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 September 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)
------------------
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 November 4, 2002, was 336,892,211.
1
PRINCIPAL FINANCIAL GROUP, INC.
TABLE OF CONTENTS
PAGE
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Statements of Financial Position at September 30, 2002
(Unaudited) and December 31, 2001.................................... 3
Unaudited Consolidated Statements of Operations for the three months
and nine months ended September 30, 2002 and 2001.................... 4
Unaudited Consolidated Statements of Stockholders' Equity for the nine
months ended September 30, 2002 and 2001............................. 5
Unaudited Consolidated Statements of Cash Flows for the nine months
ended September 30, 2002 and 2001.................................... 6
Notes to Unaudited Consolidated Financial Statements - September 30,
2002................................................................. 8
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations............................................ 26
Item 3. Quantitative and Qualitative Disclosures about Market Risk....... 80
Item 4. Controls and Procedures.......................................... 85
PART II - OTHER INFORMATION
Item 1. Legal Proceedings................................................ 86
Item 6. Exhibits and Reports on Form 8-K................................. 87
Signature and Certifications............................................. 88
2
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
PRINCIPAL FINANCIAL GROUP, INC.
CONSOLIDATED STATEMENTS OF FINANCIAL POSITION
SEPTEMBER 30, DECEMBER 31,
2002 2001
------------- ---------------
(Unaudited) (Note 1)
(IN MILLIONS,
EXCEPT PER SHARE DATA)
ASSETS
Fixed maturities, available-for-sale........... $33,057.2 $30,012.3
Fixed maturities, trading...................... 92.7 17.8
Equity securities, available-for-sale.......... 379.5 837.2
Mortgage loans................................. 11,283.6 11,065.7
Real estate.................................... 1,168.9 1,181.8
Policy loans................................... 822.9 831.9
Other investments.............................. 1,111.4 832.3
------------- ---------------
Total investments........................... 47,916.2 44,779.0
Cash and cash equivalents...................... 631.5 561.2
Accrued investment income...................... 585.1 594.1
Premiums due and other receivables............. 786.6 489.0
Deferred policy acquisition costs.............. 1,399.0 1,372.5
Property and equipment......................... 484.2 494.2
Goodwill....................................... 126.0 104.0
Other intangibles.............................. 55.8 61.5
Mortgage loan servicing rights................. 1,505.0 1,779.2
Separate account assets........................ 30,872.5 34,376.0
Assets of discontinued operations.............. 2,535.2 2,974.3
Other assets................................... 1,373.6 765.5
------------- ---------------
Total assets........................... $88,270.7 $88,350.5
============= ===============
LIABILITIES
Contractholder funds........................... $26,470.5 $24,684.4
Future policy benefits and claims.............. 14,484.3 14,034.6
Other policyholder funds....................... 608.9 589.1
Short-term debt................................ 474.3 511.6
Long-term debt................................. 1,303.7 1,378.4
Income taxes currently payable................. 326.6 35.1
Deferred income taxes.......................... 899.9 853.6
Separate account liabilities................... 30,872.5 34,376.0
Liabilities of discontinued operations......... 1,632.4 1,773.3
Other liabilities.............................. 4,563.6 3,294.1
------------- ---------------
Total liabilities........................... 81,636.7 81,530.2
STOCKHOLDERS' EQUITY
Common stock, par value $.01 per share -
2,500 million shares authorized, 376.5
million and 375.8 million shares issued,
343.2 million and 360.1 million shares
outstanding, respectively................... 3.8 3.8
Additional paid-in capital..................... 7,099.0 7,072.5
Retained-earnings deficit...................... (102.2) (29.1)
Accumulated other comprehensive income......... 507.9 147.5
Treasury stock, at cost (33.3 million and 15.7
million shares, respectively)............... (874.5) (374.4)
------------- ---------------
Total stockholders' equity.................. 6,634.0 6,820.3
------------- ---------------
Total liabilities and stockholders' equity.. $88,270.7 $88,350.5
============= ===============
SEE ACCOMPANYING NOTES.
3
PRINCIPAL FINANCIAL GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS
SEPTEMBER 30, ENDED SEPTEMBER 30,
-------------------------------- -------------------------------
2002 2001 2002 2001
--------------- ---------------- ---------------- --------------
(IN MILLIONS, EXCEPT PER SHARE DATA)
REVENUES
Premiums and other considerations.............. $ 888.7 $1,255.0 $ 2,941.0 $ 3,210.3
Fees and other revenues........................ 516.6 403.7 1,386.7 1,141.5
Net investment income.......................... 821.2 826.4 2,455.5 2,506.1
Net realized/unrealized capital losses......... (230.6) (80.1) (224.0) (257.0)
--------------- ---------------- ---------------- --------------
Total revenues........................... 1,995.9 2,405.0 6,559.2 6,600.9
EXPENSES
Benefits, claims and settlement
expenses.................................. 1,231.6 1,597.3 3,942.7 4,236.5
Dividends to policyholders..................... 79.1 79.1 241.0 241.2
Operating expenses............................. 640.2 574.2 1,832.2 1,673.3
--------------- ---------------- ---------------- --------------
Total expenses............................ 1,950.9 2,250.6 6,015.9 6,151.0
--------------- ---------------- ---------------- --------------
Income from continuing operations before income
taxes..................................... 45.0 154.4 543.3 449.9
Income taxes................................... 2.4 34.5 140.6 90.8
--------------- ---------------- ---------------- --------------
Income from continuing operations.............. 42.6 119.9 402.7 359.1
Loss from discontinued operations, net of
related income taxes...................... (201.0) (4.1) (194.9) (8.2)
--------------- ---------------- ---------------- --------------
Income (loss) before cumulative effect of
accounting changes........................ (158.4) 115.8 207.8 350.9
Cumulative effect of accounting changes,
net of related income taxes............... - - (280.9) (10.7)
--------------- ---------------- ---------------- --------------
Net income (loss).............................. $ (158.4) $ 115.8 $ (73.1) $ 340.2
=============== ================ ================ ==============
FOR THE THREE MONTHS FOR THE NINE MONTHS ENDED
ENDED SEPTEMBER 30, 2002 SEPTEMBER 30, 2002
----------------------------- --------------------------------
EARNINGS PER COMMON SHARE
Basic earnings per common share:
Income from continuing operations.............. $ 0.12 $ 1.13
Loss from discontinued operations, net
of related income taxes...................... (0.58) (0.54)
----------------------------- --------------------------------
Income (loss) before cumulative effect (0.46) 0.59
of accounting change.........................
Cumulative effect of accounting change,
net of related income taxes.................. - (0.80)
----------------------------- --------------------------------
Net loss....................................... $(0.46) $(0.21)
============================= ================================
Diluted earnings per common share:
Income from continuing operations.............. $ 0.12 $ 1.13
Loss from discontinued operations, net
of related income taxes...................... (0.57) (0.55)
----------------------------- --------------------------------
Income (loss) before cumulative effect (0.45) 0.58
of accounting change.........................
Cumulative effect of accounting change,
net of related income taxes.................. - (0.79)
----------------------------- --------------------------------
Net loss....................................... $(0.45) $(0.21)
============================= ================================
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 STOCK EQUITY SHARES
----------- ----------- ----------- ---------------- --------- ------------- --------------
(IN MILLIONS) (IN THOUSANDS)
BALANCES AT JANUARY 1, 2001..... $ - $ - $6,312.5 $(60.0) $ - $6,252.5 -
Comprehensive income:
Net income.................... - - 340.2 - - 340.2 -
Net unrealized gains.......... - - - 541.3 - 541.3 -
Provision for
deferred income taxes....... - - - (195.6) - (195.6) -
Foreign currency translation
adjustment.................. - - - (105.2) - (105.2) -
Cumulative effect of
accounting change, net of
related income taxes........ - - - (14.2) - (14.2) -
-------------
Comprehensive income............ 566.5
----------- ----------- ----------- ---------------- --------- ------------- --------------
BALANCES AT SEPTEMBER 30, 2001.. $ - $ - $6,652.7 $166.3 $ - $6,819.0 -
=========== =========== =========== ================ ========= ============= ==============
BALANCES AT JANUARY 1, 2002..... $3.8 $7,072.5 $ (29.1) $147.5 $(374.4) $6,820.3 360,142.2
Stock issued.................... - 17.8 - - - 17.8 710.8
Stock-based compensation:
Stock incentive plan.......... - 4.0 - - - 4.0 -
Directors stock plan.......... - 0.1 - - - 0.1 -
Stock purchase plan........... - 3.3 - - - 3.3 -
Treasury stock acquired
and reissued, net............. - 1.3 - - (500.1) (498.8) (17,624.8)
Comprehensive income:
Net loss...................... - - (73.1) - - (73.1) -
Net unrealized gains.......... - - - 411.2 - 411.2 -
Provision for deferred
income taxes................ - - - (146.5) - (146.5) -
Foreign currency translation
adjustment.................. - - - 95.7 - 95.7 -
-------------
Comprehensive income............ 287.3
----------- ----------- ----------- ---------------- --------- ------------- --------------
BALANCES AT SEPTEMBER 30, 2002.. $3.8 $7,099.0 $ (102.2) $507.9 $(874.5) $6,634.0 343,228.2
=========== =========== =========== ================ ========= ============= ==============
SEE ACCOMPANYING NOTES.
5
PRINCIPAL FINANCIAL GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
FOR THE NINE MONTHS ENDED
SEPTEMBER 30,
---------------------------------
2002 2001
----------------- ---------------
(IN MILLIONS)
OPERATING ACTIVITIES
Net income (loss)............................ $ (73.1) $ 340.2
Adjustments to reconcile net income (loss)
to net cash provided by operating activities:
Loss from discontinued operations, net of
related income taxes..................... 194.9 8.2
Cumulative effect of accounting changes,
net of related income taxes.............. 280.9 10.7
Amortization of deferred policy
acquisition costs........................ 109.6 130.8
Additions to deferred policy acquisition
costs.................................... (233.5) (191.4)
Accrued investment income.................. 9.1 (57.4)
Premiums due and other receivables......... (45.1) (71.5)
Contractholder and policyholder liabilities
and dividends............................ 1,545.5 1,703.3
Current and deferred income taxes.......... 310.4 62.2
Net realized/unrealized capital losses..... 224.0 257.0
Depreciation and amortization expense...... 74.5 69.7
Amortization of mortgage servicing rights.. 223.9 138.7
Stock-based compensation................... 7.4 -
Mortgage servicing rights valuation
adjustments.............................. 800.5 146.7
Other...................................... 366.6 324.0
----------------- ----------------
Net adjustments.............................. 3,868.7 2,531.0
----------------- ----------------
Net cash provided by operating activities.... 3,795.6 2,871.2
INVESTING ACTIVITIES
Available-for-sale securities:
Purchases................................ (11,882.9) (10,818.6)
Sales.................................... 6,081.3 4,157.3
Maturities............................... 3,109.1 3,457.2
Net cash flows from trading securities....... (69.1) -
Mortgage loans acquired or originated........ (33,052.9) (27,931.2)
Mortgage loans sold or repaid................ 32,703.2 28,011.9
Purchase of mortgage servicing rights........ (695.6) (651.0)
Proceeds from sale of mortgage servicing
rights..................................... 11.3 29.6
Real estate acquired......................... (143.3) (228.9)
Real estate sold............................. 198.2 535.9
Net change in property and equipment......... (41.8) (58.6)
Net proceeds (disbursements) from sales of
subsidiaries............................... 1.4 (7.9)
Purchases of interest in subsidiaries, net
of cash acquired........................... (48.0) (4.2)
Net change in other investments.............. 258.7 (222.8)
----------------- ----------------
Net cash used in investing activities........ $ (3,570.4) $ (3,731.3)
6
PRINCIPAL FINANCIAL GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
(UNAUDITED)
FOR THE NINE MONTHS ENDED
SEPTEMBER 30,
----------------------------------
2002 2001
----------------- ----------------
(IN MILLIONS)
FINANCING ACTIVITIES
Issuance of common stock..................... $ 17.8 $ -
Acquisition and reissuance of treasury stock,
net........................................ (498.8) -
Issuance of long-term debt................... 11.0 157.0
Principal repayments of long-term debt....... (85.7) (110.0)
Proceeds of short-term borrowings............ 6,350.1 6,391.1
Repayment of short-term borrowings........... (6,387.4) (6,136.8)
Investment contract deposits................. 5,510.2 4,192.8
Investment contract withdrawals.............. (5,072.1) (4,307.2)
----------------- ----------------
Net cash provided by (used in) financing
activities................................. (154.9) 186.9
----------------- ----------------
Net increase (decrease) in cash and
cash equivalents........................... 70.3 (673.2)
Cash and cash equivalents at beginning of
period..................................... 561.2 791.0
----------------- ----------------
Cash and cash equivalents at end of period... $ 631.5 $ 117.8
================= ================
SEE ACCOMPANYING NOTES.
7
PRINCIPAL FINANCIAL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 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
nine months ended September 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 September 30,
2001, financial statements to conform to the September 30, 2002, presentation.
SEPARATE ACCOUNTS
At September 30, 2002, the Separate Accounts included a separate account valued
at $942.5 million 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 (the "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 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 ("APB 25"), and accordingly, the majority of employee stock-based
compensation costs were excluded from compensation expense. For information
regarding the adoption of the fair value method defined in SFAS 123, refer to
Note 10.
In June 2002, the FASB issued SFAS No. 146, ACCOUNTING FOR COSTS ASSOCIATED WITH
EXIT OR DISPOSAL ACTIVITIES ("SFAS 146"), which is effective for exit or
disposal activities initiated after December 31, 2002. SFAS 146 addresses
financial accounting and reporting for costs incurred in connection with exit or
disposal activities and nullifies Emerging Issues Task Force ("EITF") Issue No.
94-3, LIABILITY RECOGNITION FOR CERTAIN EMPLOYEE TERMINATION BENEFITS AND OTHER
COSTS TO EXIT AN ACTIVITY (INCLUDING CERTAIN COSTS INCURRED IN A RESTRUCTURING)
("EITF 94-3"). Under SFAS 146, a liability related to an exit or disposal
activity is not recognized until such liability has actually been incurred
rather than at the date of an entity's commitment to an exit plan, which was the
standard for liability recognition under EITF 94-3. The Company has early
adopted SFAS 146, which did not have a material effect on its consolidated
financial statements.
8
PRINCIPAL FINANCIAL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2002
(UNAUDITED)
1. NATURE OF OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
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.
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
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 ("BT"), Principal International
and Life and Health Insurance 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.
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 INSURANCE 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
======================= ================ ===================
9
PRINCIPAL FINANCIAL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2002
(UNAUDITED)
1. NATURE OF OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Net income and earnings per share (basic and diluted) for the three months and
nine months ended September 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 THREE MONTHS ENDED FOR THE NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------------- ------------------------------------
2002 2001(1) 2002 2001(1)
-------------- -------------- ----------------- ----------------
Reported net income (loss) ............ $ (158.4) $ 115.8 $(73.1) $ 340.2
Adjustment for amortization expense:
Goodwill (2)......................... - 2.6 - 7.7
Amortization included in
discontinued operations (see
Note 3) ........................... - 8.7 - 30.2
-------------- -------------- ----------------- ----------------
Total amortization expense ............ - 11.3 - 37.9
Tax impacts of amortization expense ... - (3.1) - (10.4)
-------------- -------------- ----------------- ----------------
Adjusted net income (loss)............. $ (158.4) $ 124.0 $(73.1) $ 367.7
============== ============== ================= ================
Basic earnings per share:
Reported net income (loss) ............ $ (0.46) $ 0.32 $ (0.21) $ 0.94
Adjustment for amortization expense:
Goodwill............................. - 0.01 - 0.02
Amortization included in
discontinued operations............ - 0.02 - 0.09
-------------- -------------- ----------------- ----------------
Total amortization expense ............ - 0.03 - 0.11
Tax impacts of amortization expense ... - (0.01) - (0.03)
-------------- -------------- ----------------- ----------------
Adjusted net income (loss)............. $ (0.46) $ 0.34 $ (0.21) $ 1.02
============== ============== ================= ================
Diluted earnings per share:
Reported net income (loss)............. $ (0.45) $ 0.32 $ (0.21) $ 0.94
Adjustment for amortization expense:
Goodwill............................. - 0.01 - 0.02
Amortization included in
discontinued operations............ - 0.02 - 0.09
------------- -------------- ----------------- ----------------
Total amortization expense ............ - 0.03 - 0.11
Tax impacts of amortization expense ... - (0.01) - (0.03)
------------- -------------- ----------------- ----------------
Adjusted net income (loss)............. $ (0.45) $ 0.34 $ (0.21) $ 1.02
============= ============== ================= ================
- ------
(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 nine months ended September 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.
(2) Includes amortization expenses related to equity investment subsidiaries of
the Company.
10
PRINCIPAL FINANCIAL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2002
(UNAUDITED)
1. NATURE OF OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
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
("APB 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 APB 30). The Company adopted SFAS 144 on January 1, 2002, which did not have
a significant impact on the Company's consolidated financial statements as of
the adoption date. On August 25, 2002, the Company entered into an agreement to
sell substantially all of BT (see Note 3). The sale of BT is accounted for under
the provisions of SFAS 144 and consistent with such guidance, the BT results and
loss on sale are reported as a discontinued operation at September 30, 2002.
SFAS 144 also eliminated the temporary control exception when determining the
consolidation of affiliated entities. This change impacted the reporting of the
Company's investment in company sponsored mutual funds whereby the Company now
reports the change in value of its investment as a part of net income rather
than as an unrealized gain or loss on equity securities available-for-sale. The
change in value is reported in the net realized/unrealized capital losses line
on the consolidated statement of operations.
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.
11
PRINCIPAL FINANCIAL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2002
(UNAUDITED)
2. GOODWILL AND OTHER INTANGIBLE ASSETS
Amortized intangible assets are as follows (in millions):
AS OF SEPTEMBER 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............ $50.4 $6.0 $44.4 $54.4 $7.2 $47.2
Other ...................... 1.6 0.4 1.2 2.1 0.2 1.9
---------- ---------------- ----------- ----------- ------------------ --------
Total amortized
intangibles .............. $52.0 $6.4 $45.6 $56.5 $7.4 $49.1
========== ================ =========== =========== ================== ========
Unamortized intangible assets are as follows (in millions):
AS OF SEPTEMBER 30, AS OF DECEMBER 31,
2002 2001
------------------------ ------------------------
NET CARRYING NET CARRYING
AMOUNT AMOUNT
------------------------ ------------------------
Other indefinite-lived
intangible assets........ $10.2 $12.4
======================== ========================
The amortization expense for the definite-lived intangible assets were $0.8
million and $1.8 million for the three months and nine months ended September
30, 2002, respectively, and $0.5 million and $1.6 million for the three months
and nine months ended September 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................ $1.7
2003................ 1.8
2004................ 1.7
2005................ 1.6
2006................ 1.6
12
PRINCIPAL FINANCIAL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 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 nine months ended September 30, 2002, are as follows
(in millions):
U.S. ASSET
MANAGEMENT INTERNATIONAL LIFE AND
AND ASSET MANAGEMENT HEALTH MORTGAGE
ACCUMULATION AND ACCUMULATION INSURANCE BANKING CONSOLIDATED
--------------- ------------------ -------------- -------------- ----------------
Balance at January 1, 2002..... $12.5 $33.7 $49.4 $8.4 $ 104.0
Goodwill from acquisitions..... - 33.3 - - 33.3
Goodwill disposed of
during the period............ - - (0.7) - (0.7)
Cumulative effect of
accounting change (1)........ - - (4.6) - (4.6)
Foreign currency translation... - (6.0) - - (6.0)
--------------- ------------------ -------------- -------------- ----------------
Balance at September 30, 2002.. $12.5 $61.0 $44.1 $8.4 $ 126.0
=============== ================== ============== ============== ================
- ------
(1) Excludes goodwill impairments of $300.3 million related to BT (see Note 3)
and $20.9 million related to an equity investment subsidiary of Principal
International.
3. DISCONTINUED OPERATIONS
On August 25, 2002, the Company announced it had entered into an agreement to
sell substantially all of BT to Westpac Banking Corporation ("Westpac") for
estimated proceeds of A$900.0 million Australian dollars ("A$") (approximately
U.S. $500.0 million), and future contingent proceeds in 2004 of up to A$150.0
million (approximately U.S. $80.0 million). The contingent proceeds will be
based on Westpac's future success in growing retail funds under management.
Excluding the contingent proceeds, the Company estimates after-tax proceeds of
approximately U.S. $870.0 million. This amount includes cash proceeds, tax
benefits, and a gain from unwinding the hedged asset associated with debt used
to acquire BT in 1999. The Company closed the sale of BT on October 31, 2002 and
has accrued for an estimated after-tax loss on disposal of $206.6 million as of
September 30, 2002. Future adjustments to the estimated loss are expected to be
recorded through the first half of 2003, as the proceeds from the sale are
finalized.
BT is accounted for as a discontinued operation and therefore, the results of
operations (excluding corporate overhead) and cash flows have been removed from
the Company's results of continuing operations for all periods presented.
Corporate overhead allocated to BT does not qualify for discontinued operations
treatment under SFAS 144, and therefore is still included in the Company's
results of continuing operations. Assets and liabilities related to BT have been
reclassified to assets of discontinued operations and liabilities of
discontinued operations on the Company's consolidated statements of financial
position for all periods presented. Additionally, the results of operations
(excluding corporate overhead) for BT are reported as non-recurring items for
the International Asset Management and Accumulation segment in the Segment
Information note (Note 9).
