Good morning and welcome to the Principal Financial Group first quarter 2009 financial results conference call. (Operator Instructions)
I would now like to turn the conference over to Tom Graf, Senior Vice President of Investor Relations.
Thank you. Good morning and welcome to the Principal Financial Group’s quarterly conference call. If you don’t already have a copy our earnings release, financial supplement and additional investment portfolio detail can be found on our website at www.principal.com/investor. Following the reading of the Safe Harbor provision, CEO Larry Zimpleman and CFO Terry Lillis will deliver some prepared remarks, then we’ll open up for questions. Others available for the Q&A are John Aschenbrenner, Life and Health Insurance; Dan Houston, U.S. Asset Accumulation; Jim McCaughan, Global Asset Management; Norman Sorensen, International Asset Management and Accumulation; and Julia Lawler, Chief Investment Officer.
Some of the comments made during this conference call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act. The company does not revise or update them to reflect new information, subsequent events or changes in strategy. Risks and uncertainties that could cause actual results to differ materially from those expressed or implied are discussed in the company’s most recent annual report on Form 10-K filed by the company with the Securities and Exchange Commission.
Thanks, Tom, and welcome to everyone on the call. While Terry will go into more detail, we believe first quarter operating earnings of $164 million or $0.63 a share were solid. Our expense initiatives offset some of the revenue decline caused by reduced asset valuations, and our life and health businesses continued to provide revenue and earnings stability. In spite of continuing disruption in the credit markets, our investment portfolio performed well resulting in net realized capital losses of $51 million and net income of $113 million or $0.43 a share. These results reflect early adoption of the new FASB requirements related to other than temporary impairments which Terry will discuss.
With that as an overview of the quarter, I’ll focus my comments this morning on two areas. First, measures that demonstrate the continued strength and competitiveness of our asset management and accumulation businesses and second, actions we’re taking in response to this environment to insure we’re positioned to emerge even stronger when the business climate improves.
During the first quarter we continued to demonstrate our ability to attract and retain customers. Our asset management and accumulation growth engines delivered $4.6 billion of net cash flows. This includes near record flows for full service accumulation of $2.9 billion which equates to 3.7% of beginning of year account values.
We also delivered $6 billion of sales from our U.S. retirement growth engines, full service accumulation, principal funds and individual annuities. $2.8 billion of these sales came from full service accumulation, a particularly strong result given that equity market declines have significantly reduced plan assets. We continue to execute our strategy to deepen our key distribution alliances. During the quarter, we expanded our relationship with Bank of America-Merrill Lynch, our top producing mutual fund alliance to cover defined contribution plans. This gives us access to a market leader with 15,000 advisors for the small to mid-size defined contribution market. While it may take several quarters to produce meaningful sales, we’re very excited about the potential this enhanced relationship creates for full service accumulation sales over the longer term.
Expanding on the discussion of defined contribution plans, let me offer some comments on how the market and economy is influencing plan sponsor and participant behavior. Given continuing market volatility, fewer plan sponsors are looking to change providers. This impacts our pipeline for new sales but also results in improved retention of existing plans. Compared to a year ago, retention has improved 26% based on plans. Approximately 10% of our employer customers have reduced or suspended the 401k match. For most of our small medium business customers, though, the 401k plan is the only retirement vehicle and it continues to be viewed as a key retention vehicle. While 7% of plan participants either stopped or reduced their contributions in the first quarter, we actually saw 7% increase their contribution rate. And finally, compared to the year ago quarter, hardship withdrawals and loans out of our block were actually down by about $15 million.
Moving back to the sales discussion at $2.1 billion for the quarter, mutual fund sales were also strong particularly in an environment where retail investors have largely remained on the sideline. Sales of funds from our two largest sources of production, our national channel of outside broker dealers and our defined contribution investment only channel, together improved 26% from a year ago. We also delivered 10% growth in individual annuity sales on the strength of our fixed offerings which grew 18% from a year ago, offsetting weakness in demand for variable annuities.
As you know, we’ve purposely restricted our variable annuity distribution footprint to our proprietary or career distribution channel. Variable annuities with guaranteed living benefits remain a small part of our business with a block of just $1 billion. This minimizes the impact of equity market volatility on individual annuities earnings and results in our life company capital ratios being significantly less leveraged equity market changes than our peers.
Reflecting multiple wins across each of our asset classes, Principal global investors received $3.5 billion of deposits from non-affiliated clients during the quarter. Our participation in search activity remains strong, although there continues to be some delay in institutional funding due to market volatility. However, two of the three large unfunded commitments from Asian sovereign funds discussed at year end, funded or began to fund in the first four months of the year including the Japanese government pension investment fund.
On the retention front, PGIs non-affiliated withdrawals improved from 5.8% of beginning of year assets under management in first quarter 2008 to 4.3% for first quarter 2009. In terms of relative investment performance, 36%, 50% and 66% of PGIs retirement plan separate accounts were in the top two Morningstar performance core tiles for the one, three and five year periods respectively. Performance of international equities and asset allocation funds remains strong, particularly the three and five year performance.
