that is opening in Chile. And as we announced mid-July, we're going to be launching an asset management joint venture with CIMB Group, a recognized pioneer in Shariah-compliant finance, a market with tremendous growth potential.

Moving to life and health, the second quarter was a period of solid earnings and return on equity improvement. As I mentioned, specialty benefits delivered record earnings in the second quarter. On a year-to-date basis, premium and fees are up 5% as the division continues to maintain pricing discipline in a highly competitive market. Expense management remains sound, as well, and we're working on a number of initiatives to continue driving sustainable profitable growth for the division.

The individual life division continued to build sales momentum across a broad spectrum of products including 13% growth year-to-date for our non-qualified offering, one of the four pillars of Total Retirement Suite. Total first-year and single premiums and deposits are up 37% year-to-date, reflecting increasing momentum with new independent distribution relationships and solid performance from the career channel. Importantly, due to effective capital management, the division has been able to generate strong sales growth while keeping capital usage flat.

After a strong first quarter, the health division posted solid second quarter earnings in line with expectations. Based on our expected pattern of earnings from high-deductible health plans, we continue to expect the division to earn between $45 million and $55 million for the year on a reported basis. Our strategy for growing covered members remains highly focused on network discounts including Principal-specific provider contracts and on claims and expense management to improve our overall price competitiveness. While a return to membership growth is a multi-year process, I'd again reiterate the longer-term opportunities for the division in consumer-driven healthcare, health savings accounts and wellness, and our belief that we have the expertise to capitalize on these trends.

Mike?

Thanks, Larry. This morning, I'll spend a few minutes providing financial detail for the company in each of operating segments including items impacting comparability between periods. I'll also cover our investment portfolio and capital position.

Let me start with total company results. At $0.97, operating earnings per share was down $0.08 from the year-ago quarter. As communicated in last year's release, second quarter 2007 earnings included $21 million or $0.08 a share in benefiting items. Second quarter 2007 was also a period of functioning commercial mortgage-backed securitization markets, and we earned $0.03 a share that quarter in the spread and securitization business. Adjusting for these items, earnings per share is up about 3%. While this is below our long-term growth target, we view it as a very solid result.

Had market performance, over the past three quarters, been consistent with our 2%-per-quarter assumption between the US Accumulation Businesses and Principal Global Investors unaffiliated assets, we would've finished the quarter with an additional $25 billion plus of assets under management. Using current business and product mix, this would conservatively translate into an additional $0.07 to $0.08 of earnings per share for the quarter.

Moving to US Asset Accumulation, segment account values increased $2.8 billion, or 2%, from a year ago to $177 billion at quarter end, while segment earnings decreased $12 million or 7%. Excluding higher prepayment fee in the prior-year quarter of approximately $5 million after tax, primarily in the investment-only and full-service payout businesses, segment earnings were down about $7 million.

I'll focus my remaining comments relating to segment earnings on full-service accumulation, which was down $6.5 million from a year ago. The decline primarily reflects three items with lower income tax benefits and the negative impact of market conditions being partially offset by lower operating expenses.

And I'll start with lower income benefits of $7 million. As you know, we receive a tax benefit for domestic dividends in our separate accounts and selected PIF mutual funds. Due to a number of factors, we're receiving lower dividends from domestic equities within these accounts and, as a result, have a lower tax benefit. These factors include lower gains, change in product mix and investors moving out of equities.

Moving to market conditions, several factors are temporarily impacting revenue and earnings, driving about $5 million of the after-tax decline in earnings from second quarter 2007. This includes the lower interest rate environment, which has resulted in lower yields in the general account and lower market value cash-outs.

Regarding operating expenses, the corporate-wide reduction efforts initiated first quarter to offset the revenue impact of sharp market declines are working. Compared to a year ago, we reduced full-service accumulation operating expenses by about 3% while adding more than $7 billion of net cash flows over that period. While our expense efforts don't totally eliminate near-term pressure on earnings, they're clearly making a difference. Importantly, we believe they reflect the right balance between aligning expenses with revenues and the need to make ongoing investments to support out long-term growth targets.

Let me separately cover deferred acquisition costs, which represented a substantial portion of the decline in operating expenses. With acquisition expense, capitalization and amortization down $5 million and $11 million respectively from second quarter 2007, this variance resulted in a net after-tax earnings benefit of about $4 million. As expected, the drop in equity markets during the quarter did result in an increase in amortization expense, but the increase was more than offset by experience adjustments with higher deposit growth and the extension of the amortization period in the third quarter of 2007, reducing normal amortization expense.

