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Principal Financial Group, Inc. (NYSE:PFG)

Q2 2010 Earnings Conference Call

August 3, 2010 10:00 AM ET

Executives

John Egan – VP, IR

Larry Zimpleman – CEO

Terrance Lillis – CFO

Daniel Houston – U.S. Asset Accumulation and Life and Health Insurance

Norman Sorensen – International Asset Management and Accumulation

Julia Lawler – Chief Investment Officer

Jim McCaughan – Global Asset Management

Analysts

Steven Schwartz – Raymond James & Associates

Jeffrey Schuman – Keefe, Bruyette, & Woods

Darin Arita – Deutsche Bank

Thomas Gallagher – Credit Suisse AG

Randy Binner – FBR Capital Markets & Co.

Edward Spehar – BofA Merrill Lynch

Colin Devine – Citigroup Inc

Mark Finkelstein – Macquarie Research

Operator

Good morning, and welcome to the Principal Financial Group Second Quarter 2010 Financial Results Conference Call. (Operator Instructions) I would now like to turn the conference call over to John Egan, Vice President of Investor Relations.

John Egan

Thank you, and good morning. Welcome to the Principal Financial Group’s Quarterly Conference Call. As always, our earnings release, financial supplement and additional investment portfolio detail can be found on our website at www.principal.com/investor.

Following a reading of the Safe Harbor provision, CEO, Larry Zimpleman and CFO, Terry Lillis will deliver some prepared remarks. Then we’ll open up the call for questions. Others available for the Q&A are Dan Houston, U.S. Asset Accumulation and Life and Health Insurance; Jim McCaughan, Global Asset Management; Norman Sorensen, International Asset Management and Accumulation; and Julia Lawler, our Chief Investment Officer.

Some of the comments made during the 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, and quarterly report on Form 10-Q filed by the company with the Securities and Exchange Commission.

Now I’d like to turn the call over to Larry.

Larry Zimpleman

Thanks, John, and welcome to everyone on the call. In my prepared remarks, I’d like to briefly discuss the results for second quarter in 2010 to date, discuss the ongoing implementation of our global strategy and close with a few comments about the future. Terry, will cover the results in more detail following my comments.

Let’s start with second quarter results. In view of the slowdown in economic growth and negative returns for the equity market in second quarter, we view the operating results of $204 million or $0.63 per share as solid. If you adjust results for both the second quarter 2010 and 2009, for DAC amortization true-ups associated with equity market returns, we see second quarter 2010 results of $215 million against second quarter 2009 results of $186 million, an increase of 16%.

Looking at the results for our growth engines, Principal International, Principal Global Investors, and Principal Funds all had reported double digit earnings growth, improving 33% on a combined basis. If you adjust the performance of full service accumulation or the impact of equity market true-ups on DAC amortization, you see operating earnings up 21%.

In terms of other financial metrics, book value per share including AOCI ended the quarter at $26.23 up 4.6% from last quarter and up 62% from a year ago. We also moved in to a net unrealized capital gain position as of June 30th, from a $4.8 billion net unrealized capital loss position a year ago.

This improvement in financial metrics reflects the ongoing improvement in credit markets as the economy recovers. It also demonstrates the value of our strong asset liability management, the quality and diversification of our investment portfolio and our liquidity management. All of which allows us to weather even extended periods of market stress and dislocation.

As we have said before, it is difficult to draw conclusions in business trends from a single quarter. But in general, we view sales and deposits as an improving picture with results being more mixed for net cash flows.

Second quarter, again, demonstrated the importance of our international businesses as Principal International generated a record $1.5 billion in net cash flows in second quarter, bringing their 12-month total to a record $3.4 billion or 12% of beginning of period assets.

Principal Funds and individual annuities also delivered positive flows for the quarter of approximately $130 million each, thanks to solid sales.

Full service accumulation has negative flows of $330 million for second quarter. This reflects the seasonality of sales with lower transfer deposits usually in the second quarter and the loss of a larger case based primarily on price. Importantly, we are seeing a steady increase in sales pipeline.

Sales activity, which was $918 million for the quarter up 27% and recurring deposits, which were up 1% over second quarter 2009. This is the first increased in recurring deposits in seven quarters.

Full service accumulation net cash flow remains positive through six months and we expect flows to be positive for the full year against an industry projected by Siruly [ph] to be an outflow in 2010.