In response to market conditions we continue to take action with respect to our investment portfolio. We continue to invest new cash into high quality, liquid assets with the majority going into agency mortgage pass throughs and NAIC 1 corporate bonds. We’re actively managing exposures in this changing credit environment, taking the opportunity during the quarter to sell approximately $340 million of Triple B bonds and redeploying to higher quality investments.
We have not purchased commercial mortgage backed securities since July, 2008 and we expect that about $400 million will pay off at maturity in 2009, reducing our exposure. Regarding our commercial mortgage portfolio, during the first quarter 88% of the $212 million scheduled to mature found external financing. This demonstrates continued strong market demand for the type of loans we’ve historically invested in, well underwritten loans primarily in the $5 to $20 million range with high occupancy generally over 90%, low loan to value generally averaging in the mid-60% range and high debt service coverage generally greater than 1.75 times. We expect our experience for the remainder of 2009 will be similar to our first quarter experience given the size and characteristics of the loans maturing.
We also continue to be focused on liquidity as well as credit quality. Compared to a year ago, we’ve increased total cash and cash equivalent holdings by 141% to $2.7 billion. Liquidity is further supported by the company’s portfolio of government backed securities, which increased 43% from a year ago to $3.1 billion. This strong liquidity enabled us to continue scaling back on the investment only business. We reduced the block by $1.5 billion during the first quarter, freeing up another $60 million of capital. At quarter end, relative to an RBC ratio of 350%, our excess capital position was approximately $850 million all at the holding company.
Prior to quarter end we moved $645 million of cash as an ordinary dividend from the Life Company to the Holding company. We estimate our Life company risk based capital ratio to be in the range of 350 to 375% at quarter end. With cash and cash equivalents of approximately $850 million as of quarter end, the Holding company has sufficient liquidity to meet its needs for 2009, primarily senior debt maturing in August of which $441 million remains outstanding.
We also continued to have access as needed to the commercial paper markets and have $393 million of commercial paper outstanding as of April 30. Based on current projections, cash needs at the Holding company in 2010 are minimal, approximately $80 million. The Holding company also continues to meet all financial covenants necessary to access its $579 million credit facility.
Looking ahead, we will continue to focus on aligning expenses with revenues over the longer term. Management action over recent quarters has reduced compensation and other expenses by $86 million or 15% compared to the year ago quarter. We implemented additional expense initiatives in March. In total, we expect these initiatives will reduce the annual run rate for 2009 expenses by $350 to $400 million.
While aligning expenses with revenues remains a priority, we’ll do it in a thoughtful way to insure our competitive position remains strong and customers are well served. We’ll continue to protect the advantages we’ve worked so hard to build over so many years; our local network of sales, service and consulting capabilities developed to meet the needs of growing businesses, their employees and the advisors who serve them, our deep asset management capabilities that support long term investment strategies, and our broad portfolio of retirement and investment products that enables us to meet customer needs across the accumulation to pay out spectrum.
Let me take just one more minute to describe some very important recent recognition. In January we were named to the Fortune 100 Best Places to Work, and in March a Top Ten Company by the National Association for Female Executives. This is our seventh consecutive year on both lists. In April, three Principal funds received Lipper Fund Awards based on multi-year performance, an achievement that showcases our investment expertise and long term view. Also in April, the Ethisphere Institute again named The Principal to their list of world’s most ethical companies. Principal was one of only three financial service companies to make the list this year, and one of only 44 companies in the world that have been on the list for each of the three years it has been compiled. We believe this recognition demonstrates the value and character of the organization, and that Principal Financial Group remains a company that customers and investors can count on during these times.
Thanks Larry. This morning I’ll cover total company and segment results, I’ll provide color for our investment portfolio, investment losses for the quarter and new requirements for measuring and presenting other than temporary impairments. I’d like to emphasize three key points. First, strong expense management has helped offset revenue declines associated with this difficult operating environment. Second, our investment portfolio continues to perform well, resulting in a manageable level of realized capital losses in the current period. And third, independent stress testing of our CMBS portfolio validates our view that losses will occur over time and will be manageable.
Now to total company results. Operating EPS was $0.63 in first quarter 2009. This compares to $0.99 in the year ago quarter, $0.90 excluding benefiting items as previously disclosed. Clearly there was a great deal of external pressure on first quarter results. Market conditions including a 41% drop in the S&P 500 Index daily average drove down our average assets under management by 21% from a year ago. This in turn reduced earnings per share by approximately $0.20. As communicated at investor day, market conditions in 2008 are also significantly increasing 2009 costs for employee, pension and other post retirement benefits which we refer to as security benefit costs. This reduced first quarter 2009 EPS by $0.08 after tax and after DAC. Earnings per share were also dampened by $0.05 combined for foreign currency in Latin America and deflation in Chile, $0.04 from lower investment income due to holding more liquid investments, and $0.03 each for lower prepayment fee income, for change in business mix in the full service accumulation business, and for lower earnings due to the scaling back of the investment only business.
