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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-Q
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|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2002
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
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Commission file number 1-16725
PRINCIPAL FINANCIAL GROUP, INC.
(Exact name of registrant as specified in its charter)
Delaware 42-1520346
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
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711 High Street, Des Moines, Iowa 50392
(Address of principal executive offices)
(515) 247-5111
(Registrant's telephone number, including area code)
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Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the Registrant was
required to file such reports) and (2) has been subject to such filing
requirements for the past 90 days. Yes |X| No |_|
The total number of shares of the registrant's Common Stock, $0.01 par value,
outstanding as of August 5, 2002, was 346,882,550.
PRINCIPAL FINANCIAL GROUP, INC.
TABLE OF CONTENTS
Page
Part I - FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Statements of Financial Position at June 30, 2002
(Unaudited)and December 31, 2001.................................... 3
Unaudited Consolidated Statements of Operations for the three
months and six months ended June 30, 2002 and 2001.................. 4
Unaudited Consolidated Statements of Stockholders' Equity for
the six months ended June 30, 2002 and 2001......................... 5
Unaudited Consolidated Statements of Cash Flows for the
six months ended June 30, 2002 and 2001............................. 6
Notes to Unaudited Consolidated Financial Statements - June 30, 2002.. 8
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations....................................... 23
Item 3. Quantitative and Qualitative Disclosures about Market Risk...... 74
Part II - OTHER INFORMATION
Item 1. Legal Proceedings............................................... 79
Item 4. Submission of Matters to a Vote of Security Holders............. 80
Item 6. Exhibits and Reports on Form 8-K................................ 81
Signature............................................................... 82
2
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
Principal Financial Group, Inc.
Consolidated Statements of Financial Position
JUNE 30, DECEMBER 31,
2002 2001
------------------ ------------------
(Unaudited) (Note 1)
(IN MILLIONS,
EXCEPT PER SHARE DATA)
ASSETS
Fixed maturities, available-for-sale........................................ $31,584.6 $30,012.3
Fixed maturities, trading................................................... 59.6 17.8
Equity securities, available-for-sale....................................... 813.7 833.6
Mortgage loans.............................................................. 10,831.6 11,065.7
Real estate................................................................. 1,194.0 1,181.8
Policy loans................................................................ 824.7 831.9
Other investments........................................................... 862.0 829.8
------------------ ------------------
Total investments........................................................ 46,170.2 44,772.9
Cash and cash equivalents................................................... 1,261.1 623.8
Accrued investment income................................................... 606.7 594.3
Premiums due and other receivables.......................................... 1,092.4 531.3
Deferred policy acquisition costs........................................... 1,427.4 1,372.5
Property and equipment...................................................... 514.9 518.2
Goodwill.................................................................... 170.7 439.3
Other intangibles........................................................... 724.7 789.1
Mortgage loan servicing rights.............................................. 1,978.8 1,779.2
Separate account assets..................................................... 35,132.8 35,864.8
Other assets................................................................ 1,113.7 1,065.1
------------------ ------------------
Total assets............................................................. $90,193.4 $88,350.5
================== ==================
LIABILITIES
Contractholder funds........................................................ $26,013.4 $24,684.4
Future policy benefits and claims........................................... 14,440.6 14,034.6
Other policyholder funds.................................................... 589.6 589.1
Short-term debt............................................................. 400.2 511.6
Long-term debt.............................................................. 1,342.2 1,378.4
Income taxes currently payable.............................................. 165.9 0.5
Deferred income taxes....................................................... 803.7 894.6
Separate account liabilities................................................ 35,132.8 35,864.8
Other liabilities........................................................... 4,634.9 3,572.2
------------------ ------------------
Total liabilities........................................................ 83,523.3 81,530.2
STOCKHOLDERS' EQUITY
Common stock, par value $.01 per share - 2,500 million shares authorized,
376.4 million and 375.8 million shares issued, 351.4 million and
360.1 million shares outstanding, respectively........................... 3.8 3.8
Additional paid-in capital.................................................. 7,088.6 7,072.5
Retained earnings (deficit)................................................. 56.2 (29.1)
Accumulated other comprehensive income...................................... 163.0 147.5
Treasury stock, at cost (25.0 million and 15.7 million shares, respectively) (641.5) (374.4)
------------------ ------------------
Total stockholders' equity............................................... 6,670.1 6,820.3
------------------ ------------------
Total liabilities and stockholders' equity............................... $90,193.4 $88,350.5
================== ==================
See accompanying notes.
3
PRINCIPAL FINANCIAL GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
FOR THE THREE MONTHS ENDED FOR THE SIX MONTHS
JUNE 30, ENDED JUNE 30,
------------------------------- -------------------------------
2002 2001 2002 2001
--------------- --------------- --------------- ---------------
(IN MILLIONS, EXCEPT PER SHARE DATA)
REVENUES
Premiums and other considerations.............. $1,166.6 $ 891.1 $2,052.3 $1,955.3
Fees and other revenues........................ 479.4 443.3 955.4 856.3
Net investment income.......................... 825.5 846.3 1,638.7 1,686.0
Net realized capital gains (losses)............ (91.5) (96.0) 6.6 (176.9)
--------------- --------------- --------------- ---------------
Total revenues........................... 2,380.0 2,084.7 4,653.0 4,320.7
EXPENSES
Benefits, claims and settlement
expenses.................................... 1,507.9 1,247.3 2,711.1 2,639.2
Dividends to policyholders..................... 79.5 81.1 161.9 162.1
Operating expenses............................. 638.6 605.5 1,269.4 1,228.2
--------------- --------------- --------------- ---------------
Total expenses........................... 2,226.0 1,933.9 4,142.4 4,029.5
--------------- --------------- --------------- ---------------
Income before income taxes and cumulative
effect of accounting changes................ 154.0 150.8 510.6 291.2
Income taxes................................... 33.8 31.7 144.4 56.1
--------------- --------------- --------------- ---------------
Income before cumulative effect of
accounting changes.......................... 120.2 119.1 366.2 235.1
Cumulative effect of accounting changes, net of
related income taxes........................ - - (280.9) (10.7)
--------------- --------------- --------------- ---------------
Net income..................................... $ 120.2 $ 119.1 $ 85.3 $ 224.4
=============== =============== =============== ===============
FOR THE THREE MONTHS FOR THE SIX MONTHS
ENDED JUNE 30, 2002 ENDED JUNE 30, 2002
------------------------------- -------------------------------
EARNINGS PER COMMON SHARE
Basic earnings per common share:
Income before cumulative effect of
accounting change.......................... $ 0.34 $ 1.02
Cumulative effect of accounting change
net of related income taxes................ - (0.78)
------------------------------- -------------------------------
Net income..................................... $ 0.34 $ 0.24
=============================== ===============================
Diluted earnings per common share:
Income before cumulative effect of
accounting change.......................... $ 0.34 $ 1.02
Cumulative effect of accounting change,
net of related income taxes................ - (0.78)
------------------------------- -------------------------------
Net income................................... $ 0.34 $ 0.24
=============================== ===============================
See accompanying notes.
4
PRINCIPAL FINANCIAL GROUP, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(UNAUDITED)
ACCUMULATED
ADDITIONAL RETAINED OTHER TOTAL
COMMON PAID-IN EARNINGS COMPREHENSIVE TREASURY STOCKHOLDERS' OUTSTANDING
STOCK CAPITAL (DEFICIT) INCOME (LOSS) STOCK EQUITY SHARES
------ ---------- --------- ------------- -------- ------------- -----------
(IN MILLIONS) (IN THOUSANDS)
BALANCES AT JANUARY 1, 2001...... $- $ - $6,312.5 $(60.0) $ - $6,252.5 -
Comprehensive income:
Net income...................... - - 224.4 - - 224.4 -
Net unrealized gains............ - - - 227.4 - 227.4 -
Provision for deferred -
income taxes................... - - - (85.6) - (85.6)
Foreign currency translation
adjustment..................... - - - (76.1) - (76.1) -
Cumulative effect of accounting
change, net of related
income taxes................... - - - (14.2) - (14.2) -
-------------
Comprehensive income............. 275.9
------ ---------- --------- ------------- -------- ------------- -----------
BALANCES AT JUNE 30, 2001........ $- $ - $6,536.9 $ (8.5) $ - $6,528.4 -
====== ========== ========= ============= ======== ============= ===========
BALANCES AT JANUARY 1, 2002...... $3.8 $7,072.5 $ (29.1) $147.5 $(374.4) $6,820.3 360,142.2
Stock issued..................... - 14.8 - - - 14.8 569.4
Treasury stock acquired and
reissued, net................... - 1.3 - - (267.1) (265.8) (9,305.9)
Comprehensive income:
Net income...................... - - 85.3 - - 85.3 -
Net unrealized gains............ - - - 12.8 - 12.8 -
Provision for deferred -
income taxes................... - - - (3.1) - (3.1)
Foreign currency translation
adjustment..................... - - - 5.8 - 5.8 -
-------------
Comprehensive income............. 100.8
------ ---------- -------- ------------- -------- ------------- -----------
BALANCES AT JUNE 30, 2002........ $3.8 $7,088.6 $ 56.2 $163.0 $(641.5) $6,670.1 351,405.7
====== ========== ======== ============= ======== ============= ===========
SEE ACCOMPANYING NOTES.
5
PRINCIPAL FINANCIAL GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
FOR THE SIX MONTHS ENDED
JUNE 30,
-----------------------
2002 2001
----------- -----------
(IN MILLIONS)
OPERATING ACTIVITIES
Net income............................................ $ 85.3 $ 224.4
Adjustments to reconcile net income to net cash
provided by operating activities:
Cumulative effect of accounting changes,
net of related income taxes.................... 280.9 10.7
Amortization of deferred policy acquisition
costs.......................................... 67.0 104.3
Additions to deferred policy acquisition costs... (160.0) (132.9)
Accrued investment income........................ (12.4) (49.6)
Premiums due and other receivables............... 75.9 (10.0)
Contractholder and policyholder liabilities
and dividends.................................. 1,029.9 924.9
Current and deferred income taxes................ 326.7 41.7
Net realized capital (gains) losses.............. (6.6) 176.9
Depreciation and amortization expense............ 54.0 74.3
Amortization and impairment/recovery of
mortgage servicing rights..................... 201.5 128.7
Other............................................ 58.2 320.6
----------- -----------
Net adjustments....................................... 1,915.1 1,589.6
----------- -----------
Net cash provided by operating activities............. 2,000.4 1,814.0
INVESTING ACTIVITIES
Available-for-sale securities:
Purchases.......................................... (7,347.0) (7,041.0)
Sales.............................................. 3,712.2 3,035.1
Maturities......................................... 2,107.4 1,404.2
Net cash flows from trading securities................ (41.2) -
Mortgage loans acquired or originated................. (20,757.9) (16,789.4)
Mortgage loans sold or repaid......................... 20,985.0 16,778.4
Purchase of mortgage servicing rights................. (471.4) (392.3)
Proceeds from sale of mortgage servicing rights....... 8.0 26.0
Real estate acquired.................................. (126.5) (180.4)
Real estate sold...................................... 157.7 394.4
Net change in property and equipment.................. (34.7) (42.0)
Net proceeds (disbursements) from sales of
subsidiaries....................................... 1.4 (13.5)
Purchases of interest in subsidiaries, net of cash
acquired........................................... (49.0) (4.2)
Net change in other investments....................... 463.6 (237.2)
----------- -----------
Net cash used in investing activities................. $ (1,392.4) $ (3,061.9)
6
PRINCIPAL FINANCIAL GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
(UNAUDITED)
FOR THE SIX MONTHS ENDED
JUNE 30,
-----------------------
2002 2001
----------- -----------
(IN MILLIONS)
FINANCING ACTIVITIES
Issuance of common stock............................. $ 14.8 $ -
Acquisition and reissuance of treasury stock, net.... (265.8) -
Issuance of long-term debt........................... 10.7 146.4
Principal repayments of long-term debt............... (46.9) (92.3)
Proceeds of short-term borrowings.................... 5,126.0 4,276.5
Repayment of short-term borrowings................... (5,237.4) (4,060.1)
Investment contract deposits......................... 4,088.7 3,302.9
Investment contract withdrawals...................... (3,660.8) (2,880.2)
----------- -----------
Net cash provided by financing activities............ 29.3 693.2
----------- -----------
Net increase (decrease) in cash and
cash equivalents................................. 637.3 (554.7)
Cash and cash equivalents at beginning of period..... 623.8 926.6
----------- -----------
Cash and cash equivalents at end of period........... $ 1,261.1 $ 371.9
=========== ===========
SEE ACCOMPANYING NOTES.
7
PRINCIPAL FINANCIAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
JUNE 30, 2002
(UNAUDITED)
1. NATURE OF OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements of Principal
Financial Group, Inc. and its majority-owned subsidiaries ("the Company") have
been prepared in conformity with accounting principles generally accepted in the
U.S. ("U.S. GAAP") for interim financial statements and with the instructions to
Form 10-Q and Article 10 of Regulation S-X. In the opinion of management, all
adjustments (consisting of normal recurring accruals) considered necessary for a
fair presentation have been included. Operating results for the three months and
six months ended June 30, 2002, are not necessarily indicative of the results
that may be expected for the year ended December 31, 2002. These interim
unaudited consolidated financial statements should be read in conjunction with
the Company's annual audited financial statements as of December 31, 2001,
included in the Company's Form 10-K for the year ended December 31, 2001, filed
with the United States Securities and Exchange Commission. The accompanying
consolidated statement of financial position at December 31, 2001, has been
derived from the audited consolidated statement of financial position but does
not include all of the information and footnotes required by U.S. GAAP for
complete financial statements.
Reclassifications have been made to the December 31, 2001 and June 30, 2001,
financial statements to conform to the June 30, 2002, presentation.
SEPARATE ACCOUNTS
At June 30, 2002, the Separate Accounts included a separate account valued at
$1.2 billion which primarily included shares of the Company's stock that were
allocated and issued to eligible participants of qualified employee benefit
plans administered by the Company as part of the policy credits issued under the
Company's demutualization. These shares are included in both basic and diluted
earnings per share calculations. The separate account shares are recorded at
fair value and are reported as separate account assets and separate account
liabilities in the consolidated statement of financial position. Activity of the
separate account shares is reflected in both the separate account assets and
separate account liabilities and does not impact the Company's results of
operations.
ACCOUNTING CHANGES
The Financial Accounting Standards Board ("FASB") Statement of Financial
Accounting Standards ("SFAS") No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION
("SFAS 123") encourages, but does not require, companies to record compensation
cost for stock-based employee compensation plans based on the fair value of
options granted. The Company has elected to adopt the fair value based method of
accounting prescribed in SFAS 123, retroactive to January 1, 2002, for its
employee stock-based compensation plans and will implement the method during
the third quarter of 2002 for all stock-based awards granted subsequent to
January 1, 2002. Prior to January 1, 2002, the Company elected to account for
its stock-based compensation plans under the provisions of Accounting Principles
Board ("APB") Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES and,
accordingly, employee stock-based compensation costs were excluded from
compensation expense. The Company estimates an after-tax impact of between two
and three cents per diluted share in 2002 as a result of this change in
accounting policy.
In June 2001, the FASB issued SFAS No. 141, BUSINESS COMBINATIONS ("SFAS
141"), and SFAS No. 142, GOODWILL AND OTHER INTANGIBLE ASSETS ("SFAS 142"). SFAS
141 requires that the purchase method of accounting be used for all business
combinations initiated after June 30, 2001, and requires separate recognition of
intangible assets apart from goodwill, if such intangible assets meet certain
criteria. SFAS 142, effective January 1, 2002, prohibits the amortization of
goodwill and intangible assets with indefinite useful lives. Intangible assets
with finite lives will continue to be amortized over their estimated useful
lives. Additionally, SFAS 142 requires that goodwill and indefinite-lived
intangible assets be reviewed for impairment at least annually, which the
Company plans to do in the fourth quarter each year.
Upon adoption of SFAS 142, the transition provisions of SFAS 141 became
effective, which required the Company to reclassify to goodwill the carrying
amount of its intangible assets that do not meet the specified criteria enabling
an intangible asset to be recognized separately from goodwill. As a result, the
Company reclassified its assembled work force intangible asset of $22.3 million,
related to BT Financial Group, to goodwill.
The initial adoption of SFAS 142 required the Company to perform a two-step
fair-value based goodwill impairment test. The first step of the test compared
the estimated fair value of the reporting unit to its carrying value, including
goodwill. If the carrying value exceeded fair value, a second step was
performed, which compared the implied fair value of the applicable reporting
8
PRINCIPAL FINANCIAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
JUNE 30, 2002
(UNAUDITED)
1. NATURE OF OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
unit's goodwill with the carrying amount of that goodwill, to measure the
goodwill impairment, if any. Additionally, the Company was required to perform
an impairment test on its indefinite-lived intangible assets, which consisted of
a comparison of the fair value of an intangible asset with its carrying amount.
The Company's measurements of fair value were based on evaluations of future
discounted cash flows, product level analysis, market performance assumptions
and cash flow assumptions. These evaluations utilized the best information
available in the circumstances, including reasonable and supportable assumptions
and projections. The discounted cash flow evaluations considered earnings
scenarios and the likelihood of possible outcomes. Collectively, these
evaluations were management's best estimate of projected future cash flows.
As a result of performing the two-step impairment test, the Company recorded
goodwill impairments of $196.5 million, $20.9 million and $4.6 million, net of
income taxes, related to its BT Financial Group, Principal International, and
Life and Health operations, respectively. Additionally, as a result of
performing the indefinite-lived intangible asset impairment test, the Company
recognized an after-tax impairment of $58.9 million to its brand name and
management rights intangible asset related to BT Financial Group.
These impairments, recognized January 1, 2002, as a cumulative effect of a
change in accounting principle, were reported in the Company's operating
segments as follows (in millions):
INTERNATIONAL ASSET LIFE
MANAGEMENT AND AND HEALTH
ACCUMULATION SEGMENT SEGMENT CONSOLIDATED
-------------------- ---------- -------------
Goodwill............................... $321.2 $4.6 $325.8
Indefinite-lived intangibles........... 89.8 - 89.8
Income tax impact...................... (134.7) - (134.7)
-------------------- ---------- -------------
Total impairment, net of income taxes.. $276.3 $4.6 $280.9
==================== ========== =============
Net income and earnings per share (basic and diluted) for the three months and
six months ended June 30, 2002 and 2001, adjusted for the effects of SFAS 142
related to non-amortization of goodwill and indefinite-lived intangibles, are as
follows (in millions, except per share data):
FOR THE FOR THE
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------ ----------------
2002 2001(1) 2002 2001(1)
-------- -------- -------- -------
Reported net income.................... $120.2 $119.1 $85.3 $224.4
Adjustment for amortization expense:
Goodwill.............................. - 5.9 - 15.7
Brand name and management rights...... - 4.5 - 9.0
Assembled workforce................... - 0.9 - 1.9
-------- -------- -------- -------
Total amortization expense............. - 11.3 - 26.6
Tax impacts of amortization expense.... - (3.9) - (7.3)
-------- -------- -------- -------
Adjusted net income.................... $120.2 $126.5 $85.3 $243.7
======== ======== ======== =======
Basic earnings per share:
Reported net income.................... $ 0.34 $ 0.33 $ 0.24 $ 0.62
Adjustment for amortization expense:
Goodwill.............................. - 0.02 - 0.05
Brand name and management rights...... - 0.01 - 0.03
Assembled workforce................... - - - -
-------- -------- -------- -------
Total amortization expense............. - 0.03 - 0.08
Tax impacts of amortization expense.... - (0.01) - (0.02)
-------- -------- -------- -------
Adjusted net income.................... $ 0.34 $ 0.35 $ 0.24 $ 0.68
======== ======== ======== =======
9
PRINCIPAL FINANCIAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
JUNE 30, 2002
(UNAUDITED)
1. NATURE OF OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
FOR THE FOR THE
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------ ----------------
2002 2001(1) 2002 2001(1)
-------- -------- -------- -------
Diluted earnings per share:
Reported net income................... $ 0.34 $ 0.33 $ 0.24 $ 0.62
Adjustment for amortization expense:
Goodwill............................ - 0.02 - 0.05
Brand name and management rights.... - 0.01 - 0.03
Assembled workforce................. - - - -
-------- -------- -------- -------
Total amortization expense............ - 0.03 - 0.08
Tax impacts of amortization expense... - (0.01) - (0.02)
-------- -------- -------- -------
Adjusted net income................... $ 0.34 $ 0.35 $ 0.24 $ 0.68
======== ======== ======== =======
- ------------
(1) For purposes of the Company's unaudited basic and diluted pro-forma earnings
per share calculations, the weighted average number of shares outstanding during
the three months and six months ended June 30, 2001, was assumed to be 360.8
million shares. These shares represent 260.8 million shares issued to
policyholders entitled to receive compensation in the demutualization and 100.0
million shares sold to investors in the initial public offering ("IPO"),
effective October 26, 2001.
In August 2001, the FASB issued SFAS No. 144, ACCOUNTING FOR THE IMPAIRMENT OR
DISPOSAL OF LONG-LIVED ASSETS ("SFAS 144"). This Statement supersedes SFAS No.
121, ACCOUNTING FOR THE IMPAIRMENT OF LONG-LIVED ASSETS AND FOR LONG-LIVED
ASSETS TO BE DISPOSED OF, and amends APB Opinion No. 30, REPORTING THE RESULTS
OF OPERATIONS - REPORTING THE EFFECTS OF DISPOSAL OF A SEGMENT OF A BUSINESS,
AND EXTRAORDINARY, UNUSUAL AND INFREQUENTLY OCCURRING EVENTS AND TRANSACTIONS
("Opinion 30"), establishing a single accounting model for the disposal of
long-lived assets. SFAS 144 generally retains the basic provisions of existing
guidance, but broadens the presentation of any discontinued operations to
include a component of an entity (rather than a segment of a business as defined
in Opinion 30). The Company adopted SFAS 144 on January 1, 2002, which did not
have a significant impact on the Company's consolidated financial statements.
On January 1, 2001, the Company adopted SFAS No. 133, ACCOUNTING FOR DERIVATIVE
INSTRUMENTS AND HEDGING ACTIVITIES ("SFAS 133"), as amended by SFAS No. 138,
ACCOUNTING FOR CERTAIN DERIVATIVE INSTRUMENTS AND CERTAIN HEDGING ACTIVITIES -
AN AMENDMENT OF FASB STATEMENT NO. 133. As amended, SFAS 133 requires, among
other things, that all derivatives be recognized in the consolidated statement
of financial position as either assets or liabilities that are measured at fair
value. SFAS 133 also established special accounting for qualifying hedges, which
allows for matching the timing of gain or loss recognition on the hedging
instrument with the recognition of the corresponding changes in value of the
hedged item. Changes in the fair value of a derivative qualifying as a hedge are
recognized in earnings or directly in stockholders' equity depending on the
instrument's intended use. For derivatives that are not designated as hedges or
that do not meet the hedge accounting criteria in SFAS 133, changes in fair
value are required to be recognized in earnings in the period of change.
At January 1, 2001, the Company's consolidated financial statements were
adjusted to record a cumulative effect of adopting SFAS 133, as follows (in
millions):
ACCUMULATED OTHER
NET LOSS COMPREHENSIVE LOSS
---------- ------------------
Adjustment to fair value of derivative
contracts (1)............................ $(16.4) $(15.8)
Income tax impact........................ 5.7 1.6
---------- ------------------
Total ................................... $(10.7) $(14.2)
========== ==================
- ------------
(1)Amount presented is net of adjustment to hedged item.
10
PRINCIPAL FINANCIAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
JUNE 30, 2002
(UNAUDITED)
2. GOODWILL AND OTHER INTANGIBLE ASSETS
Amortized intangible assets are as follows (in millions):
AS OF JUNE 30, 2002 AS OF DECEMBER 31, 2001
------------------------------ ------------------------------
GROSS NET GROSS NET
CARRYING ACCUMULATED CARRYING CARRYING ACCUMULATED CARRYING
AMOUNT AMORTIZATION AMOUNT AMOUNT AMORTIZATION AMOUNT
-------- ------------ -------- -------- ------------ --------
Value of insurance in
force acquired.......... $77.6 $10.1 $67.5 $83.7 $10.2 $73.5
======== ============ ======== ======== ============ ========
Unamortized intangible assets are as follows (in millions):
AS OF JUNE 30, AS OF DECEMBER 31,
2002 2001
------------ -------------------
NET CARRYING NET CARRYING
AMOUNT AMOUNT
------------ -------------------
Brand name and management rights ...... $645.6 $679.0
Assembled work force .................. - 22.3
Other ................................. 11.6 14.3
------------ -------------------
Total unamortized intangible assets ... $657.2 $715.6
============ ===================
The amortization expense for the value of insurance in force acquired was $0.7
million and $1.6 million for the three months and six months ended June 30,
2002, respectively, and $1.0 million and $2.0 million for the three months and
six months ended June 30, 2001, respectively. At December 31, 2001, the
estimated amortization expense for the next five years is as follows (in
millions):
ESTIMATED
AMORTIZATION
EXPENSE
------------
2002............... $3.1
2003................ 2.9
2004................ 2.7
2005................ 2.5
2006................ 2.5
11
PRINCIPAL FINANCIAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
JUNE 30, 2002
(UNAUDITED)
2. GOODWILL AND OTHER INTANGIBLE ASSETS (CONTINUED)
The changes in the carrying amount of goodwill reported in the Company's
operating segments for the six months ended June 30, 2002, are as follows (in
millions):
INTERNATIONAL
U.S. ASSET ASSET
MANAGEMENT MANAGEMENT LIFE AND
AND AND HEALTH MORTGAGE CORPORATE AND
ACCUMULATION ACCUMULATION INSURANCE BANKING OTHER CONSOLIDATED
------------- ------------- --------- -------- ------------- ------------
Balance at January 1, 2002.. $16.1 $380.1 $49.4 $8.4 $(14.7) $ 439.3
Reclassification of
assembled workforce
intangible asset.......... 22.3 22.3
Goodwill from
acquisitions.............. - 21.6 - - - 21.6
Goodwill disposed of
during the period......... - - (0.7) - 14.7 14.0
Cumulative effect of
accounting change......... - (321.2) (4.6) - - (325.8)
Foreign currency
translation............... - (0.7) - - - (0.7)
--------------- ----------- --------- -------- ------------- ------------
Balance at June 30, 2002.... $16.1 $102.1 $44.1 $8.4 $ - $ 170.7
=============== =========== ========= ======== ============= ============
3. MERGERS, ACQUISITIONS, AND DIVESTITURES
On May 31, 2002, the Company purchased a 100% ownership of Zurich Afore S.A. de
C.V. ("Zurich Afore") from Zurich Financial Services for $49.0 million in cash.
The application of purchase accounting resulted in goodwill of approximately
$21.6 million. Zurich Afore contributed $23.9 million of assets and $0.3 million
of revenue to the consolidated statement of financial position and statement of
operations, respectively, as of June 30, 2002.
On February 1, 2002, the Company sold its remaining stake of 15.1 million shares
in Coventry Health Care, Inc. ("Coventry") common stock and a warrant,
exercisable for 3.1 million shares of Coventry common stock. Total proceeds from
the completion of this transaction were $325.4 million and the Company
recognized a net realized capital gain of $183.0 million.
4. CLOSED BLOCK
In connection with its 1998 mutual insurance holding company formation,
Principal Life Insurance Company ("Principal Life") formed and began operating a
closed block ("Closed Block") for the benefit of individual participating
dividend-paying policies in force on that date. As of June 30, 2002, cumulative
actual earnings, including consideration of net unrealized gains, have been less
than cumulative expected earnings. Therefore, no policyholder dividend
obligation has been recognized.
12
PRINCIPAL FINANCIAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
JUNE 30, 2002
(UNAUDITED)
4. CLOSED BLOCK (CONTINUED)
Closed Block liabilities and assets designated to the Closed Block are as
follows:
AS OF AS OF
JUNE 30, DECEMBER 31
2002 2001
---------- -----------
(IN MILLIONS)
CLOSED BLOCK LIABILITIES
Future policy benefits and claims.................. $5,270.0 $5,248.7
Other policyholder funds........................... 26.4 20.3
Policyholder dividends payable..................... 383.2 376.6
Other liabilities.................................. 86.8 11.8
--------- ---------
Total Closed Block liabilities................... 5,766.4 5,657.4
ASSETS DESIGNATED TO THE CLOSED BLOCK
Fixed maturities, available-for-sale............... 2,537.8 2,466.3
Equity securities, available-for-sale.............. 23.6 23.4
Mortgage loans..................................... 893.8 880.0
Policy loans....................................... 781.2 792.5
Other investments.................................. 8.3 6.9
--------- ---------
Total investments................................ 4,244.7 4,169.1
Cash and cash equivalents (deficit)................ 12.0 (8.0)
Accrued investment income.......................... 77.2 77.2
Deferred tax asset................................. 90.6 80.8
Premiums due and other receivables................. 73.2 33.3
--------- ---------
Total assets designated to the Closed Block...... 4,497.7 4,352.4
--------- ---------
Excess of Closed Block liabilities over assets
designated to the Closed Block................... 1,268.7 1,305.0
Amounts included in other comprehensive
income........................................ 55.8 43.6
--------- ---------
Maximum future earnings to be recognized from
Closed Block assets and liabilities........... $1,324.5 $1,348.6
========= =========
13
PRINCIPAL FINANCIAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
JUNE 30, 2002
(UNAUDITED)
4. CLOSED BLOCK (CONTINUED)
Closed Block revenues and expenses were as follows:
FOR THE FOR THE
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------ ------------------
2002 2001 2002 2001
--------- -------- --------- --------
(IN MILLIONS)
REVENUES
Premiums and other considerations...... $ 181.0 $ 188.9 $ 359.8 $ 376.1
Net investment income.................. 76.8 74.9 156.2 151.8
Net realized capital losses............ (15.3) (2.5) (22.0) (1.8)
--------- -------- --------- --------
Total revenues....................... 242.5 261.3 494.0 526.1
EXPENSES
Benefits, claims, and settlement
expenses............................. 146.3 147.4 291.3 305.1
Dividends to policyholders............. 77.5 80.2 155.2 158.2
Operating expenses..................... 3.2 3.1 6.2 6.2
--------- -------- --------- --------
Total expenses....................... 227.0 230.7 452.7 469.5
--------- -------- --------- --------
Closed Block revenue, net of Closed
Block expenses, before income taxes.. 15.5 30.6 41.3 56.6
Income taxes........................... 4.8 10.0 13.3 18.5
--------- -------- --------- --------
Closed Block revenue, net of Closed
Block expenses and income taxes...... 10.7 20.6 28.0 38.1
Funding adjustment charges............. (2.4) (1.5) (3.9) (3.3)
--------- -------- --------- --------
Closed Block revenue, net of Closed
Block expenses, income taxes
and funding adjustment charges....... $ 8.3 $ 19.1 $ 24.1 $ 34.8
========= ======== ========= ========
The change in maximum future earnings of the Closed Block was as follows:
AS OF OR FOR THE
SIX MONTHS ENDED JUNE 30,
---------------------------------------
2002 2001
--------------- ---------------
(IN MILLIONS)
Beginning of year.................... $ 1,348.6 $1,408.8
End of period........................ 1,324.5 1,374.0
-------------- ---------------
Change in maximum future earnings.... $ (24.1) $ (34.8)
============== ===============
Principal Life charges the Closed Block with federal income taxes, payroll
taxes, state and local premium taxes and other state or local taxes, licenses
and fees as provided in the plan of reorganization.
