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Protective Life Corp. (NYSE:PL)

Q4 2008 Earnings Call

February 11, 2008 09:00 AM ET

Executives

John D. Johns - Chairman, President and Chief Executive Officer

Richard J. Bielen - Vice Chairman and Chief Financial Officer

Carl S. Thigpen - Executive Vice President and Chief Investment Officer

Wayne E. Stuenkel - Chief Actuary

Steven G. Walker - Senior Vice President, Controller, and Chief Accounting Officer

Analysts

Jimmy Bhullar - J.P. Morgan

Jukka Lipponen - Keefe, Bruyette & Woods

Andrew Kligerman - UBS

Edward Spehar - Merrill Lynch

Darin Arita - Deutsche Bank

Mark Finklestein - Fox-Pitt Cochran Caronia

Operator

Good day ladies and gentlemen and welcome to the Fourth Quarter 2008 Protective Life Corporation Earnings Conference Call. My name is Katina and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will conduct a question-and-answer session towards the end of this presentation. (Operator Instructions). As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the presentation over to your host for today's call, Mr. Johnny Johns. Chairman and CEO. Please proceed.

John D. Johns

Good morning everyone. This is Johnny Johns. I'm the CEO of Protective Life Corporation. Welcome you to our fourth quarter conference call.

Let me start by just reporting that we did report a net loss of $0.22 for the quarter and $0.59 for the year. We were disappointed, needless to say, to report a loss both for the quarter and the year. On a more positive note, though, we did report operating income of $0.80 for the fourth quarter and $3.37 for the full year.

The difference between the net and operating... and Rich Bielen our CFO will go through this in more detail in a moment, is really driven by credit losses and impairments and earnings volatility from mark-to-market and fair value accounting items.

In terms of the operating results, we thought that our operating units performed very well in the fourth quarter. But we do report strong operating earnings in Life Marketing, Acquisitions and Stable Value. We experienced very favorable mortality in the quarter, and we were pleased with our ability to control and manage expenses.

We also recorded record annuity sales, and that's, we think, overall just a substantial improvement in the quality of our life and annuity and asset protection franchises.

I will go through this in a moment. But if you look at the full year and you take out the fair value items, DAC unlocking and a few other miscellaneous items, we actually would have reported $3.98 for the year, which would have well in line with our expectations for the year at the beginning of the year. But Rich will talk about this in detail a little bit later.

But there were some other positive things to talk about in the quarter. And for the year; we did maintain a very strong liquidity profile with an extremely challenging period of time. And as we look forward, we know that we really don't have any need to go outside to refinance our existing debt for over four years. Our next major debt refinancing date is in 2013.

In terms of capital, our RBC ratio was stable during the quarter. It should come in... we haven't closed the books on that yet. But we expect it to come in about where it was at the end of the third quarter in a range of 290 to 300%. Again, Rich will comment more on that in just a moment.

We do have a lot of issues and lot of challengers. There is no doubt about that. We are in an incredibly difficult time in terms of what's going on in the U.S. economy and the capital credit financial markets. But at the same time, we do think we have some strengths that are noteworthy and should be kept in mind when you think about our company.

First, our commercial mortgage portfolio is performing very, very well. We ended the year with a very small level of past due delinquency allowance in the portfolio. And though, we do expect that portfolio to face challenges as the economy continues to deteriorate. In fact, we expect to have some probably some defaults and foreclosures during the year. It is holding up very, very well, and we're very pleased about that.

We do have limited exposure to volatility in the equity markets. We have a very small portfolio of variable annuity product with withdrawal benefit feature. So that is not a major challenge that we face right now dealing with those sorts of issues. We have essentially no hedge fund exposure. The majority of our earnings are coming from seasoned life insurance policies that are long duration and will produce reliable statutory income and cash flows for many, many years, decades into the future.

I mentioned earlier our mortality trends are favorable for the second year in a row. We had a very nice mortality development in our core life insurance businesses. We are experiencing positive fund flows in all of our major annuity plans. But we think our life insurance business is very well positioned. We think we have excellent relationships with some of the very, very best distributors in the entire industry.

I know there would be a lot of questions as there should be about our investment portfolio during tumultuous times such as this. But I could point out that 95% of our securities are solid investment grade securities that Rich will go through that with you in much more detail.

In terms of challenges we have many, but I think the major ones are really related to the conditions in the capital markets. As you know, our term life insurance business and portion of our universal life products are really designed to have redundant reserves financed through some sort of securitization. And there is a little scarcity of securitization capacity right now and to the extent it is available it's quite expensive. As a result of that, we're taking a careful look at what pricing products and what the capital needs of our products. So we'll be making appropriate adjustments as the year goes along.

We are concerned as everyone is, I guess, about the potential for the continuing deterioration in the economy and the credit markets. Needless to say, downgrades, impairments, credit losses and mark-to-market fair value accounting can have a negative impact on us. And we continue to watch that and to the extent we can manage those exposures very carefully.

Also, the Asset Protection division segment as you know is tied very closely... its fortunes are tied very closely to sales of automobiles and marine products in the United States. And as everyone is aware there had been real collapse in sales of autos and folks (ph) in other marine products. And that's having a negative impact on the Asset Protection division.

So overall, I think we are disappointed to report a loss, but we're very pleased by the solid operating performance of our underlying segments. And we're addressing the challenges we face.

And with that, I'm going to turn it over to our Chief Financial Officer, Rich Bielen. I'll have Rich Bielen to take you through the segments in more detail.

Richard J. Bielen

Thank you, Johnny and good morning everyone. I would first point out that in addition to the information contained in our press release, we have certain supplemental financial information available on our website www.protective.com. Also, this conference call discussion includes forward-looking statements which express expectations of future events and/or results. Actual events and results may differ materially from these expectations.

Please refer to our press release and to Exhibit 99 of the company's most recent 10-K, 10-Q for more information about factors which may affect future results. This discussion may also contain non-GAAP financial information. Please see our website for additional information and reconciliation to GAAP financial measures.