Two important points. First, the decline from a year ago reflects market conditions. Our underlying fundamentals remain strong. Second, management actions have reduced fixed expenses by $0.22 a share from a year ago, softening the impact of market and unfavorable macroeconomic factors. We’ve created a lean organization that will emerge even stronger as the economy improves.
Moving to U.S. asset accumulation, segment account values were down $33 billion or 19% from a year ago to $142 billion at quarter end. Between full service accumulation and principal funds, negative investment performance largely due to equity market declines resulted in a $37 billion decrease in account values over the trailing 12 months. This was the primary cause of lower operating earnings for the segment, $93 million in first quarter 2009 compared to $139 million a year ago. The drop in earnings for the segment also reflects $9 million after tax from higher security benefit costs and $6 million after tax due to lower prepayment fees during the quarter.
Moving to individual annuities business, fixed annuity earnings improved 10% from a year ago to $17 million. Variable annuities generated a $12 million loss compared to $2 million of earnings in the prior year quarter. Unfavorable equity markets resulted in a reduction in separate account asset fees, an increase in back amortization expense, and an increase in guaranteed minimum death benefit reserves and claims from a year ago with the impact totaling $14 million after tax.
Before moving on, a couple of comments on full service accumulation back amortization. The decline from $28 million a year ago to $13 million for the first quarter 2009 primarily reflects GAAP accounting which dictates lower amortization in periods of lower gross earnings. This resulted in the first quarter 2009 amortization expense being $14 million lower than the first quarter 2008. Our quarterly review of DAC resulted in an $8 million increase in expense as we trued up for market performance, comparable to a $10 million true up in the year ago quarter.
Earnings for global asset management, $7 million in first quarter 2009 compared to $20 million in the year ago quarter, also reflected significantly lower assets under management driven by market conditions, as well as the impact of lower transaction fees due to a slowdown in the real estate market. We continue to work hard to capture institutional assets and to align expenses with revenues through active expense management. This includes headcount reduction, which resulted in severance costs of $2 million after tax in first quarter 2009 and $6 million after tax over the trailing five quarters.
Moving to Principal International, earnings of $17 million in first quarter compared to $32 million in the year ago quarter. The decline reflects macroeconomic conditions. Weakening of Latin American currencies against the dollar dampened first quarter 2009 earnings by $6.5 million compared to a year ago. And deflation in Chile dampened first quarter 2009 earnings by $7 million. In April, Chile returned to an inflationary environment. Assuming inflation continues, we would expect this drag on earnings to substantially go away. While down on a reported U.S. dollar basis, on a local country basis Principal International’s assets under management are essentially unchanged from a year ago as strong net cash flow over the trailing 12 months offset declines due to the negative market performance.
Life and Health segment earnings of $72 million in first quarter 2009 compared to $79 million in the year ago quarter. The variance reflects higher security benefit costs in the first quarter 2009 than first quarter 2008. This reduced segment earnings by $9 million. It also reflects the impact of favorable reserve adjustments in the individual disability line and in the health division, resulting in an $8 million after tax net benefit in first quarter 2008. Excluding these items, segment earnings increased 14% reflecting solid expense management across the segment and improved closed block experience in the Individual Life division. A quick explanation in light of higher Individual Life claims expense and lower DAC amortization expense in first quarter 2009. Higher gross claims were substantially offset by reinsurance. GAAP accounting requires us to defer much of the benefit of reinsurance which causes an increase in the benefit and claims line, but it also results in a substantially offsetting reduction in DAC amortization expense.
Moving to Corporate, which primarily reflects the cost of debt service coverage and payment of the preferred dividend, segment losses of $25 million were in line with expectations. Turning to net realized capital losses, in the first quarter 2009 we recognized $51 million of capital losses which compares to $189 million of losses in fourth quarter 2008 and $75 million of losses in the prior year quarter. Our internal credit exposure guidelines and the resulting diversification have continued to help limit our losses during the financial crisis.
As communicated in our earnings release, the company adopted the new FASB requirements related to other than temporary impairments. With first quarter 2009 reporting, based on new requirements on a pretax basis, total other than temporary impairment losses on available for sale securities were $147 million and the net impairment losses on available for sale securities were $96 million. The noncredit portion of the total losses, which is recognized in other comprehensive income, was $51 million. Had we not adopted early, these losses would have run through the income statement after tax and after DAC, reducing net income by $28.5 million.
At quarter end gross unrealized losses were $8.2 billion, essentially unchanged from year end. About $400 million of improvement in gross unrealized losses from narrowing of credit spreads was offset by a comparable increase caused by higher interest rates. Similar to last quarter, we continued to see a significant liquidity premium in cash market prices. Using the more actively traded credit default swap market as observable data, gross unrealized losses on our corporate bonds would have been approximately $3.5 billion lower in the first quarter.
And using the CMBX Index, gross unrealized losses on our CMBS portfolio would have been approximately $400 million lower. So in total, gross unrealized losses as of March 31, 2009 would have been $3.9 billion lower than reported using synthetic markets. This would have doubled our GAAP book value per share from a reported $8.03 to over $16. Through the month of April we’d estimate a drop in gross unrealized losses of approximately $900 million with a $1.4 billion decrease due to narrowing of credit spreads being partially offset by a $500 million increase due to higher interest rates. We continue to believe that wide credit spreads are driven more by liquidity issues than underlying credit risks.
