UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2006

OR

o  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

1-16725

(Commission file number)

PRINCIPAL FINANCIAL GROUP, INC.

(Exact name of registrant as specified in its charter)

Delaware		42-1520346
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification Number)

 

711 High Street, Des Moines, Iowa 50392

(Address of principal executive offices)

(515) 247-5111

(Registrant’s telephone number, including area code)

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  o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large Accelerated Filer     x     Accelerated Filer     o     Non-accelerated Filer     o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o   No  x

The total number of shares of the registrant’s Common Stock, $0.01 par value, outstanding as of July 27, 2006 was 269,286,643.

 

PRINCIPAL FINANCIAL GROUP, INC.

TABLE OF CONTENTS

		Page
Part I - FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Statements of Financial Position at June 30, 2006 (Unaudited) and December 31, 2005		3
Unaudited Consolidated Statements of Operations for the three and six months ended June 30, 2006 and 2005		4
Unaudited Consolidated Statements of Stockholders’ Equity for the six months ended June 30, 2006 and 2005		5
Unaudited Consolidated Statements of Cash Flows for the six months ended June 30, 2006 and 2005		6
Notes to Unaudited Consolidated Financial Statements – June 30, 2006		8
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		41
Item 3. Quantitative and Qualitative Disclosures about Market Risk		82
Item 4. Controls and Procedures		87
Part II – OTHER INFORMATION
Item 1. Legal Proceedings		88
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		89
Item 4. Submission of Matters to a Vote of Security Holders		90
Item 6. Exhibits		91
Signature		92

 

2

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PART I – FINANCIAL INFORMATION

Item 1. Financial Statements

Principal Financial Group, Inc.

Consolidated Statements of Financial Position

		June 30, 2006			December 31, 2005
		(Unaudited)
		(in millions)
Assets
Fixed maturities, available-for-sale		$	42,293.4		$	42,117.2
Fixed maturities, trading		252.0			113.2
Equity securities, available-for-sale		677.2			724.4
Equity securities, trading		148.3			90.3
Mortgage loans		11,543.9			11,484.3
Real estate		997.2			999.4
Policy loans		843.2			827.7
Other investments		1,368.8			1,113.5
Total investments		58,124.0			57,470.0
Cash and cash equivalents		1,216.9			1,641.3
Accrued investment income		666.0			682.7
Premiums due and other receivables		626.8			592.7
Deferred policy acquisition costs		2,455.6			2,174.1
Property and equipment		420.2			419.8
Goodwill		297.8			282.3
Other intangibles		199.3			202.6
Separate account assets		65,620.2			62,070.0
Other assets		1,802.6			1,499.9
Total assets		$	131,429.4		$	127,035.4
Liabilities
Contractholder funds		$	35,512.6		$	33,612.1
Future policy benefits and claims		17,006.6			16,825.5
Other policyholder funds		636.3			657.1
Short-term debt		424.4			476.4
Long-term debt		894.2			898.8
Income taxes currently payable		0.5			—
Deferred income taxes		610.9			974.8
Separate account liabilities		65,620.2			62,070.0
Other liabilities		3,879.0			3,713.5
Total liabilities		124,584.7			119,228.2
Stockholders’ equity
Series A preferred stock, par value $.01 per share with liquidation preference of $100 per share - 3.0 million shares authorized, issued and outstanding in 2006 and 2005		—			—
Series B preferred stock, par value $.01 per share with liquidation preference of $25 per share - 10.0 million shares authorized, issued and outstanding in 2006 and 2005		0.1			0.1
Common stock, par value $.01 per share - 2,500.0 million shares authorized, 382.5 million and 381.3 million shares issued, and 269.1 million and 280.6 million shares outstanding in 2006 and 2005, respectively		3.8			3.8
Additional paid-in capital		8,068.8			8,000.0
Retained earnings		2,504.8			2,008.6
Accumulated other comprehensive income		218.5			994.8
Treasury stock, at cost (113.4 million and 100.7 million shares in 2006 and 2005, respectively)		(3,951.3		)	(3,200.1		)
Total stockholders’ equity		6,844.7			7,807.2
Total liabilities and stockholders’ equity		$	131,429.4		$	127,035.4

 

See accompanying notes.

3

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Principal Financial Group, Inc.