13
PRINCIPAL FINANCIAL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2002
(UNAUDITED)
3. DISCONTINUED OPERATIONS (CONTINUED)
Selected financial information for the discontinued operations is as follows:
AS OF SEPTEMBER 30, AS OF DECEMBER 31,
2002 2001
-------------------------- -------------------------
(IN MILLIONS)
ASSETS
Goodwill and other intangibles .................... $ 419.6 $ 993.0
Separate account assets ........................... 1,539.9 1,488.8
Other assets ...................................... 575.7 492.5
-------------------------- -------------------------
Total assets of discontinued operations ......... $ 2,535.2 $ 2,974.3
========================== =========================
LIABILITIES
Separate account liabilities....................... 1,539.9 1,488.8
Other liabilities ................................. 92.5 284.5
-------------------------- -------------------------
Total liabilities of discontinued operations ... $ 1,632.4 $ 1,773.3
========================== =========================
FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------------------- -----------------------------------
2002 2001 2002 2001
-------------- --------------- -------------- -----------------
(IN MILLIONS)
Total revenues ........................ $ 39.2 $50.5 $ 128.1 $173.0
============== =============== ============== =================
Loss from continuing operations,
net of related income taxes
(corporate overhead)................ $ (0.8) $(1.0) $ (2.3) $ (2.7)
Loss from discontinued operations:
Income (loss) before income taxes... 3.9 (5.8) 16.3 (10.1)
Income taxes (benefits)............. (1.7) (1.7) 4.6 (1.9)
-------------- --------------- -------------- -----------------
Income (loss) from discontinued 5.6 (4.1) 11.7 (8.2)
operations .......................
Loss on disposal, net of related
income taxes...................... (206.6) - (206.6) -
-------------- --------------- -------------- -----------------
Loss from discontinued operations, (201.0) (4.1) (194.9) (8.2)
net of related income taxes.........
Cumulative effect of accounting change,
net of related income taxes......... - - (255.4) -
-------------- --------------- -------------- -----------------
Net loss............................... $(201.8) $(5.1) $ (452.6) $(10.9)
============== =============== ============== =================
14
PRINCIPAL FINANCIAL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2002
(UNAUDITED)
4. ACQUISITIONS AND OTHER DIVESTITURES
On May 31, 2002, the Company purchased a 100% ownership of Zurich AFORE S.A. de
C.V. ("Zurich AFORE") in Mexico from Zurich Financial Services for $49.0 million
in cash. The operations of Zurich AFORE have been integrated into Principal
International, Inc., as a part of the Company's International Asset Management
and Accumulation segment.
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.
5. 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 September 30, 2002,
cumulative actual earnings have been less than cumulative expected earnings.
However, cumulative net unrealized gains were greater than expected resulting in
the recognition of a policyholder dividend obligation of $16.1 million as of
September 30, 2002.
Closed Block liabilities and assets designated to the Closed Block are as
follows:
AS OF SEPTEMBER 30, AS OF DECEMBER 31,
2002 2001
--------------------- ----------------------
(IN MILLIONS)
CLOSED BLOCK LIABILITIES
Future policy benefits and
claims......................... $5,295.2 $5,248.7
Other policyholder funds......... 30.4 20.3
Policyholder dividends payable... 381.0 376.6
Policyholder dividend obligation. 16.1 -
Other liabilities................ 37.7 11.8
--------------------- ----------------------
Total Closed Block
liabilities.................... 5,760.4 5,657.4
ASSETS DESIGNATED TO THE CLOSED BLOCK
Fixed maturities,
available-for-sale............. 2,643.7 2,466.3
Equity securities,
available-for-sale............. 23.4 23.4
Mortgage loans................... 859.3 880.0
Policy loans..................... 779.2 792.5
Other investments................ 6.9 6.9
--------------------- ----------------------
Total investments.............. 4,312.5 4,169.1
Cash and cash equivalents
(deficit)...................... 36.0 (8.0)
Accrued investment income........ 73.9 77.2
Deferred tax asset............... 70.6 80.8
Premiums due and other
receivables.................... 29.7 33.3
--------------------- ----------------------
Total assets designated
to the Closed Block.......... 4,522.7 4,352.4
--------------------- ----------------------
Excess of Closed Block liabilities
over assets designated to the
Closed Block................... 1,237.7 1,305.0
Amounts included in other
comprehensive income........... 72.6 43.6
--------------------- ----------------------
Maximum future earnings to be
recognized from Closed Block
assets and liabilities......... $1,310.3 $1,348.6
===================== ======================
15
PRINCIPAL FINANCIAL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2002
(UNAUDITED)
5. CLOSED BLOCK (CONTINUED)
Closed Block revenues and expenses were as follows:
FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------------------- -----------------------------------
2002 2001 2002 2001
-------------- --------------- -------------- -----------------
(IN MILLIONS)
REVENUES
Premiums and other considerations..... $ 171.0 $177.2 $ 530.8 $ 553.3
Net investment income................. 77.3 78.1 233.5 229.9
Net realized/unrealized
capital losses ..................... (5.3) (1.2) (27.3) (3.0)
-------------- --------------- -------------- -----------------
Total revenues...................... 243.0 254.1 737.0 780.2
EXPENSES
Benefits, claims, and
settlement expenses................. 141.3 146.1 432.6 451.2
Dividends to policyholders............ 76.4 77.6 231.6 235.8
Operating expenses.................... 2.7 2.7 8.9 8.9
-------------- --------------- -------------- -----------------
Total expenses...................... 220.4 226.4 673.1 695.9
-------------- --------------- -------------- -----------------
Closed Block revenue, net of Closed
Block expenses, before income taxes. 22.6 27.7 63.9 84.3
Income taxes.......................... 7.5 8.8 20.8 27.3
-------------- --------------- -------------- -----------------
Closed Block revenue, net of Closed
Block expenses and income taxes..... 15.1 18.9 43.1 57.0
Funding adjustment charges............ (0.9) (3.3) (4.8) (6.6)
-------------- --------------- -------------- -----------------
Closed Block revenue, net of Closed
Block expenses, income taxes
and funding adjustment charges...... $ 14.2 $ 15.6 $ 38.3 $ 50.4
============== =============== ============== =================
The change in maximum future earnings of the Closed Block was as follows:
AS OF OR FOR THE NINE MONTHS
ENDED SEPTEMBER 30,
-------------------------------
2002 2001
-------------- ----------------
(IN MILLIONS)
Beginning of year........................... $ 1,348.6 $1,408.8
End of period............................... 1,310.3 1,358.4
-------------- ----------------
Change in maximum future earnings........... $ (38.3) $ (50.4)
============== ================
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.
16
PRINCIPAL FINANCIAL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2002
(UNAUDITED)
6. FEDERAL INCOME TAXES
The effective income tax rate on net income for the three months and nine months
ended September 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, partially offset by additional state income taxes.
7. COMPREHENSIVE INCOME
Comprehensive income is as follows:
FOR THE THREE FOR THE NINE
MONTHS ENDED MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------- -------------------------
2002 2001 2002 2001
----------- ---------- ----------- ----------
(IN MILLIONS)
COMPREHENSIVE INCOME:
Net income (loss).................................... $ (158.4) $ 115.8 $(73.1) $ 340.2
Net change in unrealized gains and losses on fixed
maturities, available-for-sale.................... 557.0 550.4 603.9 731.8
Net change in unrealized gains and losses on equity
securities, available-for-sale, including seed
money in separate accounts........................ 35.0 (109.6) 39.4 (34.9)
Adjustments for assumed changes in amortization
patterns:
Deferred policy acquisition costs................. (56.9) (73.0) (82.0) (99.8)
Unearned revenue reserves......................... 4.3 5.6 4.9 6.2
Net change in unrealized gains and losses on
derivative instruments............................ (124.9) (50.7) (138.9) (53.2)
Adjustments to unrealized gains for policyholder
dividend obligation............................... (16.1) (8.8) (16.1) (8.8)
Provision for deferred income taxes.................. (143.4) (110.0) (146.5) (195.6)
Change in net foreign currency translation
adjustment........................................ 89.9 (29.1) 95.7 (105.2)
Cumulative effect of accounting change, net of
related income taxes.............................. - - - (14.2)
----------- ---------- ---------- ----------
Comprehensive income................................. $ 186.5 $ 290.6 $287.3 $ 566.5
=========== ========== ========== ==========
8. 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. Negotiated
settlements of such class-action lawsuits have had a material adverse effect on
the business, financial condition and results of operations of certain of these
companies. Principal Life is currently a defendant in two class-action lawsuits,
which allege improper sales practices.
17
PRINCIPAL FINANCIAL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2002
(UNAUDITED)
8. COMMITMENTS AND CONTINGENCIES (CONTINUED)
In 2000, the Company reached an agreement 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, and
believes this reserve is sufficient to cover the Company's obligation under 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. 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. The Company has
accrued a loss reserve for its best estimate of its potential exposure to the
suits and claims. As uncertainties continue to exist in resolving this matter,
it is reasonably possible that all the actual costs of the suits and claims
could exceed the Company's estimate. The range of any such costs cannot be
presently estimated; however, the Company believes the additional costs will not
have a material impact on its business, financial condition or results of
operations.
9. 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. On August 25, 2002,
the Company signed an agreement to sell substantially all of BT (an asset
management company operating in Australia and New Zealand), described further in
Note 3. As a result, the results of operations (excluding corporate overhead)
for BT are reported as non-recurring items for all periods presented.
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 4. The Corporate and Other segment's equity in earnings of Coventry,
which was included in net investment income, was $2.1 million for the nine
months ended September 30, 2002, and $5.2 million and $15.1 million for the
three months and nine months ended September 30, 2001, respectively.
18
PRINCIPAL FINANCIAL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2002
(UNAUDITED)
9. 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/unrealized
capital gains and losses, as adjusted, and non-recurring items 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, 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/unrealized 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 September 30, 2002, non-recurring items of $214.0
million, net of income taxes, included the negative effects of: (1) a loss from
the discontinued operations of BT ($201.0 million); and (2) an increase to a
loss contingency reserve established for sales practice litigation ($13.0
million).
For the three months ended September 30, 2001, non-recurring items of $8.2
million, net of income taxes, included the negative effects of: (1) expenses
related to the demutualization ($4.1 million); and (2) a loss from the
discontinued operations of BT ($4.1 million).
For the nine months ended September 30, 2002, non-recurring items of $490.8
million, net of income taxes, included the negative effects of: (1) a cumulative
effect of accounting change related to the implementation of SFAS 142 ($280.9
million); (2) a loss from the discontinued operations of BT ($194.9 million);
(3) an increase to a loss contingency reserve established for sales practice
litigation ($13.0 million); and (4) expenses related to the demutualization
($2.0 million).
For the nine months ended September 30, 2001, non-recurring items of $43.7
million, net of income taxes, included the negative effects of: (1) expenses
related to the demutualization ($18.9 million); (2) a cumulative effect of
change in accounting principle related to the implementation of SFAS 133 ($10.7
million); (3) a loss from the discontinued operations of BT ($8.2 million); and
(4) 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.
19
PRINCIPAL FINANCIAL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2002
(UNAUDITED)
9. SEGMENT INFORMATION (CONTINUED)
The following tables summarize selected financial information on a continuing
basis by segment as of or for the three months ended September 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 CORPORPATE AND
ACCUMULATION ACCUMULATION INSURANCE BANKING OTHER CONSOLIDATED
-------------- --------------- ------------- ------------- --------------- --------------
2002
Revenues:
Operating revenues........ $ 865.9 $ 82.8 $ 987.7 $312.9 $ (15.8) $ 2,233.5
Net realized/unrealized
capital gains (losses).. (83.1) 0.5 (16.0) - (132.0) (230.6)
Plus recognition of
front-end fee revenues.. 2.0 - - - - 2.0
Less capital gains
distributed as market
value adjustment........ (9.0) - - - - (9.0)
-------------- --------------- ------------- ------------- --------------- --------------
Revenues.................... $ 775.8 $ 83.3 $ 971.7 $312.9 $ (147.8) $ 1,995.9
============== =============== ============= ============= =============== ==============
Net income:
Operating earnings (loss). $ 84.9 $ 5.0 $ 55.7 $ 62.5 $ (5.6) $ 202.5
Net realized/unrealized
capital gains (losses),
as adjusted............. (55.0) 3.0 (10.1) - (84.8) (146.9)
Non-recurring items....... - (201.0) - - (13.0) (214.0)
-------------- --------------- ------------- ------------- --------------- --------------
Net income (loss)........... $ 29.9 $ (193.0) $ 45.6 $ 62.5 $ (103.4) $ (158.4)
============== =============== ============= ============= =============== ==============
Other segment data:
Revenues from external
customers............... $ 763.1 $ 82.9 $ 972.8 $303.0 $ (125.9) $ 1,995.9
Intersegment revenues..... 12.7 0.4 (1.1) 9.9 (21.9) -
Interest expense.......... 0.7 0.2 0.1 - 20.0 21.0
Income tax expense
(benefit)............... (11.2) 0.7 23.9 52.5 (63.5) 2.4
Amortization of
intangibles............. 0.1 0.7 - - - 0.8
20
PRINCIPAL FINANCIAL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2002
(UNAUDITED)
9. SEGMENT INFORMATION (CONTINUED)
INTERNATIONAL
U.S. ASSET ASSET
MANAGEMENT MANAGEMENT LIFE AND
AND AND HEALTH MORTGAGE CORPORPATE AND
ACCUMULATION ACCUMULATION INSURANCE BANKING OTHER CONSOLIDATED
-------------- --------------- ------------- ------------- --------------- --------------
2001
Revenues:
Operating revenues........ $1,065.4 $ 224.2 $ 970.3 $207.7 $ 16.7 $2,484.3
Net realized/unrealized
capital losses.......... (47.2) (5.2) (7.6) - (20.1) (80.1)
Plus recognition of
front-end fee revenues.. 0.8 - - - - 0.8
-------------- --------------- -------------- ------------- -------------- --------------
Revenues.................... $1,019.0 $ 219.0 $ 962.7 $207.7 $ (3.4) $2,405.0
============== =============== ============== ============= ============== ==============
Net income:
Operating earnings (loss) $ 82.5 $ 1.7 $ 60.7 $ 26.5 $ (2.6) $ 168.8
Net realized/unrealized
capital gains (losses),
as adjusted............. (28.6) 1.3 (4.3) - (13.2) (44.8)
Non-recurring items....... - (4.1) - - (4.1) (8.2)
-------------- --------------- -------------- ------------- -------------- --------------
Net income (loss)........... $ 53.9 $ (1.1) $ 56.4 $ 26.5 $(19.9) $ 115.8
============== =============== ============== ============= ============== ==============
Other segment data:
Revenues from external
customers............... $1,007.1 $ 218.5 $ 963.5 $207.7 $ 8.2 $2,405.0
Intersegment revenues..... 11.9 0.5 (0.8) - (11.6) -
Interest expense.......... 0.7 0.1 (1.6) - 18.6 17.8
Income tax expense
(benefit)............... (2.6) (9.2) 28.1 20.4 (2.2) 34.5
Amortization of goodwill
and other intangibles... 0.3 0.9 1.1 0.1 - 2.4
21
PRINCIPAL FINANCIAL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2002
(UNAUDITED)
9. SEGMENT INFORMATION (CONTINUED)
The following tables summarize selected financial information on a continuing
basis by segment as of or for the nine months ended September 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........ $ 2,863.7 $ 252.3 $ 2,950.7 $731.3 $ 1.4 $ 6,799.4
Net realized/unrealized
capital gains (losses).. (246.0) 37.1 (66.4) - 51.3 (224.0)
Plus recognition of
front-end fee revenues.. 6.0 - - - - 6.0
Less capital gains
distributed as market
value adjustment........ (22.2) - - - - (22.2)
-------------- --------------- -------------- ------------- --------------- -------------
Revenues.................... $ 2,601.5 $ 289.4 $ 2,884.3 $731.3 $ 52.7 $ 6,559.2
============== =============== ============== ============= =============== =============
Net income:
Operating earnings (loss). $ 287.2 $ 10.1 $ 171.7 $113.8 $ (11.3) $ 571.5
Net realized/unrealized
capital gains (losses),
as adjusted............. (160.2) 14.0 (41.4) - 33.8 (153.8)
Non-recurring items....... - (471.2) (4.6) - (15.0) (490.8)
-------------- --------------- -------------- ------------- --------------- -------------
Net income (loss)........... $ 127.0 $ (447.1) $ 125.7 $113.8 $ 7.5 $ (73.1)
============== =============== ============== ============= =============== =============
Other segment data:
Revenues from external
customers............... $ 2,560.8 $ 288.2 $ 2,888.5 $721.4 $ 100.3 $ 6,559.2
Intersegment revenues..... 40.7 1.2 (4.2) 9.9 (47.6) -
Interest expense.......... 2.8 0.5 0.3 - 63.2 66.8
Income tax expense
(benefit)............... (12.4) 6.8 68.2 82.9 (4.9) 140.6
Amortization of
intangibles............. 0.1 1.6 0.1 - - 1.8
22
PRINCIPAL FINANCIAL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2002
(UNAUDITED)
9. 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........ $2,923.6 $ 409.1 $ 2,948.5 $500.8 $ 74.6 $ 6,856.6
Net realized/unrealized
capital losses.......... (112.6) (43.9) (16.7) - (83.8) (257.0)
Plus recognition of
front-end fee revenues.. 1.3 - - - - 1.3
--------------- ---------------- ------------- ------------- -------------- --------------
Revenues.................... $2,812.3 $ 365.2 $ 2,931.8 $500.8 $ (9.2) $ 6,600.9
=============== ================ ============= ============= ============== ==============
Net income:
Operating earnings........ $ 259.4 $ 1.1 $ 151.6 $ 95.3 $ 29.5 $ 536.9
Net realized/unrealized
capital losses,
as adjusted............. (69.4) (19.9) (9.0) - (54.7) (153.0)
Non-recurring items....... (10.8) (8.2) 0.1 - (24.8) (43.7)
--------------- ---------------- ------------- ------------- -------------- --------------
Net income (loss)........... $ 179.2 $ (27.0) $ 142.7 $ 95.3 $(50.0) $ 340.2
=============== ================ ============= ============= ============== ==============
Other segment data:
Revenues from external
customers............... $2,774.2 $364.1 $ 2,934.3 $500.8 $ 27.5 $ 6,600.9
Intersegment revenues..... 38.1 1.1 (2.5) - (36.7) -
Interest expense.......... 2.8 0.1 0.6 - 54.7 58.2
Income tax expense
(benefit)............... 14.2 (28.8) 71.6 57.4 (23.6) 90.8
Amortization of goodwill
and other intangibles... 0.7 2.9 3.0 0.6 - 7.2
Summarized assets by segment are as follows:
AS OF SEPTEMBER 30, AS OF DECEMBER 31,
2002 2001
---------------------- -------------------
(IN MILLIONS)
ASSETS
U.S. Asset Management and
Accumulation............... $68,556.7 $68,543.8
International Asset
Management and
Accumulation............... 4,528.1 4,956.9
Life and Health Insurance.... 11,152.0 10,776.2
Mortgage Banking ............ 3,220.3 2,718.8
Corporate and Other.......... 813.6 1,354.8
---------------------- -------------------
Total Consolidated Assets.. $88,270.7 $88,350.5
====================== ===================
23
PRINCIPAL FINANCIAL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2002
(UNAUDITED)
10. STOCK COMPENSATION PLANS
Effective July 1, 2002, the Company adopted the fair value method for
stock-based compensation as defined in SFAS 123 in accounting for the Company's
Stock Incentive Plan, Board of Directors' Stock Plan and Employee Stock Purchase
Plan. SFAS 123, which indicates that the fair value method is the preferable
method of accounting, requires that the fair value method for stock-based
compensation be applied as of the beginning of the fiscal year in which it is
adopted for all stock-based awards granted subsequent to such date. The
financial statements for the first two quarters of 2002 were not restated for
this change since its effects were not materially different from amounts
reported for both financial position and results of operations. Such effects for
the first two quarters of 2002 were charged against income for the three and
nine months ended September 30, 2002 and were not material to such results of
operations. The Company expects its stock-based compensation expense to increase
in future years due to the cumulative impact of anticipated future grants. Prior
to January 1, 2002, the Company applied the intrinsic value method (as permitted
under SFAS 123) defined in APB 25 and related Interpretations, which excluded
employee options and stock purchases from compensation expense. Compensation
expense was recognized for stock option awards issued to career agents using the
fair value method as prescribed in FASB Interpretation No. 44, ACCOUNTING FOR
CERTAIN TRANSACTIONS INVOLVING STOCK COMPENSATION - AN INTERPRETATION OF APB
OPINION NO. 25.
11. STOCKHOLDERS' EQUITY
COMMON STOCK
During the nine months ended September 30, 2002, the Company repurchased 17.9
million shares of its outstanding common stock on the open market at an
aggregate cost of $506.4 million relating to two authorized stock repurchase
programs. The Company purchased 15.9 million shares at an aggregate cost of
$450.0 million completing a stock repurchase program authorized in February
2002. The Company purchased 2.0 million shares at an aggregate cost of $56.4
million under an additional stock repurchase program authorized on August 29,
2002, for which the Company's board of directors approved repurchases of up to
$300.0 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.
12. 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.
24
PRINCIPAL FINANCIAL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 2002
(UNAUDITED)
12. EARNINGS PER SHARE (CONTINUED)
Reconciliations of weighted-average shares outstanding and income from
continuing operations for basic and diluted earnings per share for the three
months and nine months ended September 30, 2002, are presented below (in
millions, except per share data):
FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS ENDED
SEPTEMBER 30, 2002 SEPTEMBER 30, 2002
---------------------------------------- ----------------------------------------
INCOME WEIGHTED INCOME WEIGHTED
AVERAGE PER SHARE AVERAGE PER SHARE
SHARES AMOUNT SHARES AMOUNT
----------- ------------- ------------- ------------ -------------- ------------
Basic earnings per share:
Income from continuing
operations................ $42.6 347.2 $0.12 $402.7 354.8 $1.13
Dilutive effects:
Long-term performance plan - 0.6 - - 0.1 -
Stock options............. - 0.4 - - 0.4 -
Restricted stock units(1). - - - - - -
----------- ------------- ------------- ------------ -------------- ------------
Diluted earnings per share..... $42.6 348.2 $0.12 $402.7 355.3 $1.13
=========== ============= ============= ============ ============== ============
- -----------------
(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 and nine
months ended September 30, 2002, excludes the incremental effect related to
certain outstanding stock-based compensation grants due to their anti-dilutive
effect.
13. SUBSEQUENT EVENT
On October 25, 2002, the Company's Board of Directors declared an annual
dividend of approximately $84.6 million, equal to $0.25 per share, payable on
December 9, 2002, to shareholders of record as of November 8, 2002.