A couple of key points, gross unrealized losses are unrealized for a reason. Our assets are performing, our cash flows have not been diminished, and we continue to see our assets mature at PAR. We’ve built deep expertise in corporate, credit and commercial real estate as we invest our assets to match our liabilities, which are generally longer term and predictable. Our [audio impairment] ability discipline along with our strong liquidity position gives us the intent and ability to hold assets until maturity. We do not believe that we will be forced to sell assets into a thinly traded market at a loss. Given difficult market conditions, we continue to expect higher than normal losses on our investment portfolio. That said, we continue to believe that gross unrealized losses are a poor indicator of future investment losses, reflecting again a supply demand imbalance as opposed to credit fundamentals. In response to investors’ interest, we’ve continued to provide quarterly updates to investment detail on our website.
Let me focus on additional analysis related to our commercial mortgage and CMBS holdings. First, we’ve updated all our commercial mortgage properties to current value as of March 31, 2009. Average loan to value for our portfolio increased to 67% as of quarter end from 62% at year end. This is still a very strong number in wake of meaningful drop in property values. Loans exceeding 80% loan to value with debt service coverage of less than 1 times amounted to just $555 million. Even if all these loans were to default over the next couple of years, with a [audio impairment] loss on each loan, that would equate to a loss of only $108 million after tax over the same time period, a very manageable level.
One other comment. We’ve also added a new display to the select investment detail which shows the results of running our CMBS bond portfolio through two different third party models. The research group specializing in CMBS for Citigroup and J.P. Morgan have each developed proprietary models which they can run loss scenarios for a portfolio using specific bond level data. This allows their models to differentiate losses based on the underlying characteristics of each bond. The results from both models are similar to the results of our internal model for our portfolio. Even under a stress scenario, losses are very manageable, occurring later in the cycle and over a multi-year period.
In closing, we see signs that some of the environmental headwinds may be easing. While equity markets have continued to be volatile, we were pleased to see a rebound with the S&P 500 up 29% from its March low through the end of April. Credit spreads narrowed in the first quarter and continued to do so in the month of April. We remain focused on positioning The Principal to emerge even stronger when the markets recover.
This concludes our prepared remarks. Operator, please open the call to questions.
Before we take questions, I’d like to turn the call over to CEO Larry Zimpleman for a brief comment. Sir?
Thank you. We do have one new item we want to share this morning. We’ve been informed that Standard and Poor’s will downgrade Principal Life’s insured financial strength rating one notch to A+ with a stable outlook. The A+ rating is characterized as strong, the fifth highest of their 21 levels. It’s our understanding the primary reason for the change was a dividend to the Holding company from the Life Company. While we don’t agree with the decision, it is our understanding the review also considered a number of key positives for The Principal, including our sustained strength in U.S. small and medium sized retirement business, and our competitive position in our Life and Health segment businesses.
With that, Operator, let’s go to questions.
(Operator Instructions) Your first question comes from Andrew Kligerman – UBS.
Andrew Kligerman – UBS
Question on the level three assets. At the end of fourth quarter I believe they were $1.12 billion. Could you specify that figure as of the end of the first quarter? And then secondly, what was the overall impact on book value? I know you mentioned earlier in the call that net income was affected positively by about $25 million from the new FASB guidance. How about the effect including unrealized losses? What was the effect on book value from the new guidance?
Okay, Andrew, this is Larry. I think there’s two questions in there. The first one I think on level three assets and I’ll have Julia comment more specifically, but again there was not a substantial change in the amount of level three assets between fourth quarter and first quarter. And I’ll have Terry comment on your second item, but again Terry commented specifically on the $28.5 million that was the change to net income. I don’t think there was again any meaningful change in unrealized loss, but I’ll ask him to confirm that. So Julia you can go first.
Good morning, Andrew. Yes, there was no change in our level three assets as it relates in particular to FAS 115 which I think is probably what you’re referring to. We did not adjust our valuation methodology based on that change, even though we early adopted. So there was no change in the level three assets.
Andrew, as far as the FAS 115-2 there was little change to the book value. Now there was a re-categorization between routine earnings and AOCI of about $17.5 million on the accumulated basis. And then the $25.5 million that I mentioned in the opening comments was the current quarter impact of that. But once again, it didn’t change the overall book value, it just changed the categorization.
Andrew Kligerman – UBS
With operating EPS at $0.63, a lot going on, especially these expense initiatives. Do you care to give us maybe a run rate number, a normalized run rate number for earnings?
Andrew, this is Larry. We don’t really have an estimated new run rate for you. I think we did a pretty good job at investor day of laying out the pieces for you including kind of what the average S&P was, which is at least looking a little bit more reasonable now, and the impact of security benefits. So I think with those pieces you’ve got all the raw material to be able to take a good shot at it.