14
PRINCIPAL FINANCIAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
JUNE 30, 2002
(UNAUDITED)
5. FEDERAL INCOME TAXES
The effective income tax rate on net income for the three months and six months
ended June 30, 2002 and 2001, is lower than the prevailing corporate federal
income tax rate primarily due to income tax deductions allowed for corporate
dividends received.
6. COMPREHENSIVE INCOME
Comprehensive income is as follows:
FOR THE THREE FOR THE SIX
MONTHS ENDED MONTHS ENDED
JUNE 30, JUNE 30,
--------------------- ---------------------
2002 2001 2002 2001
---------- ---------- ---------- ----------
(IN MILLIONS)
COMPREHENSIVE INCOME:
Net income............................................. $ 120.2 $ 119.1 $ 85.3 $ 224.4
Net change in unrealized gains and losses on fixed
maturities, available-for-sale....................... 406.5 (205.7) 46.9 181.4
Net change in unrealized gains and losses on equity
securities, available-for-sale, including seed
money in separate accounts........................... (15.0) 88.0 4.4 74.7
Adjustments for assumed changes in amortization
patterns:
Deferred policy acquisition costs.................... (66.6) 40.3 (25.1) (26.8)
Unearned revenue reserves............................ 3.4 (4.6) 0.6 0.6
Net change in unrealized gains and losses on
derivative instruments............................... (26.6) 8.1 (14.0) (2.5)
Provision for deferred income taxes (benefits)......... (105.4) 22.6 (3.1) (85.6)
Change in net foreign currency translation adjustment.. (5.7) 19.8 5.8 (76.1)
Cumulative effect of accounting change, net of related
income taxes......................................... - - - (14.2)
---------- ---------- ---------- -----------
Comprehensive income................................... $ 310.8 $ 87.6 $ 100.8 $ 275.9
========== ========== ========== ===========
7. COMMITMENTS AND CONTINGENCIES
LITIGATION
The Company is a plaintiff or defendant in actions arising out of its
operations. The Company is, from time to time, also involved in various
governmental and administrative proceedings. While the outcome of any pending or
future litigation cannot be predicted, management does not believe that any
pending litigation will have a material adverse effect on the Company's
business, financial condition or results of operations. However, no assurances
can be given that such litigation would not materially and adversely affect the
Company's business, financial condition or results of operations.
Other companies in the life insurance industry have historically been subject to
substantial litigation resulting from claims disputes and other matters. Most
recently, such companies have faced extensive claims, including class-action
lawsuits, alleging improper life insurance sales practices. Principal Life is
currently a defendant in two class-action lawsuits which allege improper sales
practices.
15
PRINCIPAL FINANCIAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
JUNE 30, 2002
(UNAUDITED)
7. COMMITMENTS AND CONTINGENCIES (CONTINUED)
In 2000, the Company reached an agreement in principle to settle these two
class-action lawsuits alleging improper sales practices. In April 2001, the
proposed settlement of the class-action lawsuits received court approval. In
agreeing to the settlement, the Company specifically denied any wrongdoing. The
Company has accrued a loss reserve for its best estimate based on information
available. As uncertainties continue to exist in resolving this matter, it is
reasonably possible that, as the actual cost of the claims subject to
alternative dispute resolution becomes available, the final cost of settlement
could exceed the Company's estimate. The range of any additional cost related to
the settlement cannot be presently estimated; however, the Company believes the
settlement will not have a material impact on its business, financial condition
or results of operations. A number of persons and entities who were eligible to
be class members have excluded themselves from the class (or "opted out"), as
the law permits them to do. The Company has been notified that some of those who
opted out from the class will file lawsuits and make claims similar to those
addressed by the settlement. Some of these lawsuits are presently on file.
8. SEGMENT INFORMATION
The Company provides financial products and services through the following
segments: U.S. Asset Management and Accumulation, International Asset Management
and Accumulation, Life and Health Insurance and Mortgage Banking. In addition,
there is a Corporate and Other segment. The segments are managed and reported
separately because they provide different products and services, have different
strategies or have different markets and distribution channels.
The U.S. Asset Management and Accumulation segment provides retirement and
related financial products and services primarily to businesses, their employees
and other individuals and provides asset management services to the Company's
asset accumulation business, the life and health insurance operations and
third-party clients.
The International Asset Management and Accumulation segment provides asset
management products and services to retail clients in Australia and
institutional clients throughout the world and provides life insurance and
retirement and related financial products and services primarily to businesses,
their employees and other individuals principally in Australia, Chile, Brazil,
New Zealand, Mexico, India, Japan, Argentina and Hong Kong.
The Life and Health insurance segment provides individual life and disability
insurance to the owners and employees of businesses and other individuals in the
U.S. and provides group life and health insurance to businesses in the U.S.
The Mortgage Banking segment originates and services residential mortgage loan
products for customers primarily in the U.S.
The Corporate and Other segment manages the assets representing capital that has
not been allocated to any other segment. Financial results of the Corporate and
Other segment primarily reflect financing activities for the Company, income on
capital not allocated to other segments, intersegment eliminations and
non-recurring or other income or expenses not allocated to the segments based on
review of the nature of such items.
The Corporate and Other segment includes an equity ownership interest in
Coventry. The ownership interest was sold on February 1, 2002, described further
in Note 3. The Corporate and Other segment's equity in earnings of Coventry,
which was included in net investment income, was $2.1 million for the six months
ended June 30, 2002, and $4.8 million and $9.7 million for the three months and
six months ended June 30, 2001, respectively.
16
PRINCIPAL FINANCIAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
JUNE 30, 2002
(UNAUDITED)
8. SEGMENT INFORMATION (CONTINUED)
The Company evaluates segment performance on segment operating earnings, which
is determined by adjusting U.S. GAAP net income for net realized capital gains
and losses, as adjusted, and non-recurring items which management believes are
not indicative of overall operating trends. Net realized capital gains and
losses, as adjusted, are net of tax, related changes in the amortization pattern
of deferred policy acquisition costs, recognition of front-end fee revenues for
sales charges on pension products and services, net realized capital gains
credited to customers and certain market value adjustments to fee revenues.
Segment operating revenues exclude net realized capital gains and their impact
on recognition of front-end fee revenues. While these items may be significant
components in understanding and assessing the consolidated financial
performance, management believes the presentation of segment operating earnings
enhances the understanding of the Company's results of operations by
highlighting earnings attributable to the normal, recurring operations of the
business. However, segment operating earnings are not a substitute for net
income determined in accordance with U.S. GAAP.
For the three months ended June 30, 2002, the Company did not exclude any
non-recurring items from net income for its presentation of operating earnings.
For the three months ended June 30, 2001, the Company excluded $10.9 million of
non-recurring items, net of income taxes, related to the negative effects of
expenses related to the demutualization.
For the six months ended June 30, 2002, the Company excluded $282.9 million of
non-recurring items, net of income taxes, including the negative effects of: (1)
a cumulative effect of accounting change related to the implementation of SFAS
142 ($280.9 million); and (2) expenses related to the demutualization ($2.0
million).
For the six months ended June 30, 2001, the Company excluded $31.4 million of
non-recurring items, net of income taxes, including the negative effects of: (1)
expenses related to the demutualization ($14.8 million); (2) a cumulative effect
of change in accounting principle related to the implementation of SFAS 133
($10.7 million); and (3) an increase to a loss contingency reserve established
for sales practices litigation ($5.9 million).
The accounting policies of the segments are similar to those of the Company,
with the exception of capital allocation. The Company allocates capital to its
segments based upon an internal capital model that allows management to more
effectively manage the Company's capital.
17
PRINCIPAL FINANCIAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
JUNE 30, 2002
(UNAUDITED)
8. SEGMENT INFORMATION (CONTINUED)
The following tables summarize selected financial information by segment as of
or for the three months ended, June 30, 2002 and 2001, and reconciles segment
totals to those reported in the consolidated financial statements (in millions):
INTERNATIONAL
U.S. ASSET ASSET
MANAGEMENT MANAGEMENT LIFE AND
AND AND HEALTH MORTGAGE CORPORATE AND
ACCUMULATION ACCUMULATION INSURANCE BANKING OTHER CONSOLIDATED
------------- ------------- --------- -------- ------------- ------------
2002
Revenues:
Operating revenues...... $ 1,135.7 $ 138.1 $ 984.5 $ 209.7 $ 6.7 $ 2,474.7
Net realized capital
gains (losses)........ (89.7) 29.3 (33.6) - 2.5 (91.5)
Plus recognition of
front-end fee
revenues.............. 1.4 - - - - 1.4
Less capital gains
distributed as
market value
adjustment............ (4.6) - - - - (4.6)
------------- ------------- --------- -------- ------------- ------------
Revenues.................. $ 1,042.8 $ 167.4 $ 950.9 $ 209.7 $ 9.2 $ 2,380.0
============= ============= ========= ======== ============= ============
Net income:
Operating earnings
(loss).................. $ 102.1 $ 7.6 $ 61.7 $ 24.8 $ (6.0) $ 190.2
Net realized capital
gains (losses), as
adjusted................ (60.4) 5.6 (20.8) - 5.6 (70.0)
------------- ------------- --------- -------- ------------- ------------
Net income (loss)........ $ 41.7 $ 13.2 $ 40.9 $ 24.8 $ (0.4) $ 120.2
============= ============= ========= ======== ============= ============
Assets................... $ 69,752.1 $4,794.6 $11,132.5 $2,965.3 $1,548.9 $90,193.4
============= ============= ========= ======== ============= ============
Other segment data:
Revenues from external
customers............ $ 1,029.4 $ 167.0 $ 952.5 $ 209.7 $ 21.4 $ 2,380.0
Intersegment revenues.. 13.4 0.4 (1.6) - (12.2) -
Interest expense....... 0.8 0.1 - - 22.4 23.3
Income tax expense
(benefit)............ (3.9) 7.0 21.7 14.8 (5.8) 33.8
Amortization of
intangibles.......... 0.1 0.7 - - - 0.8
18
PRINCIPAL FINANCIAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
JUNE 30, 2002
(UNAUDITED)
8. SEGMENT INFORMATION (CONTINUED)
INTERNATIONAL
U.S. ASSET ASSET
MANAGEMENT MANAGEMENT LIFE AND
AND AND HEALTH MORTGAGE CORPORATE AND
ACCUMULATION ACCUMULATION INSURANCE BANKING OTHER CONSOLIDATED
------------- ------------- --------- -------- ------------- ------------
2001
Revenues:
Operating revenues..... $ 842.5 $ 165.7 $ 975.8 $ 173.5 $ 22.5 $ 2,180.0
Net realized capital
losses............... (53.5) (1.0) (7.8) - (33.7) (96.0)
Plus recognition of
front-end fee
revenues............. 0.7 - - - - 0.7
------------- ------------- --------- -------- ------------- ------------
Revenues................. $ 789.7 $ 164.7 $ 968.0 $ 173.5 $ (11.2) $ 2,084.7
============= ============= ========= ======== ============= ============
Net income:
Operating earnings..... $ 88.1 $ 0.6 $ 48.4 $ 44.9 $ 8.3 $ 190.3
Net realized capital
losses, as adjusted.. (33.4) (0.9) (4.1) - (21.9) (60.3)
Non-recurring items.... - - - - (10.9) (10.9)
------------- ------------- --------- -------- ------------- ------------
Net income (loss)........ $ 54.7 $ (0.3) $ 44.3 $ 44.9 $ (24.5) $ 119.1
============= ============= ========= ======== ============= ============
Assets................... $ 66,182.4 $ 4,919.6 $10,637.2 $2,168.9 $1,321.6 $ 85,229.7
============= ============= ========= ======== ============= ============
Other segment data:
Revenues from external
customers............ $ 777.8 $ 164.4 $ 969.0 $ 175.3 $ (1.8) $ 2,084.7
Intersegment revenues.. 11.9 0.3 (1.0) (1.8) (9.4) -
Interest expense....... 0.8 0.1 (0.1) - 19.0 19.8
Income tax expense
(benefit)............ 0.4 (1.0) 22.3 24.2 (14.2) 31.7
Amortization of
goodwill and other
intangibles.......... 0.3 10.9 1.1 0.2 (0.3) 12.2
19
PRINCIPAL FINANCIAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
JUNE 30, 2002
(UNAUDITED)
8. SEGMENT INFORMATION (CONTINUED)
The following tables summarize selected financial information by segment as of
or for the six months ended, June 30, 2002 and 2001, and reconciles segment
totals to those reported in the consolidated financial statements (in millions):
INTERNATIONAL
U.S. ASSET ASSET
MANAGEMENT MANAGEMENT LIFE AND
AND AND HEALTH MORTGAGE CORPORATE AND
ACCUMULATION ACCUMULATION INSURANCE BANKING OTHER CONSOLIDATED
------------- ------------- --------- -------- ------------- ------------
2002
Revenues:
Operating revenues........ $ 1,997.8 $ 259.2 $ 1,963.0 $ 418.4 $ 17.2 $ 4,655.6
Net realized capital
gains (losses).......... (162.9) 36.6 (50.4) - 183.3 6.6
Plus recognition of
front-end fee revenues.. 4.0 - - - - 4.0
Less capital gains
distributed as market
value adjustment........ (13.2) - - - - (13.2)
------------- ------------- --------- -------- ------------- ------------
Revenues.................... $ 1,825.7 $ 295.8 $ 1,912.6 $ 418.4 $ 200.5 $ 4,653.0
============= ============= ========= ======== ============= ============
Net income:
Operating earnings
(loss).................. $ 202.3 $ 12.8 $ 116.0 $ 51.3 $ (5.7) $ 376.7
Net realized capital
gains (losses), as
adjusted................ (105.2) 9.4 (31.3) - 118.6 (8.5)
Non-recurring items....... - (276.3) (4.6) - (2.0) (282.9)
------------- ------------- --------- -------- ------------- ------------
Net income (loss)........... $ 97.1 $ (254.1) $ 80.1 $ 51.3 $ 110.9 $ 85.3
============= ============= ========= ======== ============= ============
Assets...................... $ 69,752.1 $4,794.6 $11,132.5 $2,965.3 $1,548.9 $ 90,193.4
============= ============= ========= ======== ============= ============
Other segment data:
Revenues from external
customers............... $ 1,797.8 $ 295.0 $ 1,915.7 $ 418.4 $ 226.1 $ 4,653.0
Intersegment revenues..... 27.9 0.8 (3.1) - (25.6) -
Interest expense.......... 2.1 0.3 0.2 - 43.2 45.8
Income tax expense
(benefit)............... (1.2) 12.3 44.3 30.4 58.6 144.4
Amortization of
intangibles............. 0.1 1.6 - - - 1.7
20
PRINCIPAL FINANCIAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
JUNE 30, 2002
(UNAUDITED)
8. SEGMENT INFORMATION (CONTINUED)
INTERNATIONAL
U.S. ASSET ASSET
MANAGEMENT MANAGEMENT LIFE AND
AND AND HEALTH MORTGAGE CORPORATE AND
ACCUMULATION ACCUMULATION INSURANCE BANKING OTHER CONSOLIDATED
------------- ------------- --------- -------- ------------- ------------
2001
Revenues:
Operating revenues....... $ 1,858.2 $ 310.1 $ 1,978.2 $ 293.1 $ 57.5 $ 4,497.1
Net realized capital
losses................. (65.4) (38.7) (9.1) - (63.7) (176.9)
Plus recognition of
front-end fee
revenues............... 0.5 - - - - 0.5
------------- ------------- --------- -------- ------------- ------------
Revenues................. $ 1,793.3 $ 271.4 $ 1,969.1 $ 293.1 $ (6.2) $ 4,320.7
============= ============= ========= ======== ============= ============
Net income:
Operating earnings
(loss)................. $ 176.9 $ (4.7) $ 90.9 $ 68.8 $ 32.1 $ 364.0
Net realized capital
losses, as adjusted.... (40.8) (21.2) (4.7) - (41.5) (108.2)
Non-recurring items...... (10.8) - 0.1 - (20.7) (31.4)
------------- ------------- --------- -------- ------------- ------------
Net income (loss)........ $ 125.3 $ (25.9) $ 86.3 $ 68.8 $ (30.1) $ 224.4
============= ============= ========= ======== ============= ============
Assets................... $ 66,182.4 $ 4,919.6 $10,637.2 $2,168.9 $ 1,321.6 $ 85,229.7
============= ============= ========= ======== ============= ============
Other segment data:
Revenues from external
customers............ $ 1,767.2 $ 270.8 $ 1,970.8 $ 293.1 $ 18.8 $ 4,320.7
Intersegment revenues.. 26.1 0.6 (1.7) - (25.0) -
Interest expense....... 2.1 0.1 2.2 - 36.1 40.5
Income tax expense
(benefit)............ 16.8 (19.8) 43.5 37.0 (21.4) 56.1
Amortization of
goodwill and other
intangibles.......... 0.5 26.2 2.0 0.4 (0.5) 28.6
The Company operates in the U.S. and in selected markets internationally
(including Australia, Chile, Brazil, New Zealand, Mexico, India, Japan,
Argentina and Hong Kong). The following table summarizes selected financial
information by geographic location as of or for the three months and six months
ended June 30, 2002 and 2001 (in millions):
FOR THE THREE MONTHS FOR THE SIX MONTHS
AS OF JUNE 30, ENDED JUNE 30, ENDED JUNE 30,
------------------------ -------------------- -------------------
NET NET
LONG-LIVED INCOME INCOME
ASSETS ASSETS REVENUES (LOSS) REVENUES (LOSS)
---------- ------------ ---------- -------- ---------- --------
2002
United States..... $ 561.1 $85,398.8 $ 2,212.6 $107.0 $4,357.2 $339.4
International..... 849.2 4,794.6 167.4 13.2 295.8 (254.1)
---------- ------------ ---------- -------- ---------- --------
Total............. $ 1,410.3 $90,193.4 $ 2,380.0 $120.2 $4,653.0 $ 85.3
========== ============ ========== ======== ========== ========
2001
United States..... $ 547.9 $80,310.1 $ 1,920.0 $119.4 $4,049.3 $250.3
International..... 1,218.4 4,919.6 164.7 (0.3) 271.4 (25.9)
---------- ------------ ---------- -------- ---------- --------
Total............. $ 1,766.3 $85,229.7 $ 2,084.7 $119.1 $4,320.7 $224.4
========== ============ ========== ======== ========== ========
Long-lived assets include property and equipment, goodwill and other
intangibles.
21
PRINCIPAL FINANCIAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
JUNE 30, 2002
(UNAUDITED)
8. SEGMENT INFORMATION (CONTINUED)
The Company's operations are not materially dependent on one or a few customers,
brokers or agents, and revenues, assets and operating earnings are attributed to
geographic location based on the country of domicile the sales originate from.
9. STOCKHOLDERS' EQUITY
COMMON STOCK
On February 26, 2002, the Company's board of directors authorized the repurchase
of up to $450.0 million of the Company's common stock. The repurchases will be
made in the open market or through privately negotiated transactions from time
to time, depending on market conditions. As part of the repurchase program, the
Company sold "put options" for a premium of $3.6 million, which obligated the
Company to repurchase a total of 3.0 million shares at an aggregate cost of
$76.9 million three months after the issuance of the contracts, if the fixed
price was higher than the market price. The fixed price was lower than the
market price on those dates, therefore the options expired in June 2002 and the
Company was no longer obligated to repurchase its common stock. The proceeds
from the put transactions were reported as additional paid-in capital. During
the six months ended June 30, 2002, the Company purchased 9.7 million shares in
the open market at an aggregate cost of $273.4 million.
In February 2002, the Company reissued treasury stock held in the rabbi trust,
which generated proceeds of $8.0 million, with a cost of $6.7 million.
10. EARNINGS PER SHARE
After the Company's IPO, effective October 26, 2001, SFAS No. 128, EARNINGS PER
SHARE, was adopted, which requires disclosure of basic and diluted earnings per
share.
Reconciliations of weighted-average shares outstanding and income before
cumulative effect of accounting change for basic and diluted earnings per share
for the three months and six months ended June 30, 2002, are presented below (in
millions, except per share data):
FOR THE THREE MONTHS ENDED FOR THE SIX MONTHS ENDED
JUNE 30, 2002 JUNE 30, 2002
-------------------------- ---------------------------
WEIGHTED WEIGHTED
AVERAGE PER SHARE AVERAGE PER SHARE
INCOME SHARES AMOUNT INCOME SHARES AMOUNT
------ -------- --------- ------ -------- ---------
Basic earnings per share:
Income before cumulative
effect of accounting
change................ $120.2 356.8 $0.34 $366.2 358.6 $1.02
Dilutive effects:
Stock options........... - 0.5 - - 0.4 -
Restricted stock
units(1).............. - - - - - -
------ -------- --------- ------ -------- ---------
Diluted earnings
per share................. $120.2 357.3 $0.34 $366.2 359.0 $1.02
====== ======== ========= ====== ======== =========
- ------------
(1) The dilutive effect of the restricted stock units did not meet specified
reporting thresholds.
The calculation of diluted earnings per share for the three months ended June
30, 2002, excludes the incremental effect related to certain outstanding stock
options and certain restricted stock units. The exercise price and fair market
value of these stock options and stock units, respectively, were in excess of
the average market price of the Company's stock during the period, resulting in
an anti-dilutive effect.
The calculation of diluted earnings per share for the six months ended June 30,
2002, excludes the incremental effect related to certain outstanding stock
options and restricted stock units. The exercise price and fair market value of
these stock options and stock units, respectively, were in excess of the average
market price of the Company's stock during the period, resulting in an
anti-dilutive effect.
22
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The following analysis discusses our financial condition as of June 30, 2002,
compared with December 31, 2001, and our consolidated results of operations for
the three months and six months ended June 30, 2002 and 2001, prepared in
conformity with accounting principles generally accepted in the U.S. ("U.S.
GAAP"). The discussion and analysis includes, where appropriate, factors that
may affect our future financial performance. The discussion should be read in
conjunction with our Form 10-K, for the year ended December 31, 2001, filed with
the United States Securities and Exchange Commission, the unaudited consolidated
financial statements and the related notes to the financial statements and the
other financial information included elsewhere in this Form 10-Q.
FORWARD-LOOKING INFORMATION
Our narrative analysis below contains forward-looking statements intended to
enhance the reader's ability to assess our future financial performance.
Forward-looking statements include, but are not limited to, statements that
represent our beliefs concerning future operations, strategies, financial
results or other developments, and contain words and phrases such as
"anticipate," "believe," "plan," "estimate," "expect," "intend," and similar
expressions. Forward-looking statements are made based upon management's current
expectations and beliefs concerning future developments and their potential
effects. Such forward-looking statements are not guarantees of future
performance.
Actual results may differ materially from those included in the forward-looking
statements as a result of risks and uncertainties including, but not limited to
the following: (1) a decline or increased volatility in the securities markets
could result in investors withdrawing from the markets or decreasing their rates
of investment, either of which could reduce our net income, revenues and assets
under management; (2) our investment portfolio is subject to several risks which
may diminish the value of our invested assets and affect our sales,
profitability and the investment returns credited to our customers; (3) a
decline in Australian equity values may reduce the profitability of BT Financial
Group; (4) fluctuations in foreign currency exchange rates could reduce our
profitability; (5) competition from companies that may have greater financial
resources, broader arrays of products, higher ratings and stronger financial
performance may impair our ability to retain existing customers, attract new
customers and maintain our profitability; (6) a downgrade in Principal Life
Insurance Company's ("Principal Life") financial strength ratings may increase
policy surrenders and withdrawals, reduce new sales and terminate relationships
with distributors and cause some of our existing liabilities to be subject to
acceleration, additional collateral support, changes in terms, or creation of
additional financial obligations; (7) our efforts to reduce the impact of
interest rate changes on our profitability and surplus may not be effective; (8)
if we are unable to attract and retain sales representatives and develop new
distribution sources, sales of our products and services may be reduced; (9) our
international businesses face political, legal, operational and other risks that
could reduce our profitability in those businesses; (10) our reserves
established for future policy benefits and claims may prove inadequate,
requiring us to increase liabilities; (11) our ability to pay stockholder
dividends and meet our obligations may be constrained by the limitations on
dividends Iowa insurance laws impose on Principal Life; (12) we may need to fund
deficiencies in our closed block ("Closed Block") assets allocated to the Closed
Block which benefit only the holders of Closed Block policies; (13) changes in
regulations or accounting standards may reduce our profitability; (14)
litigation and regulatory investigations may harm our financial strength and
reduce our profitability; (15) a challenge to the Insurance Commissioner of the
State of Iowa's approval of the plan of conversion could put the terms of our
demutualization in question and reduce the market price of our common stock;
(16) applicable laws and our stockholder rights plan, certificate of
incorporation and by-laws may discourage takeovers and business combinations
that our stockholders might consider in their best interests; and (17) a
downgrade in our debt ratings may adversely affect our ability to secure funds
and cause some of our existing liabilities to be subject to acceleration,
additional collateral support, changes in terms, or creation of additional
financial obligations.
OVERVIEW
We are a leading provider of retirement savings, investment and insurance
products and services. We have four operating segments:
o U.S. Asset Management and Accumulation, which consists of our asset
accumulation operations providing retirement savings and related investment
products and services, and our asset management operations which are
conducted through Principal Capital Management, our U.S.-based asset
manager. We provide a comprehensive portfolio of asset accumulation
products and services to businesses and individuals in the U.S., with a
concentration on small and medium-sized businesses, which we define as
businesses with fewer than 1,000 employees. We offer to businesses products
23
and services for defined contribution pension plans, including 401(k) and
403(b) plans, defined benefit pension plans and non-qualified executive
benefit plans. We also offer annuities, mutual funds and bank products and
services to the employees of our business customers and other individuals.
o International Asset Management and Accumulation, which consists of BT
Financial Group, our Australia-based asset manager, and Principal
International, which offers retirement products and services, annuities,
mutual funds and life insurance through subsidiaries in Argentina, Chile,
Mexico and Hong Kong and joint ventures in Brazil, Japan and India.
o Life and Health Insurance, which provides individual life and disability
insurance as well as group life and health insurance throughout the U.S.
Our individual insurance products include interest-sensitive life,
traditional life and disability insurance. Our group insurance products
include life, disability, medical, dental and vision insurance, and
administrative services.
o Mortgage Banking, which engages in originating, purchasing, selling and
servicing residential mortgage loans in the U.S.
We also have a Corporate and Other segment, which consists of the assets and
activities that have not been allocated to any other segment.
RECENT EVENTS AND TRENDS
DECLINES IN THE U.S. AND AUSTRALIAN EQUITY MARKETS
Declines in the equity markets in the U.S. and Australia during the six months
ended June 30, 2002 have reduced our assets under management. Our assets under
management at June 30, 2002 were $119.6 billion, compared to $120.2 billion at
December 31, 2001. Continued declines could further reduce the amount of
asset-based fee revenue in our International Asset Management and Accumulation
segment and could reduce the amount of asset-based fee revenue in our U.S. Asset
Management and Accumulation segment. In addition to market declines, during the
six months ended June 30, 2002, BT Financial Group has experienced net cash
outflows from assets under management. We expect that BT Financial Group will
continue to experience negative fund flows through year-end and into early 2003.
These declines could lead to additional impairments of goodwill and other
indefinite-lived intangibles when we test for impairment during our annual
impairment testing procedures during the fourth quarter of 2002.
DECLINES IN THE VALUES OF OUR U.S. FIXED MATURITY INVESTMENTS
During the three months ended June 30, 2002, our investments in fixed maturity
securities were negatively impacted by credit problems of certain investments.
Accordingly, we recognized other than temporary impairments of $126.9 million,
before taxes. The largest impairment related to our holdings in WorldCom Inc.
for which we recognized an other than temporary impairment of $46.4 million
before taxes, and an additional $18.0 million, before taxes, related to the
sales of WorldCom, Inc., investments. The credit market continues to be
volatile.
USE OF REINSURANCE
We have entered into reinsurance contracts to reduce volatility in our Life and
Health insurance segment. Future reinsurance agreements are possible.
INTEREST RATE DECLINES
During the six months ended June 30, 2002, interest rates have remained
relatively low. Low interest rates impact our Mortgage Banking segment by
reducing the value of our mortgage loan servicing rights but can lead to higher
mortgage loan production. Interest rate declines also have a negative impact on
the investment yields of our fixed income securities.
TRANSACTIONS AFFECTING COMPARABILITY OF RESULTS OF OPERATIONS
ACQUISITIONS
We acquired the following businesses, among others, during 2002 and 2001:
24
ZURICH AFORE S.A. DE C.V. On May 31, 2002, we purchased a 100% ownership of
Zurich Afore S.A. de C.V. ("Zurich Afore") from Zurich Financial Services for
$49.0 million in cash. The application of purchase accounting resulted in
goodwill of approximately $21.6 million. Zurich Afore contributed $23.9 million
of assets and $0.3 million of revenue to the consolidated statement of financial
position and the statement of operations respectively as of June 30, 2002.