Other positive indicators besides pipeline or their close rates continue to improve and proprietary investment performance results are solid.

We expect full year 2010 full service accumulation sales to come in about 15 to 20% higher than 2009 due to our alliance distribution efforts and the competitiveness of our Total Retirement Sweep Platform, an operating margin for full service accumulation remains steady and in line with our expectations.

Principal Global Investors had unaffiliated or third party outflows of $1.6 billion during second quarter. Although their investment performance remains generally good across all asset classes, new deposits for this quarter were low relative to historic levels reflecting a decline in institutional searches in the U.S. and around the world. We also saw higher institutional withdrawals during the quarter as clients continued to change investment and asset allocation strategies and made withdrawals for the purpose of making benefit payments.

That said, unaffiliated deposits had been stable over the past several quarters and are trending up modestly from year end 2009. We continue to be search competitive and continue to win business. Second quarter deposits of $3.3 billion included more than $800 million of funding from new clients covering a wide range of offerings from large and small cap growth to high yield and preferred securities.

As I mentioned, investment performance remains solid overall and has not been a driver of client withdrawals. For Principal Global Investors and its affiliates as of quarter end, 78% of funds were in the top two Morningstar quartiles for the one-year period, 53% for the three-year period and 64% for the five-year period. This includes particular strength in asset allocation funds were 75% or more of our offerings were in the top two Morningstar quartiles for each of the one, three and five-year periods.

As institutions continue to gradually rebalance out of fixed incomes into higher risk assets, we’re seeing flows into assets in which we have particular strength, international and emerging market equities as well as currency. We also expect to benefit as institutions, retail investors and high net worth individuals move money in domestic equities to the stronger U.S. equity managers such as Columbus Circle and Edge.

We are also seeing substantial interest in new searches for core U.S. commercial real estate. Given the strength of our pipeline, dollars committed to fund in the third quarter and the pickup we’re beginning to see in institutional search activity, our outlook for institutional flows remains positive for the rest of 2010.

Moving to six-month performance, it is easier to see the underlying trends and we’re pleased with the results overall. Each of our growth engines delivered strong improvement in assets under management, which coupled with ongoing expense discipline, produced strong operating leverage.

Total company earnings at $459 million through midyear are up $95 million or 26% on 13% higher average assets under management.

Looking at our three growth engines, earnings for the U.S. accumulation businesses are up 37%. PGI’s earnings are up 62% and Principal International’s earnings are up 57%.

At $325 million, net income improved solidly as well, up 23% compared to the six months ended a year ago.

These results reflect the value of our broad and geographically diverse mix of businesses. The revenue and earnings stability of our risk businesses, the steady deposit flow from our employer sponsored retirement businesses and the superior earnings growth from asset management and accumulation businesses in Asia and Latin America.

Now, I’d like to spend a few minutes discussing the ongoing implementation of our strategy even during this difficult economic environment.

In the U.S., we continue to make progress placing multiple products on third party distribution platforms reflecting our ongoing focus on meeting customer needs across the accumulation to payout continuum. As a result, during the second quarter, each of our three largest U.S. accumulation businesses Full Service Accumulation, Mutual Funds and Individual Annuities delivered double digit sales growth compared to the year ago quarter, driving a $650 million or 22% improvement in combined sales.

We’ve also continued to broaden our distribution by putting more focus on third party administrators, which is not only resulting in new sales but also helping us retain business, where customers are looking to move to an unbundled solution.

For the first half of 2010, we sold or retained more than a half billion dollars of business through third party administrators, an increase of more than 75% from the same period a year ago.

At Principal International, we continue to work closely with bank partners to increase penetration of their existing customer base.

In the third quarter, our China joint venture will also begin marketing its recently approved Qualify Domestic Institutional Investor or QDII Fund, a fund investing in international securities for Chinese investors. A significant portion of the $700 million quota will be managed by Principal Global Investors.

We also continue to tap into growth opportunities in Southeast Asia. This includes the recent purchase by our Malaysian joint venture of a Thai mutual fund company and its subsequent successful launch of a property fund.

In June, Siruly [ph] released their asset management industry projections through 2014. This study speaks to the outstanding growth potential for Principal International and Principal Global Investors.