Consolidated Statements of Operations

(Unaudited)

		For the three months ended June 30,						For the six months ended June 30,
		2006			2005			2006			2005
		(in millions, except per share data)
Revenues
Premiums and other considerations		$	1,104.6		$	948.9		$	2,146.4		$	1,883.0
Fees and other revenues		451.3			405.3			900.1			822.5
Net investment income		911.6			836.0			1,763.8			1,629.9
Net realized/unrealized capital gains (losses)		(19.1		)	10.2			29.8			8.7
Total revenues		2,448.4			2,200.4			4,840.1			4,344.1
Expenses
Benefits, claims, and settlement expenses		1,459.6			1,264.5			2,801.4			2,498.8
Dividends to policyholders		72.5			72.2			144.4			145.1
Operating expenses		619.8			580.8			1,224.2			1,137.7
Total expenses		2,151.9			1,917.5			4,170.0			3,781.6
Income from continuing operations before income taxes		296.5			282.9			670.1			562.5
Income taxes		77.7			59.3			157.4			134.0
Income from continuing operations, net of related income taxes		218.8			223.6			512.7			428.5
Income from discontinued operations, net of related income taxes		—			15.3			—			15.9
Net income		218.8			238.9			512.7			444.4
Preferred stock dividends		8.3			—			16.5			—
Net income available to common stockholders		$	210.5		$	238.9		$	496.2		$	444.4
Earnings per common share
Basic earnings per common share:
Income from continuing operations, net of related income taxes		$	0.77		$	0.78		$	1.79		$	1.45
Income from discontinued operations, net of related income taxes		—			0.05			¾			0.05
Net income		$	0.77		$	0.83		$	1.79		$	1.50
Diluted earnings per common share:
Income from continuing operations, net of related income taxes		$	0.76		$	0.77		$	1.78		$	1.44
Income from discontinued operations, net of related income taxes		—			0.05			¾			0.05
Net income		$	0.76		$	0.82		$	1.78		$	1.49

 

See accompanying notes.

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Principal Financial Group, Inc.

Consolidated Statements of Stockholders’ Equity

(Unaudited)

		Series A preferred stock			Series B preferred stock			Common stock			Additional paid-in capital			Retained earnings			Accumulated other comprehensive income			Treasury stock			Total stockholders’ equity
		(in millions)
Balances at January 1, 2005		$	—		$	—		$	3.8		$	7,269.4		$	1,289.5		$	1,313.3		$	(2,331.7	)	$	7,544.3
Series A preferred stock issued		—			—			—			296.0			—			—			—			296.0
Series B preferred stock issued		—			0.1			—			245.9			—			—			—			246.0
Common stock issued		—			—			—			25.8			—			—			—			25.8
Capital transactions of equity method investee, net of related income taxes		—			—			—			0.4			—			—			—			0.4
Stock-based compensation, and additional related tax benefits		—			—			—			23.0			—			—			—			23.0
Treasury stock acquired, common		—			—			—			—			—			—			(868.4		)	(868.4		)
Comprehensive income:
Net income		—			—			—			—			444.4			—			—			444.4
Net unrealized gains		—			—			—			—			—			164.7			—			164.7
Provision for deferred income taxes		—			—			—			—			—			(41.0		)	—			(41.0		)
Foreign currency translation adjustment, net of related income taxes		—			—			—			—			—			16.9			—			16.9
Comprehensive income																							585.0
Balances at June 30, 2005		$	—		$	0.1		$	3.8		$	7,860.5		$	1,733.9		$	1,453.9		$	(3,200.1	)	$	7,852.1
Balances at January 1, 2006		$	—		$	0.1		$	3.8		$	8,000.0		$	2,008.6		$	994.8		$	(3,200.1	)	$	7,807.2
Common stock issued		—			—			—			38.3			—			—			—			38.3
Capital transactions of equity method investee, net of related income taxes		—			—			—			0.8			—			—			—			0.8
Stock-based compensation, and additional related tax benefits		—			—			—			29.7			—			—			—			29.7
Treasury stock acquired, common		—			—			—			—			—			—			(751.2		)	(751.2		)
Dividends to preferred stockholders		—			—			—			—			(16.5		)	—			—			(16.5		)
Comprehensive loss:
Net income		—			—			—			—			512.7			—			—			512.7
Net unrealized losses		—			—			—			—			—			(1,113.0		)	—			(1,113.0		)
Provision for deferred income tax benefits		—			—			—			—			—			369.6			—			369.6
Foreign currency translation adjustment, net of related income taxes		—			—			—			—			—			(32.9		)	—			(32.9		)
Comprehensive loss																							(263.6		)
Balances at June 30, 2006		$	—		$	0.1		$	3.8		$	8,068.8		$	2,504.8		$	218.5		$	(3,951.3	)	$	6,844.7

 

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Principal Financial Group, Inc.