What I would like to do on the website, there are some slides that we will be walking through with everybody. So everybody can follow along. We did report $0.80 of operating income for the quarter and $3.37 for the year. Unfortunately, we did take some investment losses and mark-to-market.

Below the line, it was $1.02 loss there for the fourth quarter and $3.96 for the year, resulting in net EPS for the fourth quarter of $0.22 and a loss of $0.59 for the year. What I would like to do though is just go through some of the items that don't really affect our core operating function of the company and just point out to you those items that impacted our operating EPS.

The first item is the trading account mark-to-market or sometimes we refer to it as the old Alt-A (ph) portfolio. That portfolio currently has a market value of $341 million. It is all investment grade. Our expectation as we look at it is, it has something between a three to four year average life. And as of the third quarter of this year, we put that portfolio into run-off. And at this point we are just letting those assets mature as they come due.

Unfortunately, given the market turmoil in the quarter, it impacted our operating earnings by $0.32 and $0.67 for the full year. On the second item that has an impact is the GMWB in our equity index annuity. Our total exposure there is an account value of approximately $340 million with a benefit base of approximately $400 million. And as we went through the accounting for the quarter that impacted our operating earnings by $0.10 in the fourth quarter and $0.18 for the year obviously given what was going on in the market.

The other two items that actually... we look at as kind of one-time items for the fourth quarter is in light of the market environment, we were active in the fourth quarter in repurchasing some of our funding agreements. We had a significant amount of cash on our balance sheet. And as a result, we've recognized about $0.06 of gains on the early retirement of some funding agreements and $0.09 for the full calendar year.

We also wound up with a slightly lower tax rate in both the fourth quarter and the year that we expected and that had improved our earnings by $0.02 in the fourth quarter, $0.10 for the year.

The other items that impacted us in terms of operating income were approximately $0.05 net of just positive DAC unlocking that we had in the third quarter that we're not expecting to be repeatable or thinking that's a core part of the business. So if you step back and adjust it for those items and look at what I'll call a more traditional book value approach, we would have reported $1.14 of operating type income and actually $3.98 for the calendar year.

If you then flip to the next slide, I'd like to walk through the net realized investment losses because there is a lot of noise in these numbers. The first is that for the quarter, we took about $0.27 of impairments. The bulk of that relates to our, what was formally the AA Alt-A portfolio. If you recall, we are investing approximately $230 million of AA Alt-As with a notional or face amount of approximately 300 million.

We wound it writing down in this quarter. Now they are roughly $27 million of that. The remaining book value on that $300 million notionals is approximately $85 million at this point. So we've significantly written that down. That is not a major exposure in terms of going forward.

The second item, as all of you recall, is Chase transaction. Now we entered into a Modco related arrangement. And in that Modco arrangement, we have to flow through our GAAP financials. Any of the realized losses that go through on a quarterly basis for GAAP, there were also some impacts from the Big B (ph) 36 effect. And in this quarter, there was a lot of trading activity in the portfolio. And that resulted in us needing to recognize $0.39 loss related to that, but that is all fully reimbursable from our Modco reinsurance counterparties. And we will collect that back over time, over the life of the assets which we estimate being in the 3 to 5 year range. So although we recognize this for GAAP purposes, the economic impact has passed through to the reinsurers.

So the third item now relates to interest rate related derivatives. When we look at our asset liability and all of the business model that we have, we find that we are actually sensitive to rising rates in the portfolio. As a result, we'll go retiring, being cautious of using treasury features, interest rates swaps and different types of options all in that portfolio to protect this against the rising rates.

As all of you know both treasury rates and swap rates collapsed in the fourth quarter that resulted in approximately $0.34 loss for the fourth quarter on the mark-to-market of those derivatives. And as we look, as we speak given the backup in rates at the end of the year we probably already recovered approximately half of that $0.34 if I would have marked those instruments to market as we speak.

Our next item is the credit default swaps. That had a mark-to-market loss of $0.08 for the quarter. If everyone recalls at the beginning of the year, we had approximately 210 million of notional. In the second quarter of this year, we attempted to de-risk the portfolio. We closed $145 million of those swaps in the second quarter and reduced our entire position at $65 million at this point. They were on both the investment grade index and the high yield index. At this point we don't expect that we'll incur $2 of loss but unfortunately in spread widening, we do have the mark-to-market.

And then all the other is just the normal kind of trading activity, miscellaneous things to go through for the quarter.

So that was just a picture to give you a reconciliation of the $1.02 that we recognized in the fourth quarter of this year and obviously $3.96 for the year.

The other two things that continue to kind of come up, and we'll start talking about the investment portfolio. If you turn to the following slide, what you'll see is the gross unrealized loss was approximately $3.2 billion at the end of the quarter. 82% of that loss relates to investment grade securities and only 18% relates to below investment grade.

When we went through, there were some questions and some notes earlier this week regarding the CMBS. What happens is our supplemental financials, the external CMBS that we have was all marked by third parties. It only represents $300 plus million of securities. The bulk of that was all AAA. And it is all... the bulk is also mostly '04 and prior vintage. And so you have a detail on that. It came out at about $0.93 on the dollar.

We also have approximately $900 million of our CMBS that relates to our own origination. And I'd like to give you some details on that. 143 million of that relates to securitizations that we did in the late 1990's. There was '99 and prior vintage, and there is $795 million related to securitization we did in late '07 which was a tug of our own portfolio that we wound up liquefying into a securitization model.

Those portfolios currently have zero delinquencies in them. They have an estimated loan to value of 53%. And when we went through our models, because no one else owns these securities, it really looks a lot like our own portfolio. And we valued them at $0.91 on the dollar in face amount through that portfolio. But the point is on that '99 and prior year vintage there is no senior tranche to us. It's just all tranches with respect to the deal we did in late '07.

There is one super senior tranche ahead of us at about $160 million and the balance of the 795 is just all of our securities. So there's very little leverage to those.

If you flip one more chart, you can see the breakout of the investment portfolio. 76% of it is fixed income, 15% of it is in mortgage loans. And the point to make and reasonably included this, we really don't own any real estate. We don't own in any alternatives. We own only $16 million of CDOs. Everything you see is kind of there, we don't know, and a lot of this balance (ph) to true equities in the portfolio.