Adjusting for income tax benefits, market conditions and deferred acquisition costs, full-service accumulation earnings improved about 2.5% on a 3% increase in average account values.

Moving to Global Asset Management, second quarter earnings of $24 million compared to $32 million a year ago. Consistent with the expectations we communicated last quarter, the spread and securitization business came in at break-even in second quarter 2008 compared to earnings of $8 million in the year-ago quarter.

The fee mandate business delivered very strong underlying growth, although earnings were essentially flat on a reported basis. Current quarter earnings were dampened by about $3 million after tax due to the impact on fees of a slowdown in the real estate markets, and second quarter 2007 earnings benefited by about $3 million after tax from a mandate that pays performance incentive fees every three years. Excluding these items, fee mandate earnings improved more than 30%, driven by very strong growth in non-affiliated management fees, as Larry mentioned.

Moving to International Asset Management and Accumulation, second quarter earnings were up 19% from a year ago to $32 million. The improvement primarily reflects continued strong asset-under-management growth and operational efficiencies. It also reflects a benefit from higher yields on invested assets in Chile due to higher inflation.

A couple of income statement line items merit a brief explanation. As you know, in accounting for equity method subsidiaries, all items that make up after-tax net income are collapsed together in a single line, net investment income. In the second quarter, Brazil increased its effective tax rate to 40%. The impact of this change reduced net investment income and, thus, pre-tax operating earnings by $15 million. Offsetting this impact was a $15 million reflected in the income tax line, as we are allowed a foreign tax credit.

Based on normalized earnings, Principal International's return on equity is just over 10% for the trailing 12 months. The segment remains on track to receive sustainable return on equity of 11% by 2010.

At $67 million, second quarter earnings for the life and health segment were up $7 million or 11% from a year ago. Trailing 12 months return on equity improved 70 basis points from a year ago to 12.6%. The increase in segment earnings is primarily due to an $8 million increase in earnings for the specialty benefits division, reflecting favorable claims experience, particularly in the individual disability line and growth in business. At $24 million, individual life earnings were solid, improving slightly from the year-ago quarter.

While down from a year ago, health division earnings of $12 million were solid, as well. In thinking about the remainder of the year for the health division, keep in mind that the accounting treatment of high-deductible health plans typically results in the highest level of earnings in the first quarter, moderate earnings in the second and third quarters and losses in the fourth quarter.

Let me also comment briefly on net realized/unrealized capital losses. In second quarter 2008, we recognized $85 million of capital losses through the income statement, which includes $23 million of losses related to impairments of fixed maturity securities, $7 million of impairments on equity securities and unrealized capital losses of $56 million primarily from mark-to-market of interest rate swaps.

Given interest rate movements and the volatility in the credit markets, predominantly driven by technicals, we believe our level of credit losses is reasonable, in line with peers that have already reported results and consistent with the range of expected losses that we price for over the credit cycle.

Further reflecting interest rate and market volatility during the quarter, improved credit spreads drove a decrease in net unrealized losses of approximately $1 billion, substantially offsetting an increase in net unrealized losses due to interest rates of approximately $1.5 billion. The largest credit improvement was in industrials, where the gain from improved credit spreads exceeded $250 million, but importantly we also saw more than $200 million of improvement in financials, more than $150 million of improvement from commercial mortgage backed securities, and more than $100 million of improvement from our corporate credit collateralized debt obligations.

I'd also point out that since we match asset and liability durations on an economic basis, any decline associated with rising interest rates is mirrored by a decline in the value of our liabilities. We're obviously pleased with second quarter's improvement in credit spreads, but continue to believe that fundamentals are not being fully reflected. Values remain depressed because markets are not operating efficiently, given thin trading dominated by forced sellers. I'd again emphasize that we continue to have the intent and ability to hold.

Given ongoing investor interest and exposure to certain investments, we've posted on our web site some additional detail on commercial mortgages and commercial mortgage-backed securities. I'll comment specifically on these holdings.

Regarding commercial mortgages, with 90% occupancy, 58% loan-to-value and 1.9 times interest coverage, we remain extremely comfortable with our portfolio. Even in a slowing economy, we have a tremendous amount of cushion. Regarding our CNBSCMBS holdings, delinquencies in the underlining mortgages were 0.7% through midyear. We remain very comfortable with the high quality of the underlying mortgages and the strong subordination cushioning of our CNBSCMBS holdings.