25
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following analysis discusses our financial condition as of September 30,
2002, compared with December 31, 2001, and our consolidated results of
operations for the three months and nine months ended September 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)
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; (4) 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; (5) our efforts to reduce the impact of interest rate changes on
our profitability and surplus may not be effective; (6) if we are unable to
attract and retain sales representatives and develop new distribution sources,
sales of our products and services may be reduced; (7) our international
businesses face political, legal, operational and other risks that could reduce
our profitability in those businesses; (8) our reserves established for future
policy benefits and claims may prove inadequate, requiring us to increase
liabilities; (9) 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; (10) we may need to fund deficiencies in our
closed block ("Closed Block") assets which benefit only the holders of Closed
Block policies; (11) changes in regulations or accounting standards may reduce
our profitability; (12) litigation and regulatory investigations may harm our
financial strength and reduce our profitability; (13) fluctuations in foreign
currency exchange rates could reduce our profitability; (14) 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; (15) 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
(16) 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 Global Investors, formerly known as Principal
Capital Management. 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 and services for defined contribution pension plans,
26
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 Australian-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. We have
entered into an agreement to sell substantially all of BT Financial Group,
effective October 31, 2002. See "Transactions Affecting Comparability of
Results of Operations."
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
STOCKHOLDER DIVIDENDS
On October 25, 2002, the Company's Board of Directors declared an annual
dividend of approximately $84.6 million, equal to $0.25 per share, payable on
December 9, 2002, to shareholders of record as of November 8, 2002.
RATINGS
On September 25, 2002, the rating agency Moody's Investors Service lowered
Principal Life's financial strength rating to Aa3 from Aa2. Our new rating, Aa3,
is the fourth highest rating of Moody's 21 rating levels and is defined as
"Excellent." Moody's also downgraded the commercial paper rating of Principal
Financial Services, Inc., to Prime-2 from Prime-1 and senior debt rating to A3
from A2. We do not expect these rating changes to have any adverse impact on our
business.
DECLINES IN THE U.S. AND AUSTRALIAN EQUITY MARKETS
Declines in the equity markets in the U.S. and Australia during the nine months
ended September 30, 2002 have reduced equity securities, a component of our
assets under management. Our assets under management at September 30, 2002 were
$117.4 billion, compared to $120.2 billion at December 31, 2001. Continued
declines could further reduce the amount of asset-based fee revenue in our U.S.
Asset Management and Accumulation segment. In addition to market declines,
during the nine months ended September 30, 2002, BT Financial Group has
experienced net cash outflows from assets under management.
DECLINES IN THE VALUES OF OUR U.S. FIXED MATURITY INVESTMENTS
During the nine months ended September 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
$242.0 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, and we expect additional capital losses in the fourth quarter of
2002.
INTEREST RATE DECLINES
During the nine months ended September 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.
27
TRANSACTIONS AFFECTING COMPARABILITY OF RESULTS OF OPERATIONS
ACQUISITIONS
We acquired the following businesses, among others, during 2002 and 2001:
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") in Mexico from Zurich Financial
Services for $49.0 million in cash. The operations of Zurich AFORE have been
integrated into Principal International, Inc., as a part of our International
Asset Management and Accumulation segment.
SPECTRUM ASSET MANAGEMENT. On October 1, 2001, Spectrum Asset Management
("Spectrum") became an affiliate of Principal Global Investors. 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 $1.6 million and $3.5 million for the
three months and nine months ended September 30, 2002, respectively, in our
consolidated results of operations.
DISPOSITIONS
We entered into disposition agreements or disposed of the following businesses,
among others, during 2002 and 2001:
BT FINANCIAL GROUP. On August 25, 2002, we announced we had entered into an
agreement to sell substantially all of BT Financial Group to Westpac Banking
Corporation ("Westpac") for estimated proceeds of A$900.0 million Australian
dollars ("A$") (approximately U.S. $500.0 million), and future contingent
proceeds in 2004 of up to A$150.0 million (approximately U.S. $80.0 million).
The contingent proceeds will be based on Westpac's future success in growing
retail funds under management. Excluding the contingent proceeds, we estimate
after-tax proceeds of approximately U.S. $870.0 million. This amount includes
cash proceeds, tax benefits, and gain from unwinding the hedged asset associated
with debt used to acquire BT Financial Group in 1999. We closed the sale of BT
Financial Group on October 31, 2002, and have accrued for an estimated after-tax
loss on disposal of $206.6 million as of September 30, 2002. This loss is
recorded in the loss from discontinued operations in the consolidated statement
of operations. Future adjustments to the estimated loss are expected to be
recorded through the first half of 2003, as the proceeds from the sale are
finalized.
BT Financial Group is accounted for as a discontinued operation and therefore,
the results of operations (excluding corporate overhead) and cash flows have
been removed from our results of continuing operations for all periods
presented. Corporate overhead allocated to BT Financial Group does not qualify
for discontinued operations treatment under SFAS 144, ACCOUNTING FOR THE
IMPAIRMENT OR DISPOSAL OF LONG-LIVED ASSETS, and therefore is still included in
the our results of continuing operations. Assets and liabilities related to BT
Financial Group have been reclassified to assets of discontinued operations and
liabilities of discontinued operations on our consolidated statements of
financial position for all periods presented. Additionally, the results of
operations (excluding corporate overhead) for BT Financial Group are reported as
non-recurring items in our International Asset Management and Accumulation
segment. Selected financial information for the discontinued operations is as
follows:
28
AS OF OR FOR THE THREE MONTHS AS OF OR FOR THE NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
--------------------------------- -----------------------------------
2002 2001 2002 2001
-------------- --------------- -------------- -----------------
(IN MILLIONS, EXCEPT AS INDICATED)
Total assets under management ($ in
billions)................................ $ 15.6 $20.4 $ 15.6 $ 20.4
============== =============== ============== =================
Total revenues ............................ $ 39.2 $50.5 $ 128.1 $ 173.0
============== =============== ============== =================
Loss from continuing operations
(corporate overhead) ................... $ (0.8) $(1.0) $ (2.3) $ (2.7)
Loss from discontinued operations:
Income (loss) before income taxes....... 3.9 (5.8) 16.3 (10.1)
Income taxes (benefits)................. (1.7) (1.7) 4.6 (1.9)
-------------- --------------- -------------- -----------------
Income (loss) from discontinued
operations ........................... 5.6 (4.1) 11.7 (8.2)
Loss on disposal, net of related
income taxes.......................... (206.6) - (206.6) -
-------------- --------------- -------------- -----------------
Loss from discontinued operations,
net of related income taxes............. (201.0) (4.1) (194.9) (8.2)
Cumulative effect of accounting change,
net of related income taxes............. - - (255.4) -
-------------- --------------- -------------- -----------------
Net loss................................... $(201.8) $(5.1) $ (452.6) $ (10.9)
============== =============== ============== =================
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 nine months ended September 30,
2002, and $5.2 million and $15.1 million for the three months and nine months
ended September 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 pre-tax realized capital loss of $6.7 million. We
included nominal revenues, net income and net loss from our operations in
Indonesia in our consolidated results of operations for the three months and
nine months ended September 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 nine months ended
September 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.
29
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 $11.4 million and $33.9 million of ceded
premiums for the three months and nine months ended September 30, 2002,
respectively. In addition, the reinsurance agreement resulted in $11.0 million
and $29.5 million of ceded claims for the three months and nine months ended
September 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
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
negatively impacted $1.2 million for the three months ended September 30, 2002,
and were negatively impacted $0.8 million for the three months ended September
30, 2001, as a result of fluctuations in foreign currency to U.S. dollar
exchange rates. Our consolidated operating earnings were negatively impacted
$1.9 million for the nine months ended September 30, 2002, and were negatively
impacted $1.1 million for the nine months ended September 30, 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 nine
months ended September 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.
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.
30
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 Insurance 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 our 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 our operating segments as
follows (in millions):
INTERNATIONAL ASSET LIFE
MANAGEMENT AND AND HEALTH
ACCUMULATION INSURANCE 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 for the three months and nine months ended September 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 THREE MONTHS ENDED FOR THE NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------------------- --------------------------------
2002 2001 2002 2001
---------------------- --------- ------------------- ----------
Reported net income (loss)............. $(158.4) $115.8 $(73.1) $340.2
Adjustment for amortization expense:
Goodwill............................. - 2.6 - 7.7
Amortization included in -
discontinued operations............ - 8.7 30.2
----------------------- --------- ------------------- ----------
Total amortization expense ............ - 11.3 - 37.9
Tax impacts of amortization expense ... - (3.1) - (10.4)
----------------------- --------- ------------------- ----------
Adjusted net income (loss)............. $(158.4) $124.0 $(73.1) $367.7
====================== ========= =================== ==========
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 for all stock-based awards granted subsequent to
January 1, 2002, and have recognized an additional compensation expense of $7.2
million. 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, the
majority of employee stock-based compensation costs were excluded from
compensation expense. We expect our stock-based compensation expense to increase
in future years due to the cumulative impact of anticipated future grants.
In August 2001, the FASB issued 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
("APB 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 APB 30). We adopted SFAS 144 on January 1, 2002, which did not have a
31
significant impact on our consolidated financial statements as of the adoption
date. On August 25, 2002, we entered into an agreement to sell substantially all
of BT Financial Group. The sale of BT Financial Group is accounted for under the
provisions of SFAS 144 and consistent with such guidance, the BT Financial Group
results and loss on sale are reported as a discontinued operation at September
30, 2002. SFAS 144 also eliminated the temporary control exception when
determining the consolidation of affiliated entities. This change impacted the
reporting of our investment in company sponsored mutual funds whereby we now
report the change in value of our investment as a part of net income rather than
as an unrealized gain or loss on an equity securities available-for-sale. The
change in value is reported in the net realized/unrealized capital losses line
on the statement of operations.
32
RESULTS OF OPERATIONS
The following table presents summary consolidated financial information for the
periods indicated:
FOR THE THREE FOR THE NINE
MONTHS ENDED MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------------------- -------------------------
2002 2001 2002 2001
---------- ----------- ---------- ----------
(IN MILLIONS)
INCOME STATEMENT DATA:
Revenues:
Premiums and other considerations................... $ 888.7 $ 1,255.0 $ 2,941.0 $ 3,210.3
Fees and other revenues............................. 516.6 403.7 1,386.7 1,141.5
Net investment income............................... 821.2 826.4 2,455.5 2,506.1
Net realized/unrealized capital losses.............. (230.6) (80.1) (224.0) (257.0)
----------- ----------- ---------- ----------
Total revenues................................ 1,995.9 2,405.0 6,559.2 6,600.9
Expenses:
Benefits, claims and settlement expenses............ 1,231.6 1,597.3 3,942.7 4,236.5
Dividends to policyholders.......................... 79.1 79.1 241.0 241.2
Operating expenses.................................. 640.2 574.2 1,832.2 1,673.3
----------- ----------- ---------- ----------
Total expenses................................ 1,950.9 2,250.6 6,015.9 6,151.0
----------- ----------- ---------- ----------
Income before income taxes............................. 45.0 154.4 543.3 449.9
Income taxes........................................... 2.4 34.5 140.6 90.8
----------- ----------- ---------- ---------
Income from continuing operations................. 42.6 119.9 402.7 359.1
Loss from discontinued operations...................... (201.0) (4.1) (194.9) (8.2)
----------- ----------- ---------- ---------
Income (loss) before cumulative effect of
accounting changes................................... (158.4) 115.8 207.8 350.9
Cumulative effect of accounting changes, net of
related income taxes................................. - - (280.9) (10.7)
----------- ----------- ---------- ---------
Net income (loss).............................. $ (158.4) $ 115.8 $ (73.1) $ 340.2
=========== =========== ========== =========
OTHER DATA:
Net income (loss)...................................... $ (158.4) $ 115.8 $ (73.1) $ 340.2
Less:
Net realized/unrealized capital losses, as adjusted (146.9) (44.8) (153.8) (153.0)
Non-recurring items.................................. (214.0) (8.2) (490.8) (43.7)
----------- ----------- ---------- ---------
Operating earnings..................................... $ 202.5 $ 168.8 $ 571.5 $ 536.9
=========== =========== ========== =========
THREE MONTHS ENDED SEPTEMBER 30, 2002 COMPARED TO THREE MONTHS ENDED SEPTEMBER
30, 2001
Premiums and other considerations decreased $366.3 million, or 29%, to $888.7
million for the three months ended September 30, 2002, from $1,255.0 million for
the three months ended September 30, 2001. The decrease reflected a $224.3
million, or 68%, decrease from the U.S. Asset Management and Accumulation
segment, primarily due to a decrease 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 decrease was also due to a $146.8 million, or 80%,
decrease from the International Asset Management and Accumulation segment,
primarily resulting from reduced sales of single premium annuities with life
contingencies due to the sale of a large single premium annuity case in 2001 in
Mexico. The decrease was partially offset by a $4.8 million, or 1%, increase
from the Life and Health Insurance segment, primarily due to medical premium
rate increases, strong group disability sales in late 2001 and early 2002,
partially offset by ceded premiums under a new group medical reinsurance
contract effective January 1, 2002 and the reclassification of revenues from our
group universal life insurance product from premiums to fee revenues
Fees and other revenues increased $112.9 million, or 28%, to $516.6 million for
the three months ended September 30, 2002, from $403.7 million for the three
months ended September 30, 2001. The increase was primarily due to a $90.3
million, or 45%, increase from the Mortgage Banking segment, which reflects the
growth in residential mortgage loan production and the residential mortgage loan
servicing portfolio. The increase was also due to a $16.4 million, or 26%,
increase from the Life and Health Insurance segment, primarily related to growth
33
in our individual interest-sensitive life insurance business and the
reclassification of revenues from our group universal life insurance product to
fee revenues from premiums. In addition, the increase was due to a $16.3
million, or 12% increase from the U.S. Asset Management and Accumulation
segment, primarily resulting from netting the change in unearned revenue for
selected products with the related unlocking of deferred policy acquisition
costs ("DPAC") in operating expenses. Prior to the third quarter of 2002, the
impact was reported separately in fees and other revenue and operating expenses.
The increases were partially offset by a $13.0 million decrease from the
Corporate and Other segment, primarily a result of a change in inter-segment
eliminations included in this segment.
Net investment income decreased $5.2 million, or 1%, to $821.2 million for the
three months ended September 30, 2002, from $826.4 million for the three months
ended September 30, 2001. The decrease was primarily a result of a decrease in
investment yields. The yield on average invested assets and cash was 6.9% for
the three months ended September 30, 2002, compared to 7.3% for the three months
ended September 30, 2001. The decrease reflects lower yields on fixed maturity
securities due to a lower interest rate environment. The decrease in investment
yields was partially offset by a $2,744.4 million, or 6%, increase in average
invested assets and cash.
Net realized/unrealized capital losses increased $150.5 million to $230.6
million for the three months ended September 30, 2002, from $80.1 million for
the three months ended September 30, 2001. The increased capital losses included
a $106.6 million increase related to the mark to market of our investment in
company sponsored mutual funds and due to other than temporary impairments of
equity securities, a $43.1 million increase due to other than temporary
impairments of fixed maturity securities, and a $7.2 million increase in mark to
market losses on derivatives as the result of Statement of Financial Accounting
Standards No. 133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
("SFAS 133").
Benefits, claims and settlement expenses decreased $365.7 million, or 23%, to
$1,231.6 million for the three months ended September 30, 2002, from $1,597.3
million for the three months ended September 30, 2001. The decrease was
primarily due to a $234.9 million, or 29%, decrease from the U.S. Asset
Management and Accumulation segment, primarily reflecting a decrease in sales of
single premium group annuities with life contingencies. The decrease was also
due to a $145.7 million, or 73%, decrease in the International Asset Management
and Accumulation segment, primarily due to higher reserve changes and policy and
contract benefit payments recognized in 2001 due to the sale of a large single
premium annuity case in Mexico. The decreases were partially offset by a $15.8
million, or 3%, increase from the Life and Health Insurance segment, primarily
due to higher medical claim costs, the result of unusually low claims in 2001,
partially offset by ceded claims under a new group medical reinsurance
agreement.
Operating expenses increased $66.0 million, or 11%, to $640.2 million for the
three months ended September 30, 2002, from $574.2 million for the three months
ended September 30, 2001. The increase was primarily due to a $37.1 million, or
23%, increase from the Mortgage Banking segment resulting from increased
expenses related to growth in loan production and in the servicing portfolio.
The increase was also due to a $23.2 million, or 14%, increase in the U.S. Asset
Management and Accumulation segment, primarily resulting from netting the change
in unearned revenue for selected products with the related unlocking of DPAC in
operating expenses. Prior to the third quarter of 2002, the impact was reported
separately in fees and other revenue and operating expenses. In addition, the
Life and Health segment's operating expenses increased $9.3 million, or 5%,
primarily due to increased compensation costs related to company sponsored
pension and other post-retirement benefit plans as well as expensing stock-based
compensation costs due to our adoption of the fair value method of accounting
prescribed in SFAS 123. We are in the process of finalizing our 2003 pension
expense calculation. We expect total company pension expense to increase in 2003
compared to 2002.
Income taxes decreased $32.1 million, or 93%, to $2.4 million for the three
months ended September 30, 2002, from $34.5 million for the three months ended
September 30, 2001. The effective income tax rate was 5% for the three months
ended September 30, 2002, and 22% for the three months ended September 30, 2001.
The effective income tax rates for the three months ended September 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 decrease in
the effective tax rate to 5% for the three months ended September 30, 2002, from
22% for the three months ended September 30, 2001, was primarily due to the
decrease in net income before taxes compared to the small change in benefits
from permanent tax differences. The tax reduction for the three months ended
September 30, 2002, was offset partially by additional state income taxes.
As a result of the foregoing factors, net loss increased $274.2 million to
$158.4 million of net loss for the three months ended September 30, 2002, from
$115.8 million of net income for the three months ended September 30, 2001.
34
For the three months ended September 30, 2002, non-recurring items of $214.0
million, net of income taxes, included the negative effects of: (1) the loss
from discontinued operations of BT Financial Group ($201.0 million) and (2) an
increase in our loss contingency reserve established for sales practices
litigation ($13.0 million). For the three months ended September 30, 2001,
non-recurring items of $8.2 million, net of income taxes, included the negative
effects of: (1) the loss from discontinued operations of BT Financial Group
($4.1 million) and (2) expenses related to our demutualization ($4.1 million).
As a result of the foregoing factors and the exclusion of net
realized/unrealized capital losses, as adjusted, and nonrecurring items,
operating earnings increased $33.7 million, or 20%, to $202.5 million for the
three months ended September 30, 2002, from $168.8 million for the three months
ended September 30, 2001. The increase resulted from a $36.0 million increase
from the Mortgage Banking segment primarily due to an increase in earnings from
residential mortgage loan production and residential mortgage loan servicing.
The increase was also due to a $3.3 million increase from the International
Asset Management and Accumulation segment, primarily related to improved
earnings of Principal International. In addition, the increase was due to a $2.4
million, or 3%, increase from the U.S. Asset Management and Accumulation
segment, primarily related to improved earnings of our pension operations and
from Principal Global Investors. The increases were partially offset by a $5.0
million, or 8%, decrease from the Life and Health Insurance segment, primarily a
result of a return to more expected medical and dental loss ratios partially
offset by favorable mortality experience in the individual life operations. A
decrease of $3.0 million from the Corporate and Other segment resulted primarily
from a decrease in average investment yields for the segment.
NINE MONTHS ENDED SEPTEMBER 30, 2002 COMPARED TO NINE MONTHS ENDED SEPTEMBER 30,
2001
Premiums and other considerations decreased $269.3 million, or 8%, to $2,941.0
million for the nine months ended September 30, 2002, from $3,210.3 million for
the nine months ended September 30, 2001. The decrease was primarily due to a
$171.0 million, or 58%, decrease from the International Asset Management and
Accumulation segment, primarily resulting from decreased sales of single premium
annuities with life contingencies due to the sale of a large single premium
annuity case in 2001 and, to a lesser extent, prolonged government retention of
potential annuitants in 2002 in Mexico. The decrease also reflected a $65.4
million, or 10%, decrease from the U.S. Asset Management and Accumulation
segment, primarily a result of a decrease 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. In addition, the decrease resulted from a $32.9 million,
or 1%, decrease from the Life and Health Insurance segment, primarily due to
ceded premiums from the new group medical reinsurance contract effective January
1, 2002, the classification of revenues from our group universal life insurance
product from premiums to fee revenues, and the shift in customer preference from
individual traditional life insurance products to individual interest-sensitive
life insurance products, partially offset by medical premium rate increases.
Fees and other revenues increased $245.2 million, or 21%, to $1,386.7 million
for the nine months ended September 30, 2002, from $1,141.5 million for the nine
months ended September 30, 2001. The increase was primarily due to an $179.1
million, or 37%, increase from the Mortgage Banking segment, primarily resulting
from an increase in the residential mortgage loan servicing portfolio and loan
production. The increase was also due to a $42.5 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 reclassification
of revenues from our group universal life insurance product to fee revenues from
premiums. In addition, the increase was related to a $30.9 million, or 7%,
increase in the U.S. Asset Management and Accumulation segment, primarily from
Principal Global Investors due to a reclassification of market value and hedging
activities from net investment income to fees and other revenue, an increase in
investment management and transaction fees and an increase in gains from
commercial mortgage-backed securitizations.
Net investment income decreased $50.6 million, or 2%, to $2,455.5 million for
the nine months ended September 30, 2002, from $2,506.1 million for the nine
months ended September 30, 2001. The decrease was primarily a result of a
decrease in investment yields. The yield on average invested assets and cash was
7.0% for the nine months ended September 30, 2002, compared to 7.5% for the nine
months ended September 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 average investment yields due in part to a lower interest rate
environment and to a lesser extent, due to a decrease in commercial mortgage
prepayment fee income. These decreases were partially offset by an increase in
35
income on derivatives. The decrease in investment yields was partially offset by
a $2,664.4 million, or 6%, increase in average invested assets and cash.