Flipping one more page and just give you a breakdown of the quality, 35% is AAA. We did see some downgrades in the fourth quarter or BBB percentage is currently 33% but our below investment grade is only 5%. And at the bottom of the chart, you can see that approximately 61% of the portfolio is either corporate bonds or utilities and then we have a breakdown of our mortgage backeds or CMBS and our asset backeds.

We ended the year with a book value of $10.89 versus a traditional book value or reported book value of $34.74. We do seem to get a lot of questions regarding that. Two things that I think we'd like to reemphasize everybody. One is when you look at our stockholders' equity there is very little goodwill in our stockholders' equity. It is approximately $120 million or about 5% of our recorded stockholders' equity.

The second thing and we are not sure exactly how we compare it to our competitors. But when we look at our DAC offset against the unrealized loss, our DAC offset is between 20 and 21% which we believe given our business model that is relatively low for the industry and I believe therefore impacts our book value when we look at this unrealized loss is a little more severely than some of our competitors.

With that, I'd like to turn around and turn to the divisions. We'll start with the Life Marketing division. The biggest thing there is we had $51.7 million of earnings for the quarter. And that represented our second best quarter in terms of that division in the past year.

The big factor there is we had very favorable mortality. It was a record mortality quarter for us. It was $13.7 favorable versus our pricing expectations. And we, in our plan, at the beginning of the year, assumed we'd have about $3 million a quarter. But this was an extraordinary quarter on that basis.

We also had very solid sales. We saw an uptick in our sales in terms of the UL product. We did see some decline in our term sales but that was part of our strategy at the beginning of the year where we've seen some prices and move some things around in order to emphasize the product that we wanted to sell at the marketplace.

We continue to introduce new products into the marketplace, especially on the UL side. And then we point out to you at the bottom that our sales are pretty well distributed. UL business represents the biggest portion of those sales, independent agents and then stockbrokers and things. And we weren't that kind of diversity because it allows us to hit our customer lot of different ways.

Turning to the next division which is the Annuity division. We report $6.2 million of operating earnings for the quarter. But as I already mentioned the GMWB had a $10.4 million impact. We had absolute record sales in the quarter. Our sales turned out to be $976 million dominated by our market value adjusted product at 411 and our SPDA product at 401.

We've also been able in the bank distribution channels to open up some new relationships which is contributing to that sales growth in the SPDA. As you would have expected, our VA sales came down a little bit at $112 million for the quarter. We also saw positive fund flows in all of the lines. And our contract balances are now up to approximately $8.5 billion.

We also had one item that occurred in the quarter which is we've talked about we had some unfavorable mortality in our SOP line. In the fourth quarter we actually had some favorable mortality and improved all our earnings there about $5.5 million which helped to offset some of those negative fair value changes that we saw in the quarter.

Turning to the Acquisitions segment, the Acquisitions segment continues to perform extremely well. It is a very steady source of earnings. As you can tell over the last five quarters the earnings have ranged between 33 and $36 million. We have, as we indicated, completed our conversion of all of the Chase business on to our platforms. We now are benefiting from lower expenses there.

We do have expected run-off in that line. We kind of plan for 6% type of run-off there that we expect some policies go away. But there is good stability there and the mortality given the diversification of the deal that we have done over all these years tends to be very good and steady over time. So we get good balance from that. And that's kind of, one of the points that we always try and emphasize when you look at our operating earnings between our Life Marketing division and this division, most of our earnings and the bulk of our earnings do come from very steady long life, life policies.

Now turning to the Stable Value division, we have benefited in the quarter from higher average balances. We wound up seeing... our balances actually peaked at the end of the third quarter at $6 billion. We saw increased spreads, we saw gains from early retirement of funding agreements that resulted in $27.9 million of earnings for the quarter. That's up 78.8% over the 2007 fourth quarter in this period of time.

One thing that we did see and this was a conscious decision is in light of the current environment, we brought that balance down during the third... the fourth quarter that balance is now at just under $5 billion. And we also expect to see here in the first quarter an additional run-off of approximately $0.5 billion or so bringing us under 4.5 billion.

With respect to future strategy there, we do know that the market is currently effectively closed for most life companies in terms of issuing this. If we were to start to set plans for the balance of the year, we would expect to cut balance and new sales will drop below $4 billion at the end of calendar year 2009.

Flipping to the last division, that's the Asset Protection division. It is just a very tough auto and marine market. We have seen lower sales. If you see in terms of the auto market, we've seen sale declines in annualized rates of approximately 10.5 million versus 6... 17 million that we were seeing a couple of years ago.

One of the points we wanted to make is our core business is, service contract business. We do sell some credit insurance and some other policies because they're more secondary and represent our portfolio contracts for our providers with our real focus on service contracts.

We've pointed out at the bottom of the chart that this division has really done a great job of increasing market share along the last few years in the market as we saw some competitors go away. And then in light of the activity in sales in the fourth quarter, we saw a decline in our sales which is very consistent with market. We saw our earnings for the quarter of about $6 million, and we consider that to be an ongoing run rate in light of this current environment.

I'd like to make one last point. John, you had mentioned on our risk based capital, at this point, the risk-based capital in terms of where we're winding up. We think we're very similar or slightly ahead of where we ended the third quarter which was in the '80s-'90. We do see, in the first quarter that we have an item and anomaly related to me which is the mortgage experience factor. There is nothing in our mortgage portfolio that will indicate that we don't see that factor come down for us. That impact will help our RBC ratio by approximately 25 RBC points, just being able to change that formula. On the Protective Life Insurance company, we're currently keeping 2.5 times the industry average in terms of our mortgage experience and the capital related.

The only other item that we kind of talked about is in Corporate & Other. Corporate & Other did report an operating loss of $42 million for the quarter. The bulk of that related to the $36 million loss on the trading portfolio.