To wrap up my comments, let me cover our capital position. First, I would like to state clearly that we do not anticipate any need to raise equity capital going forward. At quarter end, we had approximately $300 million of excess capital, between the life and holding companies, over and above the capital ratios appropriate to our current credit rating.

Cash flow remains strong, and we continue to generate capital in excess of what we need to support organic growth. There are also a number of normal capital management levers that would be available to us, should the environment become even more challenging, including debt issuance, expense controls and pulling back on acquisitions. As such, we remain confident in the adequacy of our capital position and our ability to navigate through this credit cycle.

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

(OPERATOR INSTRUCTIONS)

You first question is from Jimmy Bhullar with JPMorgan.

Hi, and thank you. I have a couple of questions, both on the pension business. First, if you can talk about your pipeline in the FSA business, given how weak the market's been, it doesn't see like your deposits or lapses have been impacted, but if you could just talk about what you see in the second half.

And secondly, on margin in the FSA business, how much of a decline do you expect in your margins over the next few years given that the mix is shifting slightly towards larger cases, and then also you've got more ESOP business on the books? That's all I have.

Okay, Jimmy, thanks. Good morning. We'll give those to our rookie here this morning. I'll have Dan Houston cover both of those for you.

Thanks, Larry. I appreciate it.

Let me start with the pipeline first on full-service accumulation. We're actually seeing that the pipeline for assets is actually up about 4% and the case pipeline is down slightly. If we move, then, onto the mix of business, we gave some revised guidance last earnings call to talk about ROAs and that 30 to 32 basis points, which is, again, consistent with where we think we can be long term.

We have talked about the mix of assets changing in the last few years, introducing more ESOP opportunities to PFG, but I would attribute that in large part to our competitive in the large case market. It's not unusual to have our larger prospects have a disproportionate percentage of their assets go either to ESOP, employer stock and/or excess funds, so again, we're comfortable with that 30 to 32 basis points on the FSA line.

Thank you.

Thanks, Jimmy.

Your next question is from Jeff Schuman with KBW.

Good morning. First, a comment, then a question. Just in terms of the comment, I wonder -- so I appreciated the decomposition of the unrealized investment loss into the interest component and the credit piece. I think that's instructive. I'm also wondering if you'd be able to sort of expand that going forward and give us kind of a picture of kind the accumulated impact. It's my understanding you probably don't have that right now, but to the extent you could develop that concept further, I think that's very helpful for all of us.

The question I wanted to ask was about commercial mortgages. I was wondering if you could give us a little bit more color in terms of what you're seeing in terms of your commercial mortgage loan experience, delinquency trends, and then in particular I was wondering, given you're, I think, somewhat overweight in retail and some of the bankruptcies and deterioration we've seen there, whether you're starting to see any signals or warning signs in that sector.

Okay, thanks, Jeff. This is Larry. Let me just add my own comment to yours around the unrealized losses. I think it is -- we would agree with you. I think it is absolutely critical that everyone understands the makeup of those, and particularly since we are running and have run for years a very immunized portfolio here. As we've said in our earlier comments, any increase in unrealized loss attached to interest rates is simply mirroring a comparable movement on the liability side, but that's just not reflected in accounting. So it is, we think, absolutely critical to understand the component that's making up the unrealized loss, and we appreciate your feedback on that.

I'll have Julia talk a little bit about your CMBS questions, Jeff.

Thanks.

Just to be clear, I'm asking more about the direct commercial mortgage loans than the CMBS, actually.

Yes, I can cover that. We've had -- the trend in delinquencies has been very positive in that it's zero, and it has been zero in our portfolio for some time. So the trend is good because zero is good, and it's pretty amazing considering the size of our portfolio, and as you mentioned that the economy certainly has been slowing down.

As it relates to our retail portfolio, I'm not sure it's an overweight to retail, but I will say that we've had very little exposure to the names that you've been reading about in the paper. We have no exposure to Mervyn's in our commercial loan portfolio, we have one loan exposure to Linens 'n Things. And interestingly enough, they are doing pretty well in our particular loan, and we think they are going to affirm that lead. So we track that very, very closely, and so far so good on all the names that we've seen.