Consolidated Statements of Cash Flows

(Unaudited)

		For six months ended June 30,
		2006			2005
					(As Restated - See Note 1)
		(in millions)
Operating activities
Net income		$	512.7		$	444.4
Adjustments to reconcile net income to net cash provided by operating activities:
Income from discontinued operations, net of related income taxes		—			(15.9		)
Amortization of deferred policy acquisition costs		136.6			126.7
Additions to deferred policy acquisition costs		(245.0		)	(249.4		)
Accrued investment income		16.7			5.3
Net cash flows from trading securities		(128.5		)	1.6
Premiums due and other receivables		(22.8		)	(20.4		)
Contractholder and policyholder liabilities and dividends		648.5			932.3
Current and deferred income taxes		(34.9		)	(416.0		)
Net realized/unrealized capital gains		(29.8		)	(8.7		)
Depreciation and amortization expense		49.6			47.4
Mortgage loans held for sale, acquired or originated		(282.4		)	(1,077.3		)
Mortgage loans held for sale, sold or repaid, net of gain		564.6			1,108.2
Real estate acquired through operating activities		(14.7		)	(26.7		)
Real estate sold through operating activities		11.8			4.8
Stock-based compensation		28.9			22.9
Other		(106.5		)	(72.8		)
Net adjustments		592.1			362.0
Net cash provided by operating activities		1,104.8			806.4
Investing activities
Available-for-sale securities:
Purchases		(4,384.4		)	(4,753.5		)
Sales		745.3			960.1
Maturities		1,873.0			3,046.6
Mortgage loans acquired or originated		(1,542.5		)	(1,272.9		)
Mortgage loans sold or repaid		1,192.3			1,264.4
Real estate acquired		(18.7		)	(161.0		)
Real estate sold		11.4			267.2
Net purchases of property and equipment		(23.2		)	(18.1		)
Purchases of interest in subsidiaries, net of cash acquired		(5.5		)	(54.4		)
Net change in other investments		84.3			(41.2		)
Net cash used in investing activities		$	(2,068.0	)	$	(762.8	)

 

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Principal Financial Group, Inc.

Consolidated Statements of Cash Flows (continued)

(Unaudited)

		For the six months ended, June 30,
		2006			2005
					(As Restated - See Note 1)
		(in millions)
Financing activities
Issuance of preferred stock		$	—		$	542.0
Issuance of common stock		38.3			25.8
Acquisition and sales of treasury stock, net		(751.2		)	(868.4		)
Proceeds from financing element derivatives		81.3			83.0
Payments for financing element derivatives		(69.9		)	(55.6		)
Excess tax benefits from share-based payment arrangements		2.6			—
Dividends to preferred stockholders		(16.5		)	—
Issuance of long-term debt		8.7			12.2
Principal repayments of long-term debt		(6.3		)	(11.5		)
Net proceeds (repayments) of short-term borrowings		(49.6		)	172.4
Investment contract deposits		4,835.7			4,072.6
Investment contract withdrawals		(3,609.7		)	(3,319.5		)
Net increase in banking operation deposits		75.4			22.7
Net cash provided by financing activities		538.8			675.7
Discontinued operations
Net cash used in operating activities		—			(0.1		)
Net cash used in investing activities		—			(0.1		)
Net cash used in discontinued operations		—			(0.2		)
Net increase (decrease) in cash and cash equivalents		(424.4		)	719.1
Cash and cash equivalents at beginning of period		1,641.3			452.5
Cash and cash equivalents at end of period		$	1,216.9		$	1,171.6
Cash and cash equivalents of discontinued operations included above
At beginning of period		$	—		$	1.9
At end of period		$	—		$	1.7

 

See accompanying notes

7

 

Principal Financial Group, Inc.
Notes to Consolidated Financial Statements
June 30, 2006
(Unaudited)

1. Nature of Operations and Significant Accounting Policies

Basis of Presentation

The accompanying unaudited consolidated financial statements of Principal Financial Group, Inc. (“PFG”), its majority-owned subsidiaries and its consolidated variable interest entities (“VIE”), 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 and six months ended June 30, 2006, are not necessarily indicative of the results that may be expected for the year ended December 31, 2006. These interim unaudited consolidated financial statements should be read in conjunction with our annual audited financial statements as of December 31, 2005, included in our Form 10-K for the year ended December 31, 2005, filed with the United States Securities and Exchange Commission (“SEC”). The accompanying consolidated statement of financial position at December 31, 2005, 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.

Restatement

For the year ended December 31, 2005, we separately disclosed the operating, investing and financing portions of the cash flows attributable to our discontinued operations, which in the prior interim periods were excluded from the statement of cash flows. We have restated the statements of cash flows for the interim periods of 2005 to include and separately disclose the operating, investing, and financing portions of the cash flows attributable to our discontinued operations.