Now we also in the quarter, just to note, we had very little by way of participating income, it was literally $200,000 which is the lowest ... and now we've had in years. We did see some mortgage prepayment fees of about 1.3 million. We also were holding a significant amount of cash during the quarter for liquidity. At one point during the fourth quarter we had $1.5 billion of over 5% of our investment portfolio sitting in treasury bills and treasury money market bonds.

We ended the year with approximately 1 billion, and we don't expect to hold at those high levels. As we continue to walk through 2009, we'll probably be bringing that down as markets tend to normalize. And so the cost of holding that additional liquidity came through the Corporate & Other Life, and that was one the reasons that caused the reduction.

And with that, I'm going to turn it back over to Johnny for some final comments.

John D. Johns

Thanks Rich. Let me just give you a bit of insight into our outlook, our view of the future. I will start by saying in that I regret to say that we really don't expect to see conditions in the credit and financial markets improving much at least in the short term. We are hopeful that the actions being taken by the new administration will start to get some traction, stimulus bills will kick in and some of the things that Secretary Geitner talked about yesterday, will start to improve conditions in the financial system. But it's really hard to predict that.

So we are basing our plans around an expectation, it is going to be another tough year, at least the first half of it in terms of conditions in the economy. At the same time we are very pleased with the quality of the franchise we have in life and annuity and in APD. And we are going to continue to work really hard on improving and grooming and investing in those franchises. And we expect them to continue to be very solid.

When you put all that together, our business plans are going to revolve around managing our exposures, credit exposures, managing liquidity to be sure that we continue to have very robust liquidity and supporting our statutory capital ratios, because we understand the importance of that.

At the same time, though, we are emphasizing and focusing on selling our life insurance products and Annuities and our Asset Protection division products to an ever broadening array of distributors of the highest quality.

In terms of guidance for the year, this is becoming a very difficult issue for everyone. Operating earnings per share which is what we typically use as the basis for guidance, now it is so clouded by mark-to-market and fair value accounting items which are frankly not forecastable. That we think it's just very difficult to give true guidance with respect to operating earnings.

But what we would like to tell you are what we think the sort of the core earnings power is the franchise. If you exclude those kind of accounting-driven items and our best estimate is that we should produce somewhere between $3 and $3.50 share of earnings excluding volatile items on an operating basis. We think that's sort of the core earnings power of the franchise.

We'd have a fairly high degree confidence in the level of earnings to be produced by Life, Annuity and Acquisitions because a lot of that is coming out of in force business that has a fairly stable and forecastable quality to it.

Also, as Rich said, we think we can look out and see the Stable Value business running off a bit but with that sort of a predictable item as well. Asset Protection is a little bit harder to forecast because again, the sales are tied. Its sales are tied so closely to auto and marine business. But we think that we got a pretty good handle on what we'd likely to see there as well.

So I wish we could give you more precise guidance, which we didn't have to grapple. And that's no participating income, no kind of good issue, sort of we have seen in the past too. I think there is no reversal of any fair value or mark-to-market items which could drive earnings way up during 2009 if we start to see that.

We wish we could give you more precise guidance but unfortunately given the accounting conventions that we're operating under now that is just not possible to do that. So again that's not really earnings guidance; that's just an estimate of what the earnings power is of the franchise if you exclude all of these kind of the extraneous factors.

One last comment, I think those of you who follow the company closely know that we have applied for participation in the capital purchase component of the TARP program, our application to bank in Florida, the Bank of Bonifay has been approved by the Federal Reserve System. And we have submitted an application for participation in the program.

As of today, we do not whether or not we or indeed any life insurance company will be permitted to participate in that program. And we're not sure if we're permitted, whether or not we'll participate in it. And there are an array of restrictions that are kind of emerging around that. And if we're invited, we'll just have to see what those restrictions are and see whether or not we can come balances in the best interest of our shareholders to participate.

There is some new stories out late yesterday indicating that life insurance industry would be excluded from the CPP program although permitted to participate in some of the other programs that were announced yesterday. But we really... just speculation on their part in terms of what will actually turn out to be the case.

So with that, we will stop and we will turn it over to you for your questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). Your first question comes from the line of Jimmy Bhullar representing J.P. Morgan. Please proceed.

Jimmy Bhullar - J.P. Morgan

Hi, thank you. I had a few questions. The first one is on your RBC. Do you believe like a level under 300 and even close to 300 is enough for you to maintain your A plus rating with A.M. Best especially given the level of unrealized losses that you have? That's the first one. And second one, if you could talk about your view on the securitization markets and if the markets do remain tight, is it a possibility that you'd pursue reinsurance to a greater extent than you used it recently to free up the excess reserves or would you just prefer to carry them on your balance sheet?

Richard Bielen

Jimmy, this is Rich. With respect to your first question, I don't want to speak to the rating agencies. We've communicated with all the rating agencies here prior to this earnings call. We have communicated our capital plans, the changes. So at this point, we don't expect any changes in our ratings at the A plus level. But that is the decision obviously that the rating agencies need to make and A.B. Best needs to speak for itself.

With respect to your second question on securitization, obviously in light of the tight capital markets and the difficulties in terms of obtaining securitization, if reinsurance becomes a cost effective alternative we would obviously pursue that in terms of releasing some of the redundant reserves and look at that as possibility.

Jimmy Bhullar - J.P. Morgan

And just another one on your CMBS. You mentioned the March to close to between 91 and 93%. That seems a little high even like despite the fact that you've got these vintages and you don't have a lot of stuff from recent vintage years. But given the weakening economy and just we're frustrating on the market, it seems like just 7 to 8% discount to book value is a little bit aggressive. What are your views on that and how is that that you determine the marks on your portfolio?

Richard Bielen

Let's deal with the first one. All the external CMBS was obtained from outside pricing sources. So that was just done from there and primarily obviously IDC which is the main source. So that was $0.93.

With respect to our own portfolio, we went ahead, looked at all of the delinquencies toward a risk factor charge on them, discounted those cash flows. As I mentioned seasoning on these is relatively old. I mean we have the '99 and prior vintages which are now 10 years old and well paid down. We have the deal we did in '07 which was a cut out of the portfolio. And in both cases, we had zero delinquencies in the deal with 53% loan to value.

So to tell you we are not going to see any delinquencies or any impairments or any losses there, we don't believe that's the case. But at $0.91 on the $1 we think that's a fair valuation of the underlying loan.

John Johns

And Jimmy this is Johnny Johns. Let me add to that too that our own product which we have securitized was underwritten to very different standards from the underwriting standards that have generally been applied to the conduit produced CMBS product in recent years. So only is it seasoned at very low loan to value ratios but it was underwritten differently too. So we think it merits an attractive mark when you take all that into account. Carl Thigpen, our Chief Investment Officer is here, he can comment as well.

Carl Thigpen

Yeah, if you will, to elaborate what Johnny said, our underwriting was written to our regulatory standards of 75% less and cap rates that were above what was market cap rate. So our discipline is something that is quite different from what the CMBS market was at that time.

Jimmy Bhullar - J.P. Morgan

Okay, thank you.

Operator

Your next question comes from the line of Jukka Lipponen representing KBW. Please proceed.

Jukka Lipponen - Keefe, Bruyette & Woods

I have couple of questions around capital. First of all, how much of redundant reserves are you currently carrying on your own balance sheet?

Richard Bielen

Jukka, this is Rich. The combination between our term business and the UL business, we're estimating it somewhere around $200 million versus the last our analysis We haven't finished our stat statements to confirm that number and the valuations it's roughly about that amount.

Jukka Lipponen - Keefe, Bruyette & Woods

And secondly, some of the states have provided some capital relief due to their companies and like in Connecticut, the Hartford at least has applied for capital relief. How you applied for any capital relief with your regulators?

John Johns

Jukka, this is Johnny. Yes we've had discussions with our two primary domiciliary states about their openness, their willingness to go ahead and adopt some of the proposals that were made to the ACLI by the NAIC. Unfortunately one state it doesn't work from a regulatory standpoint. And in another state we are very pleased that we believe that we will be given... this hasn't been done yet but we will be given a permitted practice that would give us a little bit of relief but it won't change the numbers from the range we gave you.

I mean it could be a few points one way or the other but nothing material. We do think, however, that if the proposals made to the NAIC that were viewed favorably by the working group that considered them we're adopted across the board. And that will be a very substantial improvement in our RBC ratios as a result.

Wayne Stuenkel, our Chief Actuary is here. So Wayne, would you like to comment further on that?

Wayne Stuenkel

Yeah, there were a number of proposals that were made by the ACLI, those were rejected by the NAIC about a week and half ago. But I believe those will then circle back through the regular NAIC process during 2009. And we are hopeful that those will be adopted within 2009 by the NAIC and that will give us some... we will be surely (ph) adopted.

Jukka Lipponen - Keefe, Bruyette & Woods

And lastly with respect to the decline in your stated book value besides the loss in the quarter and increase in unrealized investment losses, were there hits from like pension related items or other things?

John Johns

Steve Walker, our Chief Accountant is here. Steve, you can...

Steven Walker

Yeah, we had a relatively modest adjustment to our pension liability. I think it was around that $30 million that hit surplus.

Jukka Lipponen - Keefe, Bruyette & Woods

Thank you.

John Johns

Thank you.

Operator

Your next question comes from the line of Andrew Kligerman representing UBS. Please proceed.

Andrew Kligerman - UBS

Hey good morning. First question is following up around RBC, Rich I think you mentioned that you might get a 25 basis point pickup in RBC relating to your commercial mortgage loan delinquencies. Could you just clarify that again? I didn't quite follow how that would work. And also I want to tie that into the fact that Johnny said, he would expect some defaults and foreclosures on the commercial mortgage loan portfolio. So are you confident that that will come through?

John Johns

Andrew, this is Johnny. I'll comment on both points. I think as you are aware there is a complicated, formula that the NAIC RBC rules used to determine how much RBC you put behind a whole loan portfolio, it's called the mortgage experience factor. But it basically ratios your delinquency experience against an industry average. And then there's a multiplier put on a base rate and that tells you how much capital to put up. It's an eight quarter look back kind of formula. So eight quarters ago we had one or two very small foreclosures across maybe $10 million or $12 million in total properties involved. Because the industry numbers were very, very low that kicked in that multiplier. And so though we've had pristine performance in that portfolio since we still carry in the formula the foreclosure results of two years ago.

That burns off at the end of 2008. And so in the first quarter of 2009, we go back to the more normal RBC formula calculation, and that will add just mechanically about 25 points to our RBC.

Another way to think about it is, but for that we'd be exceeding comfortably over 300 right now in the 300-325 range and probably the upper end of that right now but for that worked. And so that's done. I mean we're not going to... that's not going to... there's nothing that really is going to happen. We're not going to have a foreclosure in the next month or two that we can perceive it. It's going to make a difference there.

With respect to my comment about the future, we scrutinize our portfolio daily. And we're not seeing any real pickup in delinquencies right now. We can identify any properties that would give us a lot of concern but I'm just expressing to you my layman's view that with the economy deteriorating as rapidly as it is, it would surprise me very much if we don't start to have some delinquencies or even some foreclosures down the road. But we do think that we're in a position to manage those very effectively, and we're not really that concerned about the meat kicking up. And to the extent we do other people will. So the industry numbers will actually move as well. I'll let Carl to elaborate on that.

Carl Thigpen

Yeah if you look at our portfolio the majority of it is basic goods and services. It's not high profile kind of properties, food and drug and discounters. Wal-Mart, CBS, or AHOS, our top credit exposures, these are things that are typically done well through the economic cycles. These are not the high-end luxury apparel or any kind of re-payers like that are in our portfolio. It's clearly basic commodity type products.

John Johns

And remember too Andrew, you know this. It's a very granular portfolio. It's thousands and thousands of loans with average loans size of 3 to $4 million.

Richard Bielen

923 loans with a average loan size of 2.5 million. Thank you.

Andrew Kligerman - UBS

And so if I understand this formula correctly then it would... the multiplier effects you relative to the industry, hence if the industry is seeing a big pickup and even if you were to have a few foreclosures you would still have that 25 basis point pickup. Am I understanding that right?