That's helpful. Thank you.

You bet.

Thanks, Jeff.

Your next question is from Colin Devine with Citigroup.

Hi, guys, two questions.

One, if we could just dig into net asset flows again, which are very strong, but I certainly recall in the past, Larry, you've cautioned that when markets rise, they tend to get a little bit weaker. When markets are down, they get a bit stronger just because of the way the math works. How much, if we look at your very strong net flow numbers this quarter, really is a reflection of the market just reducing the actual withdrawals?

And then, Mike, if you could just go back to the capital numbers again and just give us what is your excess capital, again, I lost that figure as you were going by, and how much excess debt capacity do you figure you have right now and is there any thought to getting back into buybacks between now and the end of the year?

Okay, Colin, thanks. I'll go ahead and comment on your first one. We've always given a range in terms of the full-service accumulation net cash flow that has been in that range of 4% of beginning-of-account value to 6%. And what we try to do with that is, in giving that range, kind of ballpark what that will be over time, given sort of normal equity markets.

Now, as we commented, we've seen a 16% decline in equity markets since September 30th. And I don't know what normal is anymore, I think we're redefining it day-by-day, but clearly that's been an extreme decline. And as a result of that I think, to your point, you would expect us to begin to move towards or maybe go outside the high side of our 4% to 6% range.

However, I don't want to diminish the fact that at 7.3% it is strong, but I also absolutely agree with your point that in the reverse situation, which we saw a year and a half, two years ago and the flows were more in the 4%, 4.5% range, we were the ones commenting at that point that it was the higher equity markets that were putting pressure on the net cash flows. And obviously, that's a condition that could repeat itself some time in the future. I'll have Mike comment on your other questions around capital and debt capacity and buybacks.

Hi, Colin.

Just a second, Mike. Larry, you said the real number here on some sort of long-term basis is closer maybe to 6.5%, which is still excellent, but the 7%-plus is partially a reflection of the markets? Is that fair?

Yes, it is fair, Colin.

Thanks. Sorry.

Colin, the number we used in the recorded part of the message was $300 million, so we've got $300 million of excess capital. That would be the sum of -- we've got three pockets. Well, the first pocket would be cash at the holding company. The second pocket would be -- think of it as excess capital or cushion at the life company. The third pocket would be debt capacity. The bulk of the $300 million is in the life company, so it would be in that middle pocket.

In terms of looking at buybacks for the rest of the year, again with market conditions being what they are, we believe it's prudent to go slow. So I think we could say, without getting in front of the Board, without really being able to speculate on what future conditions would be, I think we're in a go-slow period in terms of share repurchase.

But you're fine with the rating agencies. And to reiterate your point earlier, there's absolutely no reason to think that you would need to raise external capital.

There would be no reason that we know of to raise external capital.

Thanks, and good luck, Mike.

Okay, thank you.

Your next question is from Dan Johnson with Citadel Investments.

Great. Thanks very much.

Just a little bit of a follow-on to Colin's question, and as you mentioned when the markets were up last year you identified how it hurt withdrawals, and this quarter we talked about how markets down hurt sales. Can you help sort of net the two together? I mean, as you said, we're down 16% versus sort of a year ago. A year ago, we were actually conveniently up around the same amount. Sort of net-net, do up or down markets have a significant impact on your total flows?

Okay. Dan, good morning, this is Larry. I'll make a few general comments. Dan may want to clean that up a little bit. If you look at our total deposits, I guess you really have to sort of think about -- and again, we provide you detail in the financial supplement around how much of those are deposits from existing clients versus how much of those are deposits that come off of, if you will, new sales. And I think you again see that the majority, but by no means the vast majority, but the majority of those deposits are coming off of the deposits on existing business. So that's very solid. That's very stable. That's very predictable.

And then, so the delta component really, Dan, then relates to the other element that's shown there in the financial supplement, which is the deposits that come off of new sales, as well as transfer assets that come off of new sales. And again, about 70% of our new sales involve transfer assets. So that's a high-level talk, and maybe Dan Houston here can make a few comments. Maybe we should --.

Thanks, Larry, maybe just drilling down one additional level as it relates to how clean it is. If you looked at hardship withdrawals, which has been a question that's been coming up, actual hardship withdrawals were up about 15% -- up about 10% in terms of the number of requests. If we look at loans, surprisingly, loans are actually down by 2%, although the actual dollars are up 3%. If you combine those two together, there's still a relatively small dollar figure. So again, as it relates to whether or not the net cash flow is a clean number, I'd say it's clean, and even when you adjust it for withdrawals related to either hardship or loans.

Perfect. And just the other and final question was on the DAC in the quarter. You had mentioned that it had been lower. Part of it was related to the third quarter adjustment, and my memory doesn't go back that far. Can you remind me, do we have an annual third quarter sort of DAC true-up process?

Oh, Dan, this is Larry. I'll just take that one quickly. The comment related to third quarter was as it relates to full-service accumulation, and we went in and did what was more of a one-off study in third quarter last year, Dan, around essentially refining the expected lifetime for those contracts.

And what we're finding is frankly the experience is demonstrating that the persistency of those contracts was longer than what our DAC amortization had been at that point. So you saw the normal amortization for full-service accumulation be extended out in order to be more appropriate with a higher persistency that we're seeing on that business. But that was in third quarter last year and was more of a one-off, so it's not something that would necessarily repeat itself, but it does explain the lower amortization that has been in effect since third quarter '07.

And the market impact over the last year or so versus what would've been assumed in the DAC calculations, does that get -- how does that get reconciled given sort of deviations from sort of a 2% scenario?

Right. That is reconciled each quarter as we go along, Dan.

Great. Thank you very much.

You're welcome.

Your next question is from Suneet Kamath with Sanford Bernstein.

Thanks. Just a question about your CDO portfolios. Obviously, we've been seeing in the press that some of these investment banks are liquidating structured products, CDOs at pretty low cents on the dollar. I'm just wondering, as you think about third quarter and marking to market, you've mentioned a couple times that there's not a lot of liquidity in some of these asset classes. Can you just talk about how those trades may affect how you mark those positions as we think about the third quarter results?

Sure, Suneet. This is Larry. Let me just -- a general comment, and then I'll have Julia provide you the detail. I think, much as happens sometimes around unrealized losses, Suneet, I think it's absolutely critical that everyone understand what's inside CDO. CDO is just a generic term, and there can be a whole variety of different asset classes that sit inside a CDO.

And so to talk about someone else who sells a CDO at a certain price per dollar is not, in and of itself, controlling or helpful unless you understand what's inside that CDO as compared to what's in our holdings. And so again, I won't speak for Merrill Lynch, but I suspect the more likely scenario there was they were sitting on subprime residential, which is not essentially where most of our CDO exposure is, but then I'll have Julia provide the detail.

Thanks, Larry. Good morning, Suneet. If you are able to look on our slides that we put out on our web site, slide 6 does break out our CDOs. You can see very clearly the breakdown of credit CDOs versus CMBS CDOs versus what you're hearing about, which is the subprime CDOs, and we do it by credit quality as well. And we give you the amortized cost, and we give you the carry amount, so you can see pretty clearly that what's really been in the news of people selling or the markdowns is related to the subprime CDOs.

And you can see that we have been marking these down to those low $0.20 levels either on a market value basis for some of these, and in some cases we're permanently impairing rather than temporarily impairing some of these subprime CDOs. You can also see that our level is very, very small. Does that help, Suneet?

Yes, that's helpful. If I could just follow up, I'm assuming that you're in pretty constant contact with the rating agencies in terms of asset quality. Have you noticed any move on their part to focus a little bit more on the gross unrealized losses, and maybe factor that into their thinking? I know in the past they've not really looked at book value inclusive of AOCI, but any sense that perhaps they're moving in that direction? Thanks.

Yes, we are in constant communication with the rating agencies, and I would say that our discussion around asset quality has intensified. I think there are questions around what's behind some of these numbers, what's the quality of your portfolio, talk about what's driving some of these margins. Certainly, we've had all of those conversations. But, for the most part, I would tell you the rating agencies understand what's going on in this portfolio, they understand what's going on in the market and what's creating the dislocation in the market, and they've gotten very comfortable so far with our portfolio.

Thanks, Suneet.

Thanks, very much.

Your next question is from Tom Gallagher with Credit Suisse.