Total global assets under management are projected to increase by 44% between 2009 and 2014 for a compounded annual gross rate of about 8%. While growth in the U.S. is expected to be solid at 7% per year, more telling are the projections for growth in countries in countries where Principal International has built a significant presence, Brazil, Chile, China and Mexico are projected to have the highest growth rates of all countries in the report with mutual fund asset growth ranging from 14 to 19% and retirement asset growth ranging from 13 to 24%.

This affirms the appropriateness of our strategy and the significant opportunity we have going forward to grow our businesses given our strong positioning in these markets today.

Let me close with some thoughts on the future. Our outlook remains one of cautious optimism. We expect a more moderate but sustainable expansion. We do not view recent slowing growth as the start of a more severe slowdown or a double dip recession, and we continue to see signs in many of our businesses that support this, including improvement from a year ago and recurring contributions to define contribution plans and in fewer retirement plan terminations.

I recently returned from a trip to Asia, more convinced than ever that the strategy we’ve been pursuing for the last 10 years to export our retirement and asset management expertise is the right one. In aligning our domestic expertise with some of the largest distribution partners in the world, we’ve positioned the principal for superior long-term growth.

Between two of our joint venture partners, Banco do Brasil and China Construction Bank, we have accessed to more than 200 million customers through some 18,000 branches in two markets that are relatively untapped and that are projected to be among the five largest middle class populations by 2025.

Next a few comments on a recently passed financial regulatory reform. We do not anticipate any material impact on our operations or results. One area we are watching is the impact of reform on the derivatives markets. While we support transparency on swaps and derivatives, it may increase hedging cost in the longer term, which could have some modest impact, and well not a part of regulatory reform, we believe higher capital standards for the life industry are likely in the future.

A few final points. We believe that we will continue to see improving fundamentals for corporate credit and commercial real estate. We believe that losses in these areas have pit and that the future losses will be quite manageable. Because of the improvement in asset valuations, our capital raising activities in 2009 in growth and retained earnings, stockholders equity is at its highest level for the Principal as a publicly traded company, $9 billion at quarter end.

While we intend to hold more capital, which Terry will discuss in more detail. We have substantial flexibility with $2 billion in excess capital above a 350% risk based capital ratio at midyear.

We’ll continue to look for appropriate opportunities to deploy some of this capital. Our priorities for capital use are unchanged with our first priority to support existing business, although our action to grow our fee-based businesses and pullback on investment only means we need less for this, and our second priority, mergers and acquisitions, where we are seeing an increase in opportunities both domestically and internationally.

As we’ve demonstrated in the past, we’ll continue to deploy capital in a disciplined and thoughtful way.

Terry?

Terrance Lillis

Thanks, Larry. This morning I’ll focus on operating earnings, including continued strong expense management, net income including continued solid performance of the investment portfolio and I’ll also comment further on our strong and flexible capital position.

Starting with total company results, second quarter 2010 operating earnings at $204 million, were up 1.5% compared to a year ago quarter. There were a number of items impacting comparability between periods. The two largest were higher DAC amortization expense in the current quarter due to equity market true-ups totaling $26 million after tax between individual annuities, full service accumulation and individual life, and $7 million of lower after tax earnings from investment only reflecting the absence of earnings this quarter from early redemptions of medium term notes.

Excluding these items, total company earnings improved 20% on 17% higher average assets under management. Let me quickly quantify a couple of the larger items impacting our reported earnings per share of $0.63.

DAC true-ups for market performance and the U.S. asset accumulation segment as well as the individual life division, dampened second quarter earnings by $0.04 per share in total. Life and health segment earnings were also dampened earnings were also dampened by $0.03 per share primarily due to reserved development and strengthening in the health division.

As Larry indicated, our asset management and accumulation growth engines continued to deliver strong performance and we continue to benefit from our ongoing discipline around expense management.

Through midyear, we held operating expenses essentially flat against 13% growth in average assets under management. We’ve strategically reduced expenses in the guaranteed businesses and in the life and health segment. This has enabled us to increase investment in our asset management and accumulation growth engines in the areas of distribution resources, product development and technology to drive productivity gains.

Though earnings for the U.S.S. accumulation segment were down $8 million on a reported basis, the accumulation businesses, which are the segments growth engines delivered 20% growth adjusting for DAC equity market true-ups relative to an 18% increase in average account values.