Carl Thigpen

Yes, that's right.

Andrew Kligerman - UBS

Got it, okay. And then you pointed out managing through this, so in other words if you see a delinquency or an issue with the specific property maybe you could work through it or figure out a way to restructure the loans, is that what you were alluding here?

Carl Thigpen

Exactly.

Andrew Kligerman - UBS

Okay, perfect. Then the last question. So you mentioned... I think Rich mentioned some pressure on Stable Value and in contrast, the fixed annuity business picks up quite robustly in the quarter. I think 800 million in MBA and deferred annuity sales. Maybe you could talk about what type of spread you're seeing on the new money and where you are investing it?

Richard Bielen

Andrew, we kind of talk about... I am not sure I want to really talk about spreads, because that tells everybody where our pricing is. But we have consistently used the same pricing model with a similar asset mix now for years. We use the same one, duration adjusted for Stable Value and for fixed annuities. And so we consistently price in the quarter, and I think what actually happened in the quarter was all the turmoil among the carriers in the market we benefited from that. And that's why us and some other people saw a pickup in fixed annuity sales during the quarter.

With respect to Stable Value, that is more of an institutional market. And the holders have got especially in fund agreements or institutional in nature. And what you saw was there was tremendous illiquidity in that market, things were trading at very wide spread. And in fact, with our excess cash we were buying back funding agreements that we had issued in previous years at discounts. So it really didn't make any sense to be issuing contracts at that point.

Andrew Kligerman - UBS

Got it. Actually I just got an email from a client just in response to, he says it is the age of technology, but this size is actually pretty concerned. He wrote me, but the commercial mortgage loan portfolio is 60 plus percent retail. And he thinks that the 75% loan to values are not conservative. So as long as I got this email sitting in front of me I might as well relate that to you and see what your response is?

Richard Bielen

As I have mentioned, our retail is food and drug and discounts. I mean if you think there is going to be a problem with Wal-Mart or CBS or the major drugs or food chains then there should be concern. But I think that people are going to keep buying drugs and keep buying groceries.

John Johns

Andrew I will add a little more color to that. You have seen a number of high profile bankruptcies at retailers here in the last six weeks. And, but those are not the kind of retailers that we have major credit exposures to.

Andrew Kligerman - UBS

Make a write aid (ph) or is there something like that?

John Johns

Well we had a small bit of Circuit City, just a few stores. Out of these thousands of loans we have... we don't any Saks Fifth Avenue. We don't have hard fashion retailers. We don't have the kind of... I mean I would say we probably have a sprinkling of everything in the portfolio. But we don't want to have concentrations. I guess Carl indicated, if you look at our top 20 retail credit exposures most of them are the Wal-Marts and AHOS and the Pro Garage (ph) and kinds of necessities of life retailers that we'll just be more stable during this time we face.

When you say retail that's one that fits all concepts, that covers a lot of different kind of businesses. But we think we have underwritten, this has been some as you know we have been doing for 30 years. We have been underwriting this portfolio to stay away from the more volatile kind of segments of the retail economy. Again I am not saying we are not going to have some defaults because we are... I just think we'll probably... my expectation is that we're going to have a lot less than most people do.

Andrew Kligerman - UBS

Got it. Thanks a lot.

Operator

Your next question comes from the line of Ed Spehar representing Merrill Lynch. Please proceed.

Edward Spehar - Merrill Lynch

Thank you. Good morning. And I have few questions. I guess Rich or Johnny maybe some comments on more statutory numbers, thinking about '09, could you tell us roughly where you ended '08 in terms of adjusted capital? And what we should be thinking about in terms of the statutory earnings outlook and maybe more specifically what kind of... what you'd consider to be capital generated beyond needed to fund the business, would we see... if we assume no securitization and you implemented the pricing changes that you alluded to in the life business? And then I have a follow up. Thanks.

Richard Bielen

Ed, that's a lot of questions in one there, but let me try and kind of take it in pieces. The first is we expect our statutory surplus to be somewhere between 1.9 and $2 billion when we finalize the books. We are still working through taxes and other items in the reserving. So that's slightly down from where we ended the third quarter, and that also reflects the fact that we got ahead for stock purposes and taken all the impairments through SAP 98 will not impact us as it comes through in 2009, which is the impairments for both stat and GAAP. They are consistent in terms of our balance sheet.

In terms of... if we cannot securitize in the marketplaces, we are going to continue to build up redundant reserves. If we stick to exactly our current business plans, those redundant reserves probably approach $400 million at the end of calendar year 2009 with no changes from reserving or any of the NAIC relief that we talked about. And if we look at where the excess would be if we define the excess as being 300% RBC, I would say will generate $200 million of excess surplus above that by the end of the year, without factoring in impairments or other kinds of volatile items. So I think that would give you a full picture of where the moving parts are.

Edward Spehar - Merrill Lynch

And Rich, I guess just a follow-up, it does sound, you are going to operate with no changes approach in the life business. So I know you don't want to give away specifically what you are going to do. But can you just give us a sense for how much any action you take this year will impact what that redundant reserve level would be at year end '09?

Richard Bielen

Frankly I don't want to speculate. We will obviously... in this environment we will review all of our products. We will look at their capital consumption and return characteristics and need or potential need for securitization as a big combination. We are committed to supporting our retail distribution franchises on both the annuity side and the life side. So we will look at that entire package in order to deliver value to our consumers. But I don't want to tell you... I don't want to define exactly what that is.

Edward Spehar - Merrill Lynch

Okay and then in terms of if you were in a situation where impairments were higher and you needed to... the RBC ratio coming down. What's... how easy would it be for you to monetize any blocks of business, do you think in the Acquisitions segment?

Richard Bielen

I think we... let me just answer the question this way. We get reverse increase from numerous reinsurers regarding our acquisition block and the value that fits there and the stability of that block. We have up to now been resistant to offer that into the marketplace, because we think it is some of the most consistent and stable business that we have on the books. So we know there have been increase, we had them over the years numerous times. So I don't want to look back the effort... I have mentioned the effort that we will take. But I think that would be a viable alternative if we chose to do so.

John Johns

It's Johnny. I'll just add to that. I mean why wouldn't somebody wanted to reinsure, coinsure, buy block of business, why wouldn't you find business that we've had on the books for years and years that's very stable, have been chalked and re-chalked through the acquisition process. Why wouldn't that be as attractive block as any out there. I mean if there is a market for that, that's what people would like to have, but that's certainly not top of our list of priorities right now. We don't think that's really necessary.

Edward Spehar - Merrill Lynch

Right, I don't think it's statutory either, I guess the reason I asked it though is that, if we are thinking about a bad case scenario, where your stock is now on the economics of giving up stable earnings and acquisitions would be a more attractive alternative than in any other way to sort of raise equity capital, is that a fair assumption of the stock where it's today?

Richard Bielen

Yeah, I think that's fair. That's certainly a lever. We have a mixed metaphor, as I said our tool box if we choose to go there.

Edward Spehar - Merrill Lynch

Okay, then just one last question Rich. On the mark that you take on the 900 million of CMBS priced at $0.91, is it, let's say that... can you just give us a sense of how much of that relates to just what the market, say required returns are now on these types of assets versus your expectations of any real loss on those holdings?

Richard Bielen

Frankly, we've look to where we've got, the old season stuff probably has two parts in the aids on it. They relate to that '99 and prior vintage. The stuff that we've done in the more recent securitization has been 6's. We really don't expect any major uptick in delinquencies or foreclosures. Again, these portfolios, as you know, are extremely granular. So it really lets us work through any problems that crop up. So I would say almost all of that is related to what I would call the market discount not really any expectations of material losses on the portfolio.

Edward Spehar - Merrill Lynch

Okay. Thank you very much.

John Johns

Thank you.

Operator

Your next question comes from the line of Darin Arita representing Deutsche Bank. Please proceed.

Darin Arita - Deutsche Bank

Thank you. Just wanted to continue with Ed's questions on the statutory earnings. Can you tell us what the full year '08 statutory operating earnings were?

John Johns

We haven't closed our statutory books yet. Obviously that would include impairments and other activities that would have brought (ph) to there that were somewhat elevated during 2008. So we just don't have a number to give you at this point. I think Rich earlier indicated that there wasn't going to be much move in our statutory surplus number from year end '07 to year-end '08, net, net.

Darin Arita - Deutsche Bank

Okay. I guess when I'm looking at actually the operating earnings, ex the impairments at least for the nine months through '08, there wasn't much income generated. Can you talk a little bit about the pressures in '08 on an operated income basis for statutory earnings and why that will go away in 2009?

Richard Bielen

Darin, there is two things. One is realize that we are holding the redundant reserves on the balance sheet, protect the life insurance company, and looked those life subsidiaries. So that is holding down our statutory operating earnings during the year. The other thing that we have not talked about is that we do have a market value adjusted annuity products. We know a couple of our competitors have had that product also. And what we saw because of the disconnect between assets and liabilities, we saw through the first three quarters a reduction in our operating of about $60 million. And then in fact, in the fourth quarter we saw a loss related to that of $110 million.

And that was one thing we didn't mention in talking about RBC. We obviously expect that to come back over time but in light of the market conditions we don't know how quickly that will come back. So, that has held down our RBC projections for calendar year '08.

John Johns

It's just probably worth elaborating on little bit more in terms of sort of mechanics of that because it is... it was a pretty really material driver of our RBC ratio. And I think when you understand it, your sense would be there is much, if you look at the probabilities of which way it moves there is a greater probability of moving in our favor than against us because of the things that are driving it. Why don't you elaborate a bit on that?

Richard Bielen

Let me just kind of summarize it. First of all, at year end '08, we are holding an additional $170 million of capital against that line of business versus our normalized level which would have shown a market value adjustment of roughly zero and that's historically where we have been. We've had movements one way or the other but they have always ranged between $30 million to $50 million around 0. So it's not been a material either.

The way the calculation works is the liability side as a general rule of our policyholders is tied to treasury rates while the assets or mark to market currently in light of the environment. As all of you know, what has happened is that asset values have declined in light of the spread widening. And yet when we look at the liability side, they are tied to treasury rates and with the decline in treasuries that's caused those two numbers to separate where they're usually correlated as time goes on.

The result of that is that we wound up with a mismatch of roughly on a pretax basis $210 million and on an after-tax basis of 170 million. And all of what we've been talking about doesn't presume the debt reverses at this point. So as markets normalize it's kind of a hidden capital benefit that will come back to us over time. And the duration of the liabilities in the assets are little over 5 as we speak. So we expect that those kind of mature and the performance happens, we'll start to get back capital back to some of the prior vintage (ph).

John Johns

Yes, the calculation is very sensitive to the yield on the 10-year treasury. And as everyone knows at year-end the 12/31 we just bottom ticked at yield. I think it was about 2.2% roughly which was a historic low or recent historic low. And that was a pretty significant drain on our capital. But that's moved in our favor even during this quarter, as the 10-year treasuries really run, yields really run up that will be a capital generator for us.

Richard Bielen

And roughly about 170 would translate into about 25 RBC points again. We have required RBC amount of somewhere between 650 to $700 million.

John Johns

So that's another 25 points right there. I think we can look to coming back our way or just with treasury yields kind of returning to more normal kind of levels.

Darin Arita - Deutsche Bank

Thank you. That was a very helpful explanation there. And just one other question, if we talk about the 25 basis points with respect to the commercial mortgages, is that... if your Protective experience gets back to the industry level, is that what that means? And if the industry's experience actually ends up being worse than Protective, could you see a benefit greater than 25 basis points?

Wayne Stuenkel

This is Wayne Stuenkel. We expect to see the number we've been talking about here, no matter really what the industry does. We will be at though 25 point RBC increase, as Rich talked about that.

John Johns

It's not technical, it's not basis points, it's 25 points of RBC.