Recent Accounting Pronouncements

On July 13, 2006, the Financial Accounting Standards Board (the “FASB”) issued FASB Interpretation (“FIN”) No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”).  FIN 48, which is an interpretation of Statement of Financial Accounting Standards (“SFAS”) No. 109, Accounting for Income Taxes, prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken, or expected to be taken, in a tax return.  FIN 48 requires the affirmative evaluation that it is more likely than not, based on the technical merits of a tax position, that an enterprise is entitled to economic benefits resulting from positions taken in income tax returns.  If a tax position does not meet the more-likely-than-not recognition threshold, the benefit of that position is not recognized in the financial statements.  FIN 48 also requires companies to disclose additional quantitative and qualitative information in their financial statements about uncertain tax positions.  FIN 48 is effective for fiscal years beginning after December 15, 2006, and the cumulative effect of applying this Interpretation shall be reported as an adjustment to the opening balance of retained earnings for that fiscal year.  FIN 48 is not expected to have a material impact on our consolidated financial statements.

On March 17, 2006, the FASB issued SFAS No. 156, Accounting for Servicing of Financial Assets (“SFAS 156”), which amends SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (“SFAS 140”). This Statement (1) requires an entity to recognize a servicing asset or liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract in specified situations, (2) requires all separately recognized servicing assets and liabilities to be initially measured at fair value, (3) for subsequent measurement of each class of separately recognized servicing assets and liabilities, an entity can elect either the amortization or fair value measurement method, (4) permits a one-time reclassification of available-for-sale (“AFS”) securities to trading securities by an entity with recognized servicing rights, without calling into question the treatment of other AFS securities, provided the AFS securities are identified in some manner as offsetting the entity’s exposure to changes in fair value of servicing assets or liabilities that a servicer elects to subsequently measure at fair value, and (5) requires separate presentation of servicing assets and liabilities measured at fair value in the statement of financial position and also requires additional disclosures. The initial measurement requirements of this statement should be applied prospectively to all transactions entered into after the fiscal year beginning after September 15, 2006. The election related to the subsequent measurement of servicing assets and liabilities is also effective the first fiscal year beginning after September 15, 2006. SFAS 156 is not expected to have a material impact on our consolidated financial statements.

 

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Principal Financial Group, Inc.
Notes to Consolidated Financial Statements (continued)
June 30, 2006
(Unaudited)

1. Nature of Operations and Significant Accounting Policies (continued)

On February 16, 2006, the FASB issued SFAS No. 155, Accounting for Certain Hybrid Financial Instruments – an amendment of FASB Statements No. 133 and 140 (“SFAS 155”), which amends SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS 133”) and SFAS 140. SFAS 155 (1) permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation, (2) clarifies which interest-only and principal-only strips are not subject to the requirements of SFAS 133, (3) establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation, (4) clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives, and (5) amends SFAS 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. This Statement is effective for all financial instruments acquired or issued after the beginning of an entity’s fiscal year that begins after September 15, 2006. At adoption, the fair value election may also be applied to hybrid financial instruments that have been bifurcated under SFAS 133 prior to adoption of this Statement. Any changes resulting from the adoption of this Statement should be recognized as a cumulative effect adjustment to beginning retained earnings. SFAS 155 is not expected to have a material impact on our consolidated financial statements.

On December 16, 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment (“SFAS 123R”). SFAS 123R requires all share-based payments to employees to be recognized at fair value in the financial statements. SFAS 123R replaces SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS 123”), supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”), and SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure - an Amendment of FASB Statement No. 123 and amends SFAS No. 95, Statement of Cash Flows. On April 14, 2005, the SEC approved a new rule delaying the effective date of SFAS 123R to annual periods that begin after June 15, 2005. Accordingly, we adopted SFAS 123R effective January 1, 2006 using the modified-prospective method.

It is appropriate to recognize compensation cost either immediately for stock awards granted to retirement eligible employees, or over the period from the grant date to the date retirement eligibility is achieved, if retirement eligibility is expected to occur during the nominal vesting period. Our approach was to follow the widespread practice of recognizing compensation cost over the explicit service period (up to the date of actual retirement). For any awards that are granted after our adoption of SFAS 123R on January 1, 2006, we recognize compensation cost through the period that the employee first becomes eligible to retire and is no longer required to provide service to earn the award. If we had applied the nonsubstantive vesting provisions of SFAS 123R to awards granted prior to January 1, 2006, our consolidated financial statements would not have been materially impacted.

SFAS 123R requires that the benefits of tax deductions in excess of recognized compensation cost be reported as a financing cash flow, rather than as an operating cash flow. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after the effective date. While the Company cannot estimate what those amounts will be in the future (because they depend on, among other things, when employees exercise stock options), the amount of financing cash flows recognized for the six months ended June 30, 2006, for such excess tax deductions, was $2.6 million.