Net realized/unrealized capital losses decreased $33.0 million, or 13%, to
$224.0 million for the nine months ended September 30, 2002, from $257.0 million
for the nine months ended September 30, 2001. The decrease was due to the $183.0
million capital gain realized as the result of the sale of our investment in
Coventry in February 2002, the $38.4 million loss on the sale of our operations
in Spain in 2001, a $52.0 million decrease in losses on sales of equity
securities, and a $31.9 decrease in the mark to market adjustment related to
derivatives. These decreases were partially offset by a $149.9 million increase
in other than temporary impairments of fixed maturity securities, a $97.1
million increase in capital losses resulting from the mark to market of our
investment in company sponsored mutual funds and other than temporary declines
in value of equity securities, and a $44.8 million increase in realized losses
related to derivatives.
Benefits, claims and settlement expenses decreased $293.8 million, or 7%, to
$3,942.7 million for the nine months ended September 30, 2002, from $4,236.5
million for the nine months ended September 30, 2001. The decrease is partially
due to a $144.3 million, or 43%, decrease from the International Asset
Management and Accumulation segment due to higher reserve changes and policy and
contract benefit payments recognized in 2001 due to the sale of a large single
premium annuity case and, to a lesser extent, prolonged government retention of
potential annuitants in 2002 in Mexico. The decrease was also due to a $110.9
million, or 5%, decrease from the U.S. Asset Management and Accumulation
segment, primarily reflecting a decrease in sales of single premium group
annuities with life contingencies. In addition, the decrease was due to a $34.4
million, or 2%, decrease from the Life and Health Insurance segment due to ceded
claims under a new group medical reinsurance agreement 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 $241.0 million for the nine
months ended September 30, 2002, from $241.2 million for the nine months ended
September 30, 2001. The decrease was primarily due to a $3.5 million, or 1%,
decrease from the Life and Health Insurance segment due to a change in the
individual life insurance dividend scale implemented in February 1, 2002. The
decrease was partially offset by a $3.3 million, or 67%, 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 $158.9 million, or 9%, to $1,832.2 million for the
nine months ended September 30, 2002, from $1,673.3 million for the nine months
ended September 30, 2001. The increase was primarily due to a $186.5 million, or
54%, increase from the Mortgage Banking segment resulting from increased
expenses related to growth in loan production and in the servicing portfolio and
from an increase in impairment of capitalized mortgage servicing rights net of
servicing hedge activity. The increase was partially offset by a $13.6 million,
or 2%, decrease from the U.S. Asset Management and Accumulation segment,
primarily reflecting an increase in capitalization of DPAC resulting from an
increase in sales of selected pension products. The increase was also partially
offset by a $10.1 million, or 16%, decrease from our Corporate and Other segment
primarily due to expenses recognized in 2001 related to our demutualization. The
increase was also offset by a $10.0 million, or 13%, decrease from the
International Asset Management and Accumulation segment primarily related to the
weakening of the Argentine peso versus the U.S. dollar and of the general
economic environment in Argentina.
Income taxes increased $49.8 million, or 55%, to $140.6 million for the nine
months ended September 30, 2002, from $90.8 million for the nine months ended
September 30, 2001. The effective income tax rate was 26% for the nine months
ended September 30, 2002, and 20% for the nine months ended September 30, 2001.
The effective income tax rates for the nine months ended September 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, offset partially
in 2002 by additional state income taxes. The increase in the effective tax rate
to 26% for the nine months ended September 30, 2002, from 20% for the nine
months ended September 30, 2001, was primarily due to the increase in state
income taxes and also due to a greater increase in net income before taxes
relative to the increase in our benefits from permanent tax differences. In
addition, our effective income tax rate was further reduced for the nine months
ended September 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 loss increased $413.3
million to $73.1 million for the nine months ended September 30, 2002, from
$340.2 million of net income for the nine months ended September 30, 2001. The
36
cumulative effect of accounting changes, net of related income taxes, were
related to our implementation of SFAS 142 in 2002 and SFAS 133 in 2001.
For the nine months ended September 30, 2002, non-recurring items of $490.8
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); (2) the loss from discontinued operations of BT Financial Group
($194.9 million); (3) an increase in our loss contingency reserve established
for sales practices litigation ($13.0 million); and (4) expenses related to our
demutualization ($2.0 million). For the nine months ended September 30, 2001,
non-recurring items of $43.7 million, net of income taxes, included the negative
effects of: (1) expenses related to our demutualization ($18.9 million); (2) a
cumulative effect of accounting change related to our implementation of SFAS 133
($10.7 million); (3) the loss from discontinued operations of BT Financial Group
($8.2 million); and (4) an increase in our loss contingency reserve established
for sales practices litigation ($5.9 million).
As a result of the foregoing factors and the exclusion of net
realized/unrealized capital losses, as adjusted and nonrecurring items,
operating earnings increased $34.6 million, or 6%, to $571.5 million for the
nine months ended September 30, 2002, from $536.9 million for the nine months
ended September 30, 2001. The increase resulted from a $27.8 million, or 11%,
increase from the U.S. Asset Management and Accumulation segment, primarily
related to improved earnings of our pension operations and from Principal Global
Investors. In addition, the increase resulted from a $20.1 million, or 13%,
increase from the Life and Health Insurance segment, primarily a result of
improved medical and dental loss ratios, the absence of several one-time
expenses occurring in 2001, and improved morbidity in the group disability
business. The increase was also due to a $18.5 million, or 19%, increase from
the Mortgage Banking segment, resulting from an increase in earnings from
residential mortgage loan production. The increase was also due to a $9.0
million increase from the International Asset Management and Accumulation
segment, primarily related to improved earnings of Principal International. The
increase was partially offset by a $40.8 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 and due to a decrease of
average investment yields for the segment.
RESULTS OF OPERATIONS BY SEGMENT
We evaluate segment performance by segment operating earnings, which excludes
the effect of net realized/unrealized 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/unrealized 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.
37
The following table presents segment information as of or for the periods
indicated:
AS OF OR FOR THE THREE AS OF OR FOR THE NINE
MONTHS ENDED MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------------- ------------------------------
2002 2001 2002 2001
--------------- ------------- ------------- -------------
(IN MILLIONS)
OPERATING REVENUES BY SEGMENT:
U.S. Asset Management and Accumulation.......... $ 865.9 $ 1,065.4 $ 2,863.7 $ 2,923.6
International Asset Management and
Accumulation................................. 82.8 224.2 252.3 409.1
Life and Health Insurance....................... 987.7 970.3 2,950.7 2,948.5
Mortgage Banking................................ 312.9 207.7 731.3 500.8
Corporate and Other (1)......................... (15.8) 16.7 1.4 74.6
--------------- ------------- ------------- -------------
Total operating revenues...................... 2,233.5 2,484.3 6,799.4 6,856.6
Net realized/unrealized capital losses,
including recognition of front-end fee
revenues and certain market value
adjustments to fee revenues................... (237.6) (79.3) (240.2) (255.7)
--------------- ------------- ------------- -------------
U.S. GAAP REPORTED:
Total consolidated revenues................... $ 1,995.9 $ 2,405.0 $ 6,559.2 $ 6,600.9
=============== ============= ============= =============
OPERATING EARNINGS (LOSS) BY SEGMENT:
U.S. Asset Management and Accumulation ......... $ 84.9 $ 82.5 $ 287.2 $ 259.4
International Asset Management and
Accumulation.................................. 5.0 1.7 10.1 1.1
Life and Health Insurance....................... 55.7 60.7 171.7 151.6
Mortgage Banking................................ 62.5 26.5 113.8 95.3
Corporate and Other ............................ (5.6) (2.6) (11.3) 29.5
--------------- ------------- ------------- -------------
Total operating earnings...................... 202.5 168.8 571.5 536.9
Net realized/unrealized capital losses, as
adjusted (2).................................. (146.9) (44.8) (153.8) (153.0)
Non-recurring items (3)......................... (214.0) (8.2) (490.8) (43.7)
--------------- ------------- ------------- -------------
U.S. GAAP REPORTED:
Net income (loss)............................... $ (158.4) $ 115.8 $ (73.1) $ 340.2
=============== ============= ============= =============
U.S. GAAP REPORTED NET INCOME (LOSS) BY SEGMENT:
U.S. Asset Management and Accumulation ......... $ 29.9 $ 53.9 $ 127.0 $ 179.2
International Asset Management and
Accumulation.................................. (193.0) (1.1) (447.1) (27.0)
Life and Health Insurance....................... 45.6 56.4 125.7 142.7
Mortgage Banking................................ 62.5 26.5 113.8 95.3
Corporate and Other ............................ (103.4) (19.9) 7.5 (50.0)
--------------- ------------- ------------- -------------
Total net income (loss) ...................... $ (158.4) $ 115.8 $ (73.1) $ 340.2
=============== ============= ============= =============
TOTAL ASSETS BY SEGMENT:
U.S. Asset Management and Accumulation (4)...... $ 68,556.7 $ 64,571.9 $ 68,556.7 $ 64,571.9
International Asset Management and
Accumulation.................................. 4,528.1 4,995.2 4,528.1 4,995.2
Life and Health Insurance....................... 11,152.0 10,817.1 11,152.0 10,817.1
Mortgage Banking................................ 3,220.3 2,339.8 3,220.3 2,339.8
Corporate and Other (5)......................... 813.6 1,231.2 813.6 1,231.2
--------------- ------------- ------------- -------------
Total assets.................................. $ 88,270.7 $ 83,955.2 $ 88,270.7 $ 83,955.2
=============== ============= ============= =============
(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, internal interest paid to our
Mortgage Banking segment for escrow accounts deposited with our U.S. Asset
Management and Accumulation segment 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.
38
(2) Net realized/unrealized capital gains (losses) include unrealized gains
(losses) on mark to market changes of our investment in company sponsored
mutual funds as well as unrealized gains on certain derivatives. Net
realized/unrealized 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:
FOR THE THREE FOR THE NINE
MONTHS ENDED MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
----------------------------- ---------------------------
2002 2001 2002 2001
------------- ------------ ------------ -----------
(IN MILLIONS)
Net realized/unrealized capital gains (losses).... $ (230.6) $ (80.1) $ (224.0) $ (257.0)
Certain market value adjustments to fee revenues.. (9.0) - (22.2) -
Recognition of front-end fee revenues............. 2.0 0.8 6.0 1.3
------------ ------------ ------------ -----------
Net realized/unrealized capital losses,
including recognition of front-end fee
revenues and certain market value
adjustments to fee revenues .................. (237.6) (79.3) (240.2) (255.7)
Amortization of deferred policy acquisition
costs related to net realized/unrealized capital
gains (losses).................................. 6.5 3.4 18.8 7.3
Capital gains (losses) distributed to customers... 3.0 - (18.8) -
------------ ------------ ------------ -----------
Net realized/unrealized capital 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..................................... (228.1) (75.9) (240.2) (248.4)
Income tax effect ................................ 81.2 31.1 86.4 95.4
------------ ------------ ------------ -----------
Net realized/unrealized capital losses, as $ (146.9) $ (44.8) $ (153.8) $ (153.0)
adjusted........................................ ============ ============ ============ ===========
(3) For the three months ended September 30, 2002, non-recurring items of
$214.0 million, net of income taxes, included the negative effects of: (1)
the loss from discontinued operations of BT Financial Group ($201.0
million) and (2) an increase to a loss contingency reserve established for
sales practice litigation ($13.0 million). For the three months ended
September 30, 2001, non-recurring items of $8.2 million, net of income
taxes, resulted from the negative effects of: (1) expenses related to our
demutualization ($4.1) and (2) a loss from discontinued operations of BT
Financial Group ($4.1 million). For the nine months ended September 30,
2002, non-recurring items of $490.8 million, net of income taxes, included
the negative effects of: (1) a cumulative effect of accounting change
related to the implementation of SFAS 142 ($280.9 million); (2) the loss
from discontinued operations of BT Financial Group ($194.9 million); (3) an
increase to a loss contingency reserve established for sales practice
litigation ($13.0 million); and (4) expenses related to the demutualization
($2.0 million). For the nine months ended September 30, 2001, non-recurring
items of $43.7 million, net of income taxes, included the negative effects
of: (1) expenses related to our demutualization ($18.9 million); (2) a
cumulative effect of change in accounting principle related to our
implementation of SFAS 133 ($10.7 million); (3) the loss from discontinued
operations of BT Financial Group ($8.2 million); and (4) 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 $942.5 million at September 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.
39
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 NINE
MONTHS ENDED MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------------- ------------------------------
2002 2001 2002 2001
-------------- ------------- ------------- -------------
(IN MILLIONS)
OPERATING EARNINGS DATA:
Operating revenues(1):
Premiums and other considerations....... $ 106.5 $ 330.8 $ 595.4 $ 660.8
Fees and other revenues................. 165.0 140.9 510.1 461.7
Net investment income................... 594.4 593.7 1,758.2 1,801.1
-------------- ------------- ------------- -------------
Total operating revenues.............. 865.9 1,065.4 2,863.7 2,923.6
Expenses:
Benefits, claims and settlement expenses,
including dividends to policyholders 569.0 802.8 1,938.1 2,045.7
Operating expenses...................... 194.0 167.3 565.0 566.8
-------------- ------------- ------------- -------------
Total expenses........................ 763.0 970.1 2,503.1 2,612.5
-------------- ------------- ------------- -------------
Pre-tax operating earnings................ 102.9 95.3 360.6 311.1
Income taxes.............................. 18.0 12.8 73.4 51.7
-------------- ------------- ------------- -------------
Operating earnings........................ 84.9 82.5 287.2 259.4
Net realized/unrealized capital losses, as
adjusted................................ (55.0) (28.6) (160.2) (69.4)
Non-recurring items....................... - - - (10.8)
-------------- ------------- ------------- -------------
U. S. GAAP REPORTED:
Net income................................ $ 29.9 $ 53.9 $ 127.0 $ 179.2
============== ============= ============= =============
- --------------
(1) Excludes net realized/unrealized capital losses and their impact on
recognition of front-end fee revenues and certain market value adjustments
to fee revenues.
THREE MONTHS ENDED SEPTEMBER 30, 2002 COMPARED TO THREE MONTHS ENDED SEPTEMBER
30, 2001
Premiums and other considerations decreased $224.3 million, or 68%, to $106.5
million for the three months ended September 30, 2002, from $330.8 million for
the three months ended September 30, 2001. The decrease primarily resulted from
a $234.5 million decrease 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. Partially offsetting this decrease was a $10.2 million increase in
premium primarily resulting from higher individual payout annuity sales.
Fees and other revenues increased $24.1 million, or 17%, to $165.0 million for
the three months ended September 30, 2002, from $140.9 million for the three
months ended September 30, 2001. Pension fees and other revenues increased $19.0
million. This increase primarily resulted from netting the change in unearned
revenue for selected products with the related unlocking of DPAC in operating
expenses. Prior to the third quarter of 2002, the impact was reported separately
in fees and other revenue and operating expenses. In addition, Principal Global
Investors recognized a $3.5 million increase in fees and other revenue. This
increase was primarily due to an increase in investment management and
transaction fees and a reclassification of market value and hedging activities
from net investment income to fees and other revenue.
40
Net investment income increased $0.7 million to $594.4 million for the three
months ended September 30, 2002, from $593.7 million for the three months ended
September 30, 2001. The increase was primarily due to a $2,150.1 million, or 6%,
increase in average invested assets and cash. The increase was partially offset
by a decrease in the average yield on invested assets and cash, which was 6.6%
for the three months ended September 30, 2002, compared to 7.0% for the three
months ended September 30, 2001.
Benefits, claims and settlement expenses, including dividends to policyholders,
decreased $233.8 million, or 29%, to $569.0 million for the three months ended
September 30, 2002, from $802.8 million for the three months ended September 30,
2001. The decrease primarily resulted from a $245.3 million decrease in pension
benefits, claims and settlement expenses. This decrease was largely due to a
decrease in full-service payout sales of single premium group annuities with
life contingencies. Partially offsetting this decrease was a $10.4 million
increase in reserves resulting from higher individual payout annuity sales.
Operating expenses increased $26.7 million, or 16%, to $194.0 million for the
three months ended September 30, 2002, from $167.3 million for the three months
ended September 30, 2001. An increase of $19.3 million in pension operating
expenses resulted from netting the change in the unearned revenue for selected
products with the related unlocking of DPAC in operating expenses. Prior to the
third quarter of 2002, the impact was reported separately in fees and other
revenue and operating expenses. Also contributing to the increase was a change
in our investment performance assumptions related to amortization of DPAC
attributable to pension products. Furthermore, Principal Global Investors
operating expenses increased $2.1 million primarily due to an increase in
employee costs resulting from the acquisition of Spectrum in the fourth quarter
of 2001.
Income taxes increased $5.2 million, or 41%, to $18.0 million for the three
months ended September 30, 2002, from $12.8 million for the three months ended
September 30, 2001. The effective income tax rate for this segment was 17% for
the three months ended September 30, 2002, and 13% for the three months ended
September 30, 2001. The effective income tax rates for the three months ended
September 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 $2.4 million,
or 3%, to $84.9 million for the three months ended September 30, 2002, from
$82.5 million for the three months ended September 30, 2001.
Net realized/unrealized capital losses, as adjusted, increased $26.4 million, or
92%, to $55.0 million for the three months ended September 30, 2002, from $28.6
million for the three months ended September 30, 2001. The increase includes
capital losses related to other than temporary declines in the value of certain
fixed maturity securities for the three months ended September 30, 2002.
As a result of the foregoing factors, net income decreased $24.0 million, or
45%, to $29.9 million for the three months ended September 30, 2002, from $53.9
million for the three months ended September 30, 2001.
NINE MONTHS ENDED SEPTEMBER 30, 2002 COMPARED TO NINE MONTHS ENDED SEPTEMBER 30,
2001
Premiums and other considerations decreased $65.4 million, or 10%, to $595.4
million for the nine months ended September 30, 2002, from $660.8 million for
the nine months ended September 30, 2001. The decrease resulted from a $90.4
million decrease 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. This decrease was partially offset by a $25.0 million increase in
individual payout annuity sales.
Fees and other revenues increased $48.4 million, or 10%, to $510.1 million for
the nine months ended September 30, 2002, from $461.7 million for the nine
months ended September 30, 2001. This increase primarily resulted from an
increase of $24.4 million of fees from Principal Global Investors due to a
reclassification of market value and hedging activities from net investment
income to fees and other revenue, an increase in investment management and
transaction fees and an increase in gains from commercial mortgage-backed
securitizations. In addition, our pension fees and other revenues increased
$21.3 million which resulted from netting the change in unearned revenue for
selected products with the related unlocking of DPAC in operating expenses.
Prior to the third quarter of 2002, the impact was reported separately in fees
and other revenue and operating expenses.
41
Net investment income decreased $42.9 million, or 2%, to $1,758.2 million for
the nine months ended September 30, 2002, from $1,801.1 million for the nine
months ended September 30, 2001. The average yield on invested assets and cash
was 6.6% for the nine months ended September 30, 2002, compared to 7.2% for the
nine months ended September 30, 2001. The decrease reflects lower yields due to
a lower interest rate environment and to a lesser extent, due to a decrease in
commercial mortgage prepayment fee income. The decrease was partially offset by
a $2,122.3 million, or 6%, increase in average invested assets and cash.
Benefits, claims and settlement expenses, including dividends to policyholders,
decreased $107.6 million, or 5%, to $1,938.1 million for the nine months ended
September 30, 2002, from $2,045.7 million for the nine months ended September
30, 2001. The decrease primarily resulted from a $139.5 million decrease in
pension benefits, claims and settlement expenses. This decrease was largely due
to a decrease in full-service payout sales of single premium group annuities
with life contingencies and a decrease in cost of interest credited and in
change in reserves within pension's full-service accumulation and investment
only lines of business. Partially offsetting this decrease was a $28.6 million
increase in reserves resulting from higher individual payout annuity sales.
Operating expenses decreased $1.8 million to $565.0 million for the nine months
ended September 30, 2002, from $566.8 million for the nine months ended
September 30, 2001. The decrease primarily resulted from a $15.6 million
decrease in our pension operating expenses. The decrease was largely due to an
increase in capitalization of DPAC resulting from an increase in sales of
selected products and a change in focus and compensation of Employee Benefit
Sales and Service's field force. Partially offsetting this decrease was a $6.5
million increase in our mutual fund operating expenses. This increase primarily
relates to increased commission expense generated from sales of variable life
and annuity contracts. Of this increase, $2.1 million relates to sales within
the segment and is eliminated at an operating segment level. In addition,
Principal Bank operating expenses increased $4.2 million primarily due to
business growth in 2002. Furthermore, individual annuity operating expenses
increased $3.1 million primarily due to stronger fixed annuity sales in 2002.
Also, an increase of $2.5 million in Principal Global Investors operating
expenses was primarily due to an increase in employee costs resulting from the
acquisition of Spectrum in the fourth quarter of 2002, which was partially
offset by a decrease in securitization expense.
Income taxes increased $21.7 million, or 42%, to $73.4 million for the nine
months ended September 30, 2002, from $51.7 million for the nine months ended
September 30, 2001. The effective income tax rate for this segment was 20% for
the nine months ended September 30, 2002, and 17% for the nine months ended
September 30, 2001. The effective income tax rates for the nine months ended
September 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 $27.8
million, or 11%, to $287.2 million for the nine months ended September 30, 2002,
from $259.4 million for the nine months ended September 30, 2001.
Net realized/unrealized capital losses, as adjusted, increased $90.8 million, to
$160.2 million for the nine months ended September 30, 2002, from $69.4 million
for the nine months ended September 30, 2001. The increase includes capital
losses related to other than temporary declines in the value of certain fixed
maturity securities and sales of fixed maturity securities for the nine months
ended September 30, 2002.
As a result of the foregoing factors and the inclusion of non-recurring items
for the nine months ended September 30, 2001, net income decreased $52.2
million, or 29%, to $127.0 million for the nine months ended September 30, 2002,
from $179.2 million for the nine months ended September 30, 2001. For the nine
months ended September 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.