Zurich Afore is merged with our Mexican pension company and is reported in our
International Asset Management and Accumulation segment.
SPECTRUM ASSET MANAGEMENT. On October 1, 2001, Spectrum Asset Management became
an affiliate of Principal Capital Management, LLC. The acquisition was accounted
for using the purchase method and the results of operations of the acquired
business have been included in our financial statements from the date of
acquisition. We included revenues of $1.1 million and $1.9 million for the three
months and six months ended June 30, 2002, respectively, in our consolidated
results of operations.
DISPOSITIONS
We entered into dispositions or disposed of the following businesses, among
others, during 2002 and 2001:
COVENTRY HEALTH CARE. On February 1, 2002, we sold our remaining stake of 15.1
million shares of Coventry Health Care, Inc. ("Coventry") common stock and a
warrant, exercisable for 3.1 million shares of Coventry common stock. We
received proceeds of $325.4 million, resulting in a net realized capital gain of
$183.0 million, or $114.5 million net of income taxes.
We reported our investment in Coventry in our Corporate and Other segment and
accounted for it using the equity method prior to its sale. Our share of
Coventry's net income was $2.1 million for the six months ended June 30, 2002
and $4.8 million and $9.7 million for the three months and six months ended June
30, 2001, respectively.
PT ASURANSI JIWA PRINCIPAL INDONESIA. On September 25, 2001, we disposed of all
the stock of PT Asuransi Jiwa Principal Indonesia, our subsidiary in Indonesia.
We currently have no business operations in Indonesia. We received nominal
proceeds, which resulted in a realized capital loss of $6.7 million. We included
nominal revenues and net loss from our operations in Indonesia in our
consolidated results of operations for the three months and six months ended
June 30, 2001.
PRINCIPAL INTERNATIONAL ESPANA, S.A. DE SEGUROS DE VIDA. On February 15, 2001,
we disposed of all of the stock of Principal International Espana, S.A. de
Seguros de Vida, our subsidiary in Spain, for nominal proceeds, resulting in a
realized capital loss of $38.4 million, or $21.0 million net of income taxes,
ceasing our business operations in Spain.
We did not include revenues or net income from our operations in Spain in our
consolidated results of operations for the three months and six months ended
June 30, 2002 and 2001.
OTHER TRANSACTIONS
KEYCORP. On June 12, 2002, we announced we had entered into an agreement with
KeyCorp (through affiliates Victory Capital Management and KeyBank National
Association ) to offer transition of servicing of KeyCorp's 1,400 employer
defined contribution clients with up to $8.0 billion in assets under management.
Effective immediately, KeyCorp transitioned out of the bundled defined
contribution business and will recommend our servicing to its full-service
defined contribution clients nationwide.
REINSURANCE TRANSACTIONS. Effective January 1, 2002, we entered into a
reinsurance agreement to reinsure group medical insurance contracts, which
should result in reduced volatility of our group medical insurance earnings. The
reinsurance agreement resulted in $11.3 million and $22.5 million of ceded
premiums for the three months and six months ended June 30, 2002, respectively.
In addition, the reinsurance agreement resulted in $8.9 million and $18.5
million of ceded claims for the three months and six months ended June 30, 2002,
respectively.
FLUCTUATIONS IN FOREIGN CURRENCY TO U.S. DOLLAR EXCHANGE RATES
Fluctuations in foreign currency to U.S. dollar exchange rates for countries in
which we have operations can affect reported financial results. In years when
foreign currencies weaken against the U.S. dollar, translating foreign
25
currencies into U.S. dollars results in fewer U.S. dollars to be reported. When
foreign currencies strengthen, translating foreign currencies into U.S. dollars
results in more U.S. dollars to be reported.
In January 2002, the Argentine government ended its tie of the Argentine peso to
the U.S. dollar, creating a dual currency system with an official fixed exchange
rate of 1.4 pesos to 1.0 U.S. dollar for import and export transactions and
free-floating exchange rate for other transactions, subsequently floating the
Argentine peso in February. The devaluation did not materially impact our
consolidated results of operations.
Foreign currency exchange rate fluctuations create variances in our financial
statement line items but have not had a material impact on our consolidated
operating earnings and net income. Our consolidated operating earnings were not
materially impacted for the three months ended June 30, 2002 and were negatively
impacted $0.6 million for the three months ended June 30, 2001, as a result of
fluctuations in foreign currency to U.S. dollar exchange rates. Our consolidated
operating earnings were positively impacted $0.2 million and negatively impacted
$0.8 million for the six months ended June 30, 2002 and 2001, respectively, as a
result of fluctuations in foreign currency to U.S. dollar exchange rates. For a
discussion of our approaches to foreign currency exchange rate risk, see Item 3,
"Quantitative and Qualitative Disclosures about Market Risk."
CHANGES TO OUR CRITICAL ACCOUNTING POLICIES
Changes in the business environment and applicable authoritative accounting
guidance require us to closely monitor our accounting policies. During the six
months ended June 30, 2002, we adopted newly issued guidance from the Financial
Accounting Standards Board ("FASB") and changed our critical accounting policy
for business combinations.
ACCOUNTING FOR BUSINESS COMBINATIONS, GOODWILL AND OTHER INTANGIBLE ASSETS
In June 2001, the FASB issued Statement of Financial Accounting Standards
("SFAS") No. 141, BUSINESS COMBINATIONS ("SFAS 141"), and SFAS No. 142, GOODWILL
AND OTHER INTANGIBLE ASSETS ("SFAS 142"). SFAS 141 requires that the purchase
method of accounting be used for all business combinations initiated after June
30, 2001, and requires separate recognition of intangible assets apart from
goodwill, if such intangible assets meet certain criteria. SFAS 142, effective
January 1, 2002, prohibits the amortization of goodwill and intangible assets
with indefinite useful lives. Intangible assets with finite lives will continue
to be amortized over their estimated useful lives. Additionally, SFAS 142
requires that goodwill and indefinite-lived intangible assets be reviewed for
impairment at least annually, which we plan to do in the fourth quarter each
year.
Upon adoption of SFAS 142, the transition provisions of SFAS 141 became
effective, which required us to reclassify to goodwill the carrying amount of
our intangible assets that do not meet the specified criteria enabling an
intangible asset to be recognized separately from goodwill. As a result, we
reclassified our assembled work force intangible asset of $22.3 million, related
to BT Financial Group, to goodwill.
The initial adoption of SFAS 142 required us to perform a two-step fair-value
based goodwill impairment test. The first step of the test compared the
estimated fair value of the reporting unit to its carrying value, including
goodwill. If the carrying value exceeded fair value, a second step was
performed, which compared the implied fair value of the applicable reporting
unit's goodwill with the carrying amount of that goodwill, to measure the
goodwill impairment, if any. Additionally, we were required to perform an
impairment test on our indefinite-lived intangible assets, which consisted of a
comparison of the fair value of an intangible asset with its carrying amount.
Our measurements of fair value were based on evaluations of future discounted
cash flows, product level analysis, market performance assumptions and cash flow
assumptions. These evaluations utilized the best information available in the
circumstances, including reasonable and supportable assumptions and projections.
The discounted cash flow evaluations considered earnings scenarios and the
likelihood of possible outcomes. Collectively, these evaluations were
management's best estimate of projected future cash flows.
As a result of performing the two-step impairment test, we recorded goodwill
impairments of $196.5 million, $20.9 million and $4.6 million, net of income
taxes, related to our BT Financial Group, Principal International, and Life and
Health operations, respectively. Additionally, as a result of performing the
indefinite-lived intangible asset impairment test, we recognized an after-tax
impairment of $58.9 million to its brand name and management rights intangible
asset related to BT Financial Group.
26
These impairments, recognized January 1, 2002, as a cumulative effect of a
change in accounting principle, were reported in our operating segments as
follows (in millions):
INTERNATIONAL
ASSET
MANAGEMENT AND LIFE
ACCUMULATION AND HEALTH
SEGMENT SEGMENT CONSOLIDATED
-------------- ---------- ------------
Goodwill................................. $321.2 $4.6 $325.8
Other intangibles........................ 89.8 - 89.8
Income tax impact........................ (134.7) - (134.7)
-------------- ---------- ------------
Total impairment, net of income taxes.... $276.3 $4.6 $280.9
============== ========== ============
Net income for the three months and six months ended June 30, 2002 and 2001,
adjusted for the effects of SFAS 142 related to non-amortization of goodwill and
indefinite-lived intangibles, is as follows (in millions):
FOR THE FOR THE
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------- -------------------
2002 2001 2002 2001
-------- --------- -------- ---------
Reported net income.................... $120.2 $119.1 $85.3 $224.4
Adjustment for amortization expense:
Goodwill............................. - 5.9 - 15.7
Brand name and management rights - 4.5 - 9.0
Assembled workforce ................. - 0.9 - 1.9
-------- --------- -------- ---------
Total amortization expense ............ - 11.3 - 26.6
Tax impacts of amortization expense ... - (3.9) - (7.3)
-------- --------- -------- ---------
Adjusted net income.................... $120.2 $126.5 $85.3 $243.7
========= ========= ======== =========
OTHER ACCOUNTING CHANGES
The FASB Statement No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION ("SFAS 123")
encourages, but does not require, companies to record compensation cost for
stock-based employee compensation plans based on the fair value of options
granted. We have elected to adopt the fair value based method of accounting
prescribed in SFAS 123, retroactive to January 1, 2002, for our employee
stock-based compensation plans and will implement the method during the third
quarter of 2002 for all stock-based awards granted subsequent to January 1,
2002. Prior to January 1, 2002, we elected to account for our stock-based
compensation plans under the provisions of Accounting Principles Board ("APB")
Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES and, accordingly,
employee stock-based compensation costs were excluded from compensation expense.
We estimate an after-tax impact of between two and three cents per diluted share
in 2002 as a result of this change in accounting policy.
27
RESULTS OF OPERATIONS
The following table presents summary consolidated financial information for the
periods indicated:
FOR THE THREE FOR THE SIX
MONTHS ENDED MONTHS ENDED
JUNE 30, JUNE 30,
----------------------- -----------------------
2002 2001 2002 2001
---------- ---------- ---------- ----------
(IN MILLIONS)
INCOME STATEMENT DATA:
Revenues:
Premiums and other considerations................. $ 1,166.6 $ 891.1 $ 2,052.3 $ 1,955.3
Fees and other revenues........................... 479.4 443.3 955.4 856.3
Net investment income............................. 825.5 846.3 1,638.7 1,686.0
Net realized capital gains (losses)............... (91.5) (96.0) 6.6 (176.9)
---------- ---------- ---------- ----------
Total revenues.................................. 2,380.0 2,084.7 4,653.0 4,320.7
Expenses:
Benefits, claims and settlement expenses.......... 1,507.9 1,247.3 2,711.1 2,639.2
Dividends to policyholders........................ 79.5 81.1 161.9 162.1
Operating expenses................................ 638.6 605.5 1,269.4 1,228.2
---------- ---------- ---------- ----------
Total expenses.................................. 2,226.0 1,933.9 4,142.4 4,029.5
---------- ---------- ---------- ----------
Income before income taxes and cumulative
effect of accounting changes...................... 154.0 150.8 510.6 291.2
Income taxes........................................ 33.8 31.7 144.4 56.1
---------- ---------- ---------- ----------
Income before cumulative effect of accounting
changes............................................. 120.2 119.1 366.2 235.1
Cumulative effect of accounting changes,
net of related income taxes....................... - - (280.9) (10.7)
---------- ---------- ---------- ----------
Net income...................................... $ 120.2 $ 119.1 $ 85.3 $ 224.4
========== ========== ========== ==========
OTHER DATA:
Net income.......................................... $ 120.2 $ 119.1 $ 85.3 $ 224.4
Less:
Net realized capital gains (losses), as adjusted. (70.0) (60.3) (8.5) (108.2)
Non-recurring items............................... - (10.9) (282.9) (31.4)
---------- ---------- ---------- ----------
Operating earnings.................................. $ 190.2 $ 190.3 $ 376.7 $ 364.0
========== ========== ========== ==========
THREE MONTHS ENDED JUNE 30, 2002 COMPARED TO THREE MONTHS ENDED JUNE 30, 2001
Premiums and other considerations increased $275.5 million, or 31%, to $1,166.6
million for the three months ended June 30, 2002, from $891.1 million for the
three months ended June 30, 2001. The increase reflected a $298.8 million
increase from the U.S. Asset Management and Accumulation segment, primarily a
result of an increase in premiums from single premium group annuities with life
contingencies, which are typically used to fund defined benefit pension plan
terminations. The premium income we receive from these contracts fluctuates due
to the variability in the number and size of pension plan terminations in the
market, the interest rate environment and our ability to attract new sales. The
increase was partially offset by a $19.0 million, or 30%, decrease in the
International Asset Management and Accumulation segment, primarily resulting
from reduced sales of single premium annuities with life contingencies due to
market contraction in Chile, prolonged government retention of potential
annuitants in Mexico, and weaker currencies in Chile, Mexico, and Argentina. The
increase was also partially offset by a $4.3 million, or 1%, decrease from the
Life and Health Insurance segment, primarily due to the shift in customer
preference from individual traditional life insurance products to individual
interest-sensitive life insurance, the classification of revenues from our group
universal life insurance product from premiums to fee revenues, and due to ceded
premiums under a new group medical reinsurance contract effective January 1,
2002.
Fees and other revenues increased $36.1 million, or 8%, to $479.4 million for
the three months ended June 30, 2002, from $443.3 million for the three months
ended June 30, 2001. The increase was primarily due to a $22.5 million, or 13%,
increase from the Mortgage Banking segment, which reflects the growth in the
residential mortgage loan servicing portfolio. The increase was also due to a
$15.2 million, or 10% increase from the U.S. Asset Management and Accumulation
28
segment, primarily due to an increase in Principal Capital Management investment
management and transaction fees and reclassification of market value and hedging
activities from net investment income to fees and other revenue. In addition,
the increase was due to a $14.0 million, or 22%, increase from the Life and
Health Insurance segment, primarily related to growth in our individual
interest-sensitive life insurance business and the classification of revenues
from our group universal life insurance product to fee revenues from premiums.
The increases were partially offset by an $11.5 million, or 17%, decrease from
the International Asset Management and Accumulation segment, primarily a result
of declining assets under management in Australia for the three months ended
June 30, 2002, and divestiture of a non-core business in Australia during the
latter part of 2001.
Net investment income decreased $20.8 million, or 2%, to $825.5 million for the
three months ended June 30, 2002, from $846.3 million for the three months ended
June 30, 2001. The decrease was primarily a result of a decrease in investment
yields. The yield on average invested assets and cash was 7.1% for the three
months ended June 30, 2002, compared to 7.6% for the three months ended June 30,
2001. The decrease reflects lower yields on fixed maturity securities due to a
decrease in prepayment fee income and to a lesser extent, due to a lower
interest rate environment. The decrease in investment yields was partially
offset by a $2,068.3 million, or 5%, increase in average invested assets and
cash.
Net realized capital losses decreased $4.5 million, or 5%, to $91.5 million for
the three months ended June 30, 2002, from $96.0 million for the three months
ended June 30, 2001. Net realized capital gains on real estate and fixed
maturity securities sales during the three months ended June 30, 2002, were
partially offset by the write downs of other than temporary declines in value of
certain fixed maturity securities.
Benefits, claims and settlement expenses increased $260.6 million, or 21%, to
$1,507.9 million for the three months ended June 30, 2002, from $1,247.3 million
for the three months ended June 30, 2001. The increase was primarily due to a
$270.2 million, or 49%, increase from the U.S. Asset Management and Accumulation
segment, primarily reflecting an increase in sales of single premium group
annuities with life contingencies. The increase was partially offset by a $14.7
million, or 2%, decrease from the Life and Health Insurance segment, primarily
due to ceded claims under a new group medical reinsurance agreement and a
reduction in group medical insurance business.
Dividends to policyholders decreased $1.6 million, or 2%, to $79.5 million for
the three months ended June 30, 2002, from $81.1 million for the three months
ended June 30, 2001. The decrease was attributable to a $2.2 million, or 3%,
decrease from the Life and Health Insurance segment due to a change in the
individual life insurance dividend scale. The decrease was partially offset by a
$0.6 million, or 60% increase in the U.S. Asset Management and Accumulation
segment, resulting from an increase in dividends for our pension full-service
accumulation products.
Operating expenses increased $33.1 million, or 5%, to $638.6 million for the
three months ended June 30, 2002, from $605.5 million for the three months ended
June 30, 2001. The increase was primarily due to an $65.7 million, or 63%,
increase from the Mortgage Banking segment resulting from an increase in
impairment of capitalized mortgage servicing rights net of servicing hedge
activity and from increased expenses related to growth in the servicing
portfolio. The increase was partially offset by a $25.0 million, or 30%,
decrease from the International Asset Management and Accumulation segment, in
part related to the discontinuation of amortization expense in 2002 as a result
of the adoption of SFAS 142. In addition, staff restructuring efforts undertaken
by BT Financial Group to reduce ongoing operating expenses resulted in a 27%
decrease of staff levels, resulting in a decrease in salary and incentive costs
within this segment. In addition, Corporate and Other's operating expenses
decreased $11.0 million, or 40%, primarily due to expenses recognized in 2001
related to our demutualization.
Income taxes increased $2.1 million, or 7%, to $33.8 million for the three
months ended June 30, 2002, from $31.7 million for the three months ended June
30, 2001. The effective income tax rate was 22% for the three months ended June
30, 2002, and 21% for the three months ended June 30, 2001. The effective income
tax rates for the three months ended June 30, 2002 and 2001, were lower than the
corporate income tax rate of 35% primarily due to income tax deductions allowed
for corporate dividends received.
As a result of the foregoing factors, net income increased $1.1 million, or 1%,
to $120.2 million for the three months ended June 30, 2002, from $119.1 million
for the three months ended June 30, 2001.
For the three months ended June 30, 2002, no non-recurring items were excluded
from net income for our presentation of consolidated operating earnings. For the
three months ended June 30, 2001, non-recurring items of $10.9 million, net of
income taxes, resulted from the negative effects of expenses related to our
demutualization.
29
As a result of the foregoing factors and the exclusion of net realized capital
gains (losses), as adjusted and nonrecurring items, operating earnings decreased
$0.1 million to $190.2 million for the three months ended June 30, 2002, from
$190.3 million for the three months ended June 30, 2001. The decrease resulted
from a $20.1 million, or 45%, decrease from the Mortgage Banking segment
primarily due to a decrease in earnings from residential mortgage loan
production. The decrease was also due to a $14.3 million decrease from the
Corporate and Other segment, primarily related to a decrease in average
investment yields for the segment. The decreases were partially offset by a
$14.0 million, or 16%, increase from the U.S. Asset Management and Accumulation
segment, primarily related to improved earnings of our pension operations and
from Principal Capital Management. In addition, the decreases were partially
offset by a $13.3 million, or 27%, increase from the Life and Health Insurance
segment, primarily a result of improved medical and dental loss ratios. An
increase of $7.0 million from the International Asset Management and
Accumulation segment resulted mostly from improved earnings of Principal
International. In addition, BT Financial Group operating earnings increased as a
result of reduced operating expenses, in part related to the discontinuation of
amortization expense in 2002 as a result of the adoption of SFAS 142.
SIX MONTHS ENDED JUNE 30, 2002 COMPARED TO SIX MONTHS ENDED JUNE 30, 2001
Premiums and other considerations increased $97.0 million, or 5%, to $2,052.3
million for the six months ended June 30, 2002, from $1,955.3 million for the
six months ended June 30, 2001. The increase reflected a $158.9 million, or 48%,
increase from the U.S. Asset Management and Accumulation segment, primarily a
result of an increase in premiums from single premium group annuities with life
contingencies, which are typically used to fund defined benefit pension plan
terminations. The premium income we receive from these contracts fluctuates due
to the variability in the number and size of pension plan terminations in the
market, the interest rate environment and our ability to attract new sales. The
increase was partially offset by a $37.7 million, or 2%, decrease from the Life
and Health Insurance segment, primarily due to the classification of revenues
from our group universal life insurance product from premiums to fee revenues,
ceded premiums from the new group medical reinsurance contract effective January
1, 2002, and the shift in customer preference from individual traditional life
insurance products to individual interest-sensitive life insurance products. The
increase was also partially offset by a $24.2 million, or 22%, decrease from the
International Asset Management and Accumulation segment, primarily resulting
from the weakening of the Chilean and Argentine pesos versus the U.S. dollar and
to a lesser extent decreased sales of single premium annuities with life
contingencies due to market contraction in Chile and prolonged government
retention of potential annuitants in Mexico.
Fees and other revenues increased $99.1 million, or 12%, to $955.4 million for
the six months ended June 30, 2002, from $856.3 million for the six months ended
June 30, 2001. The increase was primarily due to an $88.8 million, or 31%,
increase from the Mortgage Banking segment, primarily resulting from an increase
in the residential mortgage loan servicing portfolio. The increase was also due
to a $26.1 million, or 20%, increase from the Life and Health Insurance segment,
primarily related to growth in our individual interest-sensitive life insurance
business and the classification of revenues from our group universal life
insurance product to fee revenues from premiums. In addition, the increase was
related to a $14.6 million, or 5% increase in the U.S. Asset Management and
Accumulation segment, primarily resulting from an increase in gains from
commercial mortgage-backed securitizations initiated by Principal Capital
Management and due to the reclassification of market value and hedging
activities from net investment income to fees and other revenue. The increases
were partially offset by a $28.0 million, or 20%, decrease from the
International Asset Management and Accumulation segment primarily a result of
declining assets under management in Australia for the six months ended June 30,
2002, and divestiture of a non-core business in Australia during the latter part
of 2001.
Net investment income decreased $47.3 million, or 3%, to $1,638.7 million for
the six months ended June 30, 2002, from $1,686.0 million for the six months
ended June 30, 2001. The decrease was primarily a result of a decrease in
investment yields. The yield on average invested assets and cash was 7.1% for
the six months ended June 30, 2002, compared to 7.7% for the six months ended
June 30, 2001. This reflects a decrease in investment gains on real estate due
to lower sales of certain real estate held-for-sale, compared to an unusually
high volume of sales during 2001. In addition, the decrease reflects lower
yields on fixed maturity securities due to a decrease in prepayment fee income
and to a lesser extent, due to a lower interest rate environment. The
decrease in investment yields was partially offset by a $2,517.8 million, or 6%,
increase in average invested assets and cash.
Net realized capital gains increased $183.5 million to $6.6 million of net
realized capital gains for the six months ended June 30, 2002, from $176.9
million of net realized capital losses for the six months ended June 30, 2001.
Net realized capital gains increased during the six months ended June 30, 2002,
primarily due to the sale of our remaining stake in Coventry. The realized
30
capital gain was partially offset by other than temporary impairments of certain
fixed maturity securities and realized capital losses on the sales of fixed
maturity securities. During the six months ended June 30, 2001, we realized
capital losses on the sales of equity securities, a result of the decline in the
equity markets, the sale of our operations in Spain, and other than temporary
declines in value of certain fixed maturity securities.
Benefits, claims and settlement expenses increased $71.9 million, or 3%, to
$2,711.1 million for the six months ended June 30, 2002, from $2,639.2 million
for the six months ended June 30, 2001. The increase was primarily due to a
$124.0 million, or 10%, increase from the U.S. Asset Management and Accumulation
segment, primarily reflecting an increase in sales of single premium group
annuities with life contingencies. The increase was partially offset by a $50.2
million, or 4%, decrease from the Life and Health Insurance segment due to ceded
claims under a new group medical reinsurance agreement; a reduction in group
medical insurance business; and improved claim experience partially offset by a
reserve established due to the withdrawal of medical products from the Florida
small employer market.
Dividends to policyholders decreased $0.2 million to $161.9 million for the six
months ended June 30, 2002, from $162.1 million for the six months ended June
30, 2001. The decrease was primarily due to a $2.4 million, or 2%, decrease from
the Life and Health Insurance segment due to a change in the individual life
insurance dividend scale. The decrease was partially offset by a $2.2 million,
or 58%, increase from the U.S. Asset Management and Accumulation segment,
resulting from an increase in dividends for our pension full-service
accumulation products.
Operating expenses increased $41.2 million, or 3%, to $1,269.4 million for the
six months ended June 30, 2002, from $1,228.2 million for the six months ended
June 30, 2001. The increase was primarily due to an $149.4 million, or 80%,
increase from the Mortgage Banking segment resulting from an increase in
impairment of capitalized mortgage servicing rights net of servicing hedge
activity and from increased expenses related to growth in the servicing
portfolio. The increase was partially offset by a $57.2 million, or 32%,
decrease from the International Asset Management and Accumulation segment, in
part related to the discontinuation of amortization expense in 2002 as a result
of the adoption of SFAS 142. In addition, staff restructuring efforts undertaken
by BT Financial Group to reduce ongoing operating expenses resulted in a 27%
decrease of staff levels, resulting in a decrease in salary and incentive costs
within this segment. The increase was also partially offset by a $36.8 million,
or 9%, decrease from the U.S. Asset Management and Accumulation segment,
primarily reflecting a decrease in amortization of deferred policy acquisition
costs of our pension products due to unlocking. The increase was also offset by
an $11.0 million, or 24%, decrease from our Corporate and Other segment
primarily due to expenses recognized in 2001 related to our demutualization.
Income taxes increased $88.3 million to $144.4 million for the six months ended
June 30, 2002, from $56.1 million for the six months ended June 30, 2001. The
effective income tax rate was 28% for the six months ended June 30, 2002, and
19% for the six months ended June 30, 2001. The effective income tax rates for
the six months ended June 30, 2002 and 2001, were lower than the corporate
income tax rate of 35% primarily due to income tax deductions allowed for
corporate dividends received. The increase in the effective tax rate to 28% for
the six months ended June 30, 2002, from 19% for the six months ended June 30,
2001, was primarily due to the greater increase in net income before taxes
relative to the increase in our permanent tax differences. In addition, our
effective income tax rate was further reduced for the six months ended June 30,
2001, due to additional tax benefits related to excess tax over book capital
losses realized from the sale of our operations in Spain.
As a result of the foregoing factors and the inclusion of the cumulative effect
of accounting changes, net of related income taxes, net income decreased $139.1
million, or 62%, to $85.3 million for the six months ended June 30, 2002, from
$224.4 million for the six months ended June 30, 2001. The cumulative effect of
accounting changes, net of related income taxes, were related to our
implementation of SFAS 142 in 2002 and Statement of Financial Accounting
Standards No. 133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
("SFAS 133") in 2001.
For the six months ended June 30, 2002, non-recurring items of $282.9 million,
net of income taxes, included the negative effects of: (1) a cumulative effect
of accounting change related to our implementation of SFAS 142 ($280.9 million);
and (2) expenses related to our demutualization ($2.0 million). For the six
months ended June 30, 2001, non-recurring items of $31.4 million, net of income
taxes, included the negative effects of: (1) expenses related to our
demutualization ($14.8 million); (2) a cumulative effect of accounting change
related to our implementation of SFAS 133 ($10.7 million); and (3) an increase
in our loss contingency reserve established for sales practices litigation ($5.9
million).
31
As a result of the foregoing factors and the exclusion of net realized capital
gains (losses), as adjusted and nonrecurring items, operating earnings increased
$12.7 million, or 3%, to $376.7 million for the six months ended June 30, 2002,
from $364.0 million for the six months ended June 30, 2001. The increase
resulted from a $25.4 million, or 14%, increase from the U.S. Asset Management
and Accumulation segment, primarily related to improved earnings of our pension
operations and from Principal Capital Management. In addition, the increase
resulted from a $25.1 million, or 28%, increase from the Life and Health
Insurance segment, primarily a result of improved medical and dental loss
ratios. The increase was also due to a $17.5 million increase from the
International Asset Management and Accumulation segment, resulting mostly from
improved earnings of BT Financial Group primarily as a result of reduced
operating expenses, in part related to the discontinuation of amortization
expense in 2002 as a result of the adoption of SFAS 142. The increase was
partially offset by a $37.8 million decrease from the Corporate and Other
segment, primarily related to a decrease in investment gains on real estate due
to lower sales of certain real estate held-for-sale, compared to an unusually
high volume of sales experienced in 2001. In addition, the increases were
partially offset by a $17.5 million, or 25%, decrease from the Mortgage Banking
segment, primarily due to a decrease in earnings from residential mortgage loan
servicing.
RESULTS OF OPERATIONS BY SEGMENT
We evaluate segment performance by segment operating earnings, which excludes
the effect of net realized capital gains and losses, as adjusted, and
non-recurring events and transactions. Segment operating earnings are determined
by adjusting U.S. GAAP net income for net realized capital gains and losses, as
adjusted, and non-recurring items that we believe are not indicative of overall
operating trends. While these items may be significant components in
understanding and assessing our consolidated financial performance, we believe
the presentation of segment operating earnings enhances the understanding of our
results of operations by highlighting earnings attributable to the normal,
recurring operations of our businesses. However, segment operating earnings are
not a substitute for net income determined in accordance with U.S. GAAP.