Under the modified-prospective method, any excess income tax deduction realized for awards accounted for under SFAS 123R (regardless of the type of award or the jurisdiction in which the tax benefit is generated) is eligible to absorb write-offs of deferred income tax assets for any awards accounted for under SFAS 123R. SFAS 123R does not require separate pools of excess income tax benefits for separate types of awards, rather the excess income tax benefits of employee and nonemployee awards may be combined in a single pool of excess tax benefits. Our policy is to pool the employee and nonemployee awards together in this manner. Deferred income tax asset write-offs resulting from deficient deductions on employee awards may be offset against previous excess income tax benefits arising from nonemployee awards, and vice versa.

 

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Principal Financial Group, Inc.
Notes to Consolidated Financial Statements (continued)
June 30, 2006
(Unaudited)

1. Nature of Operations and Significant Accounting Policies (continued)

This Statement did not have a material impact on our consolidated financial statements as we began expensing all stock options using a fair-value based method effective for the year beginning January 1, 2002. In addition, any stock options granted prior to January 1, 2002 were fully vested at the time of adoption of SFAS 123R. We use the Black-Scholes formula to estimate the value of stock options granted to employees. We applied the prospective method of transition as prescribed by SFAS 123 when we elected to begin expensing stock-based compensation in 2002. The cumulative effect of the change in accounting principle as a result of adopting this Statement is immaterial. Therefore, the pre-tax cumulative effect of the change in accounting principle is reflected in operating expenses.

See note 9, Stock-Based Compensation Plans, for further details on our stock-based compensation.

Separate Accounts

As of June 30, 2006 and December 31, 2005, the separate accounts include a separate account valued at $775.5 million and $726.6 million, respectively, which primarily includes shares of our stock that were allocated and issued to eligible participants of qualified employee benefit plans administered by us as part of the policy credits issued under our 2001 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 statements of financial position. Changes in fair value of the separate account shares are reflected in both the separate account assets and separate account liabilities and do not impact our results of operations.

2.  Significant Unconsolidated Variable Interest Entities

Synthetic Collateralized Debt Obligation.  On June 21, 2006, we invested $285.0 million in a secured limited recourse note issued by a segregated portfolio company.  The note represents Class B notes.  Class A notes are senior and Class C through Class F notes are subordinated to Class B notes.  The entity entered into a credit default swap with a third party providing credit protection in exchange for a fee.  Defaults in an underlying reference portfolio will only affect the note if cumulative losses of a synthetic reference portfolio exceed the loss attachment point on the portfolio.  We have determined we are not the primary beneficiary, as we do not hold the majority of the risk of loss.  Our maximum exposure to loss as a result of our involvement with this entity is our recorded investment of $285.0 million as of June 30, 2006.

3. Federal Income Taxes

The effective income tax rate on income from continuing operations for the three months and six months ended June 30, 2006 is lower than the prevailing corporate federal income tax rate primarily due to income tax deductions allowed for corporate dividends received and interest exclusion from taxable income. The effective income tax rate on income from continuing operations for the six months ended June 30, 2006 is also lower than the prevailing corporate federal income tax rate due to a favorable court ruling on a contested Internal Revenue Service issue for 1991 and later years. The effective income tax rate on income from continuing operations for the three months and six months ended June 30, 2005 is lower than the prevailing corporate federal income tax rate primarily due to income tax deductions allowed for corporate dividends received, tax credits received on our investment in a synthetic fuel facility and interest exclusion from taxable income.

4. Employee and Agent Benefits

Effective January 1, 2006, we made changes to our retirement program, including the Principal Select Saving Plan (“401(k)”), the Principal Pension Plan (“Pension Plan”) and the corresponding nonqualified plans. The qualified and nonqualified pension plans’ changes include a reduction to the traditional and cash balance formulas, a change in the early retirement factors, and the removal of the cost of living adjustments for traditional benefits earned after January 1, 2006. The qualified and nonqualified 401(k) plans’ company match increased from 50% of a 6% deferral to 75% of an 8% deferral. The Pension Plan changes reduced the Pension Plan expense in 2006, while the 401(k) changes increased the 401(k) expense.

 

10

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Principal Financial Group, Inc.
Notes to Consolidated Financial Statements (continued)
June 30, 2006
(Unaudited)

4. Employee and Agent Benefits (continued)

Components of net periodic benefit cost (income):

 

		Pension benefits						Other postretirement benefits
		For the three months ended June 30,						For the three months ended June 30,
		2006			2005			2006			2005
		(in millions)
Service cost		$	11.7		$	12.4		$	2.4		$	2.5
Interest cost		20.4			19.4			4.0			4.2
Expected return on plan assets		(26.3		)	(24.1		)	(8.1		)	(7.3		)
Amortization of prior service cost (benefit)		(2.2		)	0.4			(0.7		)	(0.6		)
Recognized net actuarial loss		5.1			4.1			0.1			0.1
Net periodic benefit cost (income)		$	8.7		$	12.2		$	(2.3	)	$	(1.1	)

 

		Pension benefits						Other postretirement benefits
		For the six months ended June 30,						For the six months ended June 30,
		2006			2005			2006			2005
		(in millions)
Service cost		$	23.5		$	24.8		$	4.7		$	5.0
Interest cost		40.8			38.7			8.1			8.4
Expected return on plan assets		(52.7		)	(48.1		)	(16.2		)	(14.7		)
Amortization of prior service cost (benefit)		(4.5		)	0.7			(1.3		)	(1.3		)
Recognized net actuarial loss		10.2			8.2			0.1			0.3
Net periodic benefit cost (income)		$	17.3		$	24.3		$	(4.6	)	$	(2.3	)

 

Contributions

Our funding policy for the Pension Plan is to fund the plan annually in an amount at least equal to the minimum annual contribution required under the Employee Retirement Income Security Act (“ERISA”) and, generally, not greater than the maximum amount that can be deducted for federal income tax purposes. The minimum annual contribution for 2006 will be zero so we will not be required to fund the Pension Plan during 2006. However, it is possible that we may fund the qualified and nonqualified plans in 2006 in the range of $20.0 million to $50.0 million. During the three months and six months ended June 30, 2006, $5.2 million was contributed to the plans.

 

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Principal Financial Group, Inc.
Notes to Consolidated Financial Statements (continued)
June 30, 2006
(Unaudited)

5. Contingencies, Guarantees and Indemnifications

Litigation

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 asset management and accumulation products and services, life, health and disability insurance. Some of the lawsuits are class actions, or purport to be, and some include claims for punitive damages. 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.

Several lawsuits have been filed against other insurance companies and insurance brokers alleging improper conduct relating to the payment and non-disclosure of contingent compensation and bid-rigging activity. Several of these suits were filed as purported class actions. Several state attorneys general and insurance regulators have initiated industry-wide inquiries or other actions relating to compensation arrangements between insurance brokers and insurance companies and other industry issues. Beginning in March of 2005, we have received subpoenas and interrogatories from the offices of the Attorneys General of New York and Connecticut seeking information related to compensation agreements with brokers and agents and the sale of retirement products and services. We are cooperating with these inquiries. We have received other requests from regulators and other governmental authorities relating to industry issues and may receive additional such requests, including subpoenas and interrogatories, in the future.

On December 23, 2004, a lawsuit was filed in Iowa state court against us and our wholly owned subsidiaries, Principal Life Insurance Company (“Principal Life”) and Principal Financial Services, Inc., on behalf of a proposed class comprised of the settlement class in the Principal Life sales practices class action settlement, which was approved in April 2001 by the United States District Court for the Southern District of Iowa. This more recent lawsuit claims that the treatment of the settlement costs of that sales practices litigation in relation to the allocation of demutualization consideration to Principal Life policyholders was inappropriate. Demutualization allocation was done pursuant to the terms of a plan of demutualization approved by the policyholders in July 2001 and Insurance Commissioner of the State of Iowa in August 2001. The lawsuit further claims that such allocation was not accurately described to policyholders during the demutualization process and is a breach of the sales practices settlement. On January 27, 2005, we filed a notice to remove the action from state court to the United States District Court for the Southern District of Iowa. On July 22, 2005, the plaintiff’s motion to remand the action to state court was denied, and our motion to dismiss the lawsuit was granted. On September 21, 2005, the plaintiff’s motion to alter or amend the judgment was denied. On October 4, 2005, the plaintiff filed a notice of appeal to the United States Court of Appeals for the Eighth Circuit.

A lawsuit was filed against us, Principal Life, and Principal Financial Services, Inc. in the United States District Court for the Southern District of Iowa on October 31, 2005, but the plaintiff dismissed the case without prejudice on March 17, 2006. The claims and allegations in the lawsuit were substantially the same as those in the December 23, 2004 lawsuit, but the proposed class was limited to those members of the settlement class in the Principal Life sales practices class action settlement who did not own annuities and who received demutualization consideration in the form of cash under the plan of demutualization.

 

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Principal Financial Group, Inc.
Notes to Consolidated Financial Statements (continued)
June 30, 2006
(Unaudited)

5. Contingencies, Guarantees and Indemnifications (continued)

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 our business or financial position. The outcome of litigation is always uncertain, and unforeseen results can occur. It is possible that such outcomes could materially affect net income in a particular quarter or annual period.