Darin Arita - Deutsche Bank

Okay. I was just wondering if the industry is a lot worse and then you end up looking better and the RBC factors kind of severe.

Wayne Stuenkel

If the industry does... industry and the company work on eight quarter factors. So in the uptick in delinquencies by either Protective or the industry especially the industry would factor in over a period of time.

Darin Arita - Deutsche Bank

Thank you.

John Johns

Thank you. Let us take maybe one or two more questions. I think we are running over the hour now. Take a couple more questions please.

Operator

Your next question comes from the line of Mark Finklestein representing FPK. Please proceed.

Mark Finklestein - Fox-Pitt Cochran Caronia

Good morning. Actually one clarification on Ed's question. The 200 million that you referenced of excess surplus for 2009, is that before or after a consideration of the reserve bill due to lack of a securitization? I think you mentioned that reserves will go from... redundant reserves will go from 200 to 400 million?

Richard Bielen

That is the after the reserve bill.

Mark Finklestein - Fox-Pitt Cochran Caronia

Okay, perfect. And I guess just changing gears a little bit. Rich, can you just talk about I guess surrender activity in some of the, I guess, the annuity products over the quarter. How has that trended over the quarter and how did that compare to pricing expectations?

Richard Bielen

We saw what I'll call modest uptick in surrender activity. We would have traditionally seen surrender activity in the 0.5 million to $1 million a day probably towards the peak that we saw in light of all the turmoil may we're seeing 2 or $3 million a day. We didn't see any non-material kind of activity that caused us any discomfort at all. And we were a very active in speaking with our institutional distributors and watching that numbers, as it's reported to my desk morning to make sure, we're monitoring that.

John Johns

Rich, one of the things to note too is that on the market value adjusted annuity product there were periods in there when treasuries got very lower, that worked in favor of the policyholders. So there was an economic reason for people to capture favorable market value adjustment in there. But our portion we got (ph), that's moved in our favor too with treasury rates moving up here recently.

Mark Finklestein - Fox-Pitt Cochran Caronia

Okay. And then I think you talked about adding distribution in the quarter. I guess just in light of the rating, on were there any losses in key distribution relationships and/or material declines in annuity production against what you'd expect?

Richard Bielen

We have not seen any.

John Johns

Let's also point out to, our life sales ticked up in December.

Mark Finklestein - Fox-Pitt Cochran Caronia

Okay. And then I guess just finally, putting the market value annuity issues aside, how did statutory credit impairments compared to GAAP?

Richard Bielen

I would say, Mark, here at the end of the year, our combination, we took some stat impairments and then we went ahead and non-admitted some of these Alt-A assets that came back within in the NAIC 6. So the effect of it is that all stat impairments and our GAAP impairments are comparable.

Mark Finklestein - Fox-Pitt Cochran Caronia

Okay, thank you.

John Johns

Thank you. One more question please.

Operator

Thank you. Your final question will come from the line of Thom Gallagher representing Credit Suisse. Please proceed.

Unidentified Analyst

Hi guys thanks for taking the question. This is actually Mike Crimskey (ph) covering for Thom Gallagher. I appreciate the disclosure on the RMBS. I was hoping if you can give me some more insight on basically how we can get more comfortable with the lower rated non-agency prime and Alt-A given that we all know current vacancy trends on those subordinations levels. The ones that are non-AAA are higher than typical tranche. Are your securities atypical? Like for example, you guys wrote down lots of AA Alt-A or you still have a lot that's below AA currently?

John Johns

Carl Thigpen...

Carl Thigpen

Yeah I'll give you the statistics in aggregate. On our prime portfolio, we've had cumulative losses of 11 basis points and our current credit enhancement is 4.43%. On our Alt-A we've had cumulative losses of 0.49% but half percent in our credit enhancement is 4.85%. So our losses have not been severe, and we still have substantial credit enhancement. The downgrades particularly with the prime RMBS, and you have to understand that we have sequential pays and packs primarily which will make up over 80% of the portfolio that are very short or we're at top of the capital structure. It is more related to the anticipation of losses by the rating agencies than what has actually occurred. So the changes in the ratings and the actual losses that we've seen are not running parallel.

John Johns

Carl, I think it's also worth noting, Rich can correct me, if I'm not exactly right about this. We are seeing very rapid amortization of our non-agency mortgage backed securities. So they're going to burn up the books here very quickly and as they do we continue to pick up subordination within the structure too.

Richard Bielen

Prepays were low in December, they picked up substantially in January and then the indications that February was a refinancing going on in the market, we will continue to have higher levels of prepays. And we will... we averaged 70 to 80 million or 70 million of mark in last year's prepays. And we expect that to be much higher this year as it gets shorter and shorter.

Richard Bielen

And Mike one last point to just remind you and the reason we kind of distinguish except for that one pool of what we have referred to as AA Alt-As that I saw that, they call (ph) with, literally everything else we have ever purchased in the non-agency space plus a senior or super senior tranche depending on the timing and the vintage of when those were down. And so although you are seeing the ratings migration down, the loss severity even if one of those deals should see loss, it should be relatively low because our tranches are in almost all cases currently amortizing. And it will represent a loss distribution among senior tranches, which is a fraction of what happens when it's a subordinate tranche.

Unidentified Analyst

Okay. I guess it was tough, since you guys are just disclosing the range of distribution, I wouldn't be able to see the original ratings distribution, as I know that the all agencies are downgrading everything. As a follow-up, are you guys using external vendor pricing for non-agency prime or they're using in automobiles?

Richard Bielen

Yes, it's all external.

Unidentified Analyst

Okay. Thank you very much.

John Johns

Well thanks everyone. We appreciate your joining us for this call. I can't tell you again how disappointed we are reporting a loss. And we pledge to you we are working extremely hard around here to improve our results. And we are very hopeful and optimistic that we are going to see some movement in the right direction as we proceed on into 2009. As always if you have follow-up questions, we are happy to fill them. Thanks a lot.

Operator

Ladies and gentlemen, thank you for participation in today's conference. This concludes your presentation. You may now disconnect. Good day.

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Source: Protective Life Q4 2008 Earnings Call Transcript

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