Principal Fund’s earnings improved 75% from a year ago on 23% higher average account values. Full service accumulation earnings again adjusting for DAC market true-ups grew 21% on 19% higher average account values, reflecting the rebound in account values and continued expense management, full service accumulations operating return on account values through midyear is up 11% to 30 basis points on an annualize basis. The drop in individual annuity as earnings from a year ago, primarily reflects a $14 million after tax increase in DAC amortization expense compared to the year ago quarter.

Principal International earnings improved $6 million or 19% from the year ago quarter on 41% growth in average asset under management. Excluding approximately $3 million of reserve adjustments that dampen current quarter results, earnings growth for the segment was consistent with the growth in assets under management.

Principal International has added $9 billion of asset under management over the trailing 12 months to reach a record $38 billion at quarter end. The gain reflects not only strong investment performance and favorable currency movement, but also continued strong net cash flow.

Principal Global Investor’s earnings improved $4 million or 50% on 11% growth in average assets under management. Excluding real estate where asset values decline modestly from a year ago, investment management fees increased 17%.

At $55 million in the second quarter, compared to $58 million in the prior year quarter, earnings for the Life and Health Insurance segment were also solid. Earnings from Specialty Benefits were up slightly from a year ago.

Importantly, during the quarter, the division experienced sequential growth in premium and fees for the first time since fourth quarter 2008, improved lapse rates from a year ago across all four lines of business and favorable claims results in a group disability income line after unfavorable experience in the first quarter.

Health earnings were down $1 million in line with the decline in the covered members. Favorable experience in the group medical block overall was offset by the need to strengthen reserves within our small block of individual conversion policies.

Individual Life earnings were $26 million compared to $28 million a year ago as growth in the block of business was offset by the impact of market performance on DAC amortization expense.

A quick explanation of the variances from a year ago for benefits and claims expense and DAC amortization expense, we had high growth death claims during the second quarter, which were substantially offset by reinsurance. On an economic basis, our loss in these claims was $2 million after tax. However, due to gap reinsurance accounting, we defer recognition of [inaudible] to cover the benefit of reinsurance. This resulted in an increase in benefits and claims expense and a decrease in fee revenues, which was partially offset by deferred recognition of related DAC amortization expense.

Excluding DAC market true-ups and the impact of reinsurance accounting, division earnings in the second quarter were just over $30 million. Before moving on, I’d had to remind you of the seasonality of health division results, I’d reiterate our expectation for essentially flat earnings for the Life and Health segment in 2010 compared to 2009. With the caveat that unknowns around healthcare and regulatory reform could influence results in a Health division and the segment.

I’d also remind you that the change in our economic interest in the Brasilprev joint venture reduces Principal International’s earnings run rate by approximately $10 to 12 million per quarter after tax starting in the third quarter. The second quarter impact was about 1/3 of that based upon the effective date of the new 23-year shareholder’s agreement.

Moving to net income, we view our$134 million results in the second quarter as solid. Net realized capital losses remain manageable at $70 million. Our investment portfolio performance continues to reflect strong asset liability management and broad asset diversification. Second quarter was a continuation of the steady improvement and credit related losses over the past several quarters.

We, again, saw sequential improvement in corporate credit and from structured risk including CMBS. We also saw sequential improvement from commercial mortgage whole loans, which had its lowest quarter of losses since year end 2008.

Net losses from these categories totaled $46 million in the second quarter, less than half of the losses in the year ago quarter.

Other significant items contributing to current quarter net realized capital losses are $26 million losses on derivative marks, primarily related to interest rate hedging and the impact of declining rates during the quarter, of $72 million capital gain from the change in the company’s economic interest in the Brasilprev joint venture and a $42 million capital loss for Principal Bank, primarily related to its portfolio of home equity loans.

This reflects increased reserves and write-offs due to recent increases in delinquencies and in the banks estimate of loss severity. We will continue to monitor, model and stress this portfolio going forward.

Moving to capital adequacy, as of quarter end, we estimated our risk-based capital ratio to be around 440%. Relative to a 350% RBC ratio, we have approximately $2 billion of total excess capital split evenly between the life company and the holding company. The split at midyear reflects a $300 million distribution from the life company to the holding company, which represents roughly half our distribution capacity for the full year.

Given our equity and excess capital positions, we are at one of the strongest financial points in our history, a positive in light of continued environmental uncertainty. Even with our commitment to holding a higher component of excess capital as cushion currently around $1 billion, we clearly have substantial financial flexibility.