Guarantees and Indemnifications

In the normal course of business, we have provided guarantees to third parties primarily related to a former subsidiary, joint ventures and industrial revenue bonds. These agreements generally expire from 2006 through 2019. The maximum exposure under these agreements as of June 30, 2006, was approximately $166.0 million; however, we believe the likelihood is remote that material payments will be required and therefore have not accrued for a liability on our consolidated statements of financial position. Should we be required to perform under these guarantees, we generally could recover a portion of the loss from third parties through recourse provisions included in agreements with such parties, the sale of assets held as collateral that can be liquidated in the event that performance is required under the guarantees or other recourse generally available to us, therefore, such guarantees would not result in a material adverse effect on our business or financial position. It is possible that such outcomes could materially affect net income in a particular quarter or annual period. The fair value of such guarantees is not material.

In connection with the 2002 sale of BT Financial Group, we agreed to indemnify the purchaser, Westpac Banking Corporation (“Westpac”), for among other things, the costs associated with potential late filings made by BT Financial Group in New Zealand prior to Westpac’s ownership, up to a maximum of A$250.0 million Australian dollars (approximately U.S. $186.0 million as of June 30, 2006). New Zealand securities regulations allow Australian issuers to issue their securities in New Zealand provided that certain documents are appropriately filed with the New Zealand Registrar of Companies. Specifically, the regulations require that any amendments to constitutions and compliance plans be filed in New Zealand. In April 2003, the New Zealand Securities Commission opined that such late filings would result in certain New Zealand investors having a right to return of their investment plus interest at 10% per annum from the date of investment. This technical issue affected many in the industry.

On December 24, 2004, Westpac lodged several warranty and indemnification claims related to the sale of BT Financial Group. The claims aggregated approximately A$50.0 million Australian dollars (approximately U.S. $37.0 million as of June 30, 2006) with the majority of the claims (approximately A$45.0 million Australian dollars, or U.S. $33.0 million as of June 30, 2006) related to fund pricing and accounting issues around a tax asset called future income tax benefit (“FITB”). FITB is an asset used in calculating unit pricing of funds. Westpac claimed that BT Financial Group incorrectly accrued FITB assets in valuing asset portfolios of BT funds in Australia and New Zealand and that, as a result, fund values were overstated.

The claims made by Westpac related to both indemnifications were settled and paid by us in 2006. This settlement did not have a material impact on net income.

We are also subject to various other indemnification obligations issued in conjunction with certain transactions, primarily the sale of Principal Residential Mortgage, Inc. and other divestitures, acquisitions and financing transactions whose terms range in duration and often are not explicitly defined. Certain portions of these indemnifications may be capped, while other portions are not subject to such limitations; therefore, the overall maximum amount of the obligation under the indemnifications cannot be reasonably estimated. While we are unable to estimate with certainty the ultimate legal and financial liability with respect to these indemnifications, we believe the likelihood is remote that material payments would be required under such indemnifications and therefore such indemnifications would not result in a material adverse effect on our business or financial position. It is possible that such outcomes could materially affect net income in a particular quarter or annual period. The fair value of such indemnifications is not material.

 

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Principal Financial Group, Inc.
Notes to Consolidated Financial Statements (continued)
June 30, 2006
(Unaudited)

6. Stockholders’ Equity

Common Stock

On May 19, 2006, following our Board of Directors’ share repurchase authorization, we entered into an accelerated common stock repurchase agreement with a third party investment bank for an aggregate purchase price of  $500.0 million. On this date, we paid $500.0 million and received the initial delivery of 7.7 million common shares, while retaining the right to receive additional common shares depending on the volume weighted average share price of our common stock over the program’s duration.  The maximum number of shares eligible for repurchase under this program is 19.5 million common shares. The program will be completed in the fourth quarter 2006, at which time we will receive any remaining common shares owed to us under this agreement.

Reconciliation of Outstanding Shares

 

		Series A Preferred Stock		Series B Preferred Stock		Common Stock
		(in  millions)
Outstanding shares at January 1, 2005		—		—		300.6
Shares issued		3.0		10.0		1.0
Treasury stock acquired		—		—		(22.2	)
Outstanding shares at June 30, 2005		3.0		10.0		279.4
Outstanding shares at January 1, 2006		3.0		10.0		280.6
Shares issued		—		—		1.3
Treasury stock acquired		—		—		(12.8	)
Outstanding shares at June 30, 2006		3.0		10.0		269.1

 

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Principal Financial Group, Inc.
Notes to Consolidated Financial Statements (continued)
June 30, 2006
(Unaudited)

7. Comprehensive Income (Loss)

Comprehensive income (loss) is as follows:

 