32
The following table presents segment information as of or for the periods
indicated:
AS OF OR FOR THE THREE AS OF OR FOR THE SIX
MONTHS ENDED MONTHS ENDED
JUNE 30, JUNE 30,
------------------------------- ------------------------------
2002 2001 2002 2001
-------------- ------------- ------------- -------------
(IN MILLIONS)
OPERATING REVENUES BY SEGMENT:
U.S. Asset Management and Accumulation........ $ 1,135.7 $ 842.5 $ 1,997.8 $ 1,858.2
International Asset Management and
Accumulation............................... 138.1 165.7 259.2 310.1
Life and Health Insurance..................... 984.5 975.8 1,963.0 1,978.2
Mortgage Banking.............................. 209.7 173.5 418.4 293.1
Corporate and Other (1)....................... 6.7 22.5 17.2 57.5
-------------- ------------- ------------- -------------
Total operating revenues.................... 2,474.7 2,180.0 4,655.6 4,497.1
Net realized capital losses, including
recognition of front-end fee revenues and
certain market value adjustments to fee
revenues.................................... (94.7) (95.3) (2.6) (176.4)
-------------- ------------- ------------- -------------
U.S. GAAP REPORTED:
Total consolidated revenues................. $ 2,380.0 $ 2,084.7 $ 4,653.0 $ 4,320.7
============== ============= ============= =============
OPERATING EARNINGS (LOSS) BY SEGMENT:
U.S. Asset Management and Accumulation ....... $ 102.1 $ 88.1 $ 202.3 $ 176.9
International Asset Management and
Accumulation................................ 7.6 0.6 12.8 (4.7)
Life and Health Insurance..................... 61.7 48.4 116.0 90.9
Mortgage Banking.............................. 24.8 44.9 51.3 68.8
Corporate and Other .......................... (6.0) 8.3 (5.7) 32.1
-------------- ------------- ------------- -------------
Total operating earnings.................... 190.2 190.3 376.7 364.0
Net realized capital gains (losses), as
adjusted (2).................................. (70.0) (60.3) (8.5) (108.2)
Non-recurring items (3)....................... - (10.9) (282.9) (31.4)
-------------- ------------- ------------- -------------
U.S. GAAP REPORTED:
Net income.................................... $ 120.2 $ 119.1 $ 85.3 $ 224.4
============== ============= ============= =============
U.S. GAAP REPORTED NET INCOME (LOSS) BY SEGMENT:
U.S. Asset Management and Accumulation ....... $ 41.7 54.7 $ 97.1 125.3
International Asset Management and
Accumulation............................... 13.2 (0.3) (254.1) (25.9)
Life and Health Insurance..................... 40.9 44.3 80.1 86.3
Mortgage Banking.............................. 24.8 44.9 51.3 68.8
Corporate and Other .......................... (0.4) (24.5) 110.9 (30.1)
-------------- ------------- ------------- -------------
Total net income ........................... $ 120.2 $ 119.1 $ 85.3 $ 224.4
============== ============= ============= =============
TOTAL ASSETS BY SEGMENT:
U.S. Asset Management and Accumulation (4).... $ 69,752.1 $ 66,182.4 $ 69,752.1 $ 66,182.4
International Asset Management and
Accumulation................................ 4,794.6 4,919.6 4,794.6 4,919.6
Life and Health Insurance..................... 11,132.5 10,637.2 11,132.5 10,637.2
Mortgage Banking.............................. 2,965.3 2,168.9 2,965.3 2,168.9
Corporate and Other (5)....................... 1,548.9 1,321.6 1,548.9 1,321.6
-------------- ------------- ------------- -------------
Total assets................................ $ 90,193.4 $ 85,229.7 $ 90,193.4 $ 85,229.7
============== ============= ============= =============
(1) Includes inter-segment eliminations primarily related to internal
investment management fee revenues, commission fee revenues paid to U.S.
Asset Management and Accumulation agents for selling Life and Health
Insurance segment insurance products, and real estate joint venture
rental income. In 2001, the Corporate and Other segment reported rental
income from real estate joint ventures for office space used by other
segments.
(2) Net realized capital gains (losses), as adjusted, are net of income
taxes, capital gains distributed to customers, related changes in the
amortization pattern of deferred policy acquisition costs, recognition
of front-end fee revenues for sales charges on pension products and
services and certain market value adjustments to fee revenues, as
follows:
33
FOR THE THREE FOR THE SIX
MONTHS ENDED MONTHS ENDED
JUNE 30, JUNE 30,
---------------------- ----------------------
2002 2001 2002 2001
---------- ---------- ---------- ----------
(IN MILLIONS)
Net realized capital gains (losses)................ $ (91.5) $ (96.0) $ 6.6 $ (176.9)
Certain market value adjustments to fee revenues (4.6) - (13.2) -
Recognition of front-end fee revenues.............. 1.4 0.7 4.0 0.5
---------- ---------- ---------- ----------
Net realized capital gains (losses),
including recognition of front-end fee
revenues and certain market value
adjustments to fee revenues ................... (94.7) (95.3) (2.6) (176.4)
Amortization of deferred policy acquisition
costs related to net realized capital gains
(losses)....................................... 1.4 2.9 12.3 3.9
Capital gains distributed to customers............. (21.8) - (21.8) -
---------- ---------- ---------- ----------
Net realized capital gains (losses),
including recognition of front-end fee
revenues and certain market value
adjustments to fee revenues, net of related
amortization of deferred policy acquisition
costs and capital gains distributed to
customers...................................... (115.1) (92.4) (12.1) (172.5)
Income tax effect ................................. 45.1 32.1 3.6 64.3
---------- ---------- ---------- ----------
Net realized capital gains (losses), as
adjusted......................................... $ (70.0) $ (60.3) $ (8.5) $ (108.2)
(3) For the three months ended June 30, 2002, no non-recurring items were
excluded from net income for our presentation of consolidated operating
earnings. For the three months ended June 30, 2001, non-recurring items
of $10.9 million, net of income taxes resulted from the negative effects
of expenses related to our demutualization. For the six months ended
June 30, 2002, we excluded $282.9 million of non-recurring
items, net of income taxes, including the negative effects of: (1) a
cumulative effect of accounting change related to the implementation of
SFAS 142 ($280.9 million); and (2) expenses related to the
demutualization ($2.0 million). For the six months ended June 30, 2001,
we excluded $31.4 million of non-recurring items, net of income
taxes, including the negative effects of: (1) expenses related to our
demutualization ($14.8 million); (2) a cumulative effect of change in
accounting principle related to our implementation of SFAS 133 ($10.7
million); and (3) an increase to a loss contingency reserve established
for sales practices litigation ($5.9 million).
(4) U.S. Asset Management and Accumulation separate account assets include
shares of Principal Financial Group, Inc. stock allocated to a separate
account, a result of the demutualization. The value of the separate
account was $1.2 billion at June 30, 2002. Activity of the separate
account was reflected in both separate account assets and separate
account liabilities and did not impact our results of operations.
(5) Includes inter-segment elimination amounts related to internally
generated mortgage loans and an internal line of credit. The U.S. Asset
Management and Accumulation segment and Life and Health Insurance
segment reported mortgage loan assets issued for real estate joint
ventures. These mortgage loans were reported as liabilities in the
Corporate and Other segment. In addition, the Corporate and Other
segment managed a revolving line of credit used by other segments.
34
U.S. ASSET MANAGEMENT AND ACCUMULATION SEGMENT
The following table presents certain summary financial data relating to the U.S.
Asset Management and Accumulation segment for the periods indicated:
FOR THE THREE FOR THE SIX
MONTHS ENDED MONTHS ENDED
JUNE 30, JUNE 30,
------------------------------- ------------------------------
2002 2001 2002 2001
-------------- -------------- -------------- --------------
(IN MILLIONS)
OPERATING EARNINGS DATA:
Operating revenues(1):
Premiums and other considerations......... $ 379.3 $ 80.5 $ 488.9 $ 330.0
Fees and other revenues................... 171.4 152.3 345.1 320.8
Net investment income..................... 585.0 609.7 1,163.8 1,207.4
-------------- -------------- -------------- --------------
Total operating revenues................ 1,135.7 842.5 1,997.8 1,858.2
Expenses:
Benefits, claims and settlement expenses,
including dividends to policyholders.... 821.5 550.7 1,369.1 1,242.9
Operating expenses........................ 183.5 185.3 371.0 399.5
-------------- -------------- -------------- --------------
Total expenses.......................... 1,005.0 736.0 1,740.1 1,642.4
-------------- -------------- -------------- --------------
Pre-tax operating earnings.................. 130.7 106.5 257.7 215.8
Income taxes................................ 28.6 18.4 55.4 38.9
-------------- -------------- -------------- --------------
Operating earnings.......................... 102.1 88.1 202.3 176.9
Net realized capital gains (losses), as
adjusted.................................. (60.4) (33.4) (105.2) (40.8)
Non-recurring items......................... - - - (10.8)
-------------- -------------- -------------- --------------
U. S. GAAP REPORTED:
Net income.................................. $ 41.7 $ 54.7 $ 97.1 $ 125.3
============== ============== ============== ==============
- ------------
(1) Excludes net realized capital losses and their impact on recognition of
front-end fee revenues and certain market value adjustments to fee revenues.
THREE MONTHS ENDED JUNE 30, 2002 COMPARED TO THREE MONTHS ENDED JUNE 30, 2001
Premiums and other considerations increased $298.8 million, to $379.3 million
for the three months ended June 30, 2002, from $80.5 million for the three
months ended June 30, 2001. The increase primarily resulted from a $294.6
million increase in pension full-service payout sales of single premium group
annuities with life contingencies, which are typically used to fund defined
benefit plan terminations. The premium income received from these contracts
fluctuates due to the variability in the number and size of pension plan
terminations, the interest rate environment, and the ability to attract new
sales.
Fees and other revenues increased $19.1 million, or 13%, to $171.4 million for
the three months ended
June 30, 2002, from $152.3 million for the three months ended June 30, 2001. The
increase primarily resulted from a $14.7 million increase in Principal Capital
Management due to investment management and transaction fees; reclassification
of market value and hedging activities from net investment income to fees and
other revenue; and gains from commercial mortgage-backed securitizations.
Furthermore, pension full-service accumulation experienced a $5.2 million
increase in other revenues due to the adverse impacts of market value
adjustments in 2001.
Net investment income decreased $24.7 million, or 4%, to $585.0 million for the
three months ended June 30, 2002, from $609.7 million for the three months ended
June 30, 2001. The average yield on invested assets and cash was 6.7% for the
35
three months ended June 30, 2002, compared to 7.2% for the three months ended
June 30, 2001. The decrease reflects lower yields due to a decrease in
prepayment fee income and to a lesser extent, due to a lower interest rate
environment. The decrease was partially offset by a $1,016.3 million, or 3%,
increase in average invested assets and cash.
Benefits, claims and settlement expenses, including dividends to policyholders,
increased $270.8 million, or 49%, to $821.5 million for the three months ended
June 30, 2002, from $550.7 million for the three months ended June 30, 2001. The
increase primarily resulted from a $302.2 million increase in pension
full-service payout sales of single premium group annuities with life
contingencies. Partially offsetting this increase were decreases in interest
credited of $24.2 million in the pension full-service accumulation line of
business and $15.5 million in the pension investment only products.
Operating expenses decreased $1.8 million, or 1%, to $183.5 million for the
three months ended June 30, 2002, from $185.3 million for the three months ended
June 30, 2001. The decrease primarily resulted from a $3.6 million decrease in
pension operating expenses which include a $6.6 million reduction in
compensation expenses as a result of lower staff levels in 2002, partially
offset by a $2.9 million increase in the net impact of deferred policy
acquisition costs ("DPAC"). Further offsetting the overall decrease was a $1.9
million increase in individual annuity operating expenses primarily related to
higher DPAC amortization resulting from the unlocking impacts of the poor stock
market performance and increased lapse rates.
Income taxes increased $10.2 million, or 55%, to $28.6 million for the three
months ended June 30, 2002, from $18.4 million for the three months ended June
30, 2001. The effective income tax rate for this segment was 22% for the three
months ended June 30, 2002, and 17% for the three months ended June 30, 2001.
The effective income tax rates for the three months ended June 30, 2002 and
2001, were lower than the corporate income tax rate of 35% primarily due to
income tax deductions allowed for corporate dividends received and other
tax-exempt income.
As a result of the foregoing factors, operating earnings increased $14.0
million, or 16%, to $102.1 million for the three months ended June 30, 2002,
from $88.1 million for the three months ended June 30, 2001.
Net realized capital losses, as adjusted, increased $27.0 million, or 81%, to
$60.4 million for the three months ended June 30, 2002, from $33.4 million for
the three months ended June 30, 2001. The increase includes realized capital
losses related to other than temporary declines in the value of certain fixed
maturity securities for the three months ended June 30, 2002.
As a result of the foregoing factors, net income decreased $13.0 million, or
24%, to $41.7 million for the three months ended June 30, 2002, from $54.7
million for the three months ended June 30, 2001.
SIX MONTHS ENDED JUNE 30, 2002 COMPARED TO SIX MONTHS ENDED JUNE 30, 2001
Premiums and other considerations increased $158.9 million, or 48%, to $488.9
million for the six months ended June 30, 2002, from $330.0 million for the six
months ended June 30, 2001. The increase primarily resulted from a $144.1
million increase in pension full-service payout sales of single premium group
annuities with life contingencies, which are typically used to fund defined
benefit plan terminations. The premium income received from these contracts
fluctuates due to the variability in the number and size of pension plan
terminations, the interest rate environment, and the ability to attract new
sales.
Fees and other revenues increased $24.3 million, or 8%, to $345.1 million for
the six months ended June 30, 2002, from $320.8 million for the six months ended
June 30, 2001. This increase was primarily due to an increase of $20.9 million
of fees from Principal Capital Management due to gains from commercial
mortgage-backed securitizations; a reclassification of market value and hedging
activities from net investment income to fees and other revenue; and an increase
in investment management and transaction fees.
Net investment income decreased $43.6 million, or 4%, to $1,163.8 million for
the six months ended June 30, 2002, from $1,207.4 million for the six months
ended June 30, 2001. The average yield on invested assets and cash was 6.7% for
the six months ended June 30, 2002, compared to 7.3% for the six months ended
June 30, 2001. The decrease reflects lower yields due to a decrease in
prepayment fee income and to a lesser extent, due to a lower interest rate
environment. The decrease was partially offset by a $1,718.7 million, or 5%,
increase in average invested assets and cash.
36
Benefits, claims and settlement expenses, including dividends to policyholders,
increased $126.2 million, or 10%, to $1,369.1 million for the six months ended
June 30, 2002, from $1,242.9 million for the six months ended June 30, 2001. The
increase primarily resulted from a $163.6 million increase in pension
full-service payout sales of single premium group annuities with life
contingencies. Partially offsetting this increase were decreases in interest
credited of $32.7 million in the pension full-service accumulation line of
business and $25.1 million in the pension investment only products.
Operating expenses decreased $28.5 million, or 7%, to $371.0 million for the six
months ended June 30, 2002, from $399.5 million for the six months ended June
30, 2001. A decrease of $25.6 million from our pension products was due to a
decrease in the amortization of DPAC from unlocking to reflect changes in
assumptions for equity market performance and lapse rates in 2001, and changes
in acquisition compensation in 2002. In addition, pension compensation expenses
decreased $4.6 million due to reductions in staff levels. The decreases were
offset by a $4.2 million increase in mutual fund operating expenses. This
increase primarily relates to increased commission expense generated from sales
of the variable life and annuity contracts. Of this increase, $1.5 million
relates to sales within the segment and is eliminated at an operating segment
level.
Income taxes increased $16.5 million, or 42%, to $55.4 million for the six
months ended June 30, 2002, from $38.9 million for the six months ended June 30,
2001. The effective income tax rate for this segment was 21% for the six months
ended June 30, 2002, and 18% for the six months ended June 30, 2001. The
effective income tax rates for the six months ended June 30, 2002 and 2001, were
lower than the corporate income tax rate of 35% primarily due to income tax
deductions allowed for corporate dividends received and other tax-exempt income.
As a result of the foregoing factors, operating earnings increased $25.4
million, or 14%, to $202.3 million for the six months ended June 30, 2002, from
$176.9 million for the six months ended June 30, 2001.
Net realized capital losses, as adjusted, increased $64.4 million, to $105.2
million for the six months ended June 30, 2002, from $40.8 million for the six
months ended June 30, 2001. The increase includes realized capital losses
related to other than temporary declines in the value of certain fixed maturity
securities and sales of fixed maturity securities for the six months ended June
30, 2002.
As a result of the foregoing factors and the inclusion of non-recurring items
for the six months ended June 30, 2001, net income decreased $28.2 million, or
23%, to $97.1 million for the six months ended June 30, 2002, from $125.3
million for the six months ended June 30, 2001. For the six months ended June
30, 2001, net income included the negative effect of non-recurring items
totaling $10.8 million, net of income taxes, related to a cumulative effect of
accounting change related to our implementation of SFAS 133.
37
INTERNATIONAL ASSET MANAGEMENT AND ACCUMULATION SEGMENT
The following table presents certain summary financial data relating to the
International Asset Management and Accumulation segment for the periods
indicated:
FOR THE THREE FOR THE SIX
MONTHS ENDED MONTHS ENDED
JUNE 30, JUNE 30,
---------------------------- ---------------------------
2002 2001 2002 2001
------------- ------------ ------------ ------------
(IN MILLIONS)
OPERATING EARNINGS DATA:
Operating revenues (1):
Premiums and other considerations.. $ 44.6 $ 63.6 $ 85.8 $ 110.0
Fees and other revenues............ 56.1 67.6 111.5 139.5
Net investment income.............. 37.4 34.5 61.9 60.6
------------- ------------ ------------ ------------
Total operating revenues......... 138.1 165.7 259.2 310.1
Expenses:
Benefits, claims and settlement
expenses......................... 66.5 82.1 119.2 139.6
Operating expenses................ 58.9 83.9 120.3 177.5
------------- ------------ ------------ ------------
Total expenses................... 125.4 166.0 239.5 317.1
------------- ------------ ------------ ------------
Pre-tax operating earnings (loss).... 12.7 (0.3) 19.7 (7.0)
Income taxes (benefits).............. 5.1 (0.9) 6.9 (2.3)
------------- ------------ ------------ ------------
Operating earnings (loss)............ 7.6 0.6 12.8 (4.7)
Net realized capital gains (losses),
as adjusted........................ 5.6 (0.9) 9.4 (21.2)
Non-recurring items.................. - - (276.3) -
------------- ------------ ------------ ------------
U. S. GAAP REPORTED:
Net income (loss).................... $ 13.2 $ (0.3) $ (254.1) $ (25.9)
============= ============ ============ ============
- ------------
(1) Excludes net realized capital gains (losses) and their impact on recognition
of front-end fee revenues and certain market value adjustments to fee
revenues.
THREE MONTHS ENDED JUNE 30, 2002 COMPARED TO THREE MONTHS ENDED JUNE 30, 2002
Premiums and other considerations decreased $19.0 million, or 30%, to $44.6
million for the three months ended June 30, 2002, from $63.6 million for the
three months ended June 30, 2001. A decrease of $10.3 million in Chile was
primarily a result of decreased sales of single premium annuities with life
contingencies due to market contraction and to a lesser extent the weakening of
the Chilean peso versus the U.S. dollar. A decrease of $5.2 million in Argentina
was primarily due to the weakening of the Argentine peso versus the U.S. dollar
and of the general economic environment. A net decrease of $3.3 million in
Mexico was the result of decreased sales of single premium annuities with life
contingencies due to prolonged government retention of potential annuitants,
which were partially offset by increased sales of group annuities.
Fees and other revenues decreased $11.5 million, or 17%, to $56.1 million for
the three months ended June 30, 2002, from $67.6 million for the three months
ended June 30, 2001. A decrease of $14.8 million of fee revenues generated by BT
Financial Group resulted from declining assets under management and a changing
product mix for the three months ended June 30, 2002, and divestiture of a
non-core business in the latter part of 2001. The decrease was offset by a $3.3
million increase in Principal International fee revenues, primarily a result of
an increase in the number of retirement plan participants in Mexico
Net investment income increased $2.9 million, or 8%, to $37.4 million for the
three months ended June 30, 2002, from $34.5 million for the three months ended
June 30, 2001. An increase of $2.9 million from Principal International
38
primarily related to an increase in average invested assets and cash. The yield
on average invested assets and cash was 10.0% for the three months ended June
30, 2002, compared to 11.3% for the three months ended June 30, 2001, reflecting
the negative impact of investing in higher quality, lower yielding fixed
maturity securities in Argentina.
Benefits, claims and settlement expenses decreased $15.6 million, or 19%, to
$66.5 million for the three months ended June 30, 2002, from $82.1 million for
the three months ended June 30, 2001. A $10.9 million decrease in Chile was a
result of a decrease in reserve changes due to lower sales and a result of the
weakening of the Chilean peso versus the U.S. dollar. A decrease of $4.5 million
in Argentina primarily related to the weakening of the Argentine peso versus the
U.S. dollar.
Operating expenses decreased $25.0 million, or 30%, to $58.9 million for the
three months ended June 30, 2002, from $83.9 million for the three months ended
June 30, 2001. Operating expenses incurred by BT Financial Group decreased $19.7
million, in part related to the discontinuation of amortization expense in 2002
as a result of the adoption of SFAS 142. In addition, staff restructuring
efforts undertaken by BT Financial Group to reduce ongoing operating expenses
resulted in a 27% decrease of staff levels, resulting in a decrease in salary
and incentive costs. Operating expenses also decreased $5.3 million related to
the operations of Principal International.
Income taxes increased $6.0 million to $5.1 million of income tax expense for
the three months ended June 30, 2002, from a $0.9 million income tax benefit for
the three months ended June 30, 2001. A $4.3 million increase in Principal
International was primarily due to an increase in pre-tax operating earnings. A
$1.7 million increase was primarily due to an increase in pre-tax operating
earnings from BT Financial Group.
As a result of the foregoing factors, operating earnings increased $7.0 million
to $7.6 million for the three months ended June 30, 2002, from $0.6 million for
the three months ended June 30, 2001.
Net realized capital gains (losses), as adjusted, increased $6.5 million to $5.6
million of net realized capital gains for the three months ended June 30, 2002,
from $0.9 million of net realized capital losses for the three months ended June
30, 2001. An increase of $3.8 million resulted primarily from gains realized on
the sale of fixed maturity securities in Chile. An increase of $3.0 million in
Argentina primarily related to gains realized on the remeasurement of assets and
liabilities denominated in currencies other than the Argentine peso.
As a result of the foregoing factors, net income increased $13.5 million to
$13.2 million for the three months ended June 30, 2002, from a net loss of $0.3
million for the three months ended June 30, 2001.
SIX MONTHS ENDED JUNE 30, 2002 COMPARED TO SIX MONTHS ENDED JUNE 30, 2001
Premiums and other considerations decreased $24.2 million, or 22%, to $85.8
million for the six months ended June 30, 2002, from $110.0 million for the six
months ended June 30, 2001. A decrease of $11.0 million in Chile was primarily a
result of the weakening of the Chilean peso versus the U.S. dollar and to a
lesser extent decreased sales of single premium annuities with life
contingencies due to market contraction. A net decrease of $6.7 million in
Mexico was the result of decreased sales of single premium annuities with life
contingencies due to prolonged government retention of potential annuitants,
which were partially offset by increased sales of group annuities. In addition,
a $6.0 million decrease in Argentina was primarily due to the weakening of the
Argentine peso versus the U.S. dollar and of the general economic environment.
Fees and other revenues decreased $28.0 million, or 20%, to $111.5 million for
the six months ended June 30, 2002, from $139.5 million for the six months ended
June 30, 2001. A decrease of $32.7 million of fee revenues generated by BT
Financial Group resulted from declining assets under management and a changing
product mix for the six months ended June 30, 2002, and divestiture of a
non-core business in the latter part of 2001. The decrease was offset by a $4.7
million increase in Principal International fee revenues, primarily a result of
an increase in the number of retirement plan participants in Mexico and an
increase in assets under management generated by Hong Kong.
Net investment income increased $1.3 million, or 2%, to $61.9 million for the
six months ended June 30, 2002, from $60.6 million for the six months ended June
30, 2001. An increase of $2.1 million from Principal International primarily
related to an increase in average invested assets and cash. The yield on average
invested assets and cash was 8.0% for the six months ended June 30, 2002,
39
compared to 9.7% for the six months ended June 30, 2001, reflecting the impact
of deflation on nominal yields in Chile, which, as discussed in the next
paragraph, was offset by a corresponding decrease in reserve changes.
Benefits, claims and settlement expenses decreased $20.4 million, or 15%, to
$119.2 million for the six months ended June 30, 2002, from $139.6 million for
the six months ended June 30, 2001. A $16.4 million decrease in Chile was a
result of a decrease in reserve changes to reflect the impact of deflation
adjustments and a result of the weakening of the Chilean peso versus the U.S.
dollar. A decrease of $4.8 million in Argentina primarily related to the
weakening of the Argentine peso versus the U.S. dollar.
Operating expenses decreased $57.2 million, or 32%, to $120.3 million for the
six months ended June 30, 2002, from $177.5 million for the six months ended
June 30, 2001. Operating expenses incurred by BT Financial Group decreased $50.5
million, in part related to the discontinuation of amortization expense in 2002
as a result of the adoption of SFAS 142. In addition, staff restructuring
efforts undertaken by BT Financial Group to reduce ongoing operating expenses
resulted in a 27% decrease of staff levels, resulting in a decrease in salary
and incentive costs.
Income taxes increased $9.2 million to $6.9 million of income tax expense for
the six months ended June 30, 2002, from a $2.3 million income tax benefit for
the six months ended June 30, 2001. A $5.0 million increase was primarily due to
an increase in pre-tax operating earnings from BT Financial Group. A $4.2
million increase in Principal International was primarily due to an increase in
pre-tax operating earnings.
As a result of the foregoing factors, operating earnings increased $17.5 million
to $12.8 million of operating earnings for the six months ended June 30, 2002,
from a $4.7 million operating loss for the six months ended June 30, 2001.
Net realized capital gains (losses), as adjusted, increased $30.6 million to
$9.4 million of net realized capital gains for the six months ended June 30,
2002, from $21.2 million of net realized capital losses for the six months ended
June 30, 2001. The increase was primarily due to a $21.0 million after-tax net
realized capital loss on the February 2001 sale of our operations in Spain. In
addition, a $6.8 million increase resulted primarily from gains realized on the
sale of fixed maturity securities in Chile for the six months ended June 30,
2002.
As a result of the foregoing factors and the inclusion of non-recurring items
for the six months ended June 30, 2002, net loss increased $228.2 million to
$254.1 million for the six months ended June 30, 2002, from $25.9 million for
the six months ended June 30, 2001. For the six months ended June 30, 2002, net
loss included the effect of non-recurring items totaling $276.3 million, net of
income taxes, related to the negative impact of the cumulative effect of
accounting change, a result of our implementation of SFAS 142.
40
LIFE AND HEALTH INSURANCE SEGMENT
The following table presents certain summary financial data relating to the Life
and Health Insurance segment for the periods indicated:
FOR THE THREE FOR THE SIX
MONTHS ENDED MONTHS ENDED
JUNE 30, JUNE 30,
------------------------------ -----------------------------
2002 2001 2002 2001
-------------- ------------- ------------ ------------
(IN MILLIONS)
OPERATING EARNINGS DATA:
Operating Revenues(1):
Premiums and other considerations........ $ 742.7 $ 747.0 $ 1,477.6 $ 1,515.3
Fees and other revenues.................. 78.0 64.0 155.0 128.9
Net investment income.................... 163.8 164.8 330.4 334.0
-------------- ------------- ------------ ------------
Total operating revenues.............. 984.5 975.8 1,963.0 1,978.2
Expenses:
Benefits, claims and settlement expenses. 600.7 615.4 1,210.2 1,260.4
Dividends to policyholders............... 77.9 80.1 155.9 158.3
Operating expenses....................... 211.1 207.4 419.5 422.6
-------------- ------------- ------------ ------------
Total expenses........................ 889.7 902.9 1,785.6 1,841.3
-------------- ------------- ------------ ------------
Pre-tax operating earnings................. 94.8 72.9 177.4 136.9
Income taxes............................... 33.1 24.5 61.4 46.0
-------------- ------------- ------------ ------------
Operating earnings......................... 61.7 48.4 116.0 90.9
Net realized capital gains (losses), as
adjusted................................. (20.8) (4.1) (31.3) (4.7)
Non-recurring items........................ - - (4.6) 0.1
-------------- ------------- ------------ ------------
U.S. GAAP REPORTED:
Net income................................. $ 40.9 $ 44.3 $ 80.1 $ 86.3
============== ============= ============ ============
- ------------
(1) Excludes net realized capital losses and their impact on recognition of
front-end fee revenues and certain market value adjustments to fee
revenues.
THREE MONTHS ENDED JUNE 30, 2002 COMPARED TO THREE MONTHS ENDED JUNE 30, 2001
Premiums and other considerations decreased $4.3 million, or 1%, to $742.7
million for the three months ended June 30, 2002, from $747.0 million for the
three months ended June 30, 2001. Individual life insurance premiums decreased
$7.2 million, reflecting a continued shift in customer preference from
traditional life insurance products to interest-sensitive life insurance
products and the increased use of reinsurance. Group life insurance premiums
decreased $7.0 million, due to the classification of revenues from our group
universal life insurance product from premium to fee revenues. The decreases
were partially offset by an $8.6 million increase in group medical premiums,
primarily due to premium rate increases which more than offset a decline in
covered members, as well as a reduction due to premiums ceded under a
reinsurance agreement effective January 1, 2002.
Fees and other revenues increased $14.0 million, or 22%, to $78.0 million for
the three months ended June 30, 2002, from $64.0 million for the three months
ended June 30, 2001. Fee revenues from individual interest-sensitive life
insurance products increased $7.2 million, primarily the result of the continued
shift in customer preference, as previously discussed. Group life insurance fee
revenues increased $6.8 million primarily due to the classification of revenues
from our group universal life insurance product to fee revenues from premiums.
Fee revenues from our group fee-for-service business increased $2.3 million,
primarily due to additional services provided to our customers and price
increases. The increases were partially offset by a $2.9 million decrease in
individual traditional life insurance fee revenues, primarily related to
classifying fees from reinsurance ceded as an offset to operating expenses. The
fees from reinsurance were previously reported as fee revenues.
41
Net investment income decreased $1.0 million, or 1%, to $163.8 million for the
three months ended June 30, 2002, from $164.8 million for the three months ended
June 30, 2001. The decrease reflects lower average investment yields due in part
to an overall lower interest rate environment. The yield on average invested
assets and cash was 7.2% for the three months ended June 30, 2002, compared to
7.4% for the three months ended June 30, 2001. The decrease was partially offset
by a $215.6 million, or 2%, increase in average invested assets and cash.