As you know, two of the rating agencies recently took the life insurance industry of negative outlook. This along with improving market fundamentals and our businesses ongoing ability to generate free cash flow gives us the ability to increase shareholder value overtime through a strategic capital of redeployment.

This concludes our prepared remarks. Operator, please open the call to questions.

Question-and-Answer Session

Operator

(Operator Instructions) The first question comes from Steven Schwartz of Raymond James & Associates.

Steven Schwartz – Raymond James & Associates

Hey, good morning, everybody. Just a quick couple, Larry. You were kind of going in and out at least on my phone, you mentioned FSA sales that you expected them to be up, if you could reiterate that.

And then I was wondering on the health business, you had good results on the health business on the group side. There was an article recently, I think it was the New York Times talking about people not going to the doctors despite having insurance because of economic reasons and then I was wondering if you could also possible touch on 401-K matching, what’s going on there in light of the kind of mixed article on today’s Wall Street Journal.

Larry Zimpleman

Okay. Good morning, Steven. Good to hear from you. Sorry, if my comments were cutting in and out during the early part. What I said there to sort of summarize our view for the year, Steven, is that we expect the 2010 full service accumulation sales to be up approximately – I think we said 15 to 20% over 2009.

Again, we are seeing generally positive trends albeit it’s still a bit early, but we’re seeing positive trends in sales pipeline. We’re seeing positive trends in close rates and as I said, our investment performance from PGI, other affiliates as well as some of our other sub-advisers, generally I would say remains good.

I’ll make a couple of quick comments on the health and 401-K matching and Dan Houston may want to add a little bit more.

In terms of the health business, we have seen some sort of favorable reserve development there. To your point as to whether that’s from people not going to the doctor or what all the factors maybe, I don’t really have that at my hands other than there has been favorable reserve developments, so there does seem to be some trends along the line you indicate. And as far as 401-K, it’s interesting there had been a number of articles here in the last week or so, and I think that by and large those article seem to square pretty well with our experience. Many of our plans are written with a discretionary match, so it’s a little hard to know whether it’s really been “suspend” or whether it’s just – it’s a match that can be discretionary.

But having said that, we think that somewhere between 20 and 25% matches have been restored. I think that’s not completely inconsistent with what was in the Wall Street Journal or what I think was in some of the Hewitt Information a week ago, but Dan might want to comment.

Daniel Houston

Yes. Thanks, Larry. Just a couple of quick comments, Larry is correct. If you look at the experience for Principal, our smaller plan sponsors are the ones that dialed back there or suspended their matches within the last 18 months and again, they’re probably the slower ones who put the matches back in place. The larger plans, we’ve seen about 20 to 25% of our existing customers with the matches back up to where they were previously for our …

Steven Schwartz – Raymond James & Associates

Okay. Thank you, guys.

Daniel Houston

[Inaudible].

Larry Zimpleman

Okay. Thanks, Steven.

Operator

Your next question is from the line of Jeff Schuman with KBW.

Jeffrey Schuman – Keefe, Bruyette, & Woods

Good morning. Just to quickly follow up on that. I think Danny said the 20 to 25% of the larger plans have restored and what’s the percentage on the smaller plans?

Daniel Houston

Something less than 20 to 25%. So, the small to medium size have been slower than the larger plans to add back their matches.

Larry Zimpleman

One thing, Jeff. This is Larry. If I could just throw in one additional comment though, I think that it is telling or and it is again it’s a slight positive in a sense that the matches, kind of by the nature, the way we account for things, the matches are in the recurring deposits. So, second quarter was actually the first quarter we commented in the earlier remarks, is the first quarter in I think seven quarters where we’ve seen an actual increase quarter over quarter in recurring deposits, so that’s some positive indication as it relates both to matches and the participation and to participant deferrals.

Jeffrey Schuman – Keefe, Bruyette, & Woods

Yes. Well, I guess the million dollar question is if those – you’ve given us a percentage that had been restored, but I guess what are the implications? I mean are we optimistic that most of that comes back or all of it comes back or not so much of it comes back? I mean where do you think we are in a couple of years from now?