42
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 NINE
MONTHS ENDED MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------------------------- ------------------------------
2002 2001 2002 2001
------------- -------------- ------------ -------------
(IN MILLIONS)
OPERATING EARNINGS DATA:
Operating revenues (1):
Premiums and other considerations.... $ 37.3 $ 184.1 $ 123.1 $ 294.1
Fees and other revenues.............. 15.2 12.3 40.9 33.3
Net investment income................ 30.3 27.8 88.3 81.7
------------- -------------- ------------ -------------
Total operating revenues........... 82.8 224.2 252.3 409.1
Expenses:
Benefits, claims and settlement
expenses........................... 56.1 198.8 175.3 338.4
Operating expenses.................. 21.5 26.4 64.4 74.4
------------- -------------- ------------ -------------
Total expenses.................. 77.6 225.2 239.7 412.8
------------- -------------- ------------ -------------
Pre-tax operating earnings (loss)...... 5.2 (1.0) 12.6 (3.7)
Income taxes (benefits)................ 0.2 (2.7) 2.5 (4.8)
------------- -------------- ------------ -------------
Operating earnings..................... 5.0 1.7 10.1 1.1
Net realized/unrealized capital gains
(losses), as adjusted.................. 3.0 1.3 14.0 (19.9)
Non-recurring items.................... (201.0) (4.1) (471.2) (8.2)
------------- -------------- ------------ -------------
U. S. GAAP REPORTED:
Net loss............................... $ (193.0) $ (1.1) $ (447.1) $ (27.0)
============= ============== ============ =============
OTHER DATA:
Operating earnings (loss):
Principal International............. $ 5.8 $ 2.7 $ 12.4 $ 3.8
BT Financial Group.................. (0.8) (1.0) (2.3) (2.7)
Net income (loss):
Principal International............. $ 8.8 $ 4.0 $ 5.5 $ (16.1)
BT Financial Group.................. (201.8) (5.1) (452.6) (10.9)
- ---------------
(1) Excludes net realized/unrealized capital gains (losses) and their impact on
recognition of front-end fee revenues and certain market value adjustments
to fee revenues.
THREE MONTHS ENDED SEPTEMBER 30, 2002 COMPARED TO THREE MONTHS ENDED SEPTEMBER
30, 2001
Premiums and other considerations decreased $146.8 million, or 80%, to $37.3
million for the three months ended September 30, 2002, from $184.1 million for
the three months ended September 30, 2001. A decrease of $136.1 million in
Mexico was the result of decreased sales of single premium annuities with life
contingencies primarily due to the sale of a large single premium annuity case
in 2001 and to a lesser extent prolonged government retention of potential
annuitants in 2002. A decrease of $10.8 million in Argentina was primarily due
to the weakening of the Argentine peso versus the U.S. dollar and of the general
economic environment.
43
Fees and other revenues increased $2.9 million, or 24%, to $15.2 million for the
three months ended September 30, 2002, from $12.3 million for the three months
ended September 30, 2001. An increase of $2.9 million in Mexico was primarily a
result of the acquisition of Zurich AFORE in 2002.
Net investment income increased $2.5 million, or 9%, to $30.3 million for the
three months ended September 30, 2002, from $27.8 million for the three months
ended September 30, 2001. The increase was primarily related to a $186.1
million, or 16%, increase in average invested assets and cash. The increase was
partially offset by a decrease in investment yields. The yield on average
invested assets and cash was 8.9% for the three months ended September 30, 2002,
compared to 9.2% for the three months ended September 30, 2001, reflecting the
negative impact of investing in higher quality, lower yielding fixed maturity
securities in Argentina.
Benefits, claims and settlement expenses decreased $142.7 million, or 72%, to
$56.1 million for the three months ended September 30, 2002, from $198.8 million
for the three months ended September 30, 2001. A $133.7 million decrease in
Mexico was the result of higher reserve changes and policy and contract benefit
payments recognized in 2001 due to the sale of a large single premium annuity
case and to a lesser extent prolonged government retention of potential
annuitants in 2002. A decrease of $10.6 million in Argentina was primarily
related to the weakening of the Argentine peso versus the U.S. dollar and of the
general economic environment.
Operating expenses decreased $4.9 million, or 19%, to $21.5 million for the
three months ended September 30, 2002, from $26.4 million for the three months
ended September 30, 2001. A $3.4 million decrease in Argentina was primarily
related to the weakening of the Argentine peso versus the U.S. dollar and of the
general economic environment. In addition, a net decrease of $1.2 million in
Mexico was primarily related to reduced compensation costs in 2002 and the sale
of a large annuity case in 2001, which were partially offset by decreased
capitalization of DPAC in 2002. Operating expenses incurred by BT Financial
Group were $1.3 million for the three months ended September 30, 2002 and $1.4
million for the three months ended September 30, 2001. These expenses represent
corporate overhead allocated to BT Financial Group and do not qualify for
discontinued operations treatment. Upon completion of the sale of BT Financial
Group at November 1, 2002, the expenses that would have been allocated to BT
Financial Group will be allocated to our other segments.
Income taxes increased $2.9 million to $0.2 million of income tax expense for
the three months ended September 30, 2002, from a $2.7 million income tax
benefit for the three months ended September 30, 2001. The increase was
primarily due to the reduction of valuation allowances in 2001 within Argentina
and Mexico. The remaining increase was primarily a result of an increase in
pre-tax operating earnings.
As a result of the foregoing factors, operating earnings increased $3.3 million
to $5.0 million for the three months ended September 30, 2002, from $1.7 million
for the three months ended September 30, 2001.
Net realized/unrealized capital gains, as adjusted, increased $1.7 million to
$3.0 million for the three months ended September 30, 2002, from $1.3 million
for the three months ended September 30, 2001. An increase of $1.9 million
resulted primarily from gains realized on the sale of fixed maturity securities
and other investments in Chile.
As a result of the foregoing factors and the inclusion of non-recurring items
for the three months ended September 30, 2002, net loss increased $191.9 million
to $193.0 million for the three months ended September 30, 2002, from $1.1
million for the three months ended September 30, 2001. For the three months
ended September 30, 2002, net loss included the negative effect of non-recurring
items totaling $201.0 million, net of income taxes, related to the loss from
discontinued operations of BT Financial Group. For the three months ended
September 30, 2001, net loss included the negative effect of non-recurring items
totaling $4.1 million, net of income taxes, related to the loss from
discontinued operations of BT Financial Group.
NINE MONTHS ENDED SEPTEMBER 30, 2002 COMPARED TO NINE MONTHS ENDED SEPTEMBER 30,
2001
Premiums and other considerations decreased $171.0 million, or 58%, to $123.1
million for the nine months ended September 30, 2002, from $294.1 million for
the nine months ended September 30, 2001. A decrease of $142.8 million in Mexico
was the result of decreased sales of single premium annuities with life
contingencies primarily due to the sale of a large annuity case in 2001 and to a
lesser extent prolonged government retention of potential annuitants in 2002. A
decrease of $16.8 million in Argentina was primarily due to the weakening of the
Argentine peso versus the U.S. dollar and of the general economic environment.
44
In addition, a decrease of $10.8 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.
Fees and other revenues increased $7.6 million, or 23%, to $40.9 million for the
nine months ended September 30, 2002, from $33.3 million for the nine months
ended September 30, 2001. An increase of $6.6 million in Mexico was a result of
an increase in the number of retirement plan participants and the acquisition of
Zurich AFORE in 2002. In addition, an increase in Hong Kong was primarily due to
an increase in assets under management.
Net investment income increased $6.6 million, or 8%, to $88.3 million for the
nine months ended September 30, 2002, from $81.7 million for the nine months
ended September 30, 2001. The increase was primarily related to a $182.6
million, or 16%, increase in average invested assets and cash. The increase was
partially offset by a decrease in investment yields. The yield on average
invested assets and cash was 8.5% for the nine months ended September 30, 2002,
compared to 9.3% for the nine months ended September 30, 2001. This reflects 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 and a
negative impact of investing in higher quality, lower yielding fixed maturity
securities in Argentina.
Benefits, claims and settlement expenses decreased $163.1 million, or 48%, to
$175.3 million for the nine months ended September 30, 2002, from $338.4 million
for the nine months ended September 30, 2001. A $132.5 million decrease in
Mexico was the result of higher reserve changes and policy and contract benefit
payments recognized in 2001 due to the sale of a large annuity case and to a
lesser extent prolonged government retention of potential annuitants in 2002. A
decrease of $15.3 million in Argentina was primarily related to the weakening of
the Argentine peso versus the U.S. dollar and of the general economic
environment. In addition, a decrease of $14.7 million in Chile was primarily a
result of the weakening of the Chilean peso versus the U.S. dollar and decrease
in reserve changes to reflect the impact of deflation adjustments.
Operating expenses decreased $10.0 million, or 13%, to $64.4 million for the
nine months ended September 30, 2002, from $74.4 million for the nine months
ended September 30, 2001. A $7.5 million decrease in Argentina was primarily
related to the weakening of the Argentine peso versus the U.S. dollar and of the
general economic environment. Operating expenses incurred by BT Financial Group
were $3.6 million for the nine months ended September 30, 2002 and $4.1 million
for the nine months ended September 30, 2001. These expenses represent corporate
overhead allocated to BT Financial Group and do not qualify for discontinued
operations treatment. Upon completion of the sale of BT Financial Group at
November 1, 2002, the expenses that would have been allocated to BT Financial
Group will be allocated to our other segments.
Income taxes increased $7.3 million to $2.5 million of income tax expense for
the nine months ended September 30, 2002, from a $4.8 million income tax benefit
for the nine months ended September 30, 2001. The increase was primarily a
result of an increase in pre-tax operating earnings.
As a result of the foregoing factors, operating earnings increased $9.0 million
to $10.1 million for the nine months ended September 30, 2002, from $1.1 million
for the nine months ended September 30, 2001.
Net realized/unrealized capital gains, as adjusted, increased $33.9 million to
$14.0 million for the nine months ended September 30, 2002, from $19.9 million
of net realized capital losses for the nine months ended September 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, an $8.7
million increase resulted primarily from gains realized on the sale of fixed
maturity securities in Chile for the nine months ended September 30, 2002.
As a result of the foregoing factors and the inclusion of non-recurring items
for the nine months ended September 30, 2002, net loss increased $420.1 million
to $447.1 million for the nine months ended September 30, 2002, from $27.0
million for the nine months ended September 30, 2001. For the nine months ended
September 30, 2002, net loss included the negative effect of non-recurring items
totaling $471.2 million, net of income taxes, related to: (1) the cumulative
effect of accounting change, a result of our implementation of SFAS 142 ($276.3
million) and (2) the loss from discontinued operations of BT Financial Group
($194.9 million). For the nine months ended September 30, 2001, net loss
included the negative effect of non-recurring items totaling $8.2 million, net
of income taxes, related to the loss from discontinued operations of BT
Financial Group.
45
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 NINE
MONTHS ENDED MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------------ -----------------------------
2002 2001 2002 2001
------------- ------------- ------------ ------------
(IN MILLIONS)
OPERATING EARNINGS DATA:
Operating Revenues(1):
Premiums and other considerations.......... $ 744.9 $ 740.1 $ 2,222.5 $2,255.4
Fees and other revenues.................... 78.5 62.1 233.5 191.0
Net investment income...................... 164.3 168.1 494.7 502.1
-------------- ------------- ------------ ------------
Total operating revenues................ 987.7 970.3 2,950.7 2,948.5
Expenses:
Benefits, claims and settlement expenses... 612.5 596.7 1,822.7 1,857.1
Dividends to policyholders................. 76.9 78.0 232.8 236.3
Operating expenses......................... 213.4 204.5 632.9 627.1
-------------- ------------- ------------ ------------
Total expenses.......................... 902.8 879.2 2,688.4 2,720.5
-------------- ------------- ------------ ------------
Pre-tax operating earnings................... 84.9 91.1 262.3 228.0
Income taxes................................. 29.2 30.4 90.6 76.4
-------------- ------------- ------------ ------------
Operating earnings........................... 55.7 60.7 171.7 151.6
Net realized/unrealized capital losses, as
adjusted................................... (10.1) (4.3) (41.4) (9.0)
Non-recurring items.......................... - - (4.6) 0.1
-------------- ------------- ------------ ------------
U.S. GAAP REPORTED:
Net income................................... $ 45.6 $56.4 $ 125.7 $ 142.7
============== ============= ============ ============
------------
(1) Excludes net realized/unrealized capital losses and their impact on
recognition of front-end fee revenues and certain market value adjustments
to fee revenues.
THREE MONTHS ENDED SEPTEMBER 30, 2002 COMPARED TO THREE MONTHS ENDED SEPTEMBER
30, 2001
Premiums and other considerations increased $4.8 million, or 1%, to $744.9
million for the three months ended September 30, 2002, from $740.1 million for
the three months ended September 30, 2001. Group medical premiums increased $8.8
million 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. In addition, group disability
premiums increased $6.6 million primarily due to strong sales in late 2001 and
early 2002. Individual disability premiums also increased $2.5 million,
primarily a result of increased premium from new sales. Partially offsetting the
increases was a $6.1 million decrease in group life insurance premiums due to
the classification of revenues from our group universal life insurance product
from premium to fee revenues. In addition, individual life insurance premiums
decreased $5.6 million, reflecting a continued shift in customer preference from
traditional life insurance products to fee-based interest-sensitive life
insurance products. Group dental and vision premium also decreased $1.4 million
primarily due to a decline in covered members.
Fees and other revenues increased $16.4 million, or 26%, to $78.5 million for
the three months ended September 30, 2002, from $62.1 million for the three
months ended September 30, 2001. Fee revenues from individual interest-sensitive
life insurance products increased $8.2 million, primarily the result of the
continued shift in customer preference, as previously discussed. Group life
insurance fee revenues increased $7.1 million primarily due to the
reclassification of revenues from our group universal life insurance product to
fee revenues from premiums.
46
Net investment income decreased $3.8 million, or 2%, to $164.3 million for the
three months ended September 30, 2002, from $168.1 million for the three months
ended September 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 7.1% for the three months ended September 30, 2002,
compared to 7.5% for the three months ended September 30, 2001. The decrease was
partially offset by a $240.9 million, or 3%, increase in average invested assets
and cash.
Benefits, claims and settlement expenses increased $15.8 million, or 3%, to
$612.5 million for the three months ended September 30, 2002, from $596.7
million for the three months ended September 30, 2001. Group medical insurance
benefits, claims and settlement expenses increased $16.7 million, primarily due
to higher medical claim costs, the result of unusually low claims in 2001, which
were partially offset by ceded claims under a new reinsurance agreement. In
addition, group disability benefits, claims and settlement expenses increased
$1.6 million due to growth in the business. Partially offsetting the increases
was a decrease of $4.2 million in benefits, claims and settlement expenses for
individual life insurance products primarily due to lower death claims,
resulting from losses recognized in 2001 for the September 11th terrorist
attacks.
Dividends to policyholders decreased $1.1 million, or 1%, to $76.9 million for
the three months ended September 30, 2002, from $78.0 million for the three
months ended September 30, 2001. The decrease was due to a change in the
individual life insurance dividend scale implemented February 1, 2002.
Operating expenses increased $8.9 million, or 4%, to $213.4 million for the
three months ended September 30, 2002, from $204.5 million for the three months
ended September 30, 2001. Group life and health insurance operating expenses
increased $9.0 million, primarily due to increased commission expense, interest
expense related to federal income taxes, and technology costs.
Income taxes decreased $1.2 million, or 4%, to $29.2 million for the three
months ended September 30, 2002, from $30.4 million for the three months ended
September 30, 2001. The effective income tax rate for the segment was 34% for
the three months ended September 30, 2002 and 33% for the three months ended
September 30, 2001. The effective income tax rates for the three months ended
September 30, 2002 and 2001 were lower than the corporate income tax rate of 35%
primarily due to tax-exempt income.
As a result of the foregoing factors, operating earnings decreased $5.0 million,
or 8%, to $55.7 million for the three months ended September 30, 2002, from
$60.7 million for the three months ended September 30, 2001.
Net realized/unrealized capital losses, as adjusted, increased $5.8 million to
$10.1 million for the three months ended September 30, 2002, from $4.3 million
for the three months ended September 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 partially
offset by realized capital gains on derivatives for the three months ended
September 30, 2002.
As a result of the foregoing factors, net income decreased $10.8 million, or
19%, to $45.6 million for the three months ended September 30, 2002, from $56.4
million for the three months ended September 30, 2001.
NINE MONTHS ENDED SEPTEMBER 30, 2002 COMPARED TO NINE MONTHS ENDED SEPTEMBER 30,
2001
Premiums and other considerations decreased $32.9 million, or 1%, to $2,222.5
million for the nine months ended September 30, 2002, from $2,255.4 million for
the nine months ended September 30, 2001. Group life insurance premiums
decreased $25.6 million, primarily due to the reclassification 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 $21.6 million,
reflecting a continued shift in customer preference from traditional life
insurance products to fee-based interest-sensitive life insurance products and
the increased use of reinsurance. Partially offsetting the decreases was a $9.8
million increase in group disability premiums due to strong sales in late 2001
and early 2002. Group medical premiums increased $6.0 million 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 $42.5 million, or 22%, to $233.5 million for
the nine months ended September 30, 2002, from $191.0 million for the nine
months ended September 30, 2001. Group life insurance fee revenues increased
47
$20.9 million primarily due to the reclassification of revenues from our group
universal life insurance product to fee revenues from premiums. Fee revenues
from individual life insurance products increased $15.4 million, primarily a
result of the continued shift in customer preference, as previously discussed.
Net investment income decreased $7.4 million, or 1%, to $494.7 million for the
nine months ended September 30, 2002, from $502.1 million for the nine months
ended September 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 nine months ended September 30, 2002,
compared to 7.5% for the nine months ended September 30, 2001. The decrease was
partially offset by a $191.3 million, or 2%, increase in average invested assets
and cash.
Benefits, claims and settlement expenses decreased $34.4 million, or 2%, to
$1,822.7 million for the nine months ended September 30, 2002, from $1,857.1
million for the nine months ended September 30, 2001. Group medical insurance
benefits, claims and settlement expenses decreased $21.6 million, primarily due
to ceded claims under a new reinsurance agreement, partially offset by a reserve
established due to the withdrawal of medical products from the Florida small
employer market. Individual life insurance benefits, claims, and settlement
expenses decreased $10.2 million primarily due to lower death claims and a lower
reserve increase related to the decrease in premium.
Dividends to policyholders decreased $3.5 million, or 1%, to $232.8 million for
the nine months ended September 30, 2002, from $236.3 million for the nine
months ended September 30, 2001. The decrease was due to a change in the
individual life insurance dividend scale implemented February 1, 2002.
Operating expenses increased $5.8 million, or 1%, to $632.9 million for the nine
months ended September 30, 2002, from $627.1 million for the nine months ended
September 30, 2001. Group life and health insurance operating expenses increased
$6.4 million, primarily due to increased commissions. Partially offsetting the
increase in operating expenses was a decrease due to several one-time expenses
in 2001. Individual life and disability insurance operating expenses decreased
$0.6 million primarily due to the reclassifying of fees received from
reinsurance ceded from fee revenue to operating expenses and increased
capitalization of DPAC related to higher sales, partially offset by higher
non-deferrable compensation costs.
Income taxes increased $14.2 million, or 19%, to $90.6 million for the nine
months ended September 30, 2002, from $76.4 million for the nine months ended
September 30, 2001. The effective income tax rate for the segment was 35% for
the nine months ended September 30, 2002 and 34% for the nine months ended
September 30, 2001. The effective income tax rate for the nine months ended
September 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 $20.1
million, or 13%, to $171.7 million for the nine months ended September 30, 2002,
from $151.6 million for the nine months ended September 30, 2001.
Net realized/unrealized capital losses, as adjusted, increased $32.4 million to
$41.4 million for the nine months ended September 30, 2002, from $9.0 million
for the nine months ended September 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 nine
months ended September 30, 2002.
As a result of the foregoing factors and the inclusion of non-recurring items,
net income decreased $17.0 million, or 12%, to $125.7 million for the nine
months ended September 30, 2002, from $142.7 million for the nine months ended
September 30, 2001. Non-recurring items for the nine months ended September 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 nine months ended
September 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.
48
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 NINE
MONTHS ENDED MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------------- ----------------------------
2002 2001 2002 2001
----------- ----------- ----------- ------------
(IN MILLIONS)
OPERATING EARNINGS DATA:
Operating Revenues(1):
Loan servicing....................... $ 149.5 $ 101.5 $ 429.6 $ 282.5
Loan production...................... 163.4 106.2 301.7 218.3
----------- ----------- ----------- ------------
Total operating revenues......... 312.9 207.7 731.3 500.8
Expenses:
Loan servicing....................... 146.4 124.8 405.2 254.3
Loan production...................... 51.5 36.0 129.4 93.8
----------- ----------- ----------- ------------
Total expenses................... 197.9 160.8 534.6 348.1
----------- ----------- ----------- ------------
Pre-tax operating earnings................ 115.0 46.9 196.7 152.7
Income taxes.............................. 52.5 20.4 82.9 57.4
----------- ----------- ----------- ------------
Operating earnings........................ 62.5 26.5 113.8 95.3
Net realized/unrealized capital gains
(losses), as adjusted.................. - - - -
Non-recurring items....................... - - - -
----------- ----------- ----------- ------------
U.S. GAAP REPORTED:
Net income................................ $ 62.5 $ 26.5 $ 113.8 $ 95.3
=========== =========== =========== ============
- ------------
(1) Excludes net realized/unrealized capital gains (losses) and their impact on
recognition of front-end fee revenues and certain market value adjustments
to fee revenues.
THREE MONTHS ENDED SEPTEMBER 30, 2002 COMPARED TO THREE MONTHS ENDED SEPTEMBER
30, 2001
Total operating revenues increased $105.2 million, or 51%, to $312.9 million for
the three months ended September 30, 2002, from $207.7 million for the three
months ended September 30, 2001. Residential mortgage loan production revenues
increased $57.2 million primarily due to an increase in mortgage loan production
and an increase in revenue from secondary marketing activities, the process by
which Mortgage Banking pools and sells loans. Mortgage loan production increased
to $11.1 billion for the three months ended September 30, 2002, compared to
$10.5 billion for the same period a year ago. A $48.0 million increase in
residential mortgage loan servicing revenues reflects the growth in the loan
servicing portfolio. The average balance of the servicing portfolio was $99.4
billion for the three months ended September 30, 2002, compared to $68.5 billion
for the same period a year ago.
Total expenses increased $37.1 million, or 23%, to $197.9 million for the three
months ended September 30, 2002, from $160.8 million for the three months ended
September 30, 2001. A $21.6 million increase in residential mortgage loan
servicing expenses resulted from increased expenses related to growth in the
servicing portfolio, which includes a $22.1 million decrease in impairment of
capitalized mortgage servicing rights net of servicing hedge activity. A $15.5
million increase in mortgage loan production expenses was primarily due to an
increase in mortgage loan production during the three months ended September 30,
2002.
Income taxes increased $32.1 million to $52.5 million for the three months ended
September 30, 2002, from $20.4 million for the three months ended September 30,
2001. The increase in income taxes primarily resulted from an increase in
pre-tax operating earnings. The effective income tax rate for this segment was
46% for the three months ended September 30, 2002, and 43% for the three months
ended September 30, 2001. The effective income tax rates for the three months
49
ended September 30, 2002 and 2001, were higher than the corporate income tax
rate of 35% due to state income taxes. The increase in the effective tax rate to
46% for the three months ended September 30, 2002, from 43% for the three months
ended September 30, 2001, was primarily due to the cumulative effect of
increasing deferred tax liabilities and deferred tax expense for a change in the
state income tax apportionment factor, a result of our sale of substantially all
of BT Financial Group.
As a result of the foregoing factors, operating earnings and net income
increased $36.0 million to $62.5 million for the three months ended September
30, 2002, from $26.5 million for the three months ended September 30, 2001.
NINE MONTHS ENDED SEPTEMBER 30, 2002 COMPARED TO NINE MONTHS ENDED SEPTEMBER 30,
2001
Total operating revenues increased $230.5 million, or 46%, to $731.3 million for
the nine months ended September 30, 2002, from $500.8 million for the nine
months ended September 30, 2001. A $147.1 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 $92.6 billion for the nine months ended September 30, 2002,
compared to $62.1 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 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 $83.4 million primarily due to an
increase in mortgage loan production, which increased to $30.3 billion for the
nine months ended September 30, 2002, compared to $25.9 billion for the same
period a year ago.
Total expenses increased $186.5 million, or 54%, to $534.6 million for the nine
months ended September 30, 2002, from $348.1 million for the nine months ended
September 30, 2001. A $150.9 million increase in residential mortgage loan
servicing expenses resulted from increased expenses related to growth in the
servicing portfolio and a $51.3 million increase in impairment of capitalized
mortgage servicing rights net of servicing hedge activity. Residential mortgage
loan production expenses increased $35.6 million reflecting the increase in
residential mortgage loan production volume.
Income taxes increased $25.5 million, or 44%, to $82.9 million for the nine
months ended September 30, 2002, from $57.4 million for the nine months ended
September 30, 2001. The increase in income taxes primarily resulted from an
increase in pre-tax operating earnings. The effective income tax rate for this
segment was 42% for the nine months ended September 30, 2002, and 38% for the
nine months ended September 30, 2001. The effective income tax rates for the
nine months ended September 30, 2002 and 2001, were higher than the corporate
income tax rate of 35% due to state income taxes. The increase in the effective
tax rate to 42% for the nine months ended September 30, 2002, from 38% for the
nine months ended September 30, 2001, was primarily due to the cumulative effect
of increasing deferred tax liabilities and deferred tax expense for a change in
the state income tax apportionment factor, a result of our sale of substantially
all of BT Financial Group.
As a result of the foregoing factors, operating earnings and net income
increased $18.5 million, or 19%, to $113.8 million for the nine months ended
September 30, 2002, from $95.3 million for the nine months ended September 30,
2001.
50
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 NINE
MONTHS ENDED MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------------- -----------------------------
2002 2001 2002 2001
------------ ----------- ---------- --------------
(IN MILLIONS)
OPERATING EARNINGS DATA:
Operating Revenues (1):
Total operating revenues...................... $ (15.8) $ 16.7 $ 1.4 $ 74.6
Expenses:
Total expenses................................ (0.9) 12.3 27.0 26.2
------------ ----------- ---------- --------------
Pre-tax operating earnings (loss)............... (14.9) 4.4 (25.6) 48.4
Income taxes (benefits)......................... (9.3) 7.0 (14.3) 18.9
------------ ----------- ---------- --------------
Operating earnings (loss)....................... (5.6) (2.6) (11.3) 29.5
Net realized/unrealized capital gains (losses),
as adjusted................................... (84.8) (13.2) 33.8 (54.7)
Non-recurring items............................. (13.0) (4.1) (15.0) (24.8)
------------ ----------- ---------- --------------
U.S. GAAP REPORTED:
Net income (loss)............................... $ (103.4) $ (19.9) $ 7.5 $ (50.0)
============ =========== ========== ==============
- ------------
(1) Excludes net realized/unrealized capital gains (losses) and their impact on
recognition of front-end fee revenues and certain market value adjustments
to fee revenues.
THREE MONTHS ENDED SEPTEMBER 30, 2002 COMPARED TO THREE MONTHS ENDED SEPTEMBER
30, 2001
Total operating revenues decreased $32.5 million to a negative $15.8 million for
the three months ended September 30, 2002, from a positive $16.7 million for the
three months ended September 30, 2001. Net investment income decreased $18.0
million, primarily reflecting a decrease in average investment yields for the
segment. In addition, a $15.3 million decrease was related to an increase in
inter-segment eliminations included in this segment, which was offset by a
corresponding change in total expenses.
Total expenses decreased $13.2 million to a negative $0.9 million for the three
months ended September 30, 2002, from a positive $12.3 million for the three
months ended September 30, 2001. The decrease was primarily due to a $15.3
million increase in inter-segment eliminations included in this segment.
Income tax benefits increased $16.3 million to a $9.3 million income tax benefit
for the three months ended September 30, 2002, from $7.0 million of income tax
expense for the three months ended September 30, 2001. The increase was
partially a result of a decrease in pre-tax operating earnings. The increase was
also due to a change in tax adjustments as well as additional foreign taxes
recognized in 2001.
As a result of the foregoing factors, operating loss increased $3.0 million to
$5.6 million for the three months ended September 30, 2002, from $2.6 million
for the three months ended September 30, 2001.
Net realized/unrealized capital losses, as adjusted, increased $71.6 million to
$84.8 million for the three months ended September 30, 2002, from $13.2 million
for the three months ended September 30, 2001. The increase was primarily due to
the mark to market and other than temporary impairments of our investment in
company sponsored mutual funds and equity and fixed maturity securities.
51
As a result of the foregoing factors and the inclusion of non-recurring items,
net loss increased $83.5 million to $103.4 million for the three months ended
September 30, 2002, from $19.9 million for the three months ended September 30,
2001. For the three months ended September 30, 2002, net loss included the
negative effect of non-recurring items totaling $13.0 million, net of income
taxes, related to an increase in our loss contingency reserve established for
sales practices litigation. For the three months ended September 30, 2001, net
loss included the negative effect of non-recurring items totaling $4.1 million,
net of income taxes, related to expenses of our demutualization
NINE MONTHS ENDED SEPTEMBER 30, 2002 COMPARED TO NINE MONTHS ENDED SEPTEMBER 30,
2001
Total operating revenues decreased $73.2 million, or 98%, to $1.4 million for
the nine months ended September 30, 2002, from $74.6 million for the nine months
ended September 30, 2001. Net investment income decreased $31.9 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 $30.6 million
due to a decrease of average investment yields for the segment. The decrease in
total revenues was also partially due to a $13.6 million increase in
inter-segment eliminations included in this segment, which was offset by a
corresponding change in total expenses.
Total expenses increased $0.8 million, or 3%, to $27.0 million for the nine
months ended September 30, 2002, from $26.2 million for the nine months ended
September 30, 2001. Interest expense increased $11.1 million, primarily due to
interest related to federal income tax audit activities. In addition, $4.4
million increase related to costs associated with operating as a public company.
The increases were primarily offset by a $13.6 million increase in inter-segment
eliminations included in this segment.
Income tax benefits increased $33.2 million to a $14.3 million income tax
benefit for the nine months ended September 30, 2002, from $18.9 million of
income tax expense for the nine months ended September 30, 2001. The increase
was primarily a result of a decrease in pre-tax operating earnings. In addition,
the increase was due to additional foreign taxes recognized in 2001.
As a result of the foregoing factors, operating earnings decreased $40.8 million
to $11.3 million of operating loss for the nine months ended September 30, 2002,
from $29.5 million of operating earnings for the nine months ended September 30,
2001.
Net realized/unrealized capital gains, as adjusted, increased $88.5 million to
$33.8 million of net realized capital gains for the nine months ended September
30, 2002, from $54.7 million of net realized capital losses for the nine months
ended September 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
as a result of equity security sales. The increases were partially offset by the
mark to market and other than temporary impairments of our investment in company
sponsored mutual funds, equity securities, and fixed maturity securities.
As a result of the foregoing factors and the inclusion of non-recurring items,
net income increased $57.5 million to $7.5 million of net income for the nine
months ended September 30, 2002, from $50.0 million of net loss for the nine
months ended September 30, 2001. For the nine months ended September 30, 2002,
net income included the negative effect of non-recurring items totaling $15.0
million, net of income taxes, related to: (1) an increase in our loss
contingency reserve established for sales practices litigation ($13.0 million)
and (2) expenses related to our demutualization (2.0 million). For the nine
months ended September 30, 2001, net loss included the negative effect of
non-recurring items totaling $24.8 million, net of income taxes, related to: (1)
expenses associated with our demutualization ($18.9 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 $3,795.6 million and $2,871.2
million for the nine months ended September 30, 2002 and 2001, respectively. The
increase in cash provided by our operations between periods is primarily related
52
to an increase in mortgage banking servicing and production fees, an increase in
funds collected on behalf of investors, related to mortgage banking services, an
increase in bank deposits, and decrease in federal income tax payments.
Net cash used in investing activities was $3,570.4 million and $3,731.3 million
for the nine months ended September 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 used in financing activities was $154.9 million for the nine months
ended September 30, 2002, compared to net cash provided by financing activities
of $186.9 million for the nine months ended September 30, 2001. The increase in
cash used in financing activities is primarily due to the repurchase of our
common stock. Offsetting this use of cash was an increase in investment contract
deposits, net of withdrawals.
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.
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
September 30, 2002 were $605.2 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. On August 26, 2002 an ordinary dividend of up to $250.0 million
was declared, of which $215.2 million was paid to its parent.
COMMON STOCK ISSUED AND TREASURY STOCK ACQUIRED
During the nine months ended September 30, 2002, another source of liquidity was
the issuance of our common stock which resulted in $17.8 million of proceeds due
to common stock issued to employees participating in our Employee Stock Purchase
Plan and premium received from the sale of "put options".
During the nine months ended September 30, 2002, we repurchased 17.9 million
shares of our outstanding common stock on the open market at an aggregate cost
of $506.4 million relating to two authorized stock repurchase programs. We
purchased 15.9 million shares at an aggregate cost of $450.0 million completing
a stock repurchase program authorized on February 26, 2002. We purchased 2.0
million shares at an aggregate cost of $56.4 million under an additional stock
repurchase program authorized on August 29, 2002, for which our board of
directors approved repurchase of up to $300.0 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
We expect to receive approximately $870.0 million of proceeds from our sale of
substantially all of BT Financial Group to Westpac. This amount includes cash
proceeds, tax benefits, and a gain from unwinding the hedged asset associated
with debt used to acquire BT Financial Group in 1999. An additional future
contingent receipt of $80.0 million may by received in 2004, if Westpac
experiences growth in their retail assets under management.
53
Our Brazilian and Chilean operations, along with one of our Mexican companies,
produced positive cash flow from operations for the nine months ended September
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 nine
months ended September 30, 2002, primarily to fund our acquisition of Zurich
AFORE in Mexico and $29.7 million for the nine months ended September 30, 2001,
primarily to meet the cash outflow requirements of our international operations.
These other international 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 September 30, 2002, we had $1,303.7 million of long-term debt outstanding
compared to $1,378.4 million at December 31, 2001. Non-recourse medium-term
notes outstanding as of September 30, 2002, were $3,529.8 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. At September 30, 2002, payments required,
relating to these obligations are as follows:
YEARS ENDED DECEMBER 31,
----------------------------------------------------------------------
THREE MONTHS
ENDED
DECEMBER 31, 2007 AND
2002 2003 2004 2005 2006 THEREAFTER
- -----------------------------------------------------------------------------------------------------------------------
(IN MILLIONS)
Long-term debt............... $ 88.3 $ 28.5 $ 288.9 $ 2.4 $ 2.5 $ 893.1
Non-recourse medium-term
notes...................... 130.8 538.4 530.2 757.7 104.3 1,468.4
Operating leases:
Continuing
operations............... 17.6 46.2 32.7 17.0 10.5 23.0
Discontinued
operations............... 5.2 18.7 18.0 19.5 19.5 19.5
------------------------------------------------------------------------------------------
Total contractual
cash obligations......... $241.9 $ 631.8 $ 869.8 $ 796.6 $ 136.8 $ 2,404.0
==========================================================================================
As of September 30, 2002, we had $474.3 million of short-term debt outstanding
compared to $511.6 million at December 31, 2001. Short-term debt consists
primarily of commercial paper and outstanding balances on revolving credit
facilities with various financial institutions. As of September 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 September
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.
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 $30.6 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
54
billion at inception to $4.0 billion as of September 30, 2002. PRMCR held $3.3
billion in residential mortgage loans held for sale as of September 30, 2002.
At September 30, 2002, PRMCR had outstanding equity certificates of $193.0
million, secured liquidity notes of $1.5 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 September 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 $16.5
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 September 30, 2002, PRMF
held $366.3 million in residential mortgage loans and had outstanding
participation certificates of $345.4 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 September 30, 2002, our residual
interest in such cash flows was $29.6 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, $39.1 million at
September 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 foreign currency to U.S. dollar exchange rates.
This increase was partially offset by a decrease in net cash flows.
Our margin loan securitization program is included in the operations of BT
Financial Group, which are being sold to Westpac. Effective October 31, 2002, we
no longer have a margin loan securitization program.
INVESTMENTS
We had total consolidated assets as of September 30, 2002, of $88.3 billion, of
which $47.9 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, $46.6 billion were held by
our U.S. operations and the remaining $1.3 billion were held by our
International Asset Management and Accumulation segment.
U.S. INVESTMENT OPERATIONS
Our U.S. invested assets are managed by Principal Global Investors, 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;
55
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 September 30, 2002, there are eleven
members on the Investment Committee, one of whom is a member of our board
of directors. The remaining members are senior management members
representing various areas of our company.
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. We
assess option risk in all investments we make and, when we take that risk,
we price for it accordingly.
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 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
56
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 1.9 times as of September 30, 2002.
We have limited exposure to equity risk in our common stock portfolio.
Equity securities accounted for only 1% of our U.S. invested assets as of
September 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 September 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. The following discussion analyzes the composition of U.S.
invested assets, but excludes invested assets of the participating separate
accounts.
U.S. INVESTED ASSETS
AS OF SEPTEMBER 30, AS OF DECEMBER 31,
------------------- ---------------------
2002 2001
------------------- ---------------------
CARRYING % OF CARRYING % OF
AMOUNT TOTAL AMOUNT TOTAL
---------- ------- ---------- -------
($ IN MILLIONS)
Fixed maturity securities
Public......................................... $ 21,692.0 47% $ 18,227.6 42%
Private........................................ 10,491.7 22 10,800.2 25
Equity securities, available-for-sale............. 361.9 1 812.3 2
Mortgage loans
Commercial .................................... 9,568.9 20 9,740.4 22
Residential.................................... 1,492.6 3 1,144.2 3
Real estate held for sale ........................ 282.8 1 390.7 1
Real estate held for investment................... 879.1 2 783.4 2
Policy loans...................................... 822.9 2 831.9 2
Other investments ................................ 968.9 2 663.7 1
----------- ----- ----------- -----
Total invested assets.......................... $ 46,560.8 100% $ 43,394.4 100%
===== =====
Cash and cash equivalents......................... 564.5 495.8
----------- -----------
Total invested assets and cash ................ $ 47,125.3 $ 43,890.2
=========== ===========
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 reduce the risk of prepayment by
holding securities that trade close to par. 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/unrealized gains and losses, was 6.8% and 7.3% for
the three months ended September 30, 2002, and 2001, respectively, and 6.9%
and 7.5% for the nine months ended September 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 nine
months ended September 30, 2002 and 2001, respectively:
57
U.S. INVESTED ASSETS
YIELDS BY ASSET TYPE
AS OF OR FOR THE THREE MONTHS AS OF OR FOR THE NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
---------------------------------------- --------------------------------------
2002 2001 2002 2001
------------------- ------------------- ----------------- ------------------
YIELD AMOUNT YIELD AMOUNT YIELD AMOUNT YIELD AMOUNT
----- ----------- ----- ---------- ----- --------- ----- ----------
($ IN MILLIONS)
Fixed maturity securities
Gross investment income (1)............. 6.8% $ 534.8 7.5% $ 540.4 6.9% $ 1,577.0 7.6% $ 1,585.4
Net realized/unrealized capital losses.. (1.0) (77.7) (0.4) (27.0) (1.2) (273.4) (0.5) (104.5)
----------- ---------- --------- ----------
Total................................ $ 457.1 $ 513.4 $ 1,303.6 $ 1,480.9
=========== ========== ========= ==========
Ending assets (at carrying value)....... $32,183.7 $29,504.6 $32,183.7 $29,504.6
Equity securities, available-for-sale
Gross investment income (1)............. 2.8% $ 4.1 4.5% $ 7.2 4.7% $ 20.7 2.7% $ 14.1
Net realized/unrealized capital losses.. (10.5) (15.3) (2.5) (3.9) (6.7) (29.4) (11.8) (61.5)
----------- ---------- --------- ----------
Total................................ $ (11.2) $ 3.3 $ (8.7) $ (47.4)
=========== ========== ========== ==========
Ending assets (at carrying value)....... $ 361.9 $ 724.2 $ 361.9 $ 724.2
Mortgage loans - Commercial
Gross investment income (1)............. 7.5% $ 179.4 7.4% $ 189.3 7.5% $ 544.7 7.8% $ 611.4
Net realized/unrealized capital
gains (losses)........................ - (0.3) (0.2) (4.2) (0.1) (10.2) 0.1 10.7
----------- ---------- --------- ----------
Total................................ $ 179.1 $ 185.1 $ 534.5 $ 622.1
=========== ========== ========= ==========
Ending assets (at carrying value)....... $ 9,568.9 $10,255.9 $ 9,568.9 $10,255.9
Mortgage loans - Residential
Gross investment income (1)............. 5.4% $ 17.1 7.8% $ 19.7 5.4% $ 53.2 8.4% $ 48.4
Net realized/unrealized capital
gains (losses)........................ - - - - - - - -
----------- ---------- --------- ----------
Total................................ $ 17.1 $ 19.7 $ 53.2 $ 48.4
=========== ========== ========= ==========
Ending assets (at carrying value)....... $ 1,492.6 $ 988.0 $ 1,492.6 $ 988.0
Real estate
Gross investment income (1)............. 7.8% $ 22.8 8.8% $ 26.0 8.3% $ 72.9 13.3% $ 126.0
Net realized/unrealized capital
gains (losses)........................ (0.3) (0.9) (0.4) (1.1) 2.0 17.2 (0.2) (1.4)
----------- ---------- --------- ----------
Total................................ $ 21.9 $ 24.9 $ 90.1 $ 124.6
=========== ========== ========= ==========
Ending assets (at carrying value)....... $ 1,161.9 $ 1,140.1 $ 1,161.9 $ 1,140.1
Policy loans
Gross investment income (1)............. 7.1% $ 14.6 6.4% $ 13.2 7.0% $ 43.5 7.0% $ 42.6
Net realized/unrealized capital
gains (losses)........................ - - - - - - - -
----------- ---------- --------- ----------
Total................................ $ 14.6 $ 13.2 $ 43.5 $ 42.6
=========== ========== ========= ==========
Ending assets (at carrying value)....... $ 822.9 $ 826.0 $ 822.9 $ 826.0
Cash and cash equivalents
Gross investment income (1)............. 2.3% $ 4.8 9.8% $ 3.5 3.0% $ 11.8 6.6% $ 19.9
Net realized/unrealized capital
gains (losses)........................ - 0.1 - - (0.2) (0.9) - -
----------- ---------- --------- ----------
Total................................ $ 4.9 $ 3.5 $ 10.9 $ 19.9
=========== ========== ========= ==========
Ending assets (at carrying value)....... $ 564.5 $ 47.9 $ 564.5 $ 47.9
Other investments
Gross investment income (1)............. 19.7% $ 40.4 13.8% $ 27.5 18.6% $ 113.7 10.3% $ 57.8
Net realized/unrealized capital
gains (losses)........................ (66.9) (137.0) (19.4) (38.7) 5.8 35.6 (10.1) (56.4)
----------- ---------- --------- ----------
Total................................ $ (96.6) $ (11.2) $ 149.3 $ 1.4
=========== ========== ========= ==========
Ending assets (at carrying value)....... $ 968.9 $ 827.5 $ 968.9 $ 827.5
Total before investment expenses
Gross investment income................. 7.0% $ 818.0 7.5% $ 826.8 7.1% $ 2,437.5 7.8% $ 2,505.6
Net realized/unrealized capital losses.. (2.0) (231.1) (0.7) (74.9) (0.8) (261.1) (0.7) (213.1)
----------- ---------- --------- ----------
Total................................ $ 586.9 $ 751.9 $ 2,176.4 $ 2,292.5
=========== ========== ========= ==========
Investment expenses....................... 0.2% $ 27.1 0.2% $ 28.2 0.2% $ 70.3 0.3% $ 81.2
Net investment income..................... 6.8% $ 790.9 7.3% $ 798.6 6.9% $ 2,367.2 7.5% $ 2,424.4
- --------------------
(1) Yields, which are annualized for interim periods, are based on quarterly
average asset carrying values for the three months and nine months ended
September 30, 2002 and 2001.
58
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 redeemable
preferred stock, and represented 69% of total U.S. invested assets as of
September 30, 2002 and 67% as of December 31, 2001. The fixed maturity
securities portfolio was comprised, based on carrying amount, of 67% in
publicly traded fixed maturity securities and 33% in privately placed fixed
maturity securities as of September 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 September 30, 2002, were $3.8 billion of securities eligible
for resale to qualified institutional buyers under Rule 144A under the
Securities Act of 1933. Fixed maturity securities were diversified by
category of issuer as of September 30, 2002, and December 31, 2001, as
shown in the following table:
U.S. INVESTED ASSETS
FIXED MATURITY SECURITIES BY TYPE OF ISSUER
AS OF SEPTEMBER 30, AS OF DECEMBER 31,
--------------------- ---------------------
2002 2001
--------------------- ---------------------
CARRYING % OF CARRYING % OF
AMOUNT TOTAL AMOUNT TOTAL
------------ ------- ---------- --------
($ IN MILLIONS)
U.S. Treasury securities and obligations of U.S.
Government corporations and agencies............ $ 494.8 1% $ 15.1 -%
States and political subdivisions.................. 369.5 1 317.5 1
Foreign governments................................ 384.2 1 603.5 2
Corporate - public................................. 16,073.1 50 13,038.8 45
Corporate - private................................ 8,860.4 28 9,171.1 32
Mortgage-backed securities and other asset-
backed securities............................... 6,001.7 19 5,881.8 20
------------ ------- ---------- -------
Total fixed maturities.......................... $32,183.7 100% $29,027.8 100%
============ ======= ========== =======
The international exposure in our U.S. invested assets totaled $4,090.3
million, or 13%, of total fixed maturity securities, as of September 30,
2002, comprised of corporate and foreign government fixed maturity
securities. Of the $4,090.3 million as of September 30, 2002, investments
totaled $1,138.6 million in the United Kingdom, $731.8 million in the
continental European Union, $560.2 million in Asia, $369.7 million in
Australia, $307.0 million in South America and $21.5 million in Japan. The
remaining $961.5 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 September
30, 2002, our investments in Canada totaled $1,258.4 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
59
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 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
September 30, 2002, and December 31, 2001, as well as the percentage, based
on estimated fair value, that each designation comprises:
60
U.S. INVESTED ASSETS
PUBLICLY TRADED FIXED MATURITY SECURITIES BY CREDIT QUALITY
AS OF SEPTEMBER 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............. $ 10,904.5 $ 11,732.7 54% $ 9,955.3 $ 10,406.5 57%
2 Baa.................. 8,729.3 9,019.6 42 6,939.5 7,112.8 39
3 Ba................... 663.2 612.6 3 496.3 474.5 3
4 B.................... 269.3 203.3 1 165.3 148.4 1
5 Caa and lower........ 123.9 82.5 - 28.4 26.5 -
6 In or near default... 80.2 41.3 - 60.6 58.9 -
----------- ------------ ----- ----------- ------------- -----
Total public
fixed maturities..... $20,770.4 $ 21,692.0 100% $17,645.4 $ 18,227.6 100%
=========== ============ ===== =========== ============= =====
U.S. INVESTED ASSETS
PRIVATELY PLACED FIXED MATURITY SECURITIES BY CREDIT QUALITY
AS OF SEPTEMBER 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............. $ 4,072.4 $ 4,380.5 42% $ 4,184.6 $ 4,349.7 40%
2 Baa.................. 4,389.6 4,610.0 44 4,780.5 4,921.8 46
3 Ba................... 1,055.5 1,055.6 10 1,105.7 1,085.9 10
4 B.................... 207.2 182.3 2 236.4 223.7 2
5 Caa and lower........ 84.9 74.6 - 64.0 64.3 1
6 In or near default... 192.4 188.7 2 180.3 154.8 1
----------- ------------ ----- ----------- ------------- -----
Total private
fixed maturities... $ 10,002.0 $ 10,491.7 100% $10,551.5 $ 10,800.2 100%
=========== ============ ===== =========== ============= =====
61
U.S. INVESTED ASSETS
TOTAL FIXED MATURITY SECURITIES BY CREDIT QUALITY
AS OF SEPTEMBER 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............. $ 14,976.9 $ 16,113.2 50% $14,139.9 $ 14,756.2 51%
2 Baa.................. 13,118.9 13,629.6 42 11,720.0 12,034.6 42
3 Ba................... 1,718.7 1,668.2 5 1,602.0 1,560.4 5
4 B.................... 476.5 385.6 1 401.7 372.1 1
5 Caa and lower........ 208.8 157.1 1 92.4 90.8 -
6 In or near default... 272.6 230.0 1 240.9 213.7 1
----------- ------------ ----- ----------- ------------- -----
Total fixed
maturities....... $ 30,772.4 $ 32,183.7 100% $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. Our current policy is to
limit the percentage of cash flow invested in below investment grade assets
to 7% of cash flow. As of September 30, 2002, we had invested 5% of new
cash flow for the year 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
September 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 92%.
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
September 30, 2002, and December 31, 2001. The tables also show by industry
category the relative amounts of publicly traded and privately placed
securities.
62
U.S. INVESTED ASSETS
CORPORATE FIXED MATURITY SECURITIES PORTFOLIO BY INDUSTRY
AS OF SEPTEMBER 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..... $ 5,202.0 33% $ 1,990.3 22% $ 7,192.3 29%
Finance, Insurance and Real Estate...... 4,391.9 27 2,004.3 23 6,396.2 26
Manufacturing........................... 3,780.7 24 2,397.0 27 6,177.7 25
Mining.................................. 1,334.4 8 984.8 11 2,319.2 9
Retail.................................. 660.7 4 706.7 8 1,367.4 5
Services................................ 528.0 3 501.0 6 1,029.0 4
Public Administration................... 61.2 - 154.1 2 215.3 1
Agriculture, Forestry and Fishing....... 94.7 1 49.6 - 144.3 1
Construction............................ 19.5 - 72.6 1 92.1 -
----------- ---- ----------- ---- ---------- -----
Total............................... $ 16,073.1 100% $ 8,860.4 100% $ 24,933.5 100%
=========== ==== =========== ==== ========== =====
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 September 30, 2002, our largest unaffiliated single concentration of
fixed maturity securities consisted of $379.6 million of corporate bonds by
American International Group and its affiliates. This represented
approximately 1% of our total U.S. invested assets as of September 30,
2002. No other individual non-government issuer represented more than 1% of
U.S. invested assets.
We held $6,001.7 million of mortgage-backed and asset-backed securities as
of September 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:
63
U.S. INVESTED ASSETS
MORTGAGE AND ASSET-BACKED SECURITIES
CARRYING AMOUNT
AS OF SEPTEMBER 30, AS OF DECEMBER 31,
------------------- ------------------
2002 2001
------------------- ------------------
(IN MILLIONS)
Residential pass-through securities............ $ 2,593.4 $ 2,855.5
Commercial MBS................................. 2,348.9 1,874.1
Asset-backed securities........................ 1,059.4 1,152.2
------------------- ------------------
Total MBSs and asset-backed securities...... $ 6,001.7 $ 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 reduce the
risk of prepayment by holding securities that are trading close to par. As
of September 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 SEPTEMBER 30, AS OF DECEMBER 31,
------------------- ------------------
2002 2001
------------------- ------------------
(IN MILLIONS)
Automobile receivables......................... $ 33.6 $ 49.7
Collateralized debt obligations................ 397.7 468.6
Consumer loans................................. 106.5 126.5
Credit cards................................... 185.2 131.2
Lease receivables.............................. 43.2 101.5
Other.......................................... 293.2 274.7
------------------- ------------------
Total asset-backed securities............... $ 1,059.4 $ 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 years or less. Therefore, comparable amounts of assets
64
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 September 30, 2002, and December 31, 2001,
were as follows:
U.S. INVESTED ASSETS
FIXED MATURITY SECURITIES BY CONTRACTUAL MATURITY DATES
AS OF SEPTEMBER 30, AS OF DECEMBER 31,
------------------------- ----------------------
2002 2001
------------------------- ----------------------
AMORTIZED CARRYING AMORTIZED CARRYING
COST AMOUNT COST AMOUNT
----------- ----------- ---------- ---------
(IN MILLIONS)
Due in one year or less........................... $ 1,698.0 $ 1,711.6 $ 1,358.2 $ 1,367.3
Due after one year through five years............. 10,110.7 10,546.0 10,484.3 10,815.0
Due after five years through ten years............ 6,890.6 7,241.9 5,535.6 5,722.0
Due after ten years............................... 6,515.8 6,682.5 5,159.3 5,241.7
----------- ----------- ---------- ---------
Subtotal....................................... 25,215.1 26,182.0 22,537.4 23,146.0
Mortgage-backed and other securities without a
single maturity date........................... 5,557.3 6,001.7 5,659.5 5,881.8
----------- ----------- --------- ---------
Total........................................ $ 30,772.4 $ 32,183.7 $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 $6.8 million
as of September 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 $47.2 million as of September 30, 2002.
The following table presents the total carrying amount of our fixed
maturity portfolio, as well as its problem, potential problem and
restructured fixed maturities for the periods indicated:
65
U.S. INVESTED ASSETS
PROBLEM, POTENTIAL PROBLEM AND RESTRUCTURED FIXED MATURITIES AT CARRYING AMOUNT
AS OF SEPTEMBER 30, AS OF DECEMBER 31,
------------------- ------------------
2002 2001
------------------- ------------------
($ IN MILLIONS)
Total fixed maturity securities (public and private)......... $ 32,183.7 $ 29,027.8
============ ===========
Problem fixed maturity securities............................ $ 226.3 $ 198.8
Potential problem fixed maturity securities.................. 493.1 365.1
Restructured fixed maturity securities....................... 111.9 110.8
------------ -----------
Total problem, potential problem and restructured fixed
maturity securities..................................... $ 831.3 $ 674.7
============ ===========
Total problem, potential problem and restructured fixed
maturity securities as a percent of total fixed
maturity securities..................................... 3% 2%
EQUITY SECURITIES
Our equity securities consist of non-redeemable preferred securities,
mutual funds and other investments in common stocks. We classify our
investment in equity securities as available for sale and report them at
fair value. We report unrealized gains and losses on equity securities 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 $361.9 million and $812.3
million, which represented 1% and 2% of U.S. invested assets as of
September 30, 2002, and December 31, 2001, respectively. Our investment in
company-sponsored funds was reclassified from equity securities to other
invested assets as of September 30, 2002.
MORTGAGE LOANS
Mortgage loans comprised 23% and 25% of total U.S. invested assets as of
September 30, 2002, and December 31, 2001, respectively. Mortgage loans
consist of commercial and residential loans. Commercial mortgage loans
comprised $9,568.9 million as of September 30, 2002, and $9,740.4 million
as of December 31, 2001, or 87% and 89%, of total mortgage loan
investments, respectively. Residential mortgages comprised $1,492.6 million
and $1,144.2 million, or 13% and 11%, of total mortgage loan investments as
of September 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.
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.
66
California accounted for 22% of our commercial mortgage loan portfolio as
of September 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 September 30, 2002, and December 31, 2001:
U.S. INVESTED ASSETS
COMMERCIAL MORTGAGE LOAN DISTRIBUTION BY TYPE
AS OF SEPTEMBER 30, AS OF DECEMBER 31,
----------------------- -----------------------
2002 2001
----------------------- -----------------------
CARRYING % OF CARRYING % OF
AMOUNT TOTAL AMOUNT TOTAL
--------- --------- ---------- ---------
($ IN MILLIONS)
Office........................ $ 3,317.7 35% $ 3,252.5 33%
Industrial.................... 2,958.2 31 2,948.9 30
Retail........................ 2,787.1 29 3,106.5 32
Apartments.................... 438.6 4 349.8 4
Mixed use/other............... 99.5 1 111.8 1
Hotel......................... 59.5 1 61.6 1
Valuation allowance........... (91.7) (1) (90.7) (1)
---------- ---- ---------- ----
Total...................... $ 9,568.9 100% $ 9,740.4 100%
========== ==== ========== ====
67
U.S. INVESTED ASSETS
COMMERCIAL MORTGAGE LOAN DISTRIBUTION BY REGION
AS OF SEPTEMBER 30, AS OF DECEMBER 31,
----------------------- -----------------------
2002 2001
----------------------- -----------------------
CARRYING % OF CARRYING % OF
AMOUNT TOTAL AMOUNT TOTAL
--------- --------- ---------- ---------
($ IN MILLIONS)
Pacific....................... $ 2,453.6 26% $ 2,421.3 25%
South Atlantic................ 2,200.5 23 2,403.0 25
Middle Atlantic............... 1,668.7 17 1,606.3 16
East North Central............ 931.7 10 930.1 10
Mountain...................... 694.7 7 637.7 7
West South Central............ 648.8 7 769.0 8
New England................... 382.4 4 327.4 3
East South Central............ 348.5 4 338.5 3
West North Central............ 331.7 3 397.8 4
Valuation allowance........... (91.7) (1) (90.7) (1)
---------- ---- ---------- ----
Total...................... $ 9,568.9 100% $ 9,740.4 100%
========== ==== ========== ====
Our commercial loan portfolio is highly diversified by borrower. As of
September 30, 2002, 44% of the U.S. commercial mortgage loan portfolio was
comprised of mortgage loans with principal balances of less than $10.0
million. The following table shows our U.S. commercial mortgage loan
portfolio by loan size, for the periods indicated:
U.S. INVESTED ASSETS
COMMERCIAL MORTGAGE LOAN PORTFOLIO - BY LOAN SIZE
AS OF SEPTEMBER 30, 2002 AS OF DECEMBER 31, 2001
-------------------------------- ------------------------------
NUMBER PRINCIPAL % OF NUMBER PRINCIPAL % OF
OF LOANS BALANCE TOTAL OF LOANS BALANCE TOTAL
--------- ---------- ----- --------- ---------- -----
($ IN MILLIONS)
Under $5 million........................ 1,034 $ 2,259.3 24% 1,102 $ 2,306.7 23%
$5 million but less than $10 million.... 274 1,932.6 20 275 1,925.5 20
$10 million but less than $20 million... 162 2,169.9 23 168 2,267.2 23
$20 million but less than $30 million... 57 1,387.6 14 59 1,410.6 14
$30 million and over.................... 40 1,849.2 19 42 1,925.0 20
--------- ---------- ---- --------- ---------- ----
Total............................. 1,567 $ 9,598.6 100% 1,646 $ 9,835.0 100%
========= ========== ==== ========= ========== ====
The total number of commercial mortgage loans outstanding as of September
30, 2002 and December 31, 2001 was 1,567 and 1,646, respectively. The
average loan size of our commercial mortgage portfolio was $6.1 million as
of September 30, 2002. The largest loan on any single property at such
dates aggregated $100.0 million for September 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 for both September 30, 2002, and
December 31, 2001, and 1% of total U.S. invested assets as of September 30,
2002 and 2% as of December 31, 2001. As of such dates, all such loans were
performing.
The following table presents the disposition of maturities as of September
30, 2002, and December 31, 2001:
68
U.S. INVESTED ASSETS
DISPOSITIONS OF SCHEDULED MATURITIES OF COMMERCIAL MORTGAGE LOANS
AMORTIZED COST
AS OF SEPTEMBER 30, AS OF DECEMBER 31,
------------------- ---------------------
2002 2001
------------------- ---------------------
(IN MILLIONS)
Paid as scheduled.......... $ 371.2 $ 434.7
Extended................... 151.6 138.1
Refinanced................. 45.5 75.7
Foreclosed................. - 5.4
Expired maturities......... - 10.6
------------------- ---------------------
Total................... $ 568.3 $ 664.5
=================== =====================
The amortized cost of commercial mortgage loans by contractual maturity
dates, excluding scheduled sinking funds as of September 30, 2002, and
December 31, 2001, are as follows:
U.S. INVESTED ASSETS
COMMERCIAL MORTGAGE LOAN PORTFOLIO MATURITY PROFILE
AS OF SEPTEMBER 30, AS OF DECEMBER 31,
--------------------------- --------------------------
2002 2001
--------------------------- --------------------------
AMORTIZED % OF AMORTIZED % OF
COST TOTAL COST TOTAL
------------- -------- ------------ -------
($ IN MILLIONS)
Due in one year or less................... $ 753.4 8% $ 732.6 8%
Due after one year through five years..... 3,051.3 31 3,180.8 32
Due after five years through ten years.... 2,981.5 31 2,890.8 29
Due after ten years....................... 2,874.4 30 3,026.9 31
------------- -------- ------------ -------
Total.................................. $ 9,660.6 100% $ 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 $1.0 million for the nine
months ended September 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
69
process 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 SEPTEMBER 30, AS OF DECEMBER 31,
-------------------- --------------------
2002 2001
-------------------- --------------------
($ IN MILLIONS)
Beginning balance............................. $ 90.7 $ 108.0
Provision..................................... 32.3 12.0
Release due to write downs, sales
and foreclosures............................ (31.3) (29.3)
------------------- --------------------
Ending balance................................ $ 91.7 $ 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 SEPTEMBER 30, AS OF DECEMBER 31,
-------------------- --------------------
2002 2001
-------------------- --------------------
($ IN MILLIONS)
Total commercial mortgages ................... $9,568.9 $ 9,740.4
==================== ====================
Problem commercial mortgages(1)............... $ 77.5 $ 47.1
Potential problem commercial mortgages ....... 38.9 98.9
Restructured commercial mortgages ............ 47.0 42.4
-------------------- --------------------
Total problem, potential problem and
restructured commercial mortgages........ $ 163.4 $ 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 of $0.4
million as of September 30, 2002. There were no mortgage loans in
foreclosure as of December 31, 2001.
70
EQUITY REAL ESTATE
We hold commercial equity real estate as part of our investment portfolio.
As of September 30, 2002, and December 31, 2001, the carrying amount of
equity real estate investment was $1,161.9 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 $879.1 million as of September 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 September 30, 2002 and
December 31, 2001, there were no such impairment adjustments.
The carrying amount of real estate held for sale as of September 30, 2002,
and December 31, 2001, was $282.8 million and $390.7 million, net of
valuation allowances of $17.5 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 September 30, 2002. By property
type, there is a concentration in office buildings that represented
approximately 30% of the equity real estate portfolio as of September 30,
2002. Our largest equity real estate holding as of September 30, 2002
consisted of an office/industrial park located in Durham, North Carolina
with an aggregate carrying value of approximately $150.6 million and
represented approximately 13% of total U.S. equity real estate assets and
0.3% of U.S. invested assets. The ten largest real estate properties as of
September 30, 2002 comprised 46% of total U.S. equity real estate assets
and 1% of total U.S. invested assets. In addition, our equity real estate
includes our investment in BT Hotels. As of December 31, 2001, BT Hotels
was fully consolidated into our financial statements and is reflected in
the International region and Hotel/Motel property type in the following
investment schedules:
71
U.S. INVESTED ASSETS
EQUITY REAL ESTATE BY REGION(1)
AS OF SEPTEMBER 30, AS OF DECEMBER 31,
------------------------- ------------------------
2002 2001
------------------------- ------------------------
CARRYING % OF CARRYING % OF
AMOUNT TOTAL AMOUNT TOTAL
--------- -------- ---------- -------
($ IN MILLIONS)
South Atlantic...... $ 395.4 34% $ 376.4 32%
International....... 239.7 21 223.6 19
West South Central.. 231.3 20 236.4 20
Pacific............. 164.5 14 183.8 16
East North Central.. 64.3 5 62.3 5
East South Central.. 21.6 2 32.3 3
New England......... 17.6 2 14.3 1
Mountain............ 14.3 1 8.8 1
West North Central.. 10.0 1 28.0 2
Middle Atlantic..... 3.2 - 8.2 1
--------- -------- ---------- -------
Total............ $1,161.9 100% $1,174.1 100%
========= ======== ========== =======
- ------------
(1) Regions are defined by the American Council of Life Insurers.
U.S. INVESTED ASSETS
EQUITY REAL ESTATE BY PROPERTY TYPE
AS OF SEPTEMBER 30, AS OF DECEMBER 31,
------------------------- ------------------------
2002 2001
------------------------- ------------------------
CARRYING % OF CARRYING % OF
AMOUNT TOTAL AMOUNT TOTAL
--------- -------- ---------- -------
($ IN MILLIONS)
Office.............. $ 352.0 30% $ 422.9 36%
Hotel/Motel......... 239.8 21 223.6 19
Industrial.......... 235.7 20 221.6 19
Apartments.......... 126.5 11 50.7 4
Retail.............. 92.2 8 138.9 12
Service Center...... 63.1 5 63.1 5
Land................ 52.6 5 53.3 5
--------- -------- ---------- -------
Total............ $1,161.9 100% $1,174.1 100%
========= ======== ========== =======
DERIVATIVES
Interest rate risk is the risk that we will incur economic losses due to
adverse changes in interest rates. 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.
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
72
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 September 30, 2002,
was $3,022.3 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
September 30, 2002, the fair value of our foreign currency denominated
fixed maturity securities was $303.1 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 September 30, 2002, was $291.2 million.
We entered into a total return swap as part of a structuring process of an
investment grade collateralized debt obligation ("CDO") issuance. We no
longer plan to issue the CDO. The outstanding notional amount of the total
return swap as of September 30, 2002 was $144.2 million and the mark to
market value of this swap was $(27.9) million pre-tax.
We have increased our credit exposure through credit default swaps by
investing in subordinated tranches of a synthetic collateralized debt
obligation. The outstanding notional amount as of September 30, 2002 was
$500 million and the mark-to market value was $(1.6) million pre-tax. We
also invested in a credit swap creating a replicated asset with a notional
of $10 million and mark to market value of $(0.1) million as of September
30, 2002.
In conjunction with our use of derivatives, we are exposed to counter party
risk, or the risk that counterparty fails to perform the terms of the
derivative contract. We actively manage this risk by:
o establishing exposure limits which take into account non-derivative
exposure we have with the counterparty as well as derivative exposure;
o performing similar credit analysis prior to approval on each derivatives
counterparty that we do when lending money on a long-term basis;
o limiting exposure to A+ credit or better;
o conducting stress-test analysis to determine the maximum exposure created
during the life of a prospective transaction; and
o daily monitoring of counterparty credit ratings.
All new derivative counterparties are approved by the investment committee.
We believe the risk of incurring losses due to nonperformance by our
counterparties is manageable.