Benefits, claims and settlement expenses decreased $14.7 million, or 2%, to
$600.7 million for the three months ended June 30, 2002, from $615.4 million for
the three months ended June 30, 2001. Group medical insurance benefits, claims
and settlement expenses decreased $15.0 million, primarily due to ceded claims
under a new reinsurance agreement and a reduction in group medical insurance
business. Individual traditional life insurance benefits, claims, and settlement
expenses decreased $5.5 million primarily due to lower reserve increases due to
the decrease in premium. Partially offsetting the decreases was an increase in
benefits, claims and settlement expenses for individual interest-sensitive life
insurance products of $7.8 million, primarily due to an increase in interest
credited related to growth of the business and an increase in death claims.
Dividends to policyholders decreased $2.2 million, or 3%, to $77.9 million for
the three months ended June 30, 2002, from $80.1 million for the three months
ended June 30, 2001. The decrease was due to a change in the individual life
insurance dividend scale.
Operating expenses increased $3.7 million, or 2%, to $211.1 million for the
three months ended June 30, 2002, from $207.4 million for the three months ended
June 30, 2001. Group life and health insurance operating expenses increased $6.1
million, primarily due to higher commissions and expenses related to growth in
premiums and fee- for-service income. The increase was partially offset by a
$2.4 million decrease in individual life and disability insurance operating
expenses primarily due to classifying fees received from reinsurance ceded as an
offset to operating expenses. The decreases in individual life and disability
insurance operating expenses were partially offset by increased compensation
costs related to our distribution system.
Income taxes increased $8.6 million, or 35%, to $33.1 million for the three
months ended June 30, 2002, from $24.5 million for the three months ended June
30, 2001. The effective income tax rate for the segment was 35% for the three
months ended June 30, 2002 and 34% for the three months ended June 30, 2001. The
effective income tax rate for the three months ended June 30, 2001, was lower
than the corporate income tax rate of 35% primarily due to tax-exempt income.
As a result of the foregoing factors, operating earnings increased $13.3
million, or 27%, to $61.7 million for the three months ended June 30, 2002, from
$48.4 million for the three months ended June 30, 2001.
Net realized capital losses, as adjusted, increased $16.7 million to $20.8
million for the three months ended June 30, 2002, from $4.1 million for the
three months ended June 30, 2001. The increase includes realized capital losses
related to other than temporary declines in the value of certain fixed maturity
securities partially offset by realized capital gains on the sales of fixed
maturity securities for the three months ended June 30, 2002.
As a result of the foregoing factors, net income decreased $3.4 million, or 8%,
to $40.9 million for the three months ended June 30, 2002, from $44.3 million
for the three months ended June 30, 2001.
SIX MONTHS ENDED JUNE 30, 2002 COMPARED TO SIX MONTHS ENDED JUNE 30, 2001
Premiums and other considerations decreased $37.7 million, or 2%, to $1,477.6
million for the six months ended June 30, 2002, from $1,515.3 million for the
six months ended June 30, 2001. Group life insurance premiums decreased $19.5
million, primarily due to the classification of revenues from our group
universal life insurance product from premium to fee revenues and the loss of a
large customer in late 2000, resulting in a loss of premium after March 31,
2001. Individual life insurance premiums decreased $16.0 million, reflecting a
continued shift in customer preference from traditional life insurance products
to interest-sensitive life insurance products and the increased use of
reinsurance.
Fees and other revenues increased $26.1 million, or 20%, to $155.0 million for
the six months ended June 30, 2002, from $128.9 million for the six months ended
June 30, 2001. Fee revenues from individual interest-sensitive life insurance
products increased $14.6 million, primarily a result of the continued shift in
customer preference, as previously discussed. Group life insurance fee revenues
increased $13.8 million primarily due to the classification of revenues from our
42
group universal life insurance product to fee revenues from premiums. Fee
revenues from our group fee-for-service business increased $5.9 million,
primarily due to additional services provided to existing customers and price
increases. The increases were partially offset by a $7.6 million decrease in
individual traditional life insurance fee revenues, primarily related to
classifying fees received from reinsurance ceded as an offset to operating
expenses. The fees from reinsurance were previously reported as fee revenues.
Net investment income decreased $3.6 million, or 1%, to $330.4 million for the
six months ended June 30, 2002, from $334.0 million for the six months ended
June 30, 2001. The decrease reflects lower average investment yields due in part
to an overall lower interest rate environment. The yield on average invested
assets and cash was 7.3% for the six months ended June 30, 2002, compared to
7.5% for the six months ended June 30, 2001. The decrease was partially offset
by a $206.2 million, or 2%, increase in average invested assets and cash.
Benefits, claims and settlement expenses decreased $50.2 million, or 4%, to
$1,210.2 million for the six months ended June 30, 2002, from $1,260.4 million
for the six months ended June 30, 2001. Group medical insurance benefits, claims
and settlement expenses decreased $38.3 million, due to ceded claims under a new
reinsurance agreement; a reduction in group medical insurance business; and
improved claim experience, partially offset by a reserve established due to the
withdrawal of medical products from the Florida small employer market.
Individual traditional life insurance benefits, claims, and settlement expenses
decreased $13.7 million primarily due to lower death claims and a lower reserve
increase related to the decrease in premium. Group dental insurance benefits,
claims and settlement expenses decreased $11.5 million due to improved claim
experience and a decline in business. Partially offsetting the decreases was a
$7.7 million increase in individual interest sensitive life insurance benefits,
claims, and settlement expenses primarily due to growth in the business.
Dividends to policyholders decreased $2.4 million to $155.9 million for the six
months ended June 30, 2002, from $158.3 million for the six months ended June
30, 2001. The decrease was due to a change in the individual life insurance
dividend scale.
Operating expenses decreased $3.1 million, or 1%, to $419.5 million for the six
months ended June 30, 2002, from $422.6 million for the six months ended June
30, 2001. Group life and health insurance operating expenses decreased $2.6
million, primarily due to several one-time expenses in 2001. Individual life and
disability insurance operating expenses decreased $0.5 million primarily due to
classifying fees received from reinsurance ceded from fees to operating expense
in 2002, but was partially offset by an increase in compensation costs related
to our distribution system.
Income taxes increased $15.4 million, or 33%, to $61.4 million for the six
months ended June 30, 2002, from $46.0 million for the six months ended June 30,
2001. The effective income tax rate for the segment was 35% for the six months
ended June 30, 2002 and 34% for the six months ended June 30, 2001. The
effective income tax rate for the six months ended June 30, 2001, was lower than
the corporate income tax rate of 35% primarily due to tax-exempt income.
As a result of the foregoing factors, operating earnings increased $25.1
million, or 28%, to $116.0 million for the six months ended June 30, 2002, from
$90.9 million for the six months ended June 30, 2001.
Net realized capital losses, as adjusted, increased $26.6 million to $31.3
million for the six months ended June 30, 2002, from $4.7 million for the six
months ended June 30, 2001. The increase includes realized capital losses
related to other than temporary declines in the value of certain fixed maturity
securities and sales of fixed maturity securities for the six months ended June
30, 2002.
As a result of the foregoing factors and the inclusion of non-recurring items,
net income decreased $6.2 million, or 7%, to $80.1 million for the six months
ended June 30, 2002, from $86.3 million for the six months ended June 30, 2001.
Non-recurring items for the six months ended June 30, 2002, had a negative
impact on net income of $4.6 million, net of income taxes, due to the cumulative
effect of accounting change, a result of our implementation of SFAS 142.
Non-recurring items for the six months ended June 30, 2001, had a positive
impact on net income of $0.1 million, net of income taxes, due to the cumulative
effect of accounting change, a result of our implementation of SFAS 133.
43
MORTGAGE BANKING SEGMENT
The following table presents certain summary financial data relating to the
Mortgage Banking segment for the periods indicated:
FOR THE THREE FOR THE SIX
MONTHS ENDED MONTHS ENDED
JUNE 30, JUNE 30,
--------------------------- -----------------------------
2002 2001 2002 2001
----------- ----------- ------------ ------------
(IN MILLIONS)
OPERATING EARNINGS DATA:
Operating Revenues(1):
Loan servicing..................... $ 152.5 $ 92.1 $ 280.1 $ 181.0
Loan production.................... 57.2 81.4 138.3 112.1
----------- ----------- ------------ ------------
Total operating revenues......... 209.7 173.5 418.4 293.1
Expenses:
Loan servicing..................... 130.9 69.9 258.8 129.5
Loan production.................... 39.2 34.5 77.9 57.8
----------- ----------- ------------ ------------
Total expenses................... 170.1 104.4 336.7 187.3
----------- ----------- ------------ ------------
Pre-tax operating earnings........... 39.6 69.1 81.7 105.8
Income taxes......................... 14.8 24.2 30.4 37.0
----------- ----------- ------------ ------------
Operating earnings................... 24.8 44.9 51.3 68.8
Net realized capital gains (losses),
as adjusted........................ - - - -
Non-recurring items.................. - - - -
----------- ----------- ------------ ------------
U.S. GAAP REPORTED:
Net income........................... $ 24.8 $ 44.9 $ 51.3 $ 68.8
=========== =========== ============ ============
- ------------
(1) Excludes net realized capital gains (losses) and their impact on
recognition of front-end fee revenues and certain market value adjustments
to fee revenues.
THREE MONTHS ENDED JUNE 30, 2002 COMPARED TO THREE MONTHS ENDED JUNE 30, 2001
Total operating revenues increased $36.2 million, or 21%, to $209.7 million for
the three months ended June 30, 2002, from $173.5 million for the three months
ended June 30, 2001. A $60.4 million increase in residential mortgage loan
servicing revenues reflects the growth in loan servicing portfolio. The average
balance of the servicing portfolio was $93.2 billion for the three months ended
June 30, 2002, compared to $60.6 billion for the same period a year ago. In
addition, mortgage loan servicing revenues increased due to a gain on the sale
of approximately $300.0 million of delinquent Government National Mortgage
Association ("GNMA") loans during the three months ended June 30, 2002. This
sale generated revenues of $15.0 million in 2002 with no corresponding sale of
loans in 2001. Residential mortgage loan production revenues decreased $24.2
million primarily due to the decrease in revenue from secondary marketing
activities, the process by which Mortgage Banking pools and sells loans.
Furthermore, mortgage loan production declined to $9.1 billion for the three
months ended June 30, 2002, compared to $10.5 billion for the same period a year
ago.
Total expenses increased $65.7 million, or 63%, to $170.1 million for the three
months ended June 30, 2002, from $104.4 million for the three months ended June
30, 2001. A $61.0 million increase in residential mortgage loan servicing
expenses resulted from a $32.1 million increase in impairment of capitalized
mortgage servicing rights net of servicing hedge activity and from increased
expenses related to growth in the servicing portfolio. Residential mortgage loan
production expenses increased $4.7 million, representing growth experienced in
the wholesale and mortgage direct production channels.
Income taxes decreased $9.4 million, or 39%, to $14.8 million for the three
months ended June 30, 2002, from $24.2 million for the three months ended June
30, 2001. The decrease in income taxes primarily resulted from a decrease in
44
pre-tax operating earnings. The effective income tax rate for this segment was
37% for the three months ended June 30, 2002, and 35% for the three months ended
June 30, 2001. The effective income tax rate for the three months ended June 30,
2002, was higher than the corporate income tax rate of 35% due to the allocation
of deferred state taxes.
As a result of the foregoing factors, operating earnings and net income
decreased $20.1 million, or 45%, to $24.8 million for the three months ended
June 30, 2002, from $44.9 million for the three months ended June 30, 2001.
SIX MONTHS ENDED JUNE 30, 2002 COMPARED TO SIX MONTHS ENDED JUNE 30, 2001
Total operating revenues increased $125.3 million, or 43%, to $418.4 million for
the six months ended June 30, 2002, from $293.1 million for the six months ended
June 30, 2001. A $99.1 million increase in residential mortgage loan servicing
revenues reflects an increase in the residential mortgage loan servicing
portfolio. The average balance of the servicing portfolio was $89.2 billion for
the six months ended June 30, 2002, compared to $58.8 billion for the same
period a year ago. In addition, mortgage loan servicing revenues increased due
to a gain on the sale of approximately $300.0 million of delinquent GNMA loans
during the second quarter of 2002. This sale generated revenues of $15.0 million
in 2002 with no corresponding sale of loans in 2001. Residential mortgage loan
production revenues increased $26.2 million primarily due to an increase in
mortgage loan production, which increased to $19.1 billion for the six months
ended June 30, 2002, compared to $15.4 billion for the same period a year ago.
The increase in residential mortgage loan production revenues was partially
offset by a decrease in revenue from secondary marketing activities, the process
by which Mortgage Banking pools and sells loans.
Total expenses increased $149.4 million, or 80%, to $336.7 million for the six
months ended June 30, 2002, from $187.3 million for the six months ended June
30, 2001. A $129.3 million increase in residential mortgage loan servicing
expenses resulted from a $73.4 million increase in impairment of capitalized
mortgage servicing rights net of servicing hedge activity and from increased
expenses related to growth in the servicing portfolio. Residential mortgage loan
production expenses increased $20.1 million, reflecting the increase in
residential mortgage loan production volume.
Income taxes decreased $6.6 million, or 18%, to $30.4 million for the six months
ended June 30, 2002, from $37.0 million for the six months ended June 30, 2001.
The decrease in income taxes primarily resulted from a decrease in pre-tax
operating earnings. The effective income tax rate for this segment was 37% for
the six months ended June 30, 2002, and 35% for the six months ended June 30,
2001. The effective income tax rate for the six months ended June 30, 2002, was
higher than the corporate income tax rate of 35% due to the allocation of
deferred state taxes.
As a result of the foregoing factors, operating earnings and net income
decreased $17.5 million, or 25%, to $51.3 million for the six months ended June
30, 2002, from $68.8 million for the six months ended June 30, 2001.
45
CORPORATE AND OTHER SEGMENT
The following table presents certain summary financial data relating to the
Corporate and Other segment for the periods indicated:
FOR THE THREE FOR THE SIX
MONTHS ENDED MONTHS ENDED
JUNE 30, JUNE 30,
--------------------------- ----------------------------
2002 2001 2002 2001
------------ ----------- ----------- ------------
(IN MILLIONS)
OPERATING EARNINGS DATA:
Operating Revenues (1):
Total operating revenues.............. $ 6.7 $ 22.5 $ 17.2 $ 57.5
Expenses:
Total expenses........................ 15.4 10.8 27.9 13.5
------------ ------------ ----------- ------------
Pre-tax operating earnings (loss).............. (8.7) 11.7 (10.7) 44.0
Income taxes (benefits)........................ (2.7) 3.4 (5.0) 11.9
------------ ------------ ----------- ------------
Operating earnings (loss)...................... (6.0) 8.3 (5.7) 32.1
Net realized capital gains (losses), as adjusted 5.6 (21.9) 118.6 (41.5)
Non-recurring items............................ - (10.9) (2.0) (20.7)
------------ ------------ ----------- ------------
U.S. GAAP REPORTED:
Net income (loss).............................. $ (0.4) $ (24.5) $ 110.9 $ (30.1)
============ ============ =========== ============
- ------------
(1) Excludes net realized capital gains (losses) and their impact on
recognition of front-end fee revenues and certain market value adjustments
to fee revenues.
THREE MONTHS ENDED JUNE 30, 2002 COMPARED TO THREE MONTHS ENDED JUNE 30, 2001
Total operating revenues decreased $15.8 million, or 70%, to $6.7 million for
the three months ended June 30, 2002, from $22.5 million for the three months
ended June 30, 2001. Net investment income decreased $13.4 million, primarily
reflecting a decrease in average investment yields for the segment.
Total expenses increased $4.6 million, or 43%, to $15.4 million for the three
months ended June 30, 2002, from $10.8 million for the three months ended June
30, 2001. Interest expense increased $4.0 million, primarily due to interest
related to federal income tax audit activities.
Income tax benefit decreased $6.1 million to a $2.7 million income tax benefit
for the three months ended June 30, 2002, from $3.4 million of income tax
expense for the three months ended June 30, 2001. The decrease was primarily a
result of a decrease in pre-tax operating earnings.
As a result of the foregoing factors, operating earnings decreased $14.3 million
to $6.0 million of operating loss for the three months ended June 30, 2002, from
$8.3 million of operating earnings for the three months ended June 30, 2001.
Net realized capital gains, as adjusted, increased $27.5 million to $5.6 million
of net realized capital gains for the three months ended June 30, 2002, from
$21.9 million of net realized capital losses for the three months ended June 30,
2001. The increase was primarily due to realized capital gains on real estate
sales.
As a result of the foregoing factors and the inclusion of non-recurring items,
net loss decreased $24.1 million, or 98%, to $0.4 million for the three months
ended June 30, 2002, from $24.5 million for the three months ended June 30,
2001. For the three months ended June 30, 2001, net income included the negative
effect of non-recurring items totaling $10.9 million, net of income taxes,
related to expenses of our demutualization.
46
SIX MONTHS ENDED JUNE 30, 2002 COMPARED TO SIX MONTHS ENDED JUNE 30, 2001
Total operating revenues decreased $40.3 million, or 70%, to $17.2 million for
the six months ended June 30, 2002, from $57.5 million for the six months ended
June 30, 2001. Net investment income decreased $39.4 million, reflecting a
decrease in investment gains on real estate due to lower sales of certain real
estate held-for-sale, compared to an unusually high volume of sales experienced
in 2001. In addition, net investment income decreased $8.4 million due to a
decrease of average investment yields for the segment. The decreases were
partially offset by a $5.9 million increase in net investment income, resulting
from an increase in average invested assets and cash.
Total expenses increased $14.4 million to $27.9 million for the six months ended
June 30, 2002, from $13.5 million for the six months ended June 30, 2001.
Interest expense increased $8.5 million, primarily due to interest related to
federal income tax audit activities. An increase of $3.0 million related to
corporate initiatives funded by this segment. In addition, $2.8 million increase
related to costs associated with operating as a public company.
Income tax benefits decreased $16.9 million to a $5.0 million income tax benefit
for the six months ended June 30, 2002, from $11.9 million of income tax expense
for the six months ended June 30, 2001. The decrease was primarily a result of a
decrease in pre-tax operating earnings.
As a result of the foregoing factors, operating earnings decreased $37.8 million
to $5.7 million of operating loss for the six months ended June 30, 2002, from
$32.1 million of operating earnings for the six months ended June 30, 2001.
Net realized capital gains, as adjusted, increased $160.1 million to $118.6
million of net realized capital gains for the six months ended June 30, 2002,
from $41.5 million of net realized capital losses for the six months ended June
30, 2001. The increase was primarily due to realized capital gains related to
the sale of our investment in Coventry in February 2002. In addition, the
increase was due in part to a decrease in realized capital losses on equity
security sales, and to a lesser extent, due to an increase in realized capital
gains on real estate sales.
As a result of the foregoing factors and the inclusion of non-recurring items,
net income increased $141.0 million to $110.9 million of net income for the six
months ended June 30, 2002, from $30.1 million of net loss for the six months
ended June 30, 2001. For the six months ended June 30, 2002, net income included
the negative effect of non-recurring items totaling $2.0 million, net of income
taxes, related to expenses of our demutualization. For the six months ended June
30, 2001, net income included the negative effect of non-recurring items
totaling $20.7 million, net of income taxes, related to: (1) expenses related to
our demutualization ($14.8 million) and (2) an increase in our loss contingency
reserve established for sales practices litigation ($5.9 million).
LIQUIDITY AND CAPITAL RESOURCES
SOURCES AND USES OF CASH OF CONSOLIDATED OPERATIONS
Net cash provided by operating activities was $2,000.4 million and $1,814.0
million for the six months ended June 30, 2002 and 2001, respectively. The
fluctuation in cash provided by our operations between periods is primarily
related to an increase in mortgage banking servicing and production fees, an
increase in single premium sales and an increase in bank deposits. These
increases were partially offset by fluctuations in total company payables.
Net cash used in investing activities was $1,392.4 million and $3,061.9 million
for the six months ended June 30, 2002 and 2001, respectively. The decrease in
cash used in 2002 as compared to 2001 resulted from an increase in proceeds from
the sale and maturities of available for sale securities as well as the sale of
our shares of Coventry stock.
Net cash provided by financing activities was $29.3 million and $693.2 million
for the six months ended June 30, 2002 and 2001, respectively. The fluctuation
in cash provided by financing activities between periods is primarily due to an
increase in net repayments of short-term debt as well as the repurchase of our
common stock.
Given the historical cash flow, we believe the cash flow from our consolidated
operating activities over the next year will provide sufficient liquidity for
our operations, as well as satisfy interest payments and any payments related to
debt servicing.
47
DIVIDENDS FROM PRINCIPAL LIFE
The payment of dividends by Principal Life to its parent company is limited by
Iowa laws. Under Iowa laws, Principal Life may pay dividends only from the
earned surplus arising from its business and must receive the prior approval of
the Insurance Commissioner of the State of Iowa ("the Commissioner") to pay a
stockholder dividend if such a stockholder dividend would exceed certain
statutory limitations. The current statutory limitation is the greater of:
o 10% of Principal Life's policyholder surplus as of the previous year-end; or
o the net gain from operations from the previous calendar year.
Iowa law gives the Commissioner discretion to disapprove requests for dividends
in excess of these limits. Based on this limitation and 2001 statutory results,
Principal Life could pay approximately $640.3 million in stockholder dividends
in 2002 without exceeding the statutory limitation.
Total stockholder dividends paid by Principal Life to its parent company through
June 30, 2002 was $390.0 million. On February 26, 2002, Principal Life declared
an ordinary dividend of $390.0 million, which was paid to its parent on April 5,
2002.
COMMON STOCK ISSUED AND TREASURY STOCK ACQUIRED
During the six months ended June 30, 2002, another source of liquidity was the
issuance of our common stock which resulted in $14.8 million of proceeds due to
common stock issued to employees participating in our Employee Stock Purchase
Plan and premium from the sale of "put options".
On February 26, 2002, our board of directors authorized the repurchase of up to
$450.0 million of our common stock. The repurchase will be made in the open
market or through privately negotiated transactions from time to time, depending
upon market conditions. During the six months ended June 30, 2002, we purchased
9.7 million shares in the open market at an aggregate cost of $273.4 million. In
February 2002, we reissued 0.4 million shares of treasury stock held in
the rabbi trust, which generated proceeds of $8.0 million, with a cost of $6.7
million.
INTERNATIONAL OPERATIONS
Primary sources of cash inflows for BT Financial Group are fee revenues and
interest spread earned on margin lending operations. Cash outflows consist
primarily of operating expenses. BT did not require any infusions of capital for
the six months ended June 30, 2002 or 2001.
Our Brazilian and Chilean operations, along with one of our Mexican companies,
produced positive cash flow from operations for the six months ended June 30,
2002 and 2001. These cash flows have been historically maintained at the local
country level for strategic expansion purposes. Our international operations
have required infusions of capital of $61.0 million for the six months ended
June 30, 2002, primarily to fund our acquisition of Zurich Afore in Mexico and
$19.7 million for the six months ended June 30, 2001, primarily to meet the cash
outflow requirements of our international operations. These other operations are
primarily in the start-up stage or are expanding in the short-term. Our capital
funding of these operations is consistent with our long-term strategy to
establish viable companies that can sustain future growth from internally
generated sources.
CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS
As of June 30, 2002, we had $1,342.2 million of long-term debt outstanding
compared to $1,378.4 million at December 31, 2001. Non-recourse medium-term
notes outstanding as of June 30, 2002, were $5,839.1 compared to $3,298.4 at
December 31, 2001. Non-recourse medium-term notes represent claims for principal
and interest under international funding agreements issued to non-qualified
institutional investors. The increase was due to sales of international funding
agreements during the six months ended June 30, 2002.
As of June 30, 2002, we had $400.2 million of short-term debt outstanding
compared to $511.6 million at December 31, 2001. Short-term debt consists
48
primarily of commercial paper and outstanding balances on revolving credit
facilities with various financial institutions. As of June 30, 2002, we had
credit facilities with various financial institutions in an aggregate amount of
$1.4 billion. We may borrow up to $600.0 million on a back-stop facility to
support our $1.0 billion commercial paper program. In addition, as of June 30,
2002, we have $780.0 million in credit facilities to finance a CMBS pipeline and
$45.0 million of unused lines of credit for short-term debt used for general
corporate purposes.
There have been no significant changes to the contractual obligations and
commitments since December 31, 2001.
OFF-BALANCE SHEET ARRANGEMENTS
We have entered into certain contracts to: 1) fund residential mortgage loan
production, 2) sell qualifying delinquent residential mortgage loans, and 3)
securitize margin loans. As appropriate under U.S. GAAP, the contracts involve
special purpose entities ("SPEs") or trusts that are not reported on our
consolidated statement of financial position.
RESIDENTIAL MORTGAGE LOAN PRODUCTION. Principal Residential Mortgage Capital
Resources, LLC ("PRMCR") provides an off-balance sheet source of funding for our
residential mortgage loan production. We sold approximately $19.4 billion in
residential mortgage loans to PRMCR in 2002. The maximum amount of residential
mortgage loans, which can be warehoused in PRMCR, has increased from $1.0
billion at inception to $4.0 billion as of June 30, 2002. PRMCR held $2.5
billion in residential mortgage loans held for sale as of June 30, 2002.
At June 30, 2002, PRMCR had outstanding equity certificates of $193.0 million,
secured liquidity notes of $0.8 billion, three-year fixed term notes of $800.0
million and five-year variable term notes of $800.0 million. We paid a
commitment fee to PRMCR based on the overall warehouse limit. PRMCR used a
portion of the fee to fund a cash collateral account maintained at PRMCR. These
funds are available as additional collateral to cover credit related losses on
defaulted loans. The balance in the account was $24.0 million at June 30, 2002.
Any remaining amounts in the cash collateral account will be returned to us upon
the termination of PRMCR. This right to the return of the cash collateral amount
is reflected in other assets on our consolidated statements of financial
position.
We maintain a right to the servicing of the residential mortgage loans held by
PRMCR and upon the sale of the majority of the residential mortgage loans to the
final investors. In addition, we perform certain secondary marketing, accounting
and various administrative functions on behalf of PRMCR. We received $10.9
million in servicing fees from PRMCR in 2002.
DELINQUENT RESIDENTIAL MORTGAGE LOAN FUNDING. Principal Residential Mortgage
Funding, LLC ("PRMF") provides an off-balance sheet source of funding for
qualifying delinquent residential mortgage loans. At June 30, 2002, PRMF held
$306.2 million in residential mortgage loans and had outstanding participation
certificates of $288.0 million.
We are retained as the servicer of the residential mortgage loans and also
perform accounting and various administrative functions on behalf of PRMF, in
its capacity as the managing member of PRMF. As the servicer, we receive a
servicing fee pursuant to the pooling and servicing agreement. We may also
receive a successful servicing fee only after all other conditions in the
monthly cash flow distribution are met. At June 30, 2002, our residual interest
in such cash flows was $24.7 million and was recorded in other investments on
the consolidated statements of financial position.
MARGIN LOAN SECURITIZATIONS. We sell loans under a margin loan securitization
program and retain primary servicing responsibilities and subordinated
interests. The estimated fair values of the retained interests, $41.4 million at
June 30, 2002, are based upon our relative ownership percentage of the book
value of the outstanding loan balances. Our retained interests increased
primarily due to fluctuations in foregin currency to U.S. dollar exchange rates.
This increase was partially offset by a decrease in net cash flows.
INVESTMENTS
We had total consolidated assets as of June 30, 2002, of $90.2 billion, of which
$46.2 billion were invested assets. The rest of our total consolidated assets
are comprised primarily of separate account assets for which we do not bear
investment risk. Because we generally do not bear any investment risk on assets
held in separate accounts, the discussion and financial information below does
not include such assets. Of our invested assets, $44.7 billion were held by our
U.S. operations and the remaining $1.5 billion were held by our International
Asset Management and Accumulation segment.
49
U.S. INVESTMENT OPERATIONS
Our U.S. invested assets are managed by Principal Capital Management, a
subsidiary of Principal Life. Our primary investment objective is to maximize
after-tax returns consistent with acceptable risk parameters. We seek to protect
policyholders' benefits by optimizing the risk/return relationship on an ongoing
basis, through asset/liability matching, reducing the credit risk, avoiding high
levels of investments that may be redeemed by the issuer, maintaining
sufficiently liquid investments and avoiding undue asset concentrations through
diversification. We are exposed to three primary sources of investment risk:
o credit risk, relating to the uncertainty associated with the continued
ability of a given obligor to make timely payments of principal and
interest;
o interest rate risk, relating to the market price and/or cash flow variability
associated with changes in market yield curves; and
o equity risk, relating to adverse fluctuations in a particular common stock.
Our ability to manage credit risk is essential to our business and our
profitability. We devote considerable resources to the credit analysis of each
new investment. We manage credit risk through industry, issuer and asset class
diversification. Our Investment Committee, appointed by our board of directors,
establishes all investment policies and reviews and approves all investments. As
of June 30, 2002, there are nine members on the Investment Committee, one of
whom is a member of our board of directors. The remaining eight members are
senior management members representing various areas of our company.
Our Fixed Income Securities Committee, consisting of fixed income securities
senior management members, approves the credit rating for the fixed maturity
securities we purchase. Teams of security analysts organized by industry focus
either on the public or private markets and analyze and monitor these
investments. In addition, we have teams who specialize in residential
mortgage-backed securities, commercial mortgage-backed securities and public
below investment grade securities. We establish a credit reviewed list of
approved public issuers to provide an efficient way for our portfolio managers
to purchase liquid bonds for which credit review has already been completed.
Issuers remain on the list for six months unless removed by our analyst. Our
analysts monitor issuers on the list on a continuous basis with a formal review
documented every six months or more frequently if material events affect the
issuer. The analysis includes both fundamental and technical factors. The
fundamental analysis encompasses both quantitative and qualitative analysis of
the issuer.
The qualitative analysis includes an assessment of both accounting and
management aggressiveness. In addition, technical indicators such as stock price
volatility and credit default swap levels are monitored.