Larry Zimpleman

Well, I think this is again as I said – this is Larry, Jeff. Is this is an improving picture overtime, okay. So, again, I would emphasize that for the small employers and even frankly today for many of the medium size and large employers, the only retirement benefit they offer is a 401-K plan. And again, I thought it was interesting and telling in the sense of the Wall Street Journal article this morning that you heard specific mention of individual who actually left their place of employment because their employer had not yet reinstated their 401-K match.

So, that again from my perspective is a very positive indicator because it does say that employees like 401-K matches, they value that and that will increasingly become a point of consideration as they think about where they want to work going forward. So, I think there will be a lot of – that this will be slow, will be somewhat gradual but there are positive trends developing here.

Jeffrey Schuman – Keefe, Bruyette, & Woods

Okay. The one other thing I wanted to ask you about – there was a court decision recently Tibble versus Edison and the point was that plan sponsors maybe need to be sensitive to the cost structure of the funds in their 401-Ks and where they shouldn’t retail funds when institutional type funds are available. What is your exposure to that issue both in terms of the 401-K business and then in terms of your fund business?

Larry Zimpleman

I’ll just make a couple of comments. This is Larry, Jeff. I’m not familiar with that particular case, so I can’t really comment on that one. I would say by and large that we believe for a long time that this market in terms the 401-K defined contribution market is going to move towards more sophisticated investment options, more sophisticated pricing is going to move toward institutional fees and that’s where we’ve been for many, many, many years. So, I think again this is all positive, and I think probably the bigger driver in this beyond any particular decision by court is going to be the Department of Labor’s effort to put more transparency around fees and I’ll let Dan comment on that.

Daniel Houston

Yes, maybe just a couple of quick comment on the structures that we have today. The retail share clusters are actually the least used inside our 401-K plans, separate accounts, which were originally designed to be institutional nature is very common. We have institutional share class of registered products. We also have CITs made available for our largest clients and of course, we’ve got our own institutional share classes available to our clients.

So, again, it gets back to suitability. The clients work with their investment advisers and again, there’s full disclosure on the fees for not only the plan administration record keeping but also for investment manager phase.

Jeffrey Schuman – Keefe, Bruyette, & Woods

Okay. Thanks a lot.

Larry Zimpleman

Thanks, Jeff.

Operator

You’re next question is from the line of Darin Arita with Deutsche Bank.

Darin Arita – Deutsche Bank

Thank you. Good morning. On the international segment, the withdrawals have been declining for some time. Can you provide some color on that?

Larry Zimpleman

Sure. I’ll let Norman comment on that, Darin. Thank you by the way for picking up coverage this quarter, we appreciate that.

Norman Sorensen

We’ve seen cash flow – is that what your question was Darin?

Darin Arita – Deutsche Bank

That’s right. The withdrawals or –

Norman Sorensen

Yes, consecutively net cash flows have been increasing significantly over the past year. The quarter was $1.5 billion up and the deposits obviously exceeded withdrawals. We’ve seen net cash flow at $1.5 billion, but we have seen of that about a foreign exchange impact of 500 million negative. But we have seen investment performance in the range of 700 million and obviously, we’ve seen year-to-date 3.4 billion and net cash flow improvement.

Larry Zimpleman

Some of that withdrawal, Darin, if you go back into prior periods, at one point, we had a fair amount of money markets in India and in our Indian mutual fund family and those were amounts that by the nature of money markets tend to be sort of cycle in and out. And so as we’ve focus that operation more on through long-term funds that’s another of the factors along with what Norman’s explaining around withdrawals.

Darin Arita – Deutsche Bank

Okay, that’s helpful. And then turning to Principal Bank, can we get a little more color on the side of it and the size of the home equity loan portfolio?

Larry Zimpleman

Sure. The home equity loan portfolio, I think, is in the range of $850 million. It includes I think somewhere around 16,000 loans. These are primarily loans that were put on the books in sort of the 2005 or ‘06 to 2007 period. They are pretty well diversified geographically, so they’re not concentrated necessarily in the states that have been particularly problematical. We have been monitoring this portfolio all along, so again we continue to do a lot of analysis around that. Maybe I’ll have Terry or if Terry wants to comment further.

Terrance Lillis

Yes, just to let you know the size of the bank it’s about a $2.4 billion asset under management. As Larry said, it’s around $800 million of the HELOC for the home equity loans and so the concentration is not in any particular one state, it is as Larry mentioned diversