美國信安金融集團 (PFG) 2010 Q2 法說會逐字稿

Good morning, and welcome to the Principal Financial Group's second quarter 2010 financial results conference call.

There will be a question-and-answer period after the speakers' have completed their prepared remarks.

(Operator Instructions)

If you would like to ask a question at that time, simply press star and the number one on your telephone keypad. We would ask that you be respectful of others and limit your questions to one and a follow-up so we can get to everyone in the queue. I would now like to turn the call over to John Egan, Vice President of Investor Relations.

Thank you and good morning. Welcome to the Principal Financial Group's quarterly conference call.

As always, our earnings release, financial supplement and additional investment portfolio detail can be found on our website at www.principal.com/investor. Following a reading of the Safe Harbor provision, CEO, Larry Zimpleman and CFO, Terry Lillis, will deliver some prepared remarks. Then we'll open up the call for questions. Others available for the Q&A are Dan Houston, US Asset and Accumulation and Life and Health Insurance; Jim McCaughan, Global Asset Management; Norman Sorensen, International Asset Management Accumulation; and Julia Lawler, our Chief Investment Officer.

Some of the comments made during the 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. Risk 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 10K and quarterly report on Form 10Q, filed by the Company with the Securities and Exchange Commission.

Now, I'd like to turn the call to Larry.

Thanks, John, and welcome to everyone on the call.

In my prepared remarks, I'd like to briefly discuss the results for second quarter and 2010 to date, discuss the ongoing implementation of our global strategy and close with a few comments about the future. Terry will cover the results in more detail following my comments.

Let's start with second quarter results. In view of the slowdown in economic growth and negative returns for the equity market in second quarter, we view the operating results of $204 million, or $0.63 per share, as solid. If you adjust results for both the second quarter 2010 and 2009 for DAC amortization true-ups, associated with equity market returns, we see second quarter 2010 operating results of $215 million against second quarter 2009 results of $186 million, an increase of 16%. Looking at the results for our growth engines, Principal International, Principal Global Investors and Principal Funds, all have reported double-digit earnings growth improving 33% on a combined basis. If you adjust the performance of Full Service Accumulation for the impact of equity market true-ups on DAC amortization, you see operating earnings up 21%.

In terms of other financial metrics, book value per share, including AOCI, ended the quarter at $26.23, up 4.6% from last quarter and up 62% from a year-ago. We also moved into a net unrealized capital gain position as of June 30 from a $4.8 billion net unrealized capital loss position a year-ago. This improvement in financial metrics reflects the ongoing improvement in credit markets as the economy recovers. It also demonstrates the value of our strong asset liability management, the quality and diversification of our investment portfolio and our liquidity management, all of which allows us to weather even extended periods of market stress and dislocation. As we have said before, it is difficult to draw conclusions in business trends from a single quarter. But in general, we view sales and deposits as an improving picture with results being more mixed for net cash flows.

Second quarter again demonstrated the importance of our International businesses as Principal International generated a record $1.5 billion in net cash flows in second quarter, bringing their 12-month total to a record $3.4 billion, or 12% of beginning of period assets. Principal Funds and Individual Annuities also delivered positive flows for the quarter of approximately $130 million each, thanks to solid sales. Full Service Accumulation has negative flows of $330 million for second quarter. This reflects the seasonality of sales with lower transfer deposits, usually in the second quarter and the loss of a larger case, based primarily on price. Importantly, we are seeing a steady increase in sales pipeline.

Sales activity, which was $918 million for the quarter, up 27%, and recurring deposits which were up 1% over second quarter 2009. This is the first increase in recurring deposits in seven quarters. Full Service Accumulation net cash flow remains positive through six months and we expect flows to be positive for the full year. Against an industry, projected by Cerulli, to be an outflow in 2010. Other positive indicators, besides pipeline, are that close rates continue to improve and proprietary investment performance results are solid.

We expect full-year 2010, Full Service Accumulation sales to come in about 15% to 20% higher than 2009, due to our alliance distribution efforts and the competitiveness of our Total Retirement Suite platform. An operating margin for Full Service Accumulation remains steady and in line with our expectations. Principal Global Investors had unaffiliated, or third-party outflows, of $1.6 billion during second quarter. Although their investment performance remains generally good across all asset classes, new deposits for this quarter were low, relative to historic levels, reflecting a decline in institutional searches in the US and around the world. We also saw higher institutional withdrawals during the quarter as clients continue to change investment and asset allocation strategies, and made withdrawals for the purpose of making benefit payments.

That said, unaffiliated deposits have been stable over the past several quarters and are trending up modestly from year-end 2009. We continue to be search competitive and continue to win business. Second quarter deposits of $3.3 billion included more than $800 million of funding from new clients, covering a wide range of offerings from large and small cap growth to high-yield and preferred securities. As I mentioned, investment performance remains solid overall and has not been a driver of client withdrawals. For Principal Global investors and its affiliates as of quarter-end, 78% of funds were in the top two Morningstar quartiles for the one-year period, 53% for the three-year period and 64% for the five-year period. This includes particular strength in Asset Allocation funds where 75% or more of our offerings were in the top two Morningstar quartiles for each of the one-, three- and five-year periods.