Good morning, a couple of questions. The first, just a follow-up on Suneet's question. So is your anticipation that the way, at least in terms of how you're looking at excess capital and how the rating agencies are evaluating capital adequacy, that unrealized loss positions are not going to factor into the equation, it's going to continue to be recognized losses that show up on a statutory accounting basis? Is that fair to say

Tom, I would -- this is Larry. I mean, I would say based on everything we know at this point in time I think that's a fair comment. I would just go back to what Julia said. I mean, the real important thing here is that the rating agencies do understand what's going on. I mean, they're not looking at just kind of high-level numbers, the broad metrics like just total unrealized losses. I mean, they are digging in, and I think it's important to dig in and really understand what's in a portfolio, where are the delinquencies really happening versus where are there just technical pressures in the markets.

So again, I think the point to be made here is simply that the rating agencies do understand what's going on, they do have that detail, and we're in constant communication with them.

Okay. And then, just a follow-up I guess on the CDO side for Julia. When you look at some of the bonds that are trading, let's say, between $0.50 or $0.60 on the dollar. If we kind of roll forward over the next several quarters, is there going to be some possibility that some of these get written down even if you believe they're ultimately money-good? Or maybe you could just talk a little bit about at what point the severity of the price decline might outweigh the recoverability of the cash flows and how you kind of view that balancing act. Thanks.

Tom, I think your question there really is as it relates more to what is, if you will, policy related to periods of time when market prices may remain depressed, particularly for technical reasons, and the extent to which that might derive some consideration around whether you would ultimately have to impair those, which is really more of an accounting judgment more than it is truly an investment or portfolio management decision. So maybe I'll ask Mike to see if he has any comments that he wants to offer into that. I think that --.

We always, every quarter, have very thorough discussions with our accountants, E&Y are our accountants. They're very comfortable with our process. They understand the rigor around the process we have, both in making I'll say asset valuation decisions and also impairment decisions. So we do not anticipate any significant change in policy or process in the foreseeable future.

Thanks, Tom.

Okay. And then, just lastly, any change in statutory required capital coming for you all as it relates to how you're looking at excess capital. I think there's some changes coming as it relates to structured assets and risk-based capital charges.

To our knowledge, I don't think that will have any significant impact on our risk-based capital.

Great, thanks.

Thanks, Tom.

Your next question is from Steven Schwartz with Raymond James.

Hey, good morning, everybody. And before I forget, Mike, best of luck to you.

Thank you.

Let's look at a couple of happier things maybe, the CINB deal, Larry, this is your first move into Shariah-compliant asset management?

Well I mean -- and Jim McCaughan may want to comment. We've actually done a little bit of work in the Shariah-compliant area. However, it's been sort of under the wing of Principal Global Investors. They certainly have been pursuing that market opportunity. This is actually a little bit more focused opportunity using our joint venture partner in Malaysia, CINB Commerce Group, who's a recognized leader in Shariah-compliant banking products, and they have a desire to extend that leadership over into the asset management space, as well. And obviously, recognizing the strength of our global asset management capability, they feel like we'd be an excellent partner. Maybe Jim would want to comment a little bit about our Shariah-compliant capability.

In terms of the Shariah-compliant capability, I think there's two important pieces here. One is the so-called is the Sukuk bond market where bonds are structured so that there's a rental and ownership rather than a payment of interest. And we have very strong capabilities in the quantitative analysis and the structural analysis of bonds, which are really quite well placed for helping those people to comply with those restraints.

And also, in equities, restraints on investing in particular sectors where our portfolio engineering skills allow us to implement restrictions that clients choose to have. And we're finding that in a number of parts of the world there are more religious and ethical constraints being used. And we're delighted to work with CINB here to respond to some of the concerns that their clients have, in particular their Muslim clients have about investing in particular sectors or particular stocks. Our approach allows us to engineer portfolios which are well diversified but nevertheless comply with their constraints.

So it's really very exciting to be able to address a broader client range using these techniques.

Okay. And then, on another topic, Larry, I think the American Academy of Actuaries came out earlier this week suggesting that the Social Security retirement age should be raised. I would think that --.

That's right.

I would think that that would be good for you, you being Principal as opposed to you personally.

Thanks. I am feeling a little bit younger today.

Well I think the Academy, Steven, actually was -- that particular recommendation was at it related to Social Security. And we won't go into a monologue here on Social Security. But obviously there are a number of issues there that I think we believe it would be in the interests of our country to deal with that issue. And one of the realities around the way that you would deal with a financial shortfall around Social Security is I think you -- any reasonable person who would look at this would conclude that raising the normal retirement age would be one of the primary steps that we would use for closing that financial shortfall.

I don't know, Steven, the extent to which that necessarily has -- it has some indirect implications as it relates to retirement ages generally, or normal retirement ages in, if you will, employer-sponsored plans. But I'm just noting that those two are really somewhat separate. I don't know that necessarily changes the whole view around normal retirement age being 65, but it certainly helps the financial conditions of Social Security.

Okay. All right. Thanks, guys.

You bet. Thanks.

(OPERATOR INSTRUCTIONS)

Your next question is from Eric Berg with Lehman Brothers.

Thanks very much, and good morning to everyone in Des Moines. I was hoping to return to the capital issue. And Mike or Larry, I certainly listened to -- attentively, pardon me, to all the discussion about the $300 million in excess capital and the debt capacity and the capital being generated. But it sure feels like that's not a particularly big cushion to deal with future turbulence.

In other words, it -- my ultimate question is why is this not the right take. It sort of feels like we're flying along here very smoothly with a little bit of a capital cushion, but we've got this $5.5 billion CMBS portfolio that is very stable right now, but if we would have to take large losses on it, I'm not saying we're going to, but if that were to happen that $300 million doesn't feel, given the magnitude of the size of the company, the size of the investment portfolio, to be a big number.

So my question is why isn't that the right take to say that Principal is stable from a capital position right now, but if there were a sudden change in the market it would have to raise capital? Why isn't that the right perspective to have?

Okay, Eric, good morning. This is Larry. Well again, I think we tried in our prepared comments to point out that, first of all, we do believe that we have a very high-quality portfolio and we remain very comfortable with the makeup of the portfolio. And again, we do a lot of our own internal testing to evaluate what might emerge in terms of actual losses or impairments on a quarter-by-quarter basis. And as we do that scenario testing, and I'm not talking about single-point scenario testing, I'm talking about multiple scenarios, we see that our current capital base plus the items that Mike mentioned in his comments are more than sufficient to cover any level of expected losses with even ability to have more moderate economic scenarios.

In addition to that, as I think we said in our comments, there are a variety, outside of real-time capital management levers, that we could pull. In other words, for example, today, we still envision some level of M&A as an ongoing element of our business strategy, and so there's opportunity for capital managements there. There certainly is, again, an ability to continually evaluate the level of expense. Now I want to be a little careful there because we believe that much of the expense -- we are not an organization that runs with a high level of excess expense. But like any organization, there are certain levels of investment, and they are fairly significant, that we believe have appropriate payback for us over a long-term period of time. For example, we talk a lot about our Work Secure and Retire Secure capability as just one example. And we believe those are appropriate long-term investments, and we're going to continue to do that. But these are all capital management levers that we could go to.

And so we would regard, Eric, our current level of capital as appropriate, as prudent, given our AA rating, and we don't see anything really, realistically, that changes that conclusion. But I'll have Mike add any further comments that he'd like.

Well I think the only comment I'd add, Larry, and I think it sort of wraps up what you've said, is this organization generates a lot of free cash, a lot of free capital, obviously a bit constrained just because of the stock market and our earnings right now. But if we get back to a more normal period, or even in an abnormal period, there's still a lot of additional resources that this organization generates as it moves through time, and that gives us a bit of additional cushion.

Mike, I hope you have an incredibly happy and healthy retirement. Thank you.

Thanks, Eric.

Thanks, Eric.

We have reached the end of our Q&A. Mr. Zimpleman, your closing comments, please?

Well, let me thank you again for joining us this morning. We appreciate your interest and support. As we said, we're very pleased with our results for the quarter, particularly in light of what remains a difficult operating environment. But our businesses continue to show strong momentum, and we believe that's going to continue, and we continue to stand by the quality of our investment portfolio and, importantly, the very, very disciplined process we have behind it, a process driven by strong risk management, very broad diversification and tight asset liability matching. I'd again note the improvement since first quarter in credit spreads, especially related to our commercial mortgage-backed securitizations and our credit CDO holdings. Our portfolio is relatively less exposed today to subprime residential mortgage and below investment grade securities.

While there are some headwinds due to market conditions, we believe we face them as a company with very strong fundamentals and a long track record of effectively navigating highly challenging environments, and we look forward to meeting with all of you over the next several months and having the opportunity to discuss our competitive advantages that we think make Principal a very compelling long-term investment.

Thanks, and I hope everybody has a great day.

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