		For the three months ended June 30,						For the six months ended June 30,
		2006			2005			2006			2005
		(in  millions)
Comprehensive income (loss):
Net income		$	218.8		$	238.9		$	512.7		$	444.4
Net change in unrealized gains and losses on fixed maturities, available-for-sale		(625.0		)	691.0			(1,368.3		)	158.5
Net change in unrealized gains and losses on equity securities, available-for-sale		(10.9		)	10.1			(9.6		)	3.8
Net change in unrealized gains and losses on equity method subsidiaries and minority interest adjustments		(51.2		)	(17.3		)	18.3			(17.0		)
Adjustments for assumed changes in amortization patterns:
Deferred policy acquisition costs		92.1			(36.8		)	179.8			6.8
Sales inducements		4.8			(3.8		)	9.3			(0.2		)
Unearned revenue reserves		(4.1		)	(9.5		)	(7.9		)	(2.4		)
Net change in unrealized gains and losses on derivative instruments		15.2			0.6			31.7			25.2
Adjustments to unrealized gains and losses for Closed Block policyholder dividend obligation		—			(62.9		)	33.7			(10.0		)
Change in net foreign currency translation adjustment		(31.6		)	24.2			(30.2		)	15.2
Provision for deferred income taxes (benefits)		189.9			(188.1		)	366.9			(39.3		)
Comprehensive income (loss)		$	(202.0	)	$	646.4		$	(263.6	)	$	585.0

 

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Principal Financial Group, Inc.
Notes to Consolidated Financial Statements (continued)
June 30, 2006
(Unaudited)

8. Segment Information

We provide financial products and services through the following segments: U.S. Asset Management and Accumulation, International Asset Management and Accumulation and Life and Health Insurance. 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 our asset accumulation business, the life and health insurance operations, the Corporate and Other segment and third-party clients.

The International Asset Management and Accumulation segment consists of Principal International operations in Chile, Mexico, Hong Kong, Brazil, India, China, and Malaysia. We focus on countries with favorable demographics and a trend toward private sector defined contribution pension systems. We entered these countries through acquisitions, start-up operations and joint ventures.

The Life and Health insurance segment provides individual life insurance, group health insurance and specialty benefits, which consists of group dental and vision insurance, individual and group disability insurance and group life insurance, throughout the United States.

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 our financing activities (including interest expense), income on capital not allocated to other segments, inter-segment eliminations, income tax risks and certain income, expenses and other after-tax adjustments not allocated to the segments based on the nature of such items.

Management uses segment operating earnings for goal setting, determining employee compensation and evaluating performance on a basis comparable to that used by securities analysts. We determine segment operating earnings by adjusting U.S. GAAP net income available to common stockholders for net realized/unrealized capital gains and losses, as adjusted, and other after-tax adjustments which management believes are not indicative of overall operating trends. Net realized/unrealized capital gains and losses, as adjusted, are net of income taxes, related changes in the amortization pattern of deferred policy acquisition costs (“DPAC”) and sales inducements, recognition of front-end fee revenues for sales charges on pension products and services, net realized capital gains and losses distributed, minority interest capital gains and losses and certain market value adjustments to fee revenues. Segment operating revenues exclude net realized/unrealized capital gains and their impact on recognition of front-end fee revenues and certain market value adjustments to fee revenues and include operating revenues from real estate properties that qualify for discontinued operations treatment under SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS 144”). 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 our results of operations by highlighting earnings attributable to the normal, ongoing operations of the business.

The accounting policies of the segments are consistent with the accounting policies for the consolidated financial statements, with the exception of income tax allocation. The Corporate and Other segment functions to absorb the risk inherent in interpreting and applying tax law. The segments are allocated tax adjustments consistent with our tax position. The Corporate and Other segment results reflect any differences between the tax returns and the estimated resolution of any disputes.

 

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Principal Financial Group, Inc.
Notes to Consolidated Financial Statements (continued)
June 30, 2006
(Unaudited)

8. Segment Information (continued)

The following tables summarize selected financial information by segment and reconcile segment totals to those reported in the consolidated financial statements:

 

 

 

(1)   For the three months ended June 30, 2006, other after-tax adjustments of $(1.8) million included a change in estimate associated with a favorable court ruling on a contested IRS issue for 1991 and later years.

For the three months ended June 30, 2005, other after-tax adjustments reflect a $14.7 million gain on sale of a real estate property that qualifies for discontinued operations treatment under SFAS 144.

For the six months ended June 30, 2006, other after-tax adjustments of $18.8 million included the positive effect of a favorable court ruling on a contested IRS issue for 1991 and later years.

For the six months ended June 30, 2005, other after-tax adjustments reflect a $14.7 million gain on sale of a real estate property that qualifies for discontinued operations treatment under SFAS 144.

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