As institutions continue to gradually rebalance out of fixed income into higher risk assets, we're seeing flows into assets in which we have particular strength, International and Emerging Market Equities as well as currency. We also expect to benefit as institutions, retail investors and high net worth individuals move money in domestic equities to the stronger US Equity managers such as Columbus Circle and Edge. We are also seeing substantial interest in new searches for core US commercial real estate. Given the strength of our pipeline, dollars committed to fund in the third quarter, and the pick-up we're beginning to see in institutional search activity, our outlook for institutional flows remains positive for the rest of 2010.

Moving to six-month performance, it is easier to see the underlying trends and we're pleased with the results overall. Each of our growth engines delivered strong improvement in Assets Under Management, which coupled with ongoing expense discipline, produced strong operating leverage. Total Company earnings at $459 million through mid-year are up $95 million, or 26% on 13% higher average Assets Under Management. Looking at our three growth engines, earnings for the US accumulation businesses are up 37%, PGI's earnings are up 62%, and Principal International's earnings are up 57%. At $325 million, net income improved solidly as well, up 23% compared to the six-months ended a year-ago. These results reflect the value of our broad and geographically diverse mix of businesses, the revenue and earnings stability of our risk businesses, the steady deposit flow from our employer-sponsored retirement businesses, and the superior earnings growth from our Asset Management and Accumulation businesses in Asia and Latin America.

Now I'd like to spend a few minutes discussing the ongoing implementation of our strategy, even during this difficult economic environment. In the US, we continue to make progress, placing multiple products on third-party distribution platforms, reflecting our ongoing focus on meeting customer needs across the accumulation to pay out continuum. As a result, during the second quarter, each of our three largest US Accumulation businesses; Full Service Accumulation, Mutual Funds and Individual Annuities, delivered double-digit sales growth compared to the year-ago quarter, driving a $650 million, or 22%, improvement in combined sales. We've also continued to broaden our distribution by putting more focus on third-party administrators, which is not only resulting in new sales but also helping us retain business where customers are looking to move to an unbundled solution. For the first half of 2010, we sold or retained more than a $0.5 billion of business through third-party administrators, an increase of more than 75% from the same period a year-ago.

At Principal International, we continue to work closely with bank partners to increase penetration of their existing customer base. In the third quarter, our China joint venture will also begin marketing its recently approved Qualified Domestic Institutional Investor, or QDII Fund, a fund investing in international securities for Chinese investors. A significant portion of the $700 million quota will be managed by Principal Global Investors. We also continue to tap into growth opportunities in Southeast Asia. This includes the recent purchase by our Malaysian joint venture of a Thai mutual fund company and it's subsequent successful launch of a property fund. In June, Cerulli released their Asset Management industry projections through 2014. This study speaks to the outstanding growth potential for Principal International and Principal Global investors. Total Global Assets Under Management are projected to increase by 44% between 2009 and 2014, for a compounded annual growth rate of about 8%.

While growth in the US is expected to be solid at 7% per year, more telling are the projections for growth in countries where Principal International has built a significant presence. Brazil, Chile, China, and Mexico are projected to have the highest growth rates of all countries in the report. With Mutual Fund Asset growth ranging from 14% to 19% and Retirement Asset growth ranging from 13% to 24%. This affirms the appropriateness of our strategy and the significant opportunity we have going forward to grow our businesses given our strong positioning in these markets today.

Let me close with some thoughts on the future. Our outlook remains one of cautious optimism. We expect a more moderate but sustainable expansion. We do not view recent slowing growth as the start of a more severe slowdown or a double-dip recession, and we continue to see signs in many of our businesses that support this. Including improvement from a year-ago and recurring contributions to defined contribution plans and in fewer retirement plan terminations. I recently returned from a trip to Asia, more convinced than ever, that the strategy we've been pursuing for the last ten years to export our Retirement and Asset Management expertise overseas is the right one.

In aligning our domestic expertise with some of the largest distribution partners in the world, we've positioned the Principal for superior long-term growth. Between two of our joint venture partners, Banco Brasil and China Construction Bank, we have access to more than 200 million customers through some 18,000 branches, in two markets that are relatively untapped and that are projected to be among the five largest middle-class populations by 2025.

Next, a few comments on recently passed financial regulatory reform. We do not anticipate any material impact on our operations or results. One area we are watching is the impact of reform on the derivatives market. While we support transparency on swaps and derivatives, it may increase hedging costs in the longer-term which could have some modest impact. And while not a part of regulatory reform, we believe higher capital standards for the life industry are likely in the future.

A few final points. We believe that we will continue to see improving fundamentals for corporate credit and commercial real estate. We believe that losses in these areas have peaked and that the future losses will be quite manageable. Because of the improvement in asset valuations, our capital raising activities in 2009, and growth and retained earnings, stockholders equity is at its highest level for the Principal as a publicly-traded Company, $9 billion at quarter end. While we intend to hold more capital, which Terry will discuss in more detail, we have substantial flexibility with $2 billion in excess capital above a 350% risk-based capital ratio at mid-year. We'll continue to look for appropriate opportunities to deploy some of this capital.

Our priorities for capital use are unchanged with our first priority to support existing business, although our actions to grow our fee-based businesses and pull back on investment-only means we need less for this. And our second priority, mergers and acquisitions, where we are seeing an increase in opportunities both domestically and internationally. As we've demonstrated in the past, we'll continue to deploy capital in a disciplined and thoughtful way.

Terry?