Your next question comes from John Nadel - Sterne, Agee & Leach.
John Nadel - Sterne, Agee & Leach
I have a question on Holding Company liquidity. So I understand from your comments that $850 million of cash at the Holding Company, I guess that’s as of March 31 or maybe its more current, but if you lost the ability to roll the $393 million of CP and you have to pay down the $440 million roughly of debt, I guess I’m trying to understand how the $850 million remains sufficient for the other debt interest payments for the remainder of the year, the dividend, etc. So maybe you could just walk us through where does the additional cash come from if you actually had to pay down 100% of the $440 million of debt and 100% of the CP outstanding?
Okay, John, good morning. This is Larry. I’ll see if I can kind of walk you through that. First of all you said we’ve got about $441 million of the 144-A debt outstanding, there’s about another $80 million or so during 2009 of other Holding Company expenses, primarily debt on the longer term outstanding debt. So that gets you around $520 million between the long term debt and service on a debt through the year 2009. Okay? You’ve got about $845 million in cash. Okay? $850. So now you’ve got about $325 to $330 million of excess already sitting in cash at the Holding Company. Okay?
John Nadel - Sterne, Agee & Leach
I’m with you.
You’ve got about $393 million of CP outstanding as of the end of April. So if you assume, which is a pretty draconian scenario and certainly is not consistent with the experience we’ve been seeing, if there was no ability to roll any more of that CP from today forward through the rest of 2009, we’d only find ourselves needing about $50 to $60 million of additional cash. And I would argue that the market trends are actually going the other way, they’re not going that direction. But in that scenario we also have a cash sweep capability between the Life Company and the Holding Company where we have easily up to $250 million, if not higher amounts than that, that could easily fill that $50 million gap. And as we’ve already reported we have about $2.7 billion in cash and cash equivalents within the entire complex.
So there really should be no particular issues as it relates to is there sufficient liquidity to handle not only the 144-A debt, all the service on that debt and all the CP outstanding. So I hope that walks you through that in sufficient detail.
John Nadel - Sterne, Agee & Leach
Larry, you’ve spoken over the past couple of quarters. You’ve used this comment on a few occasions, multiple parallel paths, and I’ve been thinking about that and obviously credit markets have improved pretty dramatically from the March lows, but just wondering what your current thoughts are with respect to TARP, potential participation, how you might juxtapose that if you were actually willing to participate against the idea of simply raising equity, you know, directly in the market and thus, you know, avoiding any sort of governmental restrictions if you will.
Well, yes, John, you’ve characterized our thinking. So there’s not really a whole lot more to add to that. You know, I think I’m heartened that our excess capital position at $850 million at the end of the first quarter is actually up from our position at year end. But as we’ve said before, it’s prudent that we continue to evaluate all the capital options that are out there in order that we maintain our flexibility in these uncertain times. And we don’t really have any further update on CP, CPP, I’m sorry, at this point in time. And if we were approved we’d have to consider whether we’d want to participate and at what level based on the terms and conditions and what other options were available to us. So that’s really about as much insight as I can give you at this point.
Your next question comes from Jimmy Bhullar - J.P. Morgan.
Jimmy Bhullar - J.P. Morgan
I had a couple of questions both on your pension business. The first if you could talk about your pipeline overall and just your sales in the first quarter were pretty strong but obviously part of the benefit was because of the community health assistance piece. And then secondly on your flows, to what extent have your withdrawals benefited from just restrictions on withdrawals out of accounts? There’s a story this morning in the Wall Street Journal that some of your accounts had withdrawal restrictions. If you can talk about how much of a benefit you received from that and what your outlook supposes the [inaudible].
I’ll just turn it over to Dan for the detailed answer. Again I want to be careful, Jimmy, in regards to the article today. The article today was specifically talking about the Real Estate separate account. I don’t want to have you give an impression that there are several accounts that would be in that position. That’s only the single Real Estate separate account and again that’s not an unusual situation. In fact, I believe every other similar co-mingled account that’s in the industry has similar queues and in fact I think ours was the last one to put its queue on. So that’s the only account that’s being impacted. So just that as clarification and I’ll have Dan cover the two questions.
Sure. Thanks. Hi Jimmy. A couple of quick comments. The pipeline is a bit softer in Q2 than it has been previously. A lot of that is attributable frankly to delayed decision making on the part of plan sponsors. Also remember that there’s lower account balances given the negative impact from the market performance in this past year. I’d also say that the advisors are spending an awful lot of time working on other, more pressing issues and I don’t think that really the clients are looking to make a move at this point in time given the significant market declines that’s taken place. So that effectively gives you an outlook for Q2 at this point.
As it relates to the withdrawals as Larry was saying it really is limited to our Principal Real Estate separate account. It’s about a $4 billion account. To the best of our knowledge, this daily valued account is a bit unique in the market. It performed exceedingly well for the last 25 years. We still feel good about it and we don’t think it’s had any sort of material impact on fewer withdrawals. We’ve had fewer withdrawals in total but we don’t attribute much to this specific account.
Your next question comes from Steven Schwartz - Raymond James.
Steven Schwartz - Raymond James
I was about to ask about the Wall Street Journal article. Just to make clear, I believe the article stated that there was about $1 billion of withdrawal requests that had not been, that were not being funded. Is that an accurate statement? Can you comment one way or another?
Sure, Steven. Good morning. This is Larry. I’ll have Jim McCaughan, you know, make a comment on that. Again I think it’s a little bit important to kind of understand the emotional dynamic that plays at work in a scenario like that in terms of the size of the queue, where the size of the queue itself can be impacted whether someone thinks that they may or may not have the opportunity to withdraw over a future period of time. But, so just remember the emotional dynamic there. But I’ll have Jim provide you some more detail around that.
Yes. As Larry mentioned we were one of the last co-mingled accounts to put in place a queue for withdrawals. We did so last September when the credit market completely seized up. Of the $1 billion queue, quite a lot of it and that number is roughly accurate, quite a lot of it is institutional accounts who are doing rebalancing because of the denominator effect. In other words, they have a target weight, maybe 10 or 15% in real estate. Their equities have gone down a long way. The real estate’s gone down a lot less. So they’re rebalancing and they therefore put all of their real estate holdings into queue, really to see whether they can come up with the ability to rebalance towards equities.
So that would account for a chunk, perhaps about half of the queue. So it would be wrong to think of it all as 401k participants. The second thing to say about the queue is that it really is to do with people reallocating assets within funds, not people trying to get out of our platform. And those reallocations are very often driven by a differential performance between different asset classes. And so it’s by no means certain that the $1 billion in the queue will actually choose to cash in when they come to the head of the queue, though there is a degree of uncertainty really about whether they will actually choose to do so. However, in recognition of all this, we have very diligently placed on the market a number of properties and we’re working very hard as potential buyers can in a healing credit market get some credit to do the purchases. We’re working very diligently to try to create some liquidity both for 401k participants and for the institutional clients within that account.
We can only do what the market will permit us to do, and the markets are still largely seized up, but we’re seeing positive signs. So we’re working hard to make sure that we can satisfy the legitimate liquidity demands that clients have. I hope that puts it in context.
Steven Schwartz - Raymond James
If I could ask just two more quickies, the first on the security and pension cost, were those in line with what you thought they would be as of the investor day?
Yes they are Steven.
Steven Schwartz - Raymond James
One final one back to Jim. Jim, kind of a one off, are you getting any traction in the [share] compliant market?
Yes, we are. We’re doing a fair amount of business there already both in the retail market and we’re having quite a lot of conversations with institutional clients who are interested in it. It’ll be long term but it’s a very promising initiative for us.
Your next question comes from Suneet Kamath - Sanford Bernstein.
Suneet Kamath - Sanford Bernstein
First on the $8 of incremental book value tied to the lack of liquidity in the fixed income market, it seems to me that you’ve been the most vocal about sort of throwing a number out there and it also would seem to me that the approach that you’re taking would sort of be consistent with what FASB was trying to get at in terms of possibly changing some of the mark to market rules for securities in liquid markets. So my question is why wouldn’t you use that sort of framework to adjust what your marks are in the quarter? And then the second question sort of maybe for Julia on the investment portfolio. I think Terry mentioned that realized losses are going up. I think most people expect that. Other companies have thrown out sort of a ratio of about 1%, maybe a little bit higher of the portfolio being realized over a 12 month period. Can you comment on what your expectations are with respect to that number? Thanks.
Hi Suneet. This is Larry. Let me, I’ll try to offer as the non-accountant here and Terry may want to add something, but I want to just make a few comments, you know, on your first one. I think that, you know, the media certainly very quickly reported on the FASB staff changes as though it was going to create a fairly new and different environment around the mark to market. And I think to your point it perhaps would have been a perception that for example you can move more on a wholesale basis to the synthetic indexes.
However, I have to tell you that both from our conversations with our own auditors as well as our study and we’ve done quite a lot, of others who have reported to this point in the cycle, I think save one exception, one company, I think that what you’re seeing is that the mark to market at this point has unfortunately been kind of a non-event. And, you know, whether that might change going forward I think that remains to be seen. I think that there continues to be kind of a reluctance and conservatism and maybe that’s somewhat of a portion of the times that we’re in.
I would say that I think if anything it furthers, I think, our attempt to provide investors with other ways and frankly we think more meaningful ways of understanding the markets and the conditions in the market, and specifically the sort of illiquidity premiums. So whether we might see some movement in that by auditors and other companies and ultimately have more flexibility in that in quarters to come, I guess, remains to be seen. I’ll see if Terry wants to add anything.
Yes, Larry, I’d just like to add one thing is we looked at this very closely. We talked with our auditors and basically came up with there was no meaningful change. As Larry mentioned, you know, the cash price is still significantly affected by the illiquidity premium and we just wanted to give another potential observable data point to quantify what could change.
We wish, Suneet, that we could use April 30 instead of March 31 because as Terry commented there’s already been quite a substantial improvement there. But I would note that as an even further leverage that I think the market is again as Terry said starting to gain some sense of normality.