Our Fixed Income Securities Committee also reviews private transactions on a
continuous basis to assess the quality ratings of our privately placed
investments. We regularly review our investments to determine whether we should
re-rate them, employing the following criteria:
o material declines in the issuer's revenues or margins;
o significant management or organizational changes;
o significant uncertainty regarding the issuer's industry;
o debt service coverage or cash flow ratios that fall below industry-specific
thresholds;
o violation of financial covenants; and
o other business factors that relate to the issuer.
A dedicated risk management team is responsible for centralized monitoring of
the commercial mortgage portfolio. We apply a variety of strategies to minimize
credit risk in our commercial mortgage loan portfolio. When considering the
50
origination of new commercial mortgage loans, we review the cash flow
fundamentals of the property, make a physical assessment of the underlying
security, conduct a comprehensive market analysis and compare against industry
lending practices. We use a proprietary risk rating model to evaluate all new
and a majority of existing loans within the portfolio. The proprietary risk
model is designed to stress projected cash flows under simulated economic and
market downturns. Our lending guidelines are designed to encourage 75% or less
loan-to-value ratios and a debt service coverage ratio of at least 1.2 times. We
analyze investments outside of these guidelines based on cash flow quality,
tenancy and other factors. The weighted average loan-to-value ratio at
origination for brick and mortar commercial mortgages in our portfolio was 68%
and the debt service coverage ratio at loan inception was 1.7 times as of June
30, 2002.
We have limited exposure to equity risk in our common stock portfolio. Equity
securities accounted for only 2% of our U.S. invested assets as of June 30,
2002.
Our investment decisions and objectives are a function of the underlying risks
and product profiles of each primary business operation. In addition, we
diversify our product portfolio offerings to include products that contain
features that will protect us against fluctuations in interest rates. Those
features include adjustable crediting rates, policy surrender charges and market
value adjustments on liquidations. For further information on our management of
interest rate risk, see Item 3, "Quantitative and Qualitative Disclosures about
Market Risk".
OVERALL COMPOSITION OF U.S. INVESTED ASSETS
U.S. invested assets as of June 30, 2002, were predominantly of high quality and
broadly diversified across asset class, individual credit, industry and
geographic location. As shown in the following table, the major categories of
U.S. invested assets are fixed maturity securities and commercial mortgages. The
remainder is invested in real estate, equity securities and other assets. In
addition, policy loans are included in our invested assets. We combined our
invested assets in the Closed Block with invested assets outside the Closed
Block in view of the similar asset quality characteristics of the two
portfolios. The following discussion analyzes the composition of U.S. invested
assets, which includes $4,244.7 million in invested assets of the Closed Block
as of June 30, 2002, but excludes invested assets of the participating separate
accounts.
U.S. INVESTED ASSETS
AS OF JUNE 30, AS OF DECEMBER 31,
---------------------- -------------------
2002 2001
---------------------- -------------------
CARRYING % OF CARRYING % OF
AMOUNT TOTAL AMOUNT TOTAL
----------- ------ ----------- -----
($ IN MILLIONS)
Fixed maturity securities
Public......................................... $ 20,049.4 45% $ 18,227.6 42%
Private........................................ 10,592.9 24 10,800.2 25
Equity securities, available-for-sale............. 795.3 2 808.7 2
Mortgage loans
Commercial .................................... 9,544.2 21 9,740.4 22
Residential.................................... 1,055.2 2 1,144.2 3
Real estate held for sale ........................ 307.5 1 390.7 1
Real estate held for investment................... 878.9 2 783.4 2
Policy loans...................................... 824.7 2 831.9 2
Other investments ................................ 669.0 1 678.4 1
----------- ----- ----------- -----
Total invested assets.......................... $ 44,717.1 100% $ 43,405.5 100%
===== =====
Cash and cash equivalents......................... 1,102.7 495.8
----------- -----------
Total invested assets and cash ................ $ 45,819.8 $ 43,901.3
=========== ===========
We actively manage public fixed maturity securities, including our portfolio of
residential mortgage-backed securities, in order to provide liquidity and
enhance yield and total return. Our residential mortgage-backed securities are
managed to ensure that the securities we hold trade close to or below par in
51
order to manage prepayment risk. This active management has resulted in the
realization of capital gains and losses with respect to such investments.
U.S. INVESTMENT RESULTS
The yield on U.S. invested assets and on cash and cash equivalents, excluding
net realized gains and losses, was 7.0% and 7.5% for the three months ended June
30, 2002, and 2001, respectively, and 7.0% and 7.7% for the six months ended
June 30, 2002, and 2001, respectively.
The following table illustrates the yields on average assets for each of the
components of our investment portfolio for the three months and six months ended
June 30, 2002 and 2001, respectively:
52
U.S. INVESTED ASSETS
YIELDS BY ASSET TYPE
AS OF OR FOR THE THREE MONTHS AS OF OR FOR THE SIX MONTHS
ENDED JUNE 30, ENDED JUNE 30,
---------------------------------- ----------------------------------
2002 2001 2002 2001
---------------- ---------------- ---------------- ----------------
YIELD AMOUNT YIELD AMOUNT YIELD AMOUNT YIELD AMOUNT
----- --------- ----- --------- ----- --------- ----- ---------
($ IN MILLIONS)
Fixed maturity securities
Gross investment income (1).......... 6.9% $ 524.3 7.3% $ 521.5 7.0% $ 1,042.2 7.7% $ 1,045.0
Net realized capital losses.......... (1.5) (116.6) (0.7) (52.2) (1.3) (195.7) (0.6) (77.5)
--------- --------- --------- ---------
Total.............................. $ 407.7 $ 469.3 $ 846.5 $ 967.5
========= ========= ========= =========
Ending assets (at carrying value).... $30,642.3 $28,504.0 $30,642.3 $28,504.0
Equity securities, available-for-sale
Gross investment income (1).......... 3.7% $ 7.8 2.2% $ 3.1 4.1% $ 16.6 2.3% $ 6.9
Net realized capital losses.......... (3.4) (7.0)(15.6) (21.8) (3.5) (14.1)(19.1) (57.6)
--------- --------- --------- ---------
Total.............................. $ 0.8 $ (18.7) $ 2.5 $ (50.7)
========= ========= ========= ==========
Ending assets (at carrying value).... $ 795.3 $ 539.4 $ 795.3 $ 539.4
Mortgage loans - Commercial
Gross investment income (1).......... 7.7% $ 183.1 8.2% $ 214.8 7.6% $ 365.4 8.0% $ 422.1
Net realized capital gains (losses).. (0.1) (2.9) 0.2 6.1 (0.2) (9.9) 0.3 14.9
--------- --------- --------- ---------
Total.............................. $ 180.2 $ 220.9 $ 355.5 $ 437.0
========= ========= ========= =========
Ending assets (at carrying value).... $ 9,544.2 $10,340.7 $ 9,544.2 $10,340.7
Mortgage loans - Residential
Gross investment income (1).......... 6.1% $ 16.6 8.0% $ 17.5 6.6% $ 36.1 7.3% $ 28.7
Net realized capital gains (losses).. - - - - - - - -
--------- --------- --------- ---------
Total.............................. $ 16.6 $ 17.5 $ 36.1 $ 28.7
========= ========= ========= =========
Ending assets (at carrying value).... $ 1,055.2 $ 1,023.3 $ 1,055.2 $ 1,023.3
Real estate
Gross investment income (1).......... 8.6% $ 26.2 12.2% $ 36.8 8.5% $ 50.1 15.3% $ 100.0
Net realized capital gains (losses).. 6.3 19.1 (7.0) (21.2) 3.1 18.1 - (0.3)
--------- --------- --------- ---------
Total.............................. $ 45.3 $ 15.6 $ 68.2 $ 99.7
========= ========= ========= =========
Ending assets (at carrying value).... $ 1,186.4 $ 1,230.3 $ 1,186.4 $ 1,230.3
Policy loans
Gross investment income (1).......... 7.0% $ 14.4 7.4% $ 15.1 7.0% $ 28.9 7.2% $ 29.4
Net realized capital gains (losses).. - - - - - - - -
--------- --------- --------- ---------
Total.............................. $ 14.4 $ 15.1 $ 28.9 $ 29.4
========= ========= ========= =========
Ending assets (at carrying value).... $ 824.7 $ 820.1 $ 824.7 $ 820.1
Cash and cash equivalents
Gross investment income (1).......... 1.4% $ 2.7 21.1% $ 17.0 1.8% $ 7.0 6.2% $ 15.4
Net realized capital losses.......... - - - - (0.3) (1.0) - -
--------- --------- --------- ---------
Total.............................. $ 2.7 $ 17.0 $ 6.0 $ 15.4
========= ========= ========= =========
Ending assets (at carrying value).... $ 1,102.7 $ 237.1 $ 1,102.7 $ 237.1
Other investments
Gross investment income (1).......... 24.7% $ 36.8 6.2% $ 12.0 21.8% $ 73.3 8.4% $ 30.9
Net realized capital gains (losses).. (9.0) (13.4) (3.0) (5.9) 51.2 172.6 (4.8) (17.7)
--------- --------- --------- ---------
Total.............................. $ 23.4 $ 6.1 $ 245.9 $ 13.2
========= ========= ========= =========
Ending assets (at carrying value).... $ 669.0 $ 786.9 $ 669.0 $ 786.9
Total before investment expenses
Gross investment income.............. 7.2% $ 811.9 7.7% $ 837.8 7.2% $ 1,619.6 7.9% $ 1,678.4
Net realized capital losses.......... (1.1) (120.8) (0.9) (95.0) (0.1) (30.0) (0.7) (138.2)
--------- --------- --------- ---------
Total.......................... $ 691.1 $ 742.8 $ 1,589.6 $ 1,540.2
========= ========= ========= =========
Investment expenses.................... 0.2% $ 23.8 0.2% $ 26.0 0.2% $ 42.8 0.2% $ 53.0
Net investment income.................. 7.0% $ 788.1 7.5% $ 811.8 7.0% $ 1,576.8 7.7% $ 1,625.4
- --------------------
(1) Yields, which are annualized for interim periods, are based on quarterly
average asset carrying values for the three months and six months ended June
30, 2002 and 2001.
53
FIXED MATURITY SECURITIES
We have classified the majority of our fixed maturity securities as
available-for-sale. Accordingly, we mark such securities to market, with
unrealized gains and losses excluded from earnings and reported as a separate
component of other comprehensive income, net of deferred income taxes and an
adjustment for the effect on deferred policy acquisition costs that would have
occurred had such gains and losses been realized. We write down to fair value
securities whose value is deemed other than temporarily impaired. We record
write-downs as realized losses included in net income and adjust the cost basis
of such securities to fair value. The new cost basis is not changed for
subsequent recoveries in value. Factors considered in evaluating whether a
decline in value is other than temporary are: 1) whether the decline is
substantial; 2) our ability and intent to retain the investment for a period of
time sufficient to allow for an anticipated recovery in value; 3) the duration
and extent to which the market value has been less than cost; and 4) the
financial condition and near-term prospects of the issuer.
Fixed maturity securities consist of short-term investments, publicly traded
debt securities, privately placed debt securities and small amounts of
redeemable preferred stock, and represented 69% of total U.S. invested assets as
of June 30, 2002 and 67% as of December 31, 2001. The fixed maturity securities
portfolio was comprised, based on carrying amount, of 65% in publicly traded
fixed maturity securities and 35% in privately placed fixed maturity securities
as of June 30, 2002, and 63% in publicly traded fixed maturity securities and
37% in privately placed fixed maturity securities as of December 31, 2001.
Included in the privately placed category as of June 30, 2002, were $3.6 billion
of securities eligible for resale to qualified institutional buyers under Rule
144A under the Securities Act of 1933. Fixed maturity securities were
diversified by category of issuer as of June 30, 2002, and December 31, 2001, as
shown in the following table:
U.S. INVESTED ASSETS
FIXED MATURITY SECURITIES BY TYPE OF ISSUER
AS OF JUNE 30, AS OF DECEMBER 31,
----------------- -----------------
2002 2001
----------------- -----------------
CARRYING % OF CARRYING % OF
AMOUNT TOTAL AMOUNT TOTAL
--------- ------ --------- ------
($ IN MILLIONS)
U.S. Treasury securities and obligations of U.S.
Government corporations and agencies............. $ 297.9 1% $ 15.1 -%
States and political subdivisions................... 349.5 1 317.5 1
Foreign governments................................. 504.0 2 603.5 2
Corporate - public.................................. 14,666.4 48 13,038.8 45
Corporate - private................................. 9,028.6 29 9,171.1 32
Mortgage-backed securities and other asset-
backed securities................................ 5,795.9 19 5,881.8 20
--------- ---- --------- ----
Total fixed maturities........................... $30,642.3 100% $29,027.8 100%
========= ==== ========= ====
The international exposure in our U.S. invested assets totaled $3,909.1 million,
or 13%, of total fixed maturity securities, as of June 30, 2002, comprised of
corporate and foreign government fixed maturity securities. Of the $3,909.1
million as of June 30, 2002, investments totaled $1,124.1 million in the United
Kingdom, $659.4 million in the continental European Union, $565.5 million in
Asia, $359.1 million in Australia, $319.8 million in South America and $21.1
million in Japan. The remaining $860.1 million was invested in 13 other
countries. All international fixed maturity securities held by our U.S.
operations are either denominated in U.S. dollars or have been swapped into U.S.
dollar equivalents. Our international investments are analyzed internally by
country and industry credit investment professionals. We control concentrations
using issuer and country level exposure benchmarks, which are based on the
credit quality of the issuer and the country. Our investment policy limits total
international fixed maturity securities investments to 15% of total statutory
general account assets with a 4% limit in emerging markets. Exposure to Canada
is not included in our international exposure due to its treatment by the NAIC.
As of June 30, 2002, our investments in Canada totaled $1,115.9 million.
The Securities Valuation Office of the NAIC evaluates most of the fixed maturity
securities that we and other U.S. insurance companies hold. The Securities
Valuation Office evaluates the bond investments of insurers for regulatory
reporting purposes and assigns securities to one of six investment categories.
The NAIC Designations closely mirror the nationally recognized securities rating
organizations' credit ratings for marketable bonds. NAIC Designations 1 and 2
include bonds considered investment grade by such rating organizations. Bonds
54
are considered investment grade when rated "Baa3" or higher by Moody's, or
"BBB-" or higher by Standard & Poor's. NAIC Designations 3 through 6 are
referred to as below investment grade. Bonds are considered below investment
grade when rated "Ba1" or lower by Moody's, or "BB+" or lower by Standard &
Poor's.
We also monitor the credit drift of our corporate fixed maturity securities
portfolio. Credit drift is defined as the ratio of the percentage of rating
downgrades, including defaults, divided by the percentage of rating upgrades. We
measure credit drift once each fiscal year, assessing the changes in our
internally developed credit ratings that have occurred during the year. Standard
& Poor's annual credit ratings drift ratio measures the credit rating change,
within a specific year, of companies that have been assigned ratings by Standard
& Poor's. The annual internal credit drift ratio on corporate fixed maturity
securities we held in our general account was 2.43 times compared to the
Standard & Poor's drift ratio of 4.27 times, as of December 31, 2001.
The following tables present our publicly traded, privately placed and total
fixed maturity securities by NAIC Designation and the equivalent ratings of the
nationally recognized securities rating organizations as of June 30, 2002, and
December 31, 2001, as well as the percentage, based on estimated fair value,
that each designation comprises:
U.S. INVESTED ASSETS
PUBLICLY TRADED FIXED MATURITY SECURITIES BY CREDIT QUALITY
AS OF JUNE 30, 2002 AS OF DECEMBER 31, 2001
------------------------------ ------------------------------
% OF % OF
RATING TOTAL TOTAL
NAIC AGENCY AMORTIZED CARRYING CARRYING AMORTIZED CARRYING CARRYING
RATING EQUIVALENT COST AMOUNT AMOUNT COST AMOUNT AMOUNT
- ------ --------------------- --------- --------- -------- --------- --------- --------
($ IN MILLIONS)
1 Aaa/Aa/A............. $10,276.8 $10,775.9 54% $ 9,955.3 $10,406.5 57%
2 Baa.................. 8,393.0 8,511.1 42 6,939.5 7,112.8 39
3 Ba................... 581.8 550.3 3 496.3 474.5 3
4 B.................... 154.5 148.9 1 165.3 148.4 1
5 Caa and lower........ 44.6 38.5 - 28.4 26.5 -
6 In or near default... 27.6 24.7 - 60.6 58.9 -
--------- --------- ----- --------- --------- -----
Total public
fixed maturities... $19,478.3 $20,049.4 100% $17,645.4 $18,227.6 100%
========= ========= ==== ========= ========= ====
U.S. INVESTED ASSETS
PRIVATELY PLACED FIXED MATURITY SECURITIES BY CREDIT QUALITY
AS OF JUNE 30, 2002 AS OF DECEMBER 31, 2001
------------------------------ ------------------------------
% OF % OF
RATING TOTAL TOTAL
NAIC AGENCY AMORTIZED CARRYING CARRYING AMORTIZED CARRYING CARRYING
RATING EQUIVALENT COST AMOUNT AMOUNT COST AMOUNT AMOUNT
- ------ --------------------- --------- --------- -------- --------- --------- --------
($ IN MILLIONS)
1 Aaa/Aa/A............. $ 4,081.2 $ 4,274.4 40% $ 4,184.6 $ 4,349.7 40%
2 Baa.................. 4,687.4 4,833.0 46 4,780.5 4,921.8 46
3 Ba................... 1,055.2 1,051.1 10 1,105.7 1,085.9 10
4 B.................... 199.2 184.0 2 236.4 223.7 2
5 Caa and lower........ 58.4 48.2 - 64.0 64.3 1
6 In or near default... 207.9 202.2 2 180.3 154.8 1
--------- --------- ----- --------- --------- -----
Total private
fixed maturities... $10,289.3 $10,592.9 100% $10,551.5 $10,800.2 100%
========= ========= ==== ========= ========= ====
55
U.S. INVESTED ASSETS
TOTAL FIXED MATURITY SECURITIES BY CREDIT QUALITY
AS OF JUNE 30, 2002 AS OF DECEMBER 31, 2001
------------------------------ ------------------------------
% OF % OF
RATING TOTAL TOTAL
NAIC AGENCY AMORTIZED CARRYING CARRYING AMORTIZED CARRYING CARRYING
RATING EQUIVALENT COST AMOUNT AMOUNT COST AMOUNT AMOUNT
- ------ --------------------- --------- --------- -------- --------- --------- --------
($ IN MILLIONS)
1 Aaa/Aa/A............. $14,358.0 $15,050.3 49% $14,139.9 $14,756.2 51%
2 Baa.................. 13,080.4 13,344.1 44 11,720.0 12,034.6 42
3 Ba................... 1,637.0 1,601.4 5 1,602.0 1,560.4 5
4 B.................... 353.7 332.9 1 401.7 372.1 1
5 Caa and lower........ 103.0 86.7 - 92.4 90.8 -
6 In or near default... 235.5 226.9 1 240.9 213.7 1
--------- --------- ----- --------- --------- -----
Total fixed
maturities......... $29,767.6 $30,642.3 100% $28,196.9 $29,027.8 100%
========= ========= ===== ========= ========= ====
We believe that our long-term fixed maturity securities portfolio is well
diversified among industry types and between publicly traded and privately
placed securities. Each year we direct the majority of our net cash inflows into
investment grade fixed maturity securities. We typically invest up to 7% of
general account cash flow in below investment grade assets. While the general
account investment returns have improved due to the below investment grade asset
class, we manage its growth strategically by limiting it to 10% of the total
fixed maturity securities portfolio.
We invest in privately placed fixed maturity securities to enhance the overall
value of the portfolio, increase diversification and obtain higher yields than
are possible with comparable quality public market securities. Generally,
private placements provide broader access to management information,
strengthened negotiated protective covenants, call protection features and,
where applicable, a higher level of collateral. They are, however, generally not
freely tradable because of restrictions imposed by federal and state securities
laws and illiquid trading markets. As of June 30, 2002, the percentage, based on
estimated fair value, of total publicly traded and privately placed fixed
maturity securities that were investment grade with an NAIC Designation 1 or 2
was 93%.
The following tables show the carrying amount of our corporate fixed maturity
securities by industry category, as well as the percentage of the total
corporate portfolio that each industry category comprises as of June 30, 2002,
and December 31, 2001. The tables also show by industry category the relative
amounts of publicly traded and privately placed securities.
56
U.S. INVESTED ASSETS
CORPORATE FIXED MATURITY SECURITIES PORTFOLIO BY INDUSTRY AS OF JUNE 30, 2002
PUBLICLY TRADED PRIVATELY PLACED TOTAL
------------------- ------------------ -----------------
CARRYING % OF CARRYING % OF CARRYING % OF
AMOUNT TOTAL AMOUNT TOTAL AMOUNT TOTAL
----------- ------- ----------- ----- ---------- -----
($ IN MILLIONS)
INDUSTRY CLASS
Transportation and Public Utilities..... $ 5,273.0 36% $ 2,022.2 22% $ 7,295.2 31%
Finance, Insurance and Real Estate...... 3,624.5 25 2,134.4 24 5,758.9 24
Manufacturing........................... 3,214.8 22 2,393.1 27 5,607.9 24
Mining.................................. 1,249.6 9 921.0 10 2,170.6 9
Retail.................................. 592.7 4 743.1 8 1,335.8 6
Services................................ 429.8 3 536.0 6 965.8 4
Agriculture, Forestry and Fishing....... 219.2 1 47.7 1 266.9 1
Public Administration................... 60.8 - 123.6 1 184.4 1
Construction............................ 2.0 - 107.5 1 109.5 -
----------- ---- ----------- ---- ---------- ----
Total............................... $ 14,666.4 100% $ 9,028.6 100% $23,695.0 100%
=========== === =========== === ========== ===
U.S. INVESTED ASSETS
CORPORATE FIXED MATURITY SECURITIES PORTFOLIO BY INDUSTRY AS OF DECEMBER 31, 2001
PUBLICLY TRADED PRIVATELY PLACED TOTAL
------------------- ------------------ ------------------
CARRYING % OF CARRYING % OF CARRYING % OF
AMOUNT TOTAL AMOUNT TOTAL AMOUNT TOTAL
----------- ------- ----------- ----- ----------- -----
($ IN MILLIONS)
INDUSTRY CLASS
Transportation and Public Utilities... $ 5,119.9 39% $ 2,120.7 23% $ 7,240.6 33%
Finance, Insurance and Real Estate.... 3,296.0 25 2,107.7 23 5,403.7 24
Manufacturing......................... 2,765.9 21 2,461.9 27 5,227.8 23
Mining................................ 891.5 7 865.0 9 1,756.5 8
Retail................................ 484.4 4 738.6 8 1,223.0 5
Services.............................. 384.2 3 593.9 7 978.1 4
Public Administration................. 31.8 - 122.6 1 154.4 1
Construction.......................... 1.8 - 112.5 1 114.3 1
Agriculture, Forestry and Fishing..... 63.3 1 48.2 1 111.5 1
----------- ---- ----------- ---- ----------- ----
Total............................. $ 13,038.8 100% $ 9,171.1 100% $ 22,209.9 100%
=========== === =========== === =========== ===
As of June 30, 2002, our largest unaffiliated single concentration of fixed
maturity securities consisted of $341.1 million of corporate bonds by American
International Group and its affiliates. This represented approximately 1% of our
total U.S. invested assets as of June 30, 2002. No other individual
non-government issuer represented more than 1% of U.S. invested assets.
We held $5,795.9 million of mortgage-backed and asset-backed securities as of
June 30, 2002, and $5,881.8 million as of December 31, 2001. The following table
presents the types of mortgage-backed securities ("MBSs"), as well as other
asset-backed securities, held as of the dates indicated:
57
U.S. INVESTED ASSETS
MORTGAGE AND ASSET-BACKED SECURITIES
CARRYING AMOUNT
AS OF JUNE 30, AS OF DECEMBER 31,
-------------- ------------------
2002 2001
-------------- ------------------
(IN MILLIONS)
Residential pass-through securities......... $ 2,621.4 $ 2,855.5
Commercial MBS.............................. 2,140.2 1,874.1
Asset-backed securities..................... 1,034.3 1,152.2
-------------- ------------------
Total MBSs and asset-backed securities.... $ 5,795.9 $ 5,881.8
============== ==================
We believe that it is desirable to hold residential mortgage-backed securities
due to their credit quality and liquidity as well as portfolio diversification
characteristics. Our portfolio is comprised of GNMA, FNMA and FHLMC pass-through
securities and is actively managed to ensure that the securities held are
trading close to or below par, in order to reduce risk of prepayments. As of
June 30, 2002, we held no collateralized mortgage obligations in our U.S.
invested asset portfolio.
Commercial mortgage-backed securities provide high levels of credit protection,
diversification, reduced event risk and enhanced liquidity. Commercial
mortgage-backed securities are predominantly comprised of rated large pool
securitizations that are individually and collectively diverse by property type,
borrower and geographic dispersion.
We purchase asset-backed securities, ("ABS"), to diversify the overall credit
risks of the fixed maturity securities portfolio and to provide attractive
returns. The principal risks in holding asset-backed securities are structural
and credit risks. Structural risks include the security's priority in the
issuer's capital structure, the adequacy of and ability to realize proceeds from
the collateral and the potential for prepayments. Credit risks involve
issuer/servicer risk where collateral values can become impaired in the event of
servicer credit deterioration.
Our ABS portfolio is diversified both by type of asset and by issuer. We
actively monitor holdings of asset-backed securities to ensure that the risk
profile of each security improves or remains consistent. If we are not receiving
an adequate yield for the risk, relative to other investment opportunities, we
will attempt to sell the security. Prepayments in the ABS portfolio are, in
general, insensitive to changes in interest rates or are insulated to such
changes by call protection features. In the event that we are subject to
prepayment risk, we monitor the factors that impact the level of prepayment and
prepayment speed for those asset-backed securities. To the extent we believe
that prepayment risk increases, we may attempt to sell the security and reinvest
in another security that offers better yield relative to the risk. In addition,
we diversify the risks of asset-backed securities by holding a diverse class of
securities, which limits our exposure to any one security.
U.S. INVESTED ASSETS
ASSET-BACKED SECURITIES BY TYPE
CARRYING AMOUNT
AS OF JUNE 30, AS OF DECEMBER 31,
-------------- ------------------
2002 2001
-------------- ------------------
(IN MILLIONS)
Automobile receivables............... $ 39.2 $ 49.7
Collateralized debt obligations...... 406.7 468.6
Consumer loans....................... 119.7 126.5
Credit cards......................... 119.5 131.2
Lease receivables.................... 59.2 101.5
Other................................ 290.0 274.7
-------------- -----------------
Total asset-backed securities...... $ 1,034.3 $ 1,152.2
============== =================
In accordance with our asset liability risk management techniques, we manage the
expected lives of U.S. invested assets to be similar to the lives of our
liabilities. Significant amounts of our liabilities have an expected life of six
58
years or less. Therefore, comparable amounts of assets have a similar expected
life. The amortized cost and estimated fair value of fixed maturity securities,
by contractual maturity dates, excluding scheduled sinking funds, as of June 30,
2002, and December 31, 2001, were as follows:
U.S. INVESTED ASSETS
FIXED MATURITY SECURITIES BY CONTRACTUAL MATURITY DATES
AS OF JUNE 30, AS OF DECEMBER 31,
----------------------- -----------------------
2002 2001
----------------------- -----------------------
AMORTIZED CARRYING AMORTIZED CARRYING
COST AMOUNT COST AMOUNT
----------- --------- ----------- ---------
(IN MILLIONS)
Due in one year or less.......................... $ 1,532.0 $ 1,550.6 $ 1,358.2 $ 1,367.3
Due after one year through five years............ 10,246.6 10,580.7 10,484.3 10,815.0
Due after five years through ten years........... 6,363.8 6,583.0 5,535.6 5,722.0
Due after ten years.............................. 6,089.9 6,132.1 5,159.3 5,241.7
----------- --------- ----------- ---------
Subtotal....................................... 24,232.3 24,846.4 22,537.4 23,146.0
Mortgage-backed and other securities without a
single maturity date........................... 5,535.3 5,795.9 5,659.5 5,881.8
----------- --------- ----------- ---------
Total........................................ $ 29,767.6 $30,642.3 $ 28,196.9 $29,027.8
=========== ========= =========== =========
We monitor any decline in the credit quality of fixed maturity securities
through the designation of "problem securities", "potential problem securities"
and "restructured securities". We define problem securities in our fixed
maturity portfolio as securities: (i) as to which principal and/or interest
payments are in default or (ii) issued by a company that went into bankruptcy
subsequent to the acquisition of such securities. We define potential problem
securities in our fixed maturity portfolio as securities included on an internal
"watch list" for which management has concerns as to the ability of the issuer
to comply with the present debt payment terms and which may result in the
security becoming a problem or being restructured. The decision whether to
classify a performing fixed maturity security as a potential problem involves
significant subjective judgments by our management as to the likely future
industry conditions and developments with respect to the issuer. We define
restructured securities in our fixed maturity portfolio as securities where a
concession has been granted to the borrower related to the borrower's financial
difficulties that would not have otherwise been considered. We determine that
restructures should occur in those instances where greater economic value will
be realized under the new terms than through liquidation or other disposition
and may involve a change in contractual cash flows.
In July 2002, WorldCom Inc. filed a voluntary petition for Chapter 11
reorganization with the U.S. Bankruptcy Court. We recognized realized losses for
other than temporary impairments during the second quarter of 2002. Our
remaining investment in WorldCom, Inc. is classified in our problem fixed
maturity securities portfolio in the amount of $9.8 million as of June 30, 2002.
In December 2001, Enron Corp., along with certain of its subsidiaries, filed
voluntary petitions for Chapter 11 reorganization with the U.S. Bankruptcy
Court. We recognized realized losses in 2001 for other than temporary
impairments and have classified our remaining investment in Enron Corp. and
Enron related entities in our problem fixed maturity securities in the amount of
$48.5 million as of June 30, 2002.
The following table presents the total carrying amount of our fixed maturity
portfolio, as well as its problem, potential problem and restructured fixed
maturities for the periods indicated:
59
U.S. INVESTED ASSETS
PROBLEM, POTENTIAL PROBLEM AND RESTRUCTURED FIXED MATURITIES AT CARRYING AMOUNT
AS OF JUNE 30, AS OF DECEMBER 31,
-------------- ------------------
2002 2001
-------------- ------------------
($ IN MILLIONS)
Total fixed maturity securities (public and private).......... $30,642.3 $ 29,027.8
============== ==================
Problem fixed maturity securities............................. $ 201.5 $ 198.8
Potential problem fixed maturity securities................... 354.0 365.1
Restructured fixed maturity securities........................ 119.0 110.8
-------------- ------------------
Total problem, potential problem and restructured fixed
maturity securities....................................... $ 674.5 $ 674.7
============== ==================
Total problem, potential problem and restructured fixed
maturity securities as a percent of total fixed maturity
securities................................................ 2% 2%
EQUITY SECURITIES
Our equity securities consist primarily of investments in common stocks. We
classify our investment in common stocks as available for sale and report them
at fair value. We report unrealized gains and losses on common stocks as a
separate component of other comprehensive income, net of deferred income taxes
and an adjustment for the effect on deferred policy acquisition costs that would
have occurred if such gains and losses had been realized.
Investments in equity securities, totaled $795.3 million and $808.7 million,
which represented 2% of U.S. invested assets as of June 30, 2002, and December
31, 2001, respectively. Investments in company-sponsored funds totaled $439.5
million, or 55%, of our U.S. equity securities as of June 30, 2002. These
sponsored funds are intended to be marketed to our asset management clients. Of
company-sponsored funds, $263.1 million represented underlying investments in
publicly-traded equities, $171.1 million represented investments in
publicly-traded fixed income securities and $5.3 million in balanced funds,
which represented investments in both publicly-traded equities and fixed income
securities as of June 30, 2002. The remaining balance of equity securities is a
mixture of public and private securities acquired for investment purposes or
which were acquired through equity participation features of below investment
grade bonds or through recoveries of defaulted securities.
MORTGAGE LOANS
Mortgage loans comprised 23% and 25% of total U.S. invested assets as of June
30, 2002, and December 31, 2001, respectively. Mortgage loans consist of
commercial and residential loans. Commercial mortgage loans comprised $9,544.2
million as of June 30, 2002, and $9,740.4 million as of December 31, 2001, or
90% and 89%, of total mortgage loan investments, respectively. Residential
mortgages comprised $1,055.2 million and $1,144.2 million, or 10% and 11%, of
total mortgage loan investments as of June 30, 2002, and December 31, 2001,
respectively. Principal Residential Mortgage, Inc. and Principal Bank hold the
majority of residential loans. Principal Residential Mortgage, Inc. holds
residential loans as part of its securitization inventory and Principal Bank
holds residential loans to comply with federal thrift charter requirements.
COMMERCIAL MORTGAGE LOANS. Commercial mortgages play an important role in our
investment strategy by:
o providing strong risk adjusted relative value in comparison to other
investment alternatives;
o enhancing total returns; and
o providing strategic portfolio diversification.
60
As a result, we have focused on constructing a solid, high quality portfolio of
mortgages. Our portfolio is generally comprised of mortgages with conservative
loan-to-value ratios, high debt service coverages and general purpose property
types with a strong credit tenancy.
Our commercial loan portfolio consists of primarily non-recourse, fixed rate
mortgages on fully or near fully leased properties. The mortgage portfolio is
comprised of general-purpose industrial properties, manufacturing office
properties and credit oriented retail properties.
California accounted for 23% of our commercial mortgage loan portfolio as of
June 30, 2002. We are, therefore, exposed to potential losses resulting from the
risk of catastrophes, such as earthquakes, that may affect the region. Like
other lenders, we generally do not require earthquake insurance for properties
on which we make commercial mortgage loans. With respect to California
properties, however, we obtain an engineering report specific to each property.
The report assesses the building's design specifications, whether it has been
upgraded to meet seismic building codes and the maximum loss that is likely to
result from a variety of different seismic events. We also obtain a report that
assesses by building and geographic fault lines the amount of loss our
commercial mortgage loan portfolio might suffer under a variety of seismic
events.
The following is a summary of our commercial mortgage loans by property type and
region as of June 30, 2002, and December 31, 2001:
U.S. INVESTED ASSETS
COMMERCIAL MORTGAGE LOAN DISTRIBUTION BY TYPE
AS OF JUNE 30, AS OF DECEMBER 31,
------------------ ------------------
2002 2001
------------------ ------------------
CARRYING % OF CARRYING % OF
AMOUNT TOTAL AMOUNT TOTAL
---------- ----- ---------- -----
($ IN MILLIONS)
Office........................ $ 3,268.8 34% $ 3,252.5 33%
Retail........................ 2,910.3 31 3,106.5 32
Industrial.................... 2,904.8 30 2,948.9 30
Apartments.................... 391.3 4 349.8 4
Mixed use/other............... 99.4 1 111.8 1
Hotel......................... 59.5 1 61.6 1
Valuation allowance........... (89.9) (1) (90.7) (1)
---------- ---- ---------- ----
Total...................... $ 9,544.2 100% $ 9,740.4 100%
========== === ========== ===
61
U.S. INVESTED ASSETS
COMMERCIAL MORTGAGE LOAN DISTRIBUTION BY REGION
AS OF JUNE 30, AS OF DECEMBER 31,
------------------ ------------------
2002 2001
------------------ ------------------
CARRYING % OF CARRYING % OF
AMOUNT TOTAL AMOUNT TOTAL
---------- ----- ---------- -----
($ IN MILLIONS)
Pacific....................... $ 2,478.6 26% $ 2,421.3 25%
South Atlantic................ 2,168.2 23 2,403.0 25
Middle Atlantic............... 1,614.4 17 1,606.3 16
East North Central............ 929.8 10 930.1 10
West South Central............ 759.6 8 769.0 8
Mountain...................... 647.3 7 637.7 7
West North Central............ 355.3 4 397.8 4
East South Central............ 348.0 3 338.5 3
New England................... 332.9 3 327.4 3
Valuation allowance........... (89.9) (1) (90.7) (1)
---------- ---- ---------- ----
Total...................... $ 9,544.2 100% $ 9,740.4 100%
========== === ========== ===
Our commercial loan portfolio is highly diversified by borrower. As of June 30,
2002, 42% of the U.S. commercial mortgage loan portfolio was comprised of
mortgage loans with principal balances of less than $10.0 million. The following
table shows our U.S. commercial mortgage loan portfolio by loan size, for the
periods indicated:
U.S. INVESTED ASSETS
COMMERCIAL MORTGAGE LOAN PORTFOLIO - BY LOAN SIZE
AS OF JUNE 30, 2002 AS OF DECEMBER 31, 2001
----------------------------- -----------------------------
NUMBER PRINCIPAL % OF NUMBER PRINCIPAL % OF
OF LOANS BALANCE TOTAL OF LOANS BALANCE TOTAL
--------- --------- ----- --------- --------- -----
($ IN MILLIONS)
Under $5 million........................ 1,049 $ 2,251.8 23% 1,102 $ 2,306.7 23%
$5 million but less than $10 million.... 258 1,821.7 19 275 1,925.5 20
$10 million but less than $20 million... 163 2,195.4 23 168 2,267.2 23
$20 million but less than $30 million... 59 1,417.4 15 59 1,410.6 14
$30 million and over.................... 42 1,933.4 20 42 1,925.0 20
--------- --------- ---- --------- --------- ----
Total............................. 1,571 $ 9,619.7 100% 1,646 $ 9,835.0 100%
========= ========= === ========= ========= ===
The total number of commercial mortgage loans outstanding as of June 30, 2002
and December 31, 2001 was 1,571 and 1,646, respectively. The average loan size
of our commercial mortgage portfolio was $6.1 million as of June 30, 2002. The
largest loan on any single property at such dates aggregated $100.0 million for
June 30, 2002 and December 31, 2001, respectively, and represented 0.2% of U.S.
invested assets on these dates. Total mortgage loans to the 10 largest borrowers
accounted in the aggregate for approximately 7% of the total carrying amount of
the commercial mortgage loan portfolio as of June 30, 2002, and December 31,
2001, respectively and 2% of total U.S. invested assets as of June 30, 2002 and
December 31, 2001, respectively. As of such dates, all such loans were
performing.
The following table presents the disposition of maturities as of June 30, 2002,
and December 31, 2001:
62
U.S. INVESTED ASSETS
DISPOSITIONS OF SCHEDULED MATURITIES OF COMMERCIAL MORTGAGE LOANS
AMORTIZED COST
AS OF JUNE 30, AS OF DECEMBER 31,
-------------- ------------------
2002 2001
-------------- ------------------
(IN MILLIONS)
Paid as scheduled...... $ 91.1 $ 434.7
Extended............... 142.2 138.1
Refinanced............. 40.2 75.7
Foreclosed............. - 5.4
Expired maturities..... - 10.6
-------------- ------------------
Total............... $ 273.5 $ 664.5
============== ==================
The amortized cost of commercial mortgage loans by contractual maturity dates,
excluding scheduled sinking funds as of June 30, 2002, and December 31, 2001,
are as follows:
U.S. INVESTED ASSETS
COMMERCIAL MORTGAGE LOAN PORTFOLIO MATURITY PROFILE
AS OF JUNE 30, AS OF DECEMBER 31,
------------------ ------------------
2002 2001
------------------ ------------------
AMORTIZED % OF AMORTIZED % OF
COST TOTAL COST TOTAL
---------- ----- ---------- -----
($ IN MILLIONS)
Due in one year or less................ $ 864.4 9% $ 732.6 8%
Due after one year through five years.. 3,137.7 32 3,180.8 32
Due after five years through ten years. 2,763.0 29 2,890.8 29
Due after ten years.................... 2,869.0 30 3,026.9 31
---------- ----- ---------- -----
Total............................... $ 9,634.1 100% $ 9,831.1 100%
========== ==== ========== ====
We actively monitor and manage our commercial mortgage loan portfolio.
Substantially all loans within the portfolio are analyzed regularly, based on a
proprietary risk rating cash flow model, in order to monitor the financial
quality of these assets and are internally rated. Based on ongoing monitoring,
mortgage loans with a likelihood of becoming delinquent are identified and
placed on an internal "watch list". Among criteria which would indicate a
potential problem are: imbalances in ratios of loan to value or contract rents
to debt service, major tenant vacancies or bankruptcies, borrower sponsorship
problems, late payments, delinquent taxes and loan relief/restructuring
requests.
We state commercial mortgage loans at their unpaid principal balances, net of
discount accrual and premium amortization, valuation allowances and write downs
for impairment. We provide a valuation allowance for commercial mortgage loans
based on past loan loss experience and for specific loans considered to be
impaired. Mortgage loans are considered impaired when, based on current
information and events, it is probable that all amounts due according to the
contractual terms of the loan agreement may not be collected. When we determine
that a loan is impaired, we establish a valuation allowance for loss for the
excess of the carrying value of the mortgage loan over its estimated fair value.
Estimated fair value is based on either the present value of expected future
cash flows discounted at the loan's original effective interest rate, the loan's
observable market price or the fair value of the collateral. We record increases
in such valuation allowances as realized investment losses and, accordingly, we
reflect such losses in our consolidated results of operations. Such increases
(decreases) in valuation allowances aggregated $(0.8) million for the six months
ended June 30, 2002, and $(17.3) million for the year ended December 31, 2001.
We review our mortgage loan portfolio and analyze the need for a valuation
allowance for any loan which is delinquent for 60 days or more, in process of
foreclosure, restructured, on the "watch list", or which currently has a
valuation allowance. We categorize loans, which are delinquent, loans in process
63
of foreclosure and loans to borrowers in bankruptcy as "problem" loans.
Potential problem loans are loans placed on an internal "watch list" for which
management has concerns as to the ability of the borrower to comply with the
present loan payment terms and which may result in the loan becoming a problem
or being restructured. The decision whether to classify a performing loan as a
potential problem involves significant subjective judgments by management as to
the likely future economic conditions and developments with respect to the
borrower. We categorize loans for which the original terms of the mortgages have
been modified or for which interest or principal payments have been deferred as
"restructured" loans. We also consider matured loans that are refinanced at
below market rates as restructured.
We charge mortgage loans deemed to be uncollectible against the allowance for
losses and credit subsequent recoveries to the allowance for losses. We maintain
the allowance for losses at a level management believes to be adequate to absorb
estimated probable credit losses. Management bases its periodic evaluation of
the adequacy of the allowance for losses on our past loan loss experience, known
and inherent risks in the portfolio, adverse situations that may affect the
borrower's ability to repay, the estimated value of the underlying collateral,
composition of the loan portfolio, current economic conditions and other
relevant factors. The evaluation is inherently subjective as it requires
estimating the amounts and timing of future cash flows expected to be received
on impaired loans that may change.
The following table represents our commercial mortgage valuation allowance for
the periods indicated:
U.S. INVESTED ASSETS
COMMERCIAL MORTGAGE VALUATION ALLOWANCE
AS OF JUNE 30, AS OF DECEMBER 31,
-------------- ------------------
2002 2001
-------------- ------------------
($ IN MILLIONS)
Beginning balance........................ $ 90.7 $ 108.0
Provision................................ 28.9 12.0
Release due to write downs,
sales and foreclosures................ (29.7) (29.3)
-------------- ------------------
Ending balance........................... $ 89.9 $ 90.7
============== ==================
Valuation allowance as % of carrying
value before reserves................. 1% 1%
The following table presents the carrying amounts of problem, potential problem
and restructured commercial mortgages relative to the carrying amount of all
commercial mortgages for the periods indicated:
U.S. INVESTED ASSETS
PROBLEM, POTENTIAL PROBLEM AND RESTRUCTURED
COMMERCIAL MORTGAGES AT CARRYING AMOUNT
AS OF JUNE 30, AS OF DECEMBER 31,
-------------- ------------------
2002 2001
-------------- ------------------
($ IN MILLIONS)
Total commercial mortgages .......................... $ 9,544.2 $ 9,740.4
============== ==================
Problem commercial mortgages(1)...................... $ 78.2 $ 47.1
Potential problem commercial mortgages .............. 53.1 98.9
Restructured commercial mortgages ................... 47.0 42.4
-------------- ------------------
Total problem, potential problem and
restructured commercial mortgages ............... $ 178.3 $ 188.4
============== ==================
Total problem, potential problem and
restructured commercial mortgages as a percent
of total commercial mortgages.................... 2% 2%
- ------------
(1) Problem commercial mortgages included mortgage loans in foreclosure with a
carrying amount of $0.9 million less a valuation allowance of $0.9 million
as of June 30, 2002. There were no mortgage loans in foreclosure as of
December 31, 2001.
64
EQUITY REAL ESTATE
We hold commercial equity real estate as part of our investment portfolio. As of
June 30, 2002, and December 31, 2001, the carrying amount of equity real estate
investment was $1,186.4 million and $1,174.1 million, or 3% of U.S. invested
assets, respectively. We own real estate, real estate acquired upon foreclosure
of commercial mortgage loans and interests, both majority owned and non-majority
owned, in real estate joint ventures.
Equity real estate is categorized as either "real estate held for investment" or
"real estate held for sale". Real estate held for investment totaled $878.9
million as of June 30, 2002, and $783.4 million as of December 31, 2001. The
carrying value of real estate held for investment is generally adjusted for
impairment whenever events or changes in circumstances indicate that the
carrying amount of the asset may not be recoverable. Such impairment adjustments
are recorded as realized investment losses and accordingly, are reflected in our
consolidated results of operations. For the periods ended June 30, 2002 and
December 31, 2001, there were no such impairment adjustments.
The carrying amount of real estate held for sale as of June 30, 2002, and
December 31, 2001, was $307.5 million and $390.7 million, net of valuation
allowances of $17.2 million and $19.8 million, respectively. Once we identify a
real estate property to be sold and commence a plan for marketing the property,
we classify the property as held for sale. We establish a valuation allowance
subject to periodical revisions, if necessary, to adjust the carrying value of
the property to reflect the lower of its current carrying value or the fair
value, less associated selling costs.
We use research, both internal and external, to recommend appropriate product
and geographic allocations and changes to the equity real estate portfolio. We
monitor product, geographic and industry diversification separately and together
to determine the most appropriate mix.
Equity real estate is distributed across geographic regions of the country with
larger concentrations in the South Atlantic, West South Central and Pacific
regions of the United States as of June 30, 2002. By property type, there is a
concentration in office buildings that represented approximately 31% of the
equity real estate portfolio as of June 30, 2002. Our largest equity real estate
holding as of June 30, 2002 consisted of an office/industrial park located in
Durham, North Carolina with an aggregate carrying value of approximately $151.1
million and represented approximately 13% of total U.S. equity real estate
assets and 0.3% of U.S. invested assets. The ten largest real estate properties
as of June 30, 2002 comprised 45% of total U.S. equity real estate assets and 1%
of total U.S. invested assets. In addition, our equity real estate includes our
investment in BT Hotels. As of December 31, 2001, BT Hotels was fully
consolidated into our financial statements and is reflected in the International
region and Hotel/Motel property type in the following investment schedules:
65
U.S. INVESTED ASSETS
EQUITY REAL ESTATE BY REGION(1)
AS OF JUNE 30, AS OF DECEMBER 31,
--------------- ------------------
2002 2001
--------------- ------------------
CARRYING % OF CARRYING % OF
AMOUNT TOTAL AMOUNT TOTAL
-------- ----- -------- -----
($ IN MILLIONS)
South Atlantic......... $ 402.2 34% $ 376.4 32%
International.......... 244.5 21 223.6 19
West South Central..... 232.1 20 236.4 20
Pacific................ 170.1 14 183.8 16
East North Central..... 62.4 5 62.3 5
East South Central..... 20.9 2 32.3 3
West North Central..... 19.3 2 28.0 2
New England............ 17.7 1 14.3 1
Mountain............... 14.0 1 8.8 1
Middle Atlantic........ 3.2 - 8.2 1
-------- ----- -------- ----
Total............... $1,186.4 100% $1,174.1 100%
======== === ======== ===
- ------------
(1) Regions are defined by the American Council of Life Insurers.
U.S. INVESTED ASSETS
EQUITY REAL ESTATE BY PROPERTY TYPE
AS OF JUNE 30, AS OF DECEMBER 31,
--------------- ------------------
2002 2001
--------------- ------------------
CARRYING % OF CARRYING % OF
AMOUNT TOTAL AMOUNT TOTAL
-------- ----- -------- -----
($ IN MILLIONS)
Office................. $ 369.3 31% $ 422.9 36%
Hotel/Motel............ 244.5 21 223.6 19
Industrial............. 235.6 20 221.6 19
Apartments............. 127.5 11 50.7 4
Retail................. 94.3 8 138.9 12
Service Center......... 63.8 5 63.1 5
Land................... 51.4 4 53.3 5
-------- ----- -------- -----
Total............... $1,186.4 100% $1,174.1 100%
======== ==== ======== ====
DERIVATIVES
We use various derivative financial instruments to manage our exposure to
fluctuations in interest rates, including interest rate futures and interest
rate swaps and swaptions. We use interest rate futures contracts to hedge
changes in interest rates subsequent to the issuance of an insurance liability,
such as a guaranteed investment contract, but prior to the purchase of a
supporting asset, or during periods of holding assets in anticipation of near
term liability sales. We use interest rate swaps primarily to more closely match
the interest rate characteristics of assets and liabilities. They can be used to
change the interest rate characteristics of specific assets and liabilities as
well as an entire portfolio. Occasionally, we will sell a callable liability or
a liability with attributes similar to a call option. In these cases, we will
use interest rate swaptions or similar products to hedge the risk of early
liability payment, thereby transforming the callable liability into a fixed term
liability.
We also seek to reduce call or prepayment risk arising from changes in interest
rates in individual investments. We limit our exposure to investments that are
prepayable without penalty prior to maturity at the option of the issuer, and we
require additional yield on these investments to compensate for the risk that
the issuer will exercise such option. An example of an investment we limit
because of the option risk is residential mortgage-backed securities. We assess
option risk in all investments we make and, when we take that risk, we price for
it accordingly.
66
Foreign currency risk is the risk that we will incur economic losses due to
adverse fluctuations in foreign currency exchange rates. This risk arises from
our international operations and foreign currency-denominated funding agreements
issued to non-qualified institutional investors in the international market. The
notional amount of our currency swap agreements associated with
foreign-denominated liabilities as of June 30, 2002, was $3,052.4 million. We
also have fixed maturity securities that are denominated in foreign currencies.
However, we use derivatives to hedge the foreign currency risk of these funding
agreements and securities. As of June 30, 2002, the fair value of our foreign
currency denominated fixed maturity securities was $329.8 million. We use
currency swap agreements of the same currency to hedge the foreign currency
exchange risk related to these investments. The notional amount of our currency
swap agreements associated with foreign-denominated fixed maturity securities as
of June 30, 2002, was $311.2 million.
We entered into a total return swap as part of the structuring process of an
investment grade collateralized debt obligation ("CDO") issuance. The
outstanding notional amount as of June 30, 2002 was $122.0 million and the
mark-to-market value of this swap was $(9.0) million pre-tax.
In conjunction with the interest rate swaps, interest rate swaptions and other
derivatives, we are exposed to counterparty risk, or the risk that counterparty
fails to perform the terms of the derivative contract. We actively manage this
risk by:
o establishing exposure limits which take into account non-derivative
exposure we have with the counterparty as well as derivative exposure;
o performing similar credit analysis prior to approval on each derivatives
counterparty that we do when lending money on a long-term basis;
o limiting exposure to AA- credit or better;
o conducting stress-test analysis to determine the maximum exposure created
during the life of a prospective transaction; and
o daily monitoring of counterparty credit ratings.
All new derivative counterparties are approved by the investment committee. We
believe the risk of incurring losses due to nonperformance by our counterparties
is remote and that such losses, if any, would not be material. Futures contracts
trade on organized exchanges and, therefore, effectively have no credit risk.
The notional amounts used to express the extent of our involvement in swap
transactions represent a standard measurement of the volume of our swap
business. Notional amount is not a quantification of market risk or credit risk
and it may not necessarily be recorded on the balance sheet. Notional amounts
represent those amounts used to calculate contractual flows to be exchanged and
are not paid or received, except for contracts such as currency swaps. Actual
credit exposure represents the amount owed to us under derivative contracts as
of the valuation date. The following tables present our position in, and credit
exposure to, derivative financial instruments as of June 30, 2002, and December
31, 2001:
67
U.S. INVESTED ASSETS
DERIVATIVE FINANCIAL INSTRUMENTS - NOTIONAL AMOUNTS
AS OF JUNE 30, AS OF DECEMBER 31,
----------------- ------------------
2002 2001
----------------- ------------------
NOTIONAL % OF NOTIONAL % OF
AMOUNT TOTAL AMOUNT TOTAL
---------- ----- --------- -----
($ IN MILLIONS)
Mortgage-backed forwards and options... $10,378.8 30% $ 9,250.7 34%
Interest rate swaps.................... 5,079.4 15 3,272.5 12
Foreign currency swaps................. 4,028.6 12 4,091.9 15
Swaptions ............................. 3,960.0 12 3,570.0 13
Interest rate lock commitments......... 3,863.8 11 2,565.9 9
Interest rate floors................... 3,400.0 10 3,400.0 13
U.S. Treasury futures (LIBOR).......... 1,150.0 3 - -
U.S. Treasury futures.................. 1,113.5 3 186.6 1
Principal Only swaps................... 467.0 1 250.0 1
Currency forwards...................... 380.0 1 380.0 1
Bond forwards.......................... 355.7 1 357.4 1
Total return swaps..................... 222.5 1 25.0 -
Call options........................... 30.0 - 30.0 -
Treasury rate guarantees............... 24.0 - 88.0 -
---------- ----- --------- -----
Total............................... $34,453.3 100% $27,468.0 100%
========== ==== ========= ====
U.S. INVESTED ASSETS
DERIVATIVE FINANCIAL INSTRUMENTS - CREDIT EXPOSURES
AS OF JUNE 30, AS OF DECEMBER 31,
--------------- ------------------
2002 2001
--------------- ------------------
CREDIT % OF CREDIT % OF
EXPOSURE TOTAL EXPOSURE TOTAL
-------- ----- -------- -----
($ IN MILLIONS)
Foreign currency swaps................ $ 201.9 49% $ 101.1 33%
Interest rate swaps................... 128.6 31 78.4 25
Currency forwards..................... 48.2 12 55.3 18
Swaptions ............................ 18.8 4 8.7 3
Call options.......................... 7.8 2 8.9 3
Interest rate floors.................. 6.4 2 13.2 4
Total return swaps.................... 1.6 - 0.1 -
Mortgage-backed forwards and options.. - - 41.7 14
-------- ----- -------- -----
Total.............................. $ 413.3 100% $ 307.4 100%
======== ==== ======== ====
OTHER INVESTMENTS
Our other investments totaled $669.0 million as of June 30, 2002, compared to
$678.4 million as of December 31, 2001. With the adoption of SFAS 133 on January
1, 2001, derivatives were reflected on our balance sheet and accounted for
$324.1 million in other investments as of June 30, 2002. The remaining invested
assets include leases and other private equity investments.
Our investment in Coventry is also included in other investments as we account
for it using the equity method. As of December 31, 2001, our carrying value in
Coventry was $146.0 million. On February 1, 2002, we sold our remaining
investment in Coventry for a net realized gain.
68
SECURITIES LENDING
The terms of our securities lending program, approved in 1999, allow us to lend
our securities to major brokerage firms. Our policy requires an initial minimum
of 102% of the fair value of the loaned securities as collateral. Our securities
on loan as of June 30, 2002 and December 31, 2001, had fair values of $689.4
million and $0.5 million, respectively.
INTERNATIONAL INVESTMENT OPERATIONS
As of June 30, 2002, our international investment operations consist of the
investments of Principal International and BT Financial Group and comprise $1.5
billion in invested assets, which primarily represent the assets of Principal
International. Principal Capital Management works with each Principal
International affiliate to develop investment policies and strategies that are
consistent with the products they offer. Due to the regulatory constraints in
each country, each company maintains its own investment policies which are
approved by Principal Capital Management. Each international affiliate is
required to submit a compliance report relative to its strategy to Principal
Capital Management. A credit committee comprised of Principal Capital Management
employees and international affiliate company chief investment officers review
each corporate credit annually. In addition, employees from our U.S. operations
who serve on the credit committee currently hold investment positions in two of
our international affiliates. Principal Capital Management provides credit
analysis training to Principal International personnel.
OVERALL COMPOSITION OF INTERNATIONAL INVESTED ASSETS
As shown in the following table, the major categories of international invested
assets as of June 30, 2002, and December 31, 2001, were fixed maturity
securities and residential mortgage loans:
INTERNATIONAL INVESTED ASSETS
AS OF JUNE 30, AS OF DECEMBER 31,
----------------- -------------------
2002 2001
----------------- -------------------
CARRYING % OF CARRYING % OF
AMOUNT TOTAL AMOUNT TOTAL
---------- ----- ---------- -----
($ IN MILLIONS)
Fixed maturity securities
Public................................. $ 940.0 65% $ 941.3 69%
Private................................ 61.9 4 61.0 4
Equity securities, available-for-sale.... 18.4 1 24.9 2
Mortgage loans
Residential............................ 232.2 16 181.1 13
Real estate held for investment.......... 7.6 1 7.7 1
Other investments ....................... 193.0 13 151.4 11
---------- ----- --------- -----
Total invested assets.................. $ 1,453.1 100% $ 1,367.4 100%
==== ====
Cash and cash equivalents................ 158.4 128.0
---------- ---------
Total invested assets and cash ........ $ 1,611.5 $ 1,495.4
========== =========
INTERNATIONAL INVESTMENT RESULTS
The yield on international invested assets and on cash and cash equivalents,
excluding net realized gains and losses, was 9.4% and 10.8% for the three months
ended June 30, 2002, and 2001, respectively, and 8.0% and 8.6% for the six
months ended June 30, 2002, and 2001, respectively.
The following table illustrates the yields on average assets for each of the
components of our investment portfolio for the three months and six months ended
June 30, 2002 and 2001, respectively:
69
INTERNATIONAL INVESTED ASSETS
YIELDS BY ASSET TYPE
AS OF OR FOR THE THREE MONTHS AS OF OR FOR THE SIX MONTHS
ENDED JUNE 30, ENDED JUNE 30,
---------------------------------- -----------------------------------
2002 2001 2002 2001
--------------- --------------- --------------- ---------------
YIELD AMOUNT YIELD AMOUNT YIELD AMOUNT YIELD AMOUNT
----- -------- ----- -------- ----- -------- ----- --------
($ IN MILLIONS)
Fixed maturity securities
Gross investment income (1)........... 10.3% $ 25.9 12.2% $ 24.9 8.5% $ 42.4 9.5% $ 42.4
Net realized capital gains (losses)... 1.0 2.4 (1.0) (2.0) 1.4 6.8 (0.2) (1.1)
-------- -------- -------- --------
Total............................... $ 28.3 $ 22.9 $ 49.2 $ 41.3
======== ======== ======== ========
Ending assets (at carrying value)..... $1,001.9 $ 824.2 $1,001.9 $ 824.2
Equity securities, available-for-sale
Gross investment income (1)........... 1.8% $ 0.1 - % $ - 0.9% $ 0.1 - % $ -
Net realized capital gains............ 17.7 1.0 5.2 0.5 11.1 1.2 2.4 0.7
-------- -------- -------- --------
Total............................... $ 1.1 $ 0.5 $ 1.3 $ 0.7
======== ======== ======== ========
Ending assets (at carrying value)..... $ 18.4 $ 39.4 $ 18.4 $ 39.4
Mortgage loans - Residential
Gross investment income (1)........... 11.3% $ 6.3 13.9% $ 6.0 8.9 $ 9.2 10.8% $ 9.2
Net realized capital gains (losses)... - - - - - - - -
-------- -------- -------- --------
Total............................... $ 6.3 $ 6.0 $ 9.2 $ 9.2
======== ======== ======== ========
Ending assets (at carrying value)..... $ 232.2 $ 175.1 $ 232.2 $ 175.1
Real estate
Gross investment income (1)........... 10.1% $ 0.2 (19.6)% $ (0.4) 7.8% $ 0.3 9.6% $ 0.4
Net realized capital gains............ 5.0 0.1 - - 2.6 0.1 - -
-------- -------- -------- --------
Total............................... $ 0.3 $ (0.4) $ 0.4 $ 0.4
======== ======== ======== ========
Ending assets (at carrying value)..... $ 7.6 $ 8.0 $ 7.6 $ 8.0
Cash and cash equivalents
Gross investment income (1)........... 2.5% $ 0.9 5.1% $ 1.6 2.5% $ 1.8 4.5% $ 3.5
Net realized capital gains (losses)... - - - - - - - -
-------- -------- -------- --------
Total............................... $ 0.9 $ 1.6 $ 1.8 $ 3.5
======== ======== ======== ========
Ending assets (at carrying value)..... $ 158.4 $ 134.8 $ 158.4 $ 134.8
Other investments
Gross investment income (1)........... 9.5% $ 4.3 9.6% $ 2.8 9.9% $ 8.5 9.6% $ 5.8
Net realized capital gains (losses)... 57.1 25.8 1.7 0.5 33.1 28.5 (63.4) (38.3)
-------- -------- -------- --------
Total............................... $ 30.1 $ 3.3 $ 37.0 $ (32.5)
======== ======== ======== ========
Ending assets (at carrying value)..... $ 193.0 $ 111.8 $ 193.0 $ 111.8
Total before investment expenses
Gross investment income............... 9.5% $ 37.7 10.9% $ 34.9 8.0% $ 62.3 8.7% $ 61.3
Net realized capital gains (losses)... 7.4 29.3 (0.3) (1.0) 4.7 36.6 (5.5) (38.7)
-------- -------- -------- --------
Total............................... $ 67.0 $ (33.9) $ 98.9 $ 22.6
======== ======== ======== ========
Investment expenses..................... 0.1% $ 0.3 0.1% $ 0.4 0.0% $ 0.4 0.1% $ 0.7
Net investment income................... 9.4% $ 37.4 10.8% $ 34.5 8.0% $ 61.9 8.6% $ 60.6
- ------------
(1) Yields, which are annualized for interim periods, are based on quarterly
average asset carrying values for the three months and six months ended June
30, 2002 and 2001.
FIXED MATURITY SECURITIES
Fixed maturity securities consist primarily of publicly traded debt securities
and represented 69% of total international invested assets as of June 30, 2002,
and 73% as of December 31, 2001. Fixed maturity securities were diversified by
type of issuer as of June 30, 2002, and for the year ended December 31, 2001, as
shown in the following table:
70
INTERNATIONAL INVESTED ASSETS
FIXED MATURITY SECURITIES BY TYPE OF ISSUER
AS OF JUNE 30, AS OF DECEMBER 31,
----------------- ------------------
2002 2001
----------------- ------------------
CARRYING % OF CARRYING % OF
AMOUNT TOTAL AMOUNT TOTAL
--------- ----- --------- -----
($ IN MILLIONS)
U.S. Treasury securities and obligations of U.S.
Government corporations and agencies.............. $ 5.4 1% $ 0.3 -%
Foreign governments................................. 237.0 24 322.8 32
Corporate - public.................................. 392.4 39 363.6 37
Corporate - private................................. 61.9 6 61.0 6
Mortgage-backed securities and other asset-
backed securities................................. 305.2 30 254.6 25
-------- ---- --------- -----
Total fixed maturities........................... $1,001.9 100% $1,002.3 100%
======== ==== ========= ====
The fixed maturity securities held by the international operations have not been
rated by external agencies and cannot be presented in a comparable rating agency
equivalent.
The issuers of the majority of our fixed maturity corporate securities are
mainly banks and are categorized in the finance, insurance and real estate
category as shown in the following tables:
INTERNATIONAL INVESTED ASSETS
CORPORATE FIXED MATURITY SECURITIES PORTFOLIO BY INDUSTRY AS OF JUNE 30, 2002
PUBLICLY TRADED PRIVATELY PLACED TOTAL
---------------- ----------------- ----------------
CARRYING % OF CARRYING % OF CARRYING % OF
AMOUNT TOTAL AMOUNT TOTAL AMOUNT TOTAL
-------- ----- -------- ----- -------- -----
($ IN MILLIONS)
INDUSTRY CLASS
Finance, Insurance and Real Estate.... $ 178.6 45% $ 14.4 23% $ 193.0 42%
Services.............................. 62.9 16 14.2 23 77.1 17
Retail................................ 50.3 13 1.1 2 51.4 11
Transportation and Public Utilities... 49.6 13 - - 49.6 11
Construction.......................... 39.5 10 5.7 9 45.2 10
Manufacturing......................... 8.2 2 21.7 35 29.9 7
Mining................................ - - 4.8 8 4.8 1
Agriculture, Forestry and Fishing..... 3.3 1 - - 3.3 1
-------- ----- -------- ----- -------- -----
Total.............................. $ 392.4 100% $ 61.9 100% $ 454.3 100%
======== ==== ======== ==== ======== ====
71
INTERNATIONAL INVESTED ASSETS
CORPORATE FIXED MATURITY SECURITIES PORTFOLIO
BY INDUSTRY AS OF DECEMBER 31, 2001
PUBLICLY TRADED PRIVATELY PLACED TOTAL
---------------- ----------------- ----------------
CARRYING % OF CARRYING % OF CARRYING % OF
AMOUNT TOTAL AMOUNT TOTAL AMOUNT TOTAL
-------- ----- -------- ----- -------- -----
($ IN MILLIONS)
INDUSTRY CLASS
Finance, Insurance and Real Estate.... $ 180.2 50% $ 17.5 29% $ 197.7 47%
Services.............................. 50.3 14 9.8 16 60.1 14
Construction.......................... 47.6 13 6.0 10 53.6 12
Transportation and Public Utilities... 49.7 14 - - 49.7 12
Retail................................ 35.6 9 1.2 2 36.8 9
Manufacturing......................... 0.1 - 26.5 43 26.6 6
Public Administration................. 0.1 - - - 0.1 -
-------- ----- -------- ----- -------- -----
Total.............................. $ 363.6 100% $ 61.0 100% $ 424.6 100%
======== ==== ======== ==== ======== ====
The international operations held $305.2 million of residential pass-through
securities as of June 30, 2002, and $254.6 million as of December 31, 2001.
The amortized cost and estimated fair value of fixed maturity securities, by
contractual maturity dates excluding scheduled sinking funds, as of June 30,
2002, and December 31, 2001, were as follows:
INTERNATIONAL INVESTED ASSETS
FIXED MATURITY SECURITIES BY CONTRACTUAL MATURITY DATES
AS OF JUNE 30, AS OF DECEMBER 31,
-------------------- --------------------
2002 2001
-------------------- --------------------
AMORTIZED CARRYING AMORTIZED CARRYING
COST AMOUNT COST AMOUNT
--------- -------- --------- --------
(IN MILLIONS)
Due in one year or less.............................. $ 38.5 $ 39.0 $ 35.5 $ 36.0
Due after one year through five years................ 144.2 147.8 161.7 162.3
Due after five years through ten years............... 196.2 199.8 212.8 211.8
Due after ten years.................................. 302.3 310.1 326.6 337.6
--------- -------- --------- --------
Subtotal.......................................... 681.2 696.7 736.6 747.7
Mortgage-backed and other securities without a
single maturity date.............................. 296.9 305.2 248.8 254.6
--------- -------- --------- --------
Total............................................. $ 978.1 $1,001.9 $ 985.4 $1,002.3
========= ======== ========= ========
The international operations held $1.6 million of restructured government bonds
in Argentina, which represented 0.2% of international fixed maturity securities
as of June 30, 2002.
EQUITY SECURITIES
Our equity securities represented 1% of international invested assets as of June
30, 2002 and 2% as of December 31, 2001. Our equity securities consisted of
$13.5 million in common stock and $4.9 million in mutual funds as of June 30,
2002.
RESIDENTIAL MORTGAGE LOANS
Our Chilean operations originate and purchase residential mortgage loans.
Residential mortgage loans comprised $232.2 million, or 16%, of international
invested assets as of June 30, 2002, and $181.1 million, or 13%, as of December
31, 2001.
72
DERIVATIVES
The following table presents our position in derivative financial instruments as
of June 30, 2002, and December 31, 2001. Our international operations did not
have credit exposure relating to derivatives as of these dates.
INTERNATIONAL INVESTED ASSETS
DERIVATIVE FINANCIAL INSTRUMENTS - CREDIT EXPOSURES
AS OF JUNE 30, AS OF DECEMBER 31,
--------------- ------------------
2002 2001
--------------- ------------------
NOTIONAL % OF NOTIONAL % OF
AMOUNT TOTAL AMOUNT TOTAL
-------- ----- -------- -----
($ IN MILLIONS)
Currency forwards... $ - -% $ 13.4 100%
-------- ----- -------- -----
Total............ $ - -% $ 13.4 100%
======== ===== ======== =====
OTHER INVESTMENTS
Our other investments totaled $193.0 million as of June 30, 2002, compared to
$151.4 million as of December 31, 2001. Of the $193.0 million, $68.6 million
represents our international investments in unconsolidated subsidiaries, $47.7
million represents other invested assets from our operations in Chile, Brazil,
and Mexico, $41.4 million is related to subordinated notes in BT Financial
Group's margin lending program and $35.3 million represents BT Financial Group's
investment in unit trusts.
73
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
MARKET RISK EXPOSURES AND RISK MANAGEMENT
Market risk is the risk that we will incur losses due to adverse fluctuations in
market rates and prices. Our primary market risk exposure is to changes in
interest rates, although we also have exposures to changes in equity prices and
foreign currency exchange rates.
The active management of market risk is an integral part of our operations. We
manage our overall market risk exposure within established risk tolerance ranges
by using the following approaches:
o rebalance our existing asset or liability portfolios;
o control the risk structure of newly acquired assets and liabilities; or
o use derivative instruments to modify the market risk characteristics of
existing assets or liabilities or assets expected to be purchased.
INTEREST RATE RISK
Interest rate risk is the risk that we will incur economic losses due to adverse
changes in interest rates. Our exposure to interest rate risk stems largely from
our substantial holdings of guaranteed fixed rate liabilities in our U.S. Asset
Management and Accumulation segment.
We manage the interest rate risk inherent in our assets relative to the interest
rate risk inherent in our liabilities. One of the measures we use to quantify
this exposure is duration. To calculate duration, we project asset and liability
cashflows. These cashflows are discounted to a net present value basis using a
spot yield curve, which is a blend of the spot yield curves for each of the
asset types in the portfolio. Duration is calculated by re-calculating these
cashflows and redetermining the net present value based upon an alternative
level of interest rates, and determining the percentage change in fair value.
As of June 30, 2002, the difference between the asset and liability durations on
our primary duration managed portfolio was .05 years. This duration gap
indicates that as of this date the sensitivity of the fair value of our assets
to interest rate movements is greater than that of the fair value of our
liabilities. Our goal is to minimize the duration gap. Currently, our guidelines
dictate that total duration gaps between the asset and liability portfolios must
be within 0.25 years. The value of the assets in this portfolio was $24,978.9
million as of June 30, 2002.
For products such as whole life insurance and term life insurance that are less
sensitive to interest rate risk, and for other products such as single premium
deferred annuities, we manage interest rate risk based on a modeling process
that considers the target average life, maturities, crediting rates and
assumptions of policyholder behavior. As of June 30, 2002, the weighted-average
difference between the asset and liability durations on these portfolios was
(.48) years. This duration gap indicates that as of this date the sensitivity of
the fair value of our assets to interest rate movements is less than that of the
fair value of our liabilities. We attempt to monitor this duration gap
consistent with our overall risk/reward tolerances. The value of the assets in
these portfolios was $9,589.1 million as of June 30, 2002.
We also have a block of participating general account pension business that
passes the actual investment performance of the assets to the customer. The
investment strategy of this block is to maximize investment return to the
customer on a "best efforts" basis, and there is little or no attempt to manage
the duration of this portfolio since there is little or no interest rate risk.
The value of the assets in these portfolios was $5,877.1 million as of June 30,
2002.
Using the assumptions and data in effect as of June 30, 2002, we estimate that a
100 basis point immediate, parallel increase in interest rates increases the net
fair value of our portfolio by $33.9 million. The following table details the
estimated changes by risk management strategy:
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AS OF
RISK MANAGEMENT JUNE 30, 2002 NET FAIR VALUE
STRATEGY VALUE OF TOTAL ASSETS CHANGE
- ------------------------------ --------------------- --------------
(IN MILLIONS)
Primary duration-managed...... $ 24,978.9 $ (12.5)
Duration-monitored............ 9,589.1 46.4
Non duration-managed.......... 5,877.1 -
--------------------- --------------
Total...................... $ 40,445.1 $ 33.9
===================== ==============
We are also exposed to interest rate risk in our Mortgage Banking segment. We
manage this risk by striving to balance our loan origination and loan servicing
operations, the two of which are generally counter-cyclical. In addition, we use
various financial instruments, including derivatives contracts, to manage the
interest rate risk specifically related to committed loans in the pipeline and
mortgage servicing rights. The overall objective of our interest rate risk
management policies is to offset changes in the values of these items resulting
from changes in interest rates. We do not speculate on the direction of interest
rates in our management of interest rate risk.
We manage interest rate risk on our mortgage loan pipeline by buying and selling
mortgage-backed securities in the forward markets, over-the-counter options on
mortgage-backed securities, U.S. Treasury and Eurodollar futures contracts and
options on futures contracts. We also use interest rate floors, futures
contracts, options on futures contracts, swaps and swaptions, mortgage-backed
securities and principal-only strips in hedging a portion of our portfolio of
mortgage servicing rights from prepayment risk associated with changes in
interest rates.
We measure pipeline interest rate risk exposure by adjusting the at-risk
pipeline in light of the theoretical optionality of each applicant's rate/price
commitment. The at-risk pipeline, which consists of closed loans and rate locks,
is then refined at the product type level to express each product's sensitivity
to changes in market interest rates in terms of a single current coupon MBS
duration. Suitable hedges are selected and a similar methodology applied to this
hedge position. The variety of hedging instruments allows us to match the
behavior of the financial instrument with that of the different types of loans
originated. We limit our risk exposure by requiring that the net position value
not change by more than $10.0 million given an instantaneous change in the
benchmark MBS price of +/- 2.5%. This price sensitivity analysis is performed at
least once daily. The value of the loans in the pipeline as of June 30, 2002,
was $7.4 billion. Due to the impact of our hedging activities, we estimate that
a 100 basis point immediate parallel increase in the interest rates decreases
the June 30, 2002, net position value by $28.1 million.
The financial risk associated with our mortgage servicing operations is the risk
that the market value of the servicing asset falls below its U.S. GAAP book
value. To measure this risk, we analyze each servicing risk tranche's U.S. GAAP
book value in relation to the then current market value for similar servicing
rights. We perform this valuation using option-adjusted spread valuation
techniques applied to each risk tranche. We produce tranche market values at
least monthly.
The market value of the servicing asset declines as interest rates decrease due
to possible mortgage loan servicing rights impairment that may result from
increased current and projected future prepayment activity. The change in value
of the servicing asset due to interest rate movements is reduced by the use of
financial instruments, including derivative contracts, that increase in
aggregate value when interest rates decline. Based on values as of June 30,
2002, a 100 basis point parallel decrease in interest rates produces a $158.8
million decline in value of the servicing asset of our Mortgage Banking segment,
net of the impact of these hedging vehicles, due to the differences between
market values and U.S. GAAP book values.
DERIVATIVES. We use various derivative financial instruments to manage our
exposure to fluctuations in interest rates, including interest rate swaps,
Principal-only swaps, interest rate floors, swaptions, U.S. Treasury futures,
Treasury rate guarantees, interest rate lock commitments and mortgage-backed
forwards and options. We use interest rate futures contracts and mortgage-backed
forwards to hedge changes in interest rates subsequent to the issuance of an
insurance liability, such as a guaranteed investment contract, but prior to the
purchase of a supporting asset, or during periods of holding assets in
anticipation of near term liability sales. We use interest rate swaps and
Principal-only swaps primarily to more closely match the interest rate
characteristics of assets and liabilities. They can be used to change the
interest rate characteristics of specific assets and liabilities as well as an
entire portfolio. Occasionally, we will sell a callable liability or a liability
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with attributes similar to a call option. In these cases, we will use interest
rate swaptions or similar products to hedge the risk of early liability payment
thereby transforming the callable liability into a fixed term liability.
We also seek to reduce call or prepayment risk arising from changes in interest
rates in individual investments. We limit our exposure to investments that are
prepayable without penalty prior to maturity at the option of the issuer, and we
require additional yield on these investments to compensate for the risk that
the issuer will exercise such option. An example of an investment we limit
because of the option risk is residential mortgage-backed securities. We assess
option risk in all investments we make and, when we assume such risk, we seek to
price for it accordingly to achieve an appropriate return on our investments.
In conjunction with the interest rate swaps, interest rate swaptions and other
derivatives, we are exposed to counterparty risk, or the risk that counterparty
fails to perform the terms of the derivative contract.
The following table shows the interest rate sensitivity of our derivatives
measured in terms of fair value. These exposures will change as a result of
ongoing portfolio and risk management activities.
AS OF JUNE 30, 2002
---------------------------------------------------------------
FAIR VALUE (NO ACCRUED INTEREST)
-----------------------------------
WEIGHTED -100 BASIS +100 BASIS
NOTIONAL AVERAGE TERM POINT POINT
AMOUNT (YEARS) CHANGE NO CHANGE CHANGE
---------- ------------ ---------- --------- ----------
($ IN MILLIONS)
Interest rate swaps.................. $ 5,079.4 8.10(1) $ 127.8 $ 37.9 $ (47.8)
Principal-only swaps................. 467.0 1.55(1) 56.3 8.8 (50.8)
Total return swaps................... 222.5 0.16(1) 9.8 (3.2) (16.2)
Interest rate floors................. 3,400.0 4.45(2) 69.4 55.9 (31.6)
U.S. Treasury futures................ 1,113.5 0.24(3) 52.3 3.3 (49.2)
U.S. Treasury futures (LIBOR)........ 1,150.0 0.50(3) (1.8) (3.1) 1.8
Swaptions............................ 3,960.0 1.31(4) 160.7 115.4 (111.7)
Treasury rate guarantees............. 24.0 0.03(5) (5.0) (3.6) (2.2)
Bond forwards........................ 355.7 1.12(5) 16.9 (5.4) (27.2)
Mortgage-backed forwards and options. 10,378.8 0.10(5) (171.4) (22.3) 219.3
Interest rate lock commitments....... 3,863.8 0.12(6) 71.3 24.9 (181.0)
---------- --------- --------- ----------
Total............................. $ 30,014.7 $ 386.3 $ 208.6 $ (296.6)
========== ========= ========= ==========
- --------------------
(1) Based on maturity date of swap.
(2) Based on maturity date of floor.
(3) Based on maturity date.
(4) Based on option date of swaption.
(5) Based on settlement date.
(6) Based on expiration date.
We use U.S. Treasury futures to manage our over/under commitment position, and
our position in these contracts changes daily.
DEBT ISSUED AND OUTSTANDING. As of June 30, 2002, the aggregate fair value of
debt was $1,437.7 million. A 100 basis point, immediate, parallel decrease in
interest rates would increase the fair value of debt by approximately $67.0
million.
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AS OF JUNE 30, 2002
-----------------------------------------
FAIR VALUE (NO ACCRUED INTEREST)
-----------------------------------------
-100 BASIS +100 BASIS
POINT CHANGE NO CHANGE POINT CHANGE
------------ ----------- ------------
(IN MILLIONS)
7.95% notes payable, due 2004...................... $ 219.4 $ 215.1 $ 211.0
8.2% notes payable, due 2009....................... 556.4 526.0 497.7
7.875% surplus notes payable, due 2024............. 217.7 205.8 191.6
8% surplus notes payable, due 2044................. 114.3 102.8 92.6
Non-recourse mortgages and notes payable........... 255.7 246.8 238.5
Other mortgages and notes payable.................. 141.2 141.2 141.2
------------ ----------- ------------
Total long-term debt............................ $1,504.7 $1,437.7 $1,372.6
============ =========== ============
EQUITY RISK
Equity risk is the risk that we will incur economic losses due to adverse
fluctuations in a particular common stock. As of June 30, 2002, the fair value
of our equity securities was $813.7 million. A 10% decline in the value of the
equity securities would result in an unrealized loss of $81.4 million.
We also have indirect equity risk exposure with respect to BT Financial Group
margin lending operations. Under the terms of this financing arrangement, BT
Financial Group margin lending operations allow retail clients and independent
financial advisors on behalf of clients, within limits approved by senior
management, to borrow funds from BT Financial Group to invest in an approved
list of securities and mutual fund investments which serve as security for the
loan. The risk of loan default increases as the value of the underlying
securities declines. This risk is actively managed through the use of margin
calls on loans when the underlying securities fall below established levels.
Overall, the margin lending portfolio is limited to a ratio of borrowed funds to
market value of securities of an average of 67%. On November 30, 1999, BT
Financial Group margin lending operations securitized its margin lending
portfolio with Westpac Banking Corporation, an Australian bank. Under the terms
of this financing, BT Financial Group margin lending operations are required to
allocate capital equal to approximately 7% of the outstanding borrowed amount,
as a cushion for loan defaults. As of June 30, 2002, the margin lending
portfolio was $591.2 million, or Australian $1,053.1 million, while the ratio of
borrowed funds to market value of securities was 46%, below that of the maximum
allowed.
FOREIGN CURRENCY RISK
Foreign currency risk is the risk that we will incur economic losses due to
adverse fluctuations in foreign currency exchange rates. This risk arises from
our international operations and foreign currency-denominated funding agreements
issued to non-qualified institutional investors in the international market. The
notional amount of our currency swap agreements associated with
foreign-denominated liabilities as of June 30, 2002, was $3,052.4 million. We
also have fixed maturity securities that are denominated in foreign currencies.
However, we use derivatives to hedge the foreign currency risk, both interest
payments and the final maturity payment, of these funding agreements and
securities. As of June 30, 2002, the fair value of our foreign currency
denominated fixed maturity securities was $329.8 million. We use currency swap
agreements of the same currency to hedge the foreign currency exchange risk
related to these investments. The notional amount of our currency swap
agreements associated with foreign-denominated fixed maturity securities as of
June 30, 2002, was $311.2 million. With regard to our international operations,
we attempt to do as much of our business as possible in the functional currency
of the country of operation. At times, however, we are unable to do so, and in
these cases, we use foreign exchange derivatives to hedge the resulting risks.
Additionally, we utilize foreign currency swaps related to $665.0 million of
private notes issued in connection with our acquisition of BT Financial Group.
The interest payments related to these notes were initially serviced through
operating cash flows of our Australian operations. By utilizing the foreign
currency and interest rate swaps, the impact of Australian and U.S. dollar
exchange rate fluctuations had a minimal effect on our ability to rely on the
cash flows of our Australian operations to service the interest and principal
payments related to the notes. On December 28, 2001, all of the long-term debt
obligations of Principal Financial Group (Australia) Holdings Pty Limited were
ceased and were assumed by its parent, PFSI.
77
We estimate that as of June 30, 2002, a 10% immediate unfavorable change in each
of the foreign currency exchange rates to which we are exposed would result in
no change to the net fair value of our foreign currency denominated instruments
identified above, including the currency swap agreements. The selection of a 10%
immediate unfavorable change in all currency exchange rates should not be
construed as a prediction by us of future market events, but rather as an
illustration of the potential impact of such an event. Our largest individual
currency exposure is to fluctuations between the Australian dollar and the U.S.
dollar.
EFFECTS OF INFLATION
We do not believe that inflation, in the United States or in the other countries
in which we operate, has had a material effect on our consolidated operations
over the past five years. In the future, however, we may be affected by
inflation to the extent it causes interest rates to rise.
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PART II - OTHER INFORMATION
ITEM 1. - LEGAL PROCEEDINGS
We are regularly involved in litigation, both as a defendant and as a plaintiff
but primarily as a defendant. Litigation naming us as a defendant ordinarily
arises out of our business operations as a provider of medical insurance, life
insurance, annuities and residential mortgages. In addition, regulatory bodies,
such as state insurance departments, the SEC, the National Association of
Securities Dealers, Inc., the Department of Labor and other regulatory bodies
regularly make inquiries and conduct examinations or investigations concerning
our compliance with, among other things, insurance laws, securities laws, ERISA
and laws governing the activities of broker-dealers.
Recently, companies in the life insurance business have faced extensive claims,
including class-action lawsuits, alleging improper life insurance sales
practices. Principal Life is currently a defendant in two purported class-action
lawsuits alleging improper sales practices. We have reached an agreement in
principle to settle both of those lawsuits. The settlement has received court
approval. We have established reserves at a level we believe sufficient to cover
the cost of the settlement. A number of persons and entities who were eligible
to be class members have excluded themselves from the class (or "opted out"), as
the law permits them to do. Some of those class members have filed lawsuits and
we have been notified that others who opted out from the class will file
lawsuits and make claims similar to those addressed by the settlement. Similar
opt-out lawsuits have been brought against other life insurance companies as a
result of settlement of similar class-action lawsuits. Defense of these lawsuits
may cause us to incur significant costs. At this time, we are not able to
estimate the number of such lawsuits that may be filed, the costs of defending
the lawsuits or whether our defense will be successful.
A lawsuit was filed on September 27, 2001, in the United States District Court
for the Northern District of Illinois, seeking damages and other relief on
behalf of a putative class of policyholders based on allegations that the plan
of conversion of Principal Mutual Holding Company from a mutual insurance
holding company into a stock company violates the United States Constitution.
The action is captioned ESTHER L. GAYMAN V. PRINCIPAL MUTUAL HOLDING COMPANY, ET
AL. On April 16, 2002, the Court granted our Motion to Dismiss and ordered the
lawsuit be dismissed in its entirety. On April 17, 2002, a Judgment was entered
to that effect. The Plaintiffs filed an appeal on May 15, 2002, with the 7th
Circuit Court of Appeals.
While we cannot predict the outcome of any pending or future litigation,
examination or investigation, we do not believe any pending matter will have a
material adverse effect on our business, financial condition or results of
operations.
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ITEM 4. - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
At the Company's annual meeting of stockholders on May 20, 2002, the
stockholders elected four Class I directors each for a term expiring at the
Company's 2005 annual meeting. The voting results are as follows:
VOTES FOR VOTES WITHHELD
Betsy J. Bernard 192,436,936 3,262,397
Jocelyn Carter-Miller 191,167,476 4,531,857
Gary E. Costley 192,456,089 3,243,244
William T. Kerr 191,916,086 3,783,247
The directors whose terms of office continued and the years their terms expire
are as follows:
CLASS II DIRECTORS - TERM EXPIRES IN 2003
J. Barry Griswell
Charles S. Johnson
Richard L. Keyser
Donald M. Stewart
Elizabeth E. Tallett
CLASS III DIRECTORS - TERM EXPIRES IN 2004
David J. Drury
C. Daniel Gelatt
Sandra L. Helton
Victor H. Loewenstein
Federico F. Pena
The stockholders also ratified the appointment of Ernst & Young LLP as the
Company's independent auditors for 2002. The voting results are as follows:
FOR AGAINST ABSTAIN
188,374,668 6,165,808 1,158,560
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ITEM 6. - EXHIBITS AND REPORTS ON FORM 8-K
A. EXHIBITS
Certification Pursuant to Section 1350 of Chapter 63 of Title 18 of the
United States Code - J. Barry Griswell
Certification Pursuant to Section 1350 of Chapter 63 of Title 18 of the
United States Code - Michael H. Gersie
B. REPORTS ON FORM 8-K
None
81
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
PRINCIPAL FINANCIAL GROUP, INC.
Dated: August 8, 2002 By /s/ Michael H. Gersie
-----------------------------------
Michael H. Gersie
Executive Vice President and
Chief Financial Officer
Duly Authorized Officer, Principal Financial
Officer, and Chief Accounting Officer
82
EXHIBIT INDEX
Exhibit
Index Exhibit
- ------- -------
99.1 Certification Pursuant to Section 1350 of Chapter 63 of Title 18 of
the United States Code - J. Barry Griswell
99.2 Certification Pursuant to Section 1350 of Chapter 63 of Title 18 of
the United States Code - Michael H. Gersie
83
Exhibit 99.1
CERTIFICATION PURSUANT TO SECTION 1350 OF CHAPTER 63
OF TITLE 18 OF THE UNITED STATES CODE
I, J. Barry Griswell, Chairman, President and Chief Executive Officer of
Principal Financial Group, Inc., certify that (i) the Form 10-Q for the quarter
ended June 30, 2002 fully complies with the requirements of Section 13(a) of the
Securities Exchange Act of 1934 and (ii) the information contained in the Form
10-Q for the quarter ended June 30, 2002 fairly presents, in all material
respects, the financial condition and results of operations of Principal
Financial Group, Inc.
/s/ J. Barry Griswell
--------------------------
J. Barry Griswell
Chairman, President and Chief Executive Officer
Date: August 8, 2002
84
Exhibit 99.2
CERTIFICATION PURSUANT TO SECTION 1350 OF CHAPTER 63
OF TITLE 18 OF THE UNITED STATES CODE
I, Michael H. Gersie, Executive Vice President and Chief Financial Officer
of Principal Financial Group, Inc., certify that (i) the Form 10-Q for the
quarter ended June 30, 2002 fully complies with the requirements of Section
13(a) of the Securities Exchange Act of 1934 and (ii) the information contained
in the Form 10-Q for the quarter ended June 30, 2002 fairly presents, in all
material respects, the financial condition and results of operations of
Principal Financial Group, Inc.
/s/ Michael H. Gersie
-------------------------
Michael H. Gersie
Executive Vice President and Chief Financial Officer
Date: August 8, 2002
85