Thanks, Larry. This morning, I'll focus on operating earnings, including continued strong expense management, net income, including continued solid performance of the investment portfolio, and I'll also comment further on our strong and flexible capital position.

Starting with total Company results. Second quarter 2010 operating earnings at $204 million were up 1.5% compared to a year-ago quarter. There were a number of items impacting comparability between periods. The two largest were higher DAC amortization expense in the current quarter due to equity market true-ups totaling $26 million after-tax between Individual Annuities, Full Service Accumulation and Individual Life, and $7 million of lower after-tax earnings from investment-only, reflecting the absence of earnings this quarter from early redemptions of medium-term notes. Excluding these items, total Company earnings improved 20% on 17% higher average Assets Under Management.

Let me quickly quantify a couple of the larger items impacting our reported earnings per share of $0.63. DAC true-ups for market performance in the US Asset Accumulation segment as well as the Individual Life division, dampened second quarter earnings by $0.04 per share in total. Life and Health segment earnings were also dampened by $0.03 per share, primarily due to reserve development and strengthening in the Health division. As Larry indicated, our Asset Management and Accumulation growth engines continue to deliver strong performance and we continue to benefit from our ongoing discipline around expense management. Through mid-year, we held operating expenses essentially flat against 13% growth in average Assets Under Management.

We've strategically reduced expenses in the guaranteed businesses and in the Life and Health segment. This has enabled us to increase investment in our Asset Management and Accumulation growth engines in the areas of distribution resources, product development and technology to drive productivity gains. Though earnings for the US Accumulation segment were down $8 million on a reported basis, the Accumulation businesses, which are the segment's growth engine, delivered 20% growth adjusting for DAC equity market true-ups relative to an 18% increase in average account values. Principal Funds earnings improved 75% from a year-ago on 23% higher average account values.

Full Service Accumulation earnings, again adjusting for DAC market true-ups, grew 21% on 19% higher average count values. Reflecting the rebound in account values and continued expense management, Full Service Accumulations operating return on account values through mid-year is up 11% to 30 basis points on an annualized basis. The drop in individual annuities earnings from a year-ago primarily reflects a $14 million after-tax increase in DAC amortization expense compared to the year-ago quarter. Principal International earnings improved $6 million, or 19%, from the year-ago quarter on 41% growth in average Assets Under Management. Excluding approximately $3 million of reserve adjustments that dampened current quarter results, earnings growth for the segment was consistent with the growth in Assets Under Management.

Principal International has added $9 billion of Assets Under Management over the trailing 12-months to reach a record $38 billion at quarter-end. The gain reflects not only strong investment performance and favorable currency movement, but also continued strong net cash flow. Principal Global Investors earnings improved $4 million, or 50%, on 11% growth in average Assets Under Management. Excluding Real Estate, where asset values declined modestly from a year-ago, investment management fees increased 17%. At $55 million in the second quarter, compared to $58 million in the prior-year quarter, earnings for the Life and Health Insurance segment were also solid. Earnings for Specialty Benefits were up slightly from a year ago. Importantly, during the quarter the division experienced sequential growth in premium and fees for the first time since fourth quarter 2008, improved lapse rates from a year-ago across all four lines of business and favorable claims results in a group disability income line after unfavorable experience in the first quarter.

Health earnings were down $1 million, in line with the decline in the covered members. Favorable experience in the group medical block, overall, was offset by the need to strengthen reserves within our small block of individual conversion policies. Individual Life earnings were $26 million compared to $28 million a year-ago, as growth in the block of business was offset by the impact of market performance on DAC amortization expense. A quick explanation of the variances from a year-ago for benefits and claims experience and DAC amortization expense. We had high gross death claims during the second quarter, which were substantially offset by reinsurance. On an economic basis, our loss on these claims was $2 million after-tax.

However, due to GAAP reinsurance accounting, we defer recognition of much of the benefit of reinsurance. This resulted in an increase in benefits and claims expense, and a decrease in fee-revenues which was partially offset by deferred recognition of related DAC amortization expense. Excluding DAC market true-ups and the impact of reinsurance accounting, division earnings in the second quarter were just over $30 million. Before moving on, I'd remind you of the seasonality of health division results. I'd reiterate our expectation for essentially flat earnings for the Life and Health segment in 2010 compared to 2009. With the caveat that unknowns around health care and regulatory reform could influence results in the health division and the segment.

I'd also remind you that the change in our economic interest in the BrazilPrev joint venture, reduces Principal International earnings run rate by approximately $10 million to $12 million per quarter after-tax, starting in the third quarter. The second quarter impact was about one-third of that based upon the effective date of the new 23-year shareholders agreement. Moving to net income, we view our $134 million results in the second quarter as solid. Net realized capital losses remain manageable at $70 million. Our investment portfolio performance continues to reflect strong asset liability management and broad asset diversification. Second quarter was a continuation of the steady improvement in credit-related losses over the past several quarters. We again saw sequential improvement in corporate credit and from structured risk, including CMBS.

We also saw sequential improvement from commercial mortgage [whole] loans, which had its lowest quarter of losses since year-end 2008. Net losses from these categories totaled $46 million in the second quarter, less than half of the losses in the year-ago quarter. Other significant items contributing to current quarter net realized capital losses are $26 million of losses on derivative marks, primarily related to interest rate hedging and the impact of declining rates during the quarter. A $72 million capital gain from the change in the Company's economic interest in the BrasilPrev joint venture and a $42 million capital loss for Principal Bank, primarily related to its portfolio of home equity loans. This reflects increased reserves and write-offs due to recent increases in delinquencies and in the banks estimate of loss severity.

We will continue to monitor, model and stress this portfolio going-forward. Moving to capital adequacy, as of quarter-end, we estimate our risk-based capital ratio to be around 440%. Relative to a 350% RBC ratio, we have approximately $2 billion of total excess capital, split evenly between the Life Company and the Holding Company. The split at mid-year reflects a $300 million distribution from the Life Company to the Holding Company, which represents roughly half our distribution capacity for the full-year. Given our equity and excess capital positions, we're at one of the strongest financial points in our history, a positive in light of continued environmental uncertainty. Even with our commitment to holding a higher component of excess capital as cushion, currently around $1 billion, we clearly have substantial financial flexibility. As you know, two of the rating agencies recently took the life insurance industry off negative outlook. This, along with improving market fundamentals and our businesses ongoing ability to generate free cash flow, gives us the ability to increase shareholder value over time through strategic capital redeployment.

This concludes our prepared remarks. Operator, please open the call to questions.

(Operator Instructions). We'll pause for a moment to compile the Q&A roster.

The first question comes from Steven Schwartz with Raymond James & Associates.

Good morning, everybody. Just a quick couple, Larry, you were kind of going in and out at least on my phone. You mentioned FSA sales, that you expected them to be up. If you could reiterate that. And then I was wondering, on the Health business, you had good results on the Health business on the group's side. There was an article recently, I think it was the New York Times, talking about people not going to the doctors despite having insurance because of economic reasons. And then I was wondering if you could also possibly touch on matching what's going on there in light of the kind of mixed article in today's Wall Street Journal?

Okay. Good morning, Steven. Good to hear from you.

Sorry if my comments were cutting in and out during the early part. What I said there to summarize, our view for the year, Steven, is that we expect the 2010 Full Service Accumulation sales to be up approximately, I think we said 15% to 20% over 2009. Again, we are seeing, generally positive trends albeit it's still a bit early, but we're seeing positive trends in sales pipeline. We're seeing positive trends in close rates. And as I said, our investment performance from PGI, they're affiliates, as well as some of our other sub-advisors, generally I would say, remains good.

I'll make a couple of quick comments on the Health and 401K matching and then Dan Houston may want to add a little bit more. In terms of the Health business, we have seen some sort of favorable reserve development there. To your point as to whether that's from people not going to the doctor or what all the factors may be, I don't really have that at my hands, other than there has been favorable reserve developments. So there does seem to be some trends along the lines you indicate. And as far as 401K matching, it's interesting, there have been a number of articles here in the last week or so. And I think that by and large those articles seem to square pretty well with our experience.

Many of our plans are written with a discretionary match so it's a little hard to know whether it's really been quote "suspended" or it's a match that can be discretionary. But having said that, we think that somewhere between 20% and 25% of our matches that have been restored. I think that's not completely inconsistent with what was in the Wall Street Journal or what I think was in some of the Hewitt information a week ago, but Dan might want to comment.

Yes, thanks, Larry. Just a couple quick comments, Larry's correct. If you look at the experience for Principal, our smaller plan sponsors were the ones that dialed back their, or suspended their matches, within the last 18 months. And again there will probably be the slower ones to put the matches back in place. The larger plans, we've seen about 20% to 25% of our existing customers with matches back up to where they were previously.

Okay, thank you, guys.

Thanks, Steven.

Your next question is from the line of Jeff Schuman with KBW.

Good morning, just to quickly follow-up on that. I think Dan, you said the 20% to 25% of the larger plants have restored? What's the percent on the smaller plan?

Something less than 20%, 25%. So the small to medium-size have been slower than the larger plans to add back their matches.

One thing, Jeff, this is Larry, if I could just throw in one additional comment though. I think it is telling, and again, it's a slight positive in the sense that the matches, kind of by the nature to the way we account for things, the matches are in the recurring deposits. So second quarter was actually the first quarter, we commented in the earlier remarks is the first quarter. I think seven quarters where we've seen an actual increase quarter-over-quarter in recurring deposits. So that's some positive indication as it relates both to matches and to participation and to participant deferrals.

Yes, I guess the million dollar question is, if those, given the percentages that have been restored, , what are the implications there? I mean, are we optimistic that most of that comes back, or all of it comes back, or not so much of it comes back? Where do you think we are a couple years from

I think this, again, as I said, this is Larry, Jeff, this is an improving picture over time. Okay? So, again, I would emphasize that for these small employers and even frankly today for many of the medium-sized and large employers, the only retirement benefit they offer is a 401K plan.

And, again, I thought it was interesting and telling in the sense of the Wall Street Journal article this morning, that you heard specific mention of an individual who actually left their place of employment because their employer had not yet reinstated their 401K match. So that from my perspective, is a very positive indicator because it does say that, employees like 401K matches, they value that and will increasingly become a point of consideration, as they think about where they want to work going forward. So I think there'll be a lot of slow, somewhat gradual, but there are positive trends developing here.

Okay. And the one other thing I wanted to ask about. There was a court decision recently, Tibble versus Edison, and the point was that plan sponsors maybe need to be sensitive to the cost structure of the funds in their 401Ks. In other words they shouldn't use retail funds when institutional-type funds are available. What is your exposure to that issue, both in terms of the 401K business and in terms of your fund business?

I'll just make a couple comments. This is Larry, Jeff. I'm not familiar with that particular case, so I can't really comment on that one. I would say, by and large that - - we believe for a long time that this market, in terms, the 401K, the defined contribution market, is going to move towards more sophisticated investment options, more sophisticated pricing, it's going to move toward institutional fees and that's where we've been for many, many, many, many years. So, I think again, that this is all positive, and I think probably the bigger driver in this, beyond any particular decision by courts, is going to be the Department of Labor's efforts to put more transparencies around fees. I'll let Dan comment on that.

Yes. Maybe just a couple quick comments on the structures that we have today, the retail share classes are actually the least used inside our 401K plans. Separate accounts, which were originally designed to be institutional nature, is very common. We have institutional share class of registered products. We also have CITs made available for our largest clients. And of course we have our own institutional share classes available to our clients. So, again, it gets back to suitability, the clients work with their investment advisors. And, again, there's full disclosure on the fees, for not only the plan administration record keeping but also for investment management fees.

Okay, thanks a lot.

Thanks, Jeff.

Your next question is from the line of Darin Arita with Deutsche Bank.

Thank you, good morning. On the International segment, the withdrawals have been declining for sometime, can you provide color on that?

Sure, I'll let Norman comment on that, Darin. Thank you, by the way, for picking up coverage this quarter, we appreciate that.

We've seen cash withdrawals- is that what your question was, Darin?

That's right, the withdrawals.

Yes, basically net cash flows have been increasing significantly over the past year. The quarter was $1.5 billion up, and the deposits, obviously, exceeded withdrawals. We've seen net cash flow of $1.5 billion. We have seen of that about a foreign exchange impact of $500 million negative. But we have seen investment performance in the range of $700 million. And, obviously, we've seen year-to-date $3.4 billion in net cash flow improvement.

Some of that withdrawal, Darin, if you go back into prior periods, at one point we had a fair amount of money markets in India and in our India Mutual Fund family. Those were amounts by the nature of money market tended to kind of cycle in and out. And so as we have focused that operation more on true long-term funds, that's another of the factors, along with what Norm's explaining around withdrawals.

Okay, that's helpful. - - and then, turning to, to Principal Bank, can we get a little more color on the size of it and the size of the home equity loan portfolio?

Sure, the home equity loan portfolio I think is in the range of $850 million. It includes I think somewhere around 16,000 loans. These are primarily loans that were put on the books in sort of the 2005 or 2006 or 2007 period. They are pretty well diversified geographically. So they're not concentrated necessarily in the states that have been particularly problematical. We have been monitoring this portfolio all along so, again, we continue to do a lot of analysis around that. Maybe I'll have Terry, or Terry wants to comment further.

Yes. Just to let you know the size of the bank, it's about a $2.4 billion Assets Under Management. As Larry said, it's around $800 million of these HELOC or home equity loans. So, the concentration is, is not in any particular one state, it is, as Larry mentioned - - diversified and, we are monitoring, modeling it and looking at the portfolio with a fine view.

So I think our expectation going forward Darin, we probably see losses out of that portfolio, probably in the range of $8 million to $10 million a quarter, which would be offset by operating earnings for the bank. So we expect that to be about a break-even situation going forward.

Okay. That's helpful. If I could just follow-up on that. Do you have the total reserves and write-downs on that portfolio?

Yes. Darin, this is Terry. The reserves that we have set against that portfolio is about $32 million, that's against the Heloc loans. In total we have about $40 million of reserves against the entire portfolio. But we think at 4% we feel that's an appropriate reserve at this point.

All right, thanks very much.

Thanks, Darin.

Your next question is from Thomas Gallagher from Credit Suisse.

Good morning. First question I had is on Full Service Accumulation flows, you lost a large plan. Can you comment on the AUM associated with the plan? And broadly speaking, are you seeing intensive price competition particularly in the larger end of the market?

I'll just kick that off and have Dan comment. First of all in terms of overall price competition, again, this is a business that has always been competitive. And as I've said to you, our responsibility really is to manage the business in such a way that it produces a desired profitability.

And I think, you're seeing in terms of the profitability both in the second quarter and on a rolling basis that it continues to perform very much in line with our expectation. So, again, that's part of the thing that we manage and I don't know that I would necessarily say that large cases are somehow more price competitive than small cases. It really just - - every part of the market is competitive, but I think we've demonstrated to have the ability to manage through that. I'll let Dan comment on the one particular case.

Sure, the one case was roughly a quarter of a billion dollars, $300 million, $250 million to $300 million. This is a piece of business that actually had come over on one of our endorsed transfers five-years ago. It's been a very price-sensitive sort of customer during that entire period of time and if finally reached a point, if we looked at it from a profitable perspective, we weren't pleased with it from a profitability perspective.

They took it out to bid and they went with who I would have described as a very low-cost, no frills provider in the marketplace. There wasn't value placed on, a total retirement suite approach, it was a stand-alone 401K. And they certainly wouldn't put value on the Retire Secure worksite sort of solution. So, again, not a good match post acquisition some five-years ago.

Just a couple final comments, Tom. If we look at the lapse rates on Full Service Accumulations through mid-year, they're running a little bit under 3.5%. And if you look at 2009, they ran about 7.4% for the year. So, again, it's actually running a little bit better than it did in 2009. And what is interesting, is that the larger case end of that, the lapse rates are closer to 2%, instead of that 3.5%. So that differential really reflects more plan terminations and very small employers going out of business. So the lapse rates here continue to be very much under control.

And Larry or Dan, just a follow-up. So as we look to the back half of the year, do you expect flows to turn positive in FSA for 3Q and 4 Q? Or is it going to be lumpy, or how should we be thinking about that?

I think the best way to think of it is, it always could be lumpy but we anticipate by year-end, we will be positive. We're positive today and we fully intend that we'll finish positive for the year. And again, just maybe to reiterate maybe my confidence around the Full Service line. When we go back and adjust the one large plan that we had in the first quarter of 2009, which again was $1.4 billion. We look at our increased close ratio. If you look at the average-sized plan excluding that large plan a year-ago, the average-sized plan is up 45%.

If we look at sales with plans with less than $10 million, so kind of back to that core sweet spot of small- to medium-sized business. Year-to-date that business is up 38%. And as Larry cited earlier, our created pipeline is 12%. So we go into this cautiously optimistic around the second half of the year, feel good about the quality of the pipeline and feel good that we can reach our stated objectives.

Okay, and then just one for Julia. I noticed the CMBS delinquencies continue to move up - - And just a question on I think your stress, your moderate stress scenario for CMBS and CMBS CDOs is $387 million. Can you talk about what you have already taken on those? And I guess it breaks out over what period of time you'd expect to recognize those? But how much have you already taken of that $387?

Okay, good morning, Tom. We have taken about 30%. And remember when we started doing these stress analyses and scenarios, we said this is how actual losses were more likely to emerge. And what I tell you, what we've done is more an impairment basis. So we haven't actually experienced the actual losses yet, but we have impaired about 30% to 40% of this total.

And Julia, of those that you've impaired, how much have you actually absorbed in terms of real losses versus - - impairment accounting recognition?

Virtually none.

I think this is the key point, Tom, and something that does sometimes gets lost in the understanding around this particular issue. Again, you know, Julia and her team do continuous stress modeling, looking for future losses and then are taking impairments against that.

So we're already taking impairments for losses that won't occur in many cases for another one or two years. And I think in the case of many investors they get confused between the timing for impairments as compared to when the actual bond losses occur. And by the time the bond losses occur, if we've done our work well, and Julia's team is as good as it gets, we've already taken those impairments. So those have already been front-loaded into our financials. And I think investors need to have sort of a better understanding and appreciation for that.

And, Tom, I do want to comment on the delinquencies because as you mentioned, they have increased quarter-over-quarter. That was anticipated, that's really in our stress-modeling scenarios. So all of it was in line with what we expected and we are actually seeing a slow-down in the increase. So, again, all in line with our expectations to our scenarios.

Okay, thanks.

Thanks, Tom

Your next question is from Randy Binner with FBR Capital.

Oh, hi, thanks. I guess I'm following-up on Tom Gallagher's questions on - - a little bit different but back to FSA on fees. So fees to total fund value were a little bit better than they have been running. So - - I guess, Larry, from your commentary, it doesn't sound like there's too much competition that's destructive there. So, can we expect kind of a stabilization on fees relative to account values? And maybe another way to hit this is could we think about Principal being able to maintain kind of 30% ROA in the FSA business, going forward?

Well, a couple comments, Randy. Again, it's 30 basis points ROA, which has been sort of the historical range that we've talked about. And I would say yes with one caveat, and then I'll let Dan comment as well. The one caveat is that, as we've said before, Randy, there is a mix of business issue that's involved here.

So for example, on our ESOP business, - - employer securities provide little if any in the way of fee revenue. Our proprietary investment options generate a higher degree of fee revenue. So there is very much a mix of business issue here. And so the caveat in terms of maintaining fees. The answer is yes, with the caveat that we're assuming there's not a substantial shift or change in mix of business. So that would be the only thing you'll need to watch. And you can see that in the financial supplement. You can track that quarter-by-quarter and kind of see how those various buckets are trending. And I'll let Dan add his comments.

Yes. That's exactly right. The only other comment I would make about fees and fee disclosures - - the Department of Labor has handed down a requirement that by July of next year, 2011, we'll have to comply to the standard approach in terms of disclosing fees for record keeping, administration, asset management fee, trust fees and advisory fees. We're already, feel very good about our current disclosure. We've been at it for many years and so, to the extent that it's raised out there in the marketplace, we feel like ours will compete very well with the competition.

Okay, great and just one more if I could. Also just on the CMBS, I guess maybe this is for Terry or Julia, but would you characterize the CMBS charges this quarter as kind of a catch-up? I mean certainly it seems that way for the home equity products. But I mean, it was a little bit higher than the run rate has been. So is there something in this quarter that caused you to kind of take a lump of impairments that may not be recurring going forward?

I think certainly, this is Larry, Randy. On the home equity piece, it was definitely - - I mean when I say catch-up what I mean is that we started to see delinquencies and severities increase in the last quarter or two. So I don't know if that's catch-up but certainly we felt it was appropriate to increase the loss recognition around that portfolio. I think on the CMBS, I'll let Julia comment on that.

Yes. No, actually, what we're seeing is from third quarter 2009, really second quarter 2009, we started to see impairments because we actually started to see forecast for losses at that point in time. So again remember, we're impairing long before the losses actually emerge. First quarter was the peak.

We've actually seen a trend down in CMBS losses impairment. So first quarter was really our peak number and we're trending downward. I guess the answer is no, there's no catch-up. We're really impairing as we see - - in forecast losses and severity of those losses. And we're seeing the trend sort of play out as we would have anticipated and first quarter was kind of our peak.

Very good, thank you.

Your next question comes from Ed Spehar with Bank of America.

Thank you, good morning, everyone. Two questions. The first is on capital. When you talk about the $2 billion excess number and you talk about you want to hold a billion dollar cushion. So I think you're saying there's a billion dollars you could do something with in the near-term. Is that a correct interpretation?

Well I think, Ed, this is Larry. I think that, yes, generally speaking, but I'll say it back to you. We have, if you use the 350 RBC and we could - - people might have different lines. But just to have a common measuring stick, there's about $2 billion of excess capital. And our thinking right now is that as we look both to higher capital requirements that I alluded to in my remarks, plus we're very sensitive also around sort of near-term obligations of the Holding Company. We'd probably be of a mind today that we would want to hold somewhere around $1 billion to $1.2 billion.

The higher amount does not necessarily, mean however, that we have a desire to go out in the next quarter or two and - - spend down the remaining amount. As I said, I think that the rating agencies, two of the four have moved the industry to neutral. So that there are some signs that are positive. And so I think as we go forward, as we keep adding to our excess capital position, as the economy and the markets normalize, I think that sort of $750 million number will grow. And we will and we are currently working on lots of plans and ideas around ways to deploy it.

Yes, I guess Larry, just a follow-up on that. I mean I understand the desire to hold a cushion. But I guess the question is, your stock is below book value. And I think when you think about the prospects for this business and when you think about the marginal return on capital that you expect, I find it hard to see any other alternative use for capital being compelling other than buying your stock.

And when you talk about funding growth, I mean it doesn't seem like you need to hold capital to fund growth, at least significant amounts considering the mix shift. When you talk about M&A, it's again, it seems impossible, almost impossible, to find something that's more compelling than your stock below book. So can you just give us some sense of, how you're thinking about timing of deploying capital? Because this is, I'm not so sure that this is an opportunity that stays forever.

Right, no, I mean, I think there's a general agreement with many of the points, Ed, that you were talking about. And it's really more I would say a matter of timing more than anything else. As you've said and, again, you've written and commented on this, which I appreciate. We have made conscious decisions here to pull back on some of the more capital intensive businesses, particularly the IO business. And that has very positive implications going forward.

We used to talk about needing 50% of our operating earnings to support the growth of the businesses. We haven't really retested that in detail to give you a new number today. But clearly because of the pull back of IO, we would need less than the sort of that 50% number going forward. So we will be generating higher amounts of free cash flow. We will be adding to our excess capital position. And again, as we go forward through the rest of 2010 and into 2011, we will need to have and we have been working and continue to have a plan for capital deployment.

But, again, I think it's a little bit early to be pulling the trigger on that. So for now it's a very nice position to be in, we want to continue to watch the things that are going on. We have the opportunity to be very opportunistic both in Global Asset Management in International and US retirement, that's where the capital will go to. And so we just like the position we're in and we'll see how it works out over the next quarter or two.

Okay and then one quick follow-up just for some clarification on International. The $35 million that you earned this quarter, there was about a $3 million or $4 million dollar impact from the change in the JV ownership. When we're thinking forward over the next couple quarters, we have earnings that should come down from that level by something in the neighborhood of $9 million. Is that correct?

Well, this is Norman. On a quarterly basis we have indicated that we expect earnings to drop by about - - between $10 million and $12 million per quarter after-tax.

Again, we have one quarter, we should be in the $27 million to $28 million per quarter range basically, Ed.

And then how quickly, now is it going to grow still off of that as sort of your 15%? Or is there a faster growth rate recovery because of what you see as sort of near-term opportunities?

We anticipate growth between 15% and 20%. Obviously, the 23-year agreement with Banco do Brasil gives us tremendous opportunity in that market as well the other markets. So roughly between 15% and 20% growth going forward.

Okay. Thank you

Thanks, Ed.

Your next question is from Colin Devine with Citi.

Good morning. Just a couple quick questions just to make sure that I'm sort of getting the message that I think you're trying to convey. First is, in terms of capital redeployment, the way that Principal used to do it, the buybacks and such, nobody should be holding their breath for a while. And that the ROEs that we're looking at today in the sort of 10.5% range is going to be here for a while or actually maybe go down as you continue to build capital. That's question number one.

Question number two, as I look at the FSA business again, the number of plans you're managing continues to decline. Is that just really a reflection of the overall shrinkage you alluded to in the 401K market more than a problem with Principal? And then three, can you just confirm, the home equity lines in the bank, are those loans you originated yourselves or portfolios that you purchased? Then finally, if you could just confirm one more time for me at least on the DPAC with the Life business, exactly what happened there? Was it sort of what Genworth had where - - because of low rates, somewhat of a more permanent impairment or - - against their original pricing assumptions? Or was it more market driven? I know you've written a bunch of secondary guarantee Universal Life. And I didn't know if we were seeing some of the adverse lapse experience come through?

Okay, I'll try to take them quickly, Colin, and Terry will want to comment on a couple of these as well. But in terms of ROE growth, the fact we're holding higher capital, we think probably impacts ROE around 50, 60 basis points. But having said that, I think our current ROE of 10.6% I think is still reasonably competitive within the industry. Having said that, I guess we still believe that we have the opportunity to grow that ROE, even at these higher levels of capital, we continue to grow that ROE about 50 basis points a year. So there's really been no change around that. Because of the fee nature of our growth businesses, we do see opportunities to continue to grow from this kind of 10.5%, 10.6% level.

In terms of numbers of plans, that's really a combination of two things. Number one, there's fewer start-up plans and so we're not writing quite as many plans in this kind of environment. And number two, of course, there are a few more terminations of plans, meaning very small employers that go out of business. So, again, we think those are trends that will normalize and reverse themselves over time. Quickly on the Heloc, I would just comment, that's basically a portfolio that was purchased through a few different sources. But basically those are all correspondents, we don't necessarily have a basis to originate those. Again, that activity would cease as of a number of years ago. So we are not - - haven't been adding any of those home equity loans in the portfolio over the last couple of years.

I'll have Terry comment very quickly on the Individual Life DPAC issue.

Yes, Colin, this is Terry. As we have two large claims that generated losses in the current period, they were offset by reinsurance. So the economic impact of it this quarter was about $2 million. However accounting practice does not allow you to recognize the - - reinsurance reimbursement during the current period. You have to spread that over the life of the portfolio which could be 75 years plus. So there's going to be very little impact.

The net, net effect of this in several different lines through geography was a $5 million after-tax impact of the underwriting, of the reinsurance amortization or impact. As a result, we said that a $2 million economic impact versus a $5 million GAAP impact generated a lower earnings in the Life line by about $3 million after-tax this quarter. Therefore we feel that that was an appropriate adjustment to make to our EPS in the current period.

Thank you very much.

Thanks, Colin.

Your next question comes from Mark Finkelstein with Macquarie.

Good morning. Just to talk a little bit about the health business, premium continues to go down at a fairly rapid clip. I guess what is your premium outlook and when do we start to really kind of have more meaningful expense ratio issues? Particularly when we start thinking about Health Care Reform and minimum loss ratios. That's my first question.

Okay. This is Larry, I'll make a quick comment on that. Dan may want to comment as well. I don't know there's necessarily such a thing as a bright line, Mark, where that becomes an issue. And clearly - - we're well aware of the membership decline, which again is a combination of in plan shrink as well as lapses exceeding new sales. Again, you see this across most of the commercial blocks of pretty much of all the carriers. So there's not a magic point. I would say that we're looking at, in regard to minimum loss ratios, we are looking at the potential impact of that.

And, again, that's just something that we'll have to manage towards. But, Dan, do you have any comments?

Yes, maybe just two real quick ones. As you know, we've talked about previously the buildout of our pen networks, which is our proprietary network development going on in roughly six or seven cities around the country to get better discounts from hospitals, physicians and clinics, et cetera. So it does involve some investment to build out that capability role. We're also making a modest investment in distribution as well as back office to comply with Health Care Reform. So we're going to have some pressure on expenses. We continue to manage that very aggressively. And at the same time, you get to see a nice improvement in overall loss ratios. And, again, those two areas are, are certainly driving cost up for our overhead and administrative expenses.

Okay, and then just secondly on PGI, unaffiliated flows. I think you attributed some of the issues in the quarter to a rebalancing where you're not as competitive in those strategies or even have them in some instances. I guess, one, has that rebalancing essentially ended? And did I hear you correctly in suggesting that you expect that particular area to show positive flows in the third and fourth quarters?

I'll have Jim comment on that. Jim?

It so much differs by client that it is hard to generalize. - - you can point, one can point to two or three clients to rebalance in particular ways. And therefore, that cost us flows during the quarter. But it is very hard to generalize about a process that goes across a lot of clients and I would hesitate to do that. I think really the way to look at it is that - - not only is, as Larry mentioned quoting Cerulli, the DC industry in an outflow. But the DB industry also, or the DB funds across the country are also in net outflows. So to have $1.6 billion of net outflow, 2% of the total nonaffiliated book of business is actually not a particularly bad result, given the influence of the economy on the funds.

And really the key to us turning positive is that clients start allocating both US and that International client to the active strategies they're in. And we see signs of that as coming. I would be disappointed to see continued negative flows through the next two quarters, but it's very difficult to predict client movement. We do have participation in quite a few searches at the moment. And are search competitive in a number of popular investment choices. But I do think that it's very hard to predict at this point whether it will actually turn positive in the next two quarters. So for the next two or three years we remain very positive.

Okay, thanks, Jim.

Thanks, Mark

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

Well, again, I want to thank all of you for joining us this morning and for your continuing interest in the Principal. As we've mentioned in our call today, we do see increasing evidence that the economy in the small- to medium-business sector are now at the beginning of what we hope to be a growth cycle going forward. Although we're going to continue to focus on challenges that remain, we also believe we're well positioned to grow our businesses as we go forward for the next few quarters. And we look forward to speaking with many of you about the opportunities that we believe will continue to differentiate Principal Financial Group from our peers. Thank you and have a great day

Thank you for participating in todays conference call. This call will be available for replay beginning at approximately at 8;00 PM Eastern time until end of day August 10, 2010. 4587874 is the access code for the replay. The number to dial for the replay is 800-642-1687, US and Canadian callers or 706-645-9291 International callers.