And on the realized losses I’ll have Julia make some comments on that.
Morning Suneet. We have tried to give some different scenarios in different environments around each of our asset classes. At investor day you’ll recall we gave some views around bond losses over historical loss periods. In today’s script Terry talked a little bit about what commercial mortgage losses could look like in a different scenario. And the 1% actually comes very, very close to all of those. So we tried to give that in each different asset class. CMBS we’ve given some scenarios as well, so 1% actually comes quite close.
Let me emphasize that’s over a multi-year period of time, Suneet. That’s not in any particular quarter, it’s over a multi-year, multi-quarter period of time.
Overall asset classes.
Suneet Kamath - Sanford Bernstein
And then one quick follow up on the unrealized loss as of April. I think you said $900 million decline. That’s pretax and pre-DAC so can we talk about half that, $450 divide by 260, that would be an incremental $1.73 of book value per share. Is that the right way to think about it?
I think you’re in the ballpark, Suneet.
Your next question comes from Edward Spehar - Merrill Lynch.
Edward Spehar - Merrill Lynch
First, Terry, I was wondering on RBC if we looked at the impact of the dividend and I think some modest statutory income, it looks like the RBC ratio could be higher than sort of the range you’re talking about. And I was wondering if you could go through maybe just a little bit on some of these assumptions because I think you have sort of assumed that there’s going to be an elimination of this deferred tax relief that you’ve received, that the mortgage experience factor’s not going to be a benefit any more. Maybe you could talk a little bit about whether or not there’s some conservatism in that number.
And then just the second one really quickly is on repurchasing debt. Could you talk about the idea of sort of you did a little bit of the long term debt that’s maturing in August, could you talk about plans to do a little more? Thanks.
Good morning Ed. This is Larry. I’ll let Terry comment. I would just say quickly on the RBC one I think one of the issues there really is more related to credit drift and what assumptions you want to make as it relates to credit drift, whether that’s, you know, throughout the year or whatever. So I think that’s the other piece that goes into that. And again we’ve tried to be very fair and balanced in that number that Terry quoted. But I’ll let him give you more of the details.
Yes, Ed, let me lead you through where we were at the end of last year. At the end of the year we had a 440 RBC ratio. To reconcile is we moved about $645 million out of the Holding Company, excuse me, to the Holding Company as a dividend. That reduced the estimate by about 65%. We also were seeing downgrades in our investment portfolio that will cause some drift in asset classes, so we’re expecting an additional 25 basis point drop there. But then we have some positives. As you mentioned some statutory earnings, we scaled back on the investment only business, and also at the 350 range, the 375 reflects a [MEAP] of one. What we’re actually seeing is a MEAP of 0.5 at this point in time. We have not included that in our estimate, so you could probably add another 35 to 40 basis points on top of that.
In terms of the repurchase, you know, we did take an opportunity repurchasing about $14 million early and we’ll continue to evaluate that as the opportunity comes to.
Edward Spehar - Merrill Lynch
On the investment only capital that’s being freed up, is that going directly to the capital or is that coming through statutory earnings?
It’s going right to capital. It’s freeing up the required capital.
Stays inside the Life Company.
Edward Spehar - Merrill Lynch
But that’s outside, it’s not coming through in statutory earnings. It’s just directly capital being freed up?
Exactly. Not coming through earnings.
Your next question comes from Randy Binner - FBR Capital Markets & Co.
Randy Binner - FBR Capital Markets & Co.
I had a few questions just on the CMBS. You had mentioned that there’s about $400 million of CMBS paying off in 2009. Could you break out the ratings of those that are paying off in ’09, the timing they’re paying off in ’09 and if you have it handy what similar payoff numbers are for 2010 and 2011?
Okay, Randy. Let me, in terms of the CMBS I’ll have Julia comment. I was looking a little bit at the maturities for the CMBS and they’re certainly not perfectly spaced during the quarters, but at the same time they’re not substantially different quarter by quarter. So if it’s $400 million in four quarters, you know, it might be $80 in one, $120 in another and now I think we’re getting into probably refinements that are not significant. But I’ll have Julia comment on the other question.
And Randy we don’t have them split out by credit quality but they are generally the higher quality securities because they’re older vintages obviously paying off. But we don’t have them actually split by triple A, double A, etc. And they are evenly disbursed for the most part throughout the year and in 2010 it would be a similar dollar amount maturing.
Randy Binner - FBR Capital Markets & Co.
I wasn’t clear with the $350 to $375 RBC range. Terry had mentioned there’s 25 basis points for ratings drift. Is that, I’m sorry 25% for ratings drift. Is that a forward-looking item or is that just what the drift we’ve seen through this past quarter?
It’s about the drift we’ve seen through this quarter, Randy. Whether that turns around, I mean again that might look a little different frankly at the end of April. Okay? So that’s a number as of the end of March and again it’s very much of a moving part to try to predict where that’s going to be, you know, at any where during the year. But that’s where it was at the end of March.
Randy Binner - FBR Capital Markets & Co.