The notional amounts used to express the extent of our involvement in swap
transactions represent a standard measurement of the volume of our swap
business. Notional amount is not a quantification of market risk or credit
risk and it may not necessarily be recorded on the balance sheet. Notional
amounts represent those amounts used to calculate contractual flows to be
exchanged and are not paid or received, except for contracts such as
currency swaps. Actual credit exposure represents the amount owed to us
under derivative contracts as of the valuation date. The following tables
present our position in, and credit exposure to, derivative financial
instruments as of September 30, 2002, and December 31, 2001:
73
U.S. INVESTED ASSETS
DERIVATIVE FINANCIAL INSTRUMENTS - NOTIONAL AMOUNTS
AS OF SEPTEMBER 30, AS OF DECEMBER 31,
--------------------- ---------------------
2002 2001
--------------------- ---------------------
NOTIONAL % OF NOTIONAL % OF
AMOUNT TOTAL AMOUNT TOTAL
------------ ------- ----------- -------
($ IN MILLIONS)
Mortgage-backed forwards and options..... $ 18,680.5 35% $ 9,250.7 34%
Interest rate lock commitments........... 9,129.2 17 2,565.9 9
Swaptions ............................... 8,487.5 16 3,570.0 13
Interest rate swaps...................... 5,769.9 11 3,272.5 12
Foreign currency swaps................... 3,978.5 8 4,091.9 15
U.S. Treasury futures (LIBOR)............ 3,050.0 6 - -
Interest rate floors..................... 1,650.0 3 3,400.0 13
U.S. Treasury futures.................... 545.7 1 186.6 1
Credit default swaps .................... 510.0 1 - -
Currency forwards........................ 380.0 1 380.0 1
Bond forwards............................ 353.7 1 357.4 1
Total return swaps....................... 244.2 - 25.0 -
Principal Only swaps..................... 134.9 - 250.0 1
Treasury rate guarantees................. 113.0 - 88.0 -
Call options............................. 30.0 - 30.0 -
------------ ------- ----------- -------
Total................................. $ 53,057.1 100% $27,468.0 100%
============ ======= =========== =======
U.S. INVESTED ASSETS
DERIVATIVE FINANCIAL INSTRUMENTS - CREDIT EXPOSURES
AS OF SEPTEMBER 30, AS OF DECEMBER 31,
2002 2001
---------------------- -----------------------
CREDIT % OF CREDIT % OF
EXPOSURE TOTAL EXPOSURE TOTAL
------------ -------- ------------ -------
($ IN MILLIONS)
Foreign currency swaps................... $ 215.9 45% $ 101.1 33%
Interest rate swaps...................... 170.6 35 78.4 25
Currency forwards........................ 69.8 15 55.3 18
Swaptions ............................... 21.0 4 8.7 3
Total return swaps....................... 2.8 1 0.1 -
Interest rate floors..................... 1.4 - 13.2 4
Call options............................. 0.3 - 8.9 3
Mortgage-backed forwards and options..... - - 41.7 14
------------ -------- ----------- ------
Total................................. $ 481.8 100% $ 307.4 100%
============ ======== =========== ======
OTHER INVESTMENTS
Our other investments totaled $968.9 million as of September 30, 2002,
compared to $663.7 million as of December 31, 2001. Our investment in
company-sponsored funds was reclassified from equity securities to other
invested assets as of September 30, 2002. With the adoption of SFAS 133 on
January 1, 2001, derivatives were reflected on our balance sheet and
accounted for $258.8 million in other investments as of September 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.
74
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 September 30, 2002 and December
31, 2001, had fair values of $1,084.3 million and $0.5 million,
respectively.
INTERNATIONAL INVESTMENT OPERATIONS
As of September 30, 2002, our international investment operations consist
of the investments of Principal International comprised of $1.3 billion in
invested assets. Invested assets related to BT Financial Group have been
reclassified to asset of discontinued operations on our consolidated
statements of financial position. Principal Global Investors works with
each Principal International affiliate to develop investment policies and
strategies that are consistent with the products they offer. Due to the
regulatory constraints in each country, each company maintains its own
investment policies, which are approved by Principal Global Investors. Each
international affiliate is required to submit a compliance report relative
to its strategy to Principal Global Investors. Principal Global Investors
employees and international affiliate company credit analysts jointly
review each corporate credit annually.
OVERALL COMPOSITION OF INTERNATIONAL INVESTED ASSETS
As shown in the following table, the major categories of international
invested assets as of September 30, 2002, and December 31, 2001, were fixed
maturity securities and residential mortgage loans:
INTERNATIONAL INVESTED ASSETS
AS OF SEPTEMBER 30, AS OF DECEMBER 31,
---------------------- ---------------------
2002 2001
---------------------- ---------------------
CARRYING % OF CARRYING % OF
AMOUNT TOTAL AMOUNT TOTAL
----------- -------- ----------- ---------
($ IN MILLIONS)
Fixed maturity securities
Public......................................... $ 899.6 66% $ 941.3 68%
Private........................................ 66.6 5 61.0 4
Equity securities, available-for-sale............. 17.6 1 24.9 2
Mortgage loans
Residential.................................... 222.1 16 181.1 13
Real estate held for investment................... 7.0 1 7.7 1
Other investments ................................ 142.5 11 168.6 12
----------- ----- ----------- -----
Total invested assets.......................... $ 1,355.4 100% $ 1,384.6 100%
===== =====
Cash and cash equivalents......................... 67.0 65.4
----------- -----------
Total invested assets and cash ................ $ 1,422.4 $ 1,450.0
=========== ===========
INTERNATIONAL INVESTMENT RESULTS
The yield on international invested assets and on cash and cash
equivalents, excluding net realized gains and losses, was 8.3% and 8.5% for
the three months ended September 30, 2002, and 2001, respectively, and 8.2%
and 7.9% for the nine months ended September 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 nine
months ended September 30, 2002 and 2001, respectively:
75
INTERNATIONAL INVESTED ASSETS
YIELDS BY ASSET TYPE
AS OF OR FOR THE THREE MONTHS AS OF OR FOR THE NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
----------------------------------------- ---------------------------------------
2002 2001 2002 2001
------------------ ------------------ ------------------ ---------------
YIELD AMOUNT YIELD AMOUNT YIELD AMOUNT YIELD AMOUNT
----- -------- ----- -------- ----- -------- ----- -------
($ IN MILLIONS)
Fixed maturity securities
Gross investment income (1)............ 9.6% $ 23.7 10.1% $ 21.8 9.0% $ 66.1 9.2% $ 64.2
Net realized/unrealized capital
gains (losses)....................... 10.8 26.6 (1.1) (2.3) 4.5 33.4 (0.5) (3.4)
-------- -------- -------- --------
Total.............................. $ 50.3 $ 19.5 $ 99.5 $ 60.8
======== ======== ======== ========
Ending assets (at carrying value)...... $ 966.2 $ 897.5 $ 966.2 $ 897.5
Equity securities, available-for-sale
Gross investment income (1)............ -% $ - 1.9% $ 0.2 0.6% $ 0.1 0.4% $ 0.2
Net realized/unrealized capital gains.. (2.2) (0.1) 1.9 0.2 6.9 1.1 2.0 0.9
-------- -------- -------- --------
Total.............................. $ (0.1) $ 0.4 $ 1.2 $ 1.1
======== ======== ======== ========
Ending assets (at carrying value)...... $ 17.6 $ 43.8 $ 17.6 $ 43.8
Mortgage loans - Residential
Gross investment income (1)............ 10.4% $ 5.9 8.7% $ 3.7 10.0% $ 15.1 10.3% $ 12.9
Net realized/unrealized capital
gains (losses)....................... - - - - - - - -
-------- -------- -------- --------
Total.............................. $ 5.9 $ 3.7 $ 15.1 $ 12.9
======== ======== ======== ========
Ending assets (at carrying value)...... $ 222.1 $ 165.9 $ 222.1 $ 165.9
Real estate
Gross investment income (1)............ 5.5% $ 0.1 5.2% $ 0.1 7.3% $ 0.4 8.3% $ 0.5
Net realized/unrealized capital gains.. (5.5) (0.1) - - - - - -
-------- -------- -------- --------
Total.............................. $ - $ 0.1 $ 0.4 $ 0.5
======== ======== ======== ========
Ending assets (at carrying value....... $ 7.0 $ 7.3 $ 7.0 $ 7.3
Cash and cash equivalents
Gross investment income (1)............ 0.6% $ 0.1 1.2% $ 0.2 0.4% $ 0.2 1.0% $ 0.4
Net realized/unrealized capital
gains (losses)....................... - - - - - - - -
-------- -------- -------- --------
Total.............................. $ 0.1 $ 0.2 $ 0.2 $ 0.4
======== ======== ======== ========
Ending assets (at carrying value....... $ 67.0 $ 70.0 $ 67.0 $ 70.0
Other investments
Gross investment income (1)............ 2.0% $ 0.8 5.2% $ 2.0 6.1% $ 7.1 3.6% $ 4.4
Net realized/unrealized capital
gains (losses).......................(65.3) (25.9) (8.1) (3.1) 2.2 2.6 (34.0) (41.4)
-------- -------- -------- --------
Total.............................. $ (25.1) $ (1.1) $ 9.7 $ (37.0)
======== ======== ======== ========
Ending assets (at carrying value)..... $ 142.5 $ 156.6 $ 142.5 $ 156.6
Total before investment expenses
Gross investment income............... 8.4% $ 30.6 8.6% $ 28.0 8.3% $ 89.0 8.0% $ 82.6
Net realized/unrealized capital
gains (losses)...................... 0.1 0.5 (1.6) (5.2) 3.4 37.1 (4.2) (43.9)
-------- -------- -------- --------
Total.............................. $ 31.1 $ 22.8 $ 126.1 $ 38.7
======== ======== ======== ========
Investment expenses...................... 0.1% $ 0.3 0.1% $ 0.2 0.1% $ 0.7 0.1% $ 0.9
Net investment income.................... 8.3% $ 30.3 8.5% $ 27.8 8.2% $ 88.3 7.9% $ 81.7
- --------------------
(1) Yields, which are annualized for interim periods, are based on quarterly
average asset carrying values for the three months and nine months ended
September 30, 2002 and 2001.
FIXED MATURITY SECURITIES
Fixed maturity securities consist primarily of publicly traded debt
securities and represented 71% of total international invested assets as of
September 30, 2002, and 72% as of December 31, 2001. Fixed maturity
securities were diversified by type of issuer as of September 30, 2002, and
for the year ended December 31, 2001, as shown in the following table:
76
INTERNATIONAL INVESTED ASSETS
FIXED MATURITY SECURITIES BY TYPE OF ISSUER
AS OF SEPTEMBER 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.............. $ 6.7 1% $ 0.3 -%
Foreign governments.................................. 224.9 23 322.8 32
Corporate - public................................... 402.8 42 363.6 37
Corporate - private.................................. 66.6 7 61.0 6
Mortgage-backed securities and other asset-
backed securities................................. 265.2 27 254.6 25
----------- ----- ----------- -----
Total fixed maturities............................ $ 966.2 100% $ 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 SEPTEMBER 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.... $ 183.3 45% $ 13.8 21% $ 197.1 42%
Services.............................. 64.2 16 13.8 21 78.0 17
Retail................................ 51.4 13 1.1 1 52.5 11
Transportation and Public Utilities... 51.8 13 - - 51.8 11
Construction.......................... 40.4 10 5.5 8 45.9 10
Manufacturing......................... 8.3 2 27.9 42 36.2 7
Mining................................ - - 4.5 7 4.5 1
Agriculture, Forestry and Fishing..... 3.4 1 - - 3.4 1
--------- ----- --------- ----- ---------- ------
Total.............................. $ 402.8 100% $ 66.6 100% $ 469.4 100%
========= ===== ========= ===== ========== ======
77
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 $265.2 million of residential
pass-through securities as of September 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
September 30, 2002, and December 31, 2001, were as follows:
INTERNATIONAL INVESTED ASSETS
FIXED MATURITY SECURITIES BY CONTRACTUAL MATURITY DATES
AS OF SEPTEMBER 30, AS OF DECEMBER 31,
------------------------- -------------------------
2002 2001
------------------------- -------------------------
AMORTIZED CARRYING AMORTIZED CARRYING
COST AMOUNT COST AMOUNT
---------- ----------- ------------ -----------
(IN MILLIONS)
Due in one year or less.............................. $ 40.1 $ 41.0 $ 35.5 $ 36.0
Due after one year through five years................ 143.6 147.7 161.7 162.3
Due after five years through ten years............... 178.7 185.9 212.8 211.8
Due after ten years.................................. 315.7 326.4 326.6 337.6
---------- ------------ ------------ -----------
Subtotal.......................................... 678.1 701.0 736.6 747.7
Mortgage-backed and other securities without a
single maturity date.............................. 259.9 265.2 248.8 254.6
---------- ------------ ------------ -----------
Total............................................. $ 938.0 $ 966.2 $ 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 September 30, 2002.
EQUITY SECURITIES
Our equity securities represented 1% of international invested assets as of
September 30, 2002 and 2% as of December 31, 2001. Our equity securities
consisted of $13.2 million in common stock and $4.4 million in mutual funds
as of September 30, 2002.
RESIDENTIAL MORTGAGE LOANS
Our Chilean operations originate and purchase residential mortgage loans.
Residential mortgage loans comprised $222.1 million, or 16%, of
international invested assets as of September 30, 2002, and $181.1 million,
or 13%, as of December 31, 2001.
78
DERIVATIVES
The following table presents our position in derivative financial
instruments as of September 30, 2002, and December 31, 2001. Our
international operations did not have credit exposure relating to
derivatives as of these dates.
INTERNATIONAL INVESTED ASSETS
DERIVATIVE FINANCIAL INSTRUMENTS - NOTIONAL AMOUNTS
AS OF SEPTEMBER 30, AS OF DECEMBER 31,
----------------------- ----------------------
2002 2001
----------------------- ----------------------
NOTIONAL % OF NOTIONAL % OF
AMOUNT TOTAL AMOUNT TOTAL
----------- --------- ----------- --------
($ IN MILLIONS)
Currency forwards.......... $ 0.2 100% $ 13.4 100%
----------- --------- ----------- --------
Total................... $ 0.2 100% $ 13.4 100%
=========== ========= =========== ========
OTHER INVESTMENTS
Our other investments totaled $142.5 million as of September 30, 2002,
compared to $168.6 million as of December 31, 2001. Of the $142.5 million,
$121.9 million represents our international investments in unconsolidated
subsidiaries and $20.6 million represents other invested assets from our
operations in Chile, Brazil, and Mexico.
79
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 September 30, 2002, the difference between the asset and liability
durations on our primary duration managed portfolio was .09 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 $25,965.6 million as of September 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 September
30, 2002, the weighted-average difference between the asset and liability
durations on these portfolios was (.49) 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 $9,923.3 million as of September 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 $5,693.4 million
as of September 30, 2002.
Using the assumptions and data in effect as of September 30, 2002, we
estimate that a 100 basis point immediate, parallel increase in interest
rates increases the net fair value of our portfolio by $24.8 million. The
following table details the estimated changes by risk management strategy:
80
AS OF
RISK MANAGEMENT SEPTEMBER 30, 2002 NET FAIR VALUE
STRATEGY VALUE OF TOTAL ASSETS CHANGE
- -------------------------------------------------------- ---------------------------- ------------------
(IN MILLIONS)
Primary duration-managed........................... $ 25,965.6 $ (23.4)
Duration-monitored................................. 9,923.3 48.2
Non duration-managed............................... 5,693.4 -
-------------------------- ---------------------
Total........................................... $ 41,582.3 $ 24.8
========================== =====================
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 ("benchmark interest rate"). 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. Price sensitivity analysis is performed at least once
daily. The face amount of the loans in the pipeline as of September 30,
2002, was $12.6 billion. Due to the impact of our hedging activities, we
estimate that a 100 basis point immediate and sustained parallel increase
in the benchmark interest rates decreases the September 30, 2002, net
position value by $85.4 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 fair value for similar
servicing rights. We perform this valuation using option-adjusted spread
valuation techniques applied to each risk tranche. We produce tranche fair
values at least monthly.
The fair 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 September 30, 2002, a 100 basis point immediate parallel and sustained
decrease in interest rates produces a $5.2 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 fair 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 with
81
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 SEPTEMBER 30, 2002
-----------------------------------------------------------------------------
FAIR VALUE (NO ACCRUED INTEREST)
------------------------------------------
WEIGHTED -100 BASIS +100 BASIS
AVERAGE TERM POINT POINT
NOTIONAL AMOUNT (YEARS) CHANGE NO CHANGE CHANGE
---------------- -------------- ---------- ------------ -----------
($ IN MILLIONS)
Interest rate swaps.................. $ 5,769.9 10.81(1) $ 246.0 $ 184.9 $ (217.3)
Principal-only swaps................. 134.9 2.07(1) 14.3 3.5 (14.8)
Total return swaps................... 244.2 0.06(1) 12.5 (1.4) (15.4)
Interest rate floors................. 1,650.0 3.75(2) 39.2 49.9 (23.4)
U.S. Treasury futures................ 545.7 0.22(3) (0.5) (2.5) 4.2
U.S. Treasury futures (LIBOR)........ 3,050.0 0.66(3) (7.7) (6.4) 7.7
Swaptions............................ 8,487.5 1.04(4) 239.7 318.4 (99.3)
Treasury rate guarantees............. 113.0 0.08(5) (13.8) (6.7) 0.5
Bond forwards........................ 353.7 0.94(5) 43.2 20.6 (1.5)
Mortgage-backed forwards and options. 18,680.5 0.06(5) (225.7) (53.5) 218.8
Interest rate lock commitments....... 9,129.2 0.12(6) 105.4 112.1 (309.4)
---------- ---------- ------------ -----------
Total............................. $ 48,158.6 $ 452.6 $ 618.9 $ (449.9)
=========== ========== ============ ===========
- --------------------
(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 September 30, 2002, the aggregate fair
value of debt was $1,429.1 million. A 100 basis point, immediate, parallel
decrease in interest rates would increase the fair value of debt by
approximately $65.4 million.
82
AS OF SEPTEMBER 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...................... $ 220.9 $ 215.6 $ 213.3
8.2% notes payable, due 2009....................... 572.0 541.3 512.7
7.875% surplus notes payable, due 2024............. 221.4 212.0 199.3
8% surplus notes payable, due 2044................. 118.8 106.9 96.2
Non-recourse mortgages and notes payable........... 244.6 236.5 228.9
Other mortgages and notes payable.................. 116.8 116.8 116.8
-------------- -------------- -------------
Total long-term debt............................ $ 1,494.5 $ 1,429.1 $ 1,367.2
============== ============== =============
EQUITY RISK
Equity risk is the risk that we will incur economic losses due to adverse
fluctuations in a particular common stock. As of September 30, 2002, the
fair value of our equity securities was $379.5 million. A 10% decline in
the value of the equity securities would result in an unrealized loss of
$38.0 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 September 30, 2002, the
margin lending portfolio was $558.6 million, or Australian $1,028.4
million, while the ratio of borrowed funds to market value of securities
was 50%, below that of the maximum allowed.
Our margin lending operations are included in the operations of BT
Financial Group, which are being sold to Westpac. Effective October 31,
2002, we no longer have margin lending operations.
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 September 30, 2002,
was $3,022.3 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 September 30,
2002, the fair value of our foreign currency denominated fixed maturity
securities was $303.1 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 September 30,
2002, was $291.2 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
83
the long-term debt obligations of Principal Financial Group (Australia)
Holdings Pty Limited were ceased and were assumed by its parent, Principal
Financial Services, Inc.
We estimate that as of September 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.
84
ITEM 4. CONTROLS AND PROCEDURES
In order to ensure that the information that we must disclose in our
filings with the Securities and Exchange Commission ("SEC") is recorded,
processed, summarized and reported on a timely basis, we have adopted
disclosure controls and procedures. Our Chief Executive Officer, J. Barry
Griswell, and our Chief Financial Officer, Michael H. Gersie, have reviewed
and evaluated our disclosure controls and procedures as of November 6,
2002, and have concluded that our disclosure controls and procedures are
effective.
There were no significant changes in our internal controls, or in other
factors that could significantly affect our internal controls subsequent to
November 6, 2002.
85
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 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. Some of the lawsuits are presently on
file. We have accrued a loss reserve for our best estimate of our potential
exposure to the suits and claims. As uncertainties continue to exist in
resolving this matter, it is reasonably possible that all the actual costs
of the suits and claims could exceed our estimate. The range of any such
costs cannot be presently estimated; however, we believe the additional
costs will not have a material impact on our business, financial condition
or results of operations.
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.
86
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
A. EXHIBITS
EXHIBIT
NUMBER DESCRIPTION
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
B. REPORTS ON FORM 8-K
The Current Report on Form 8-K (Item 9), dated August 8, 2002, filed
August 8, 2002.
The Current Report on Form 8-K (Item 9), dated August 25, 2002, filed
August 28, 2002.
87
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: November 7, 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
88
STATEMENT UNDER OATH OF PRINCIPAL EXECUTIVE OFFICER
REGARDING FACTS AND CIRCUMSTANCES RELATING TO
EXCHANGE ACT FILINGS
I, J. Barry Griswell, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Principal Financial
Group, Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly
report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and material
weaknesses.
Date: November 7, 2002
/S/ J. BARRY GRISWELL
--------------------------
J. Barry Griswell
Chairman, President and Chief Executive Officer
89
STATEMENT UNDER OATH OF PRINCIPAL FINANCIAL OFFICER
REGARDING FACTS AND CIRCUMSTANCES RELATING TO
EXCHANGE ACT FILINGS
I, Michael H. Gersie, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Principal Financial
Group, Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this
quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the
filing date of this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on
our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and material
weaknesses.
Date: November 7, 2002
/S/ MICHAEL H. GERSIE
---------------------
Michael H. Gersie
Executive Vice President and Chief Financial
Officer
90
EXHIBIT INDEX
EXHIBIT
NUMBER DESCRIPTION PAGE
99.1 Certification Pursuant to Section 1350 of Chapter 63
of Title 18 of the United States Code - J. Barry Griswell.. 92
99.2 Certification Pursuant to Section 1350 of Chapter 63
of Title 18 of the United States Code - Michael H. Gersie.. 93
91
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 September 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 September 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: November 7, 2002
92
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 September 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 September 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: November 7, 2002
93