Was that 25% just from the drift in?
It’s about 25 basis points, Randy, just to make this clear.
Randy Binner - FBR Capital Markets & Co.
Is that from drift just in the quarter or is that kind of a running total?
No, that’s just that during the first quarter, Randy.
Your next question comes from Mark Finkelstein - Fox-Pitt Kelton.
Mark Finkelstein - Fox-Pitt Kelton
I understand your comments, Terry, just on the commercial mortgage loan portfolio but I was a little surprised by the increase in some of the statistics in the quarter in terms of the lowered DFCs, etc. And I guess what I’m curious about is firstly what were the delinquency ratios at year end and Q1 ’09 if it’s in the stuff I just missed it. And then two, I guess the valuation reserve went up about $27 million. Can you just talk about kind of how you arrived at that number and maybe just the methodology on that? That’s my first question.
Okay. I think there’s two there, but okay, Mark. I think first of all on the delinquencies that’s even a number I know. The answer there is one. So I think there was one at the end of the first quarter. And I’ll let Julia talk a little bit more about the valuation reserve.
Yes. For the most part we do not do a total portfolio reserve. We do, but it doesn’t change much. Most of the reserving you will see against our commercial mortgage portfolio will be loan specific reserves. And that is determined by valuations and delinquencies. To the extent we have very low delinquencies and we still have equity in our loan portfolio you will see those loan specific reserves be smaller. That’s why we gave you an indication of the loans greater than 80% with debt service coverage below one so you get some indication of what will be occurring over the next two to three years.
Mark Finkelstein - Fox-Pitt Kelton
I guess, can you just talk about the timing of the dividend? I mean the maturity of the debt isn’t until August. You obviously pulled it up well before then. I guess what was the rationale? We talked a little bit about this last night, but can you just go through the rationale of why now and I guess how should we think about it in the context of other capital initiatives?
Well I think really in terms of the, you know, the why now I think basically it’s just to I think demonstrate the strong liquidity not only of the entire organization but specifically at Hold Co and to eliminate any feeling that somehow that was going to be an issue in terms of the, you know, the refinance ability of the debt. So that was the reason the decision was made to go ahead and do it as of the end of the first quarter.
Your next question comes from Thomas Gallagher - Credit Suisse.
Thomas Gallagher - Credit Suisse
Just a follow up on I guess the question of how things play out with commercial mortgage loans. So Julia if $675 million of loans with debt service coverage under one times, how should we think about that playing out? I know you’ve referenced two to three years. Is there a reason why it’s going to take less than 12 months to have to do something to those whether it’s restructured, foreclose or overall how should we be thinking about that portfolio? Especially on the ones that are now below debt service coverage.
Sure. I’ll have Julia walk you through that.
First of all, Tom, I think it’s important again just because it’s below one debt service coverage doesn’t mean that the borrower can’t continue to pay. And in fact, borrowers have continued to pay on all of those loans under one debt service coverage. So we have very strong borrowers and they believe in their properties and they generally continue to pay which is why we try to focus on the greater than 80% loan to value where debt service coverage is one. That becomes more at risk. The more equity you see fade away, the more at risk those properties become. Even those are unlikely to all become delinquent loans. But it takes a long time for borrowers to decide that they no longer have the wherewithal or they don’t want to protect the equity in their property.
You must remember, Tom, that most of these borrowers have substantial net worth. So it’s not their issue around the loan is not really related to necessarily the characteristics of the property, but they’re really looking at protecting their own longer term economic interest trying to assess, you know, how long the downturn might be, what the longer term value to property is, and recognizing their own substantial net worth. For all those reasons as Julia said it’s certainly not an automatic that under 1.0 means that a problem is going to immediately result.
Thomas Gallagher - Credit Suisse
Just a follow up on that, Larry. So are most, should we assume most of those have personal guarantees attached to them? And also understanding that there’s still cash flowing today, is there, have you typically seen a substantial lag in terms of when it drops below one times debt service coverage? And can we typically see these perform for another couple of years before it becomes an issue?
I’ll let Julia comment, Tom. Good question.
Tom, I would not suggest that most of those have personal guarantees. Some do. Some have further structure behind them whether it’s an escrow or a letter of credit. So there is other credit behind it, but not all of them. So I wouldn’t want to indicate that there’s a lot of personal guarantees behind them. What we were indicating is though that these are very, very strong borrowers that do want to protect the economics of their property, so they are willing and able to come out of pocket to service the debt service when the property itself doesn’t cover any longer. And yes we do see a lag from the time it goes below to the time it becomes a problem.
And ladies and gentlemen we have reached the end of our Q&A. Mr. Zimpleman your closing comments, please.
Well thank you. I just in closing want to thank all of you with us this morning for your interest and taking time to join us in the call. Certainly it continues to be a bit of a challenging environment and those challenges will certainly continue going forward, but I hope that first quarter provides ample evidence that we believe we are a company with very strong fundamentals and a very, very strong and experienced management team with a proven ability to execute. So again thanks for your interest. We look forward to meeting with many of you in the near future. Have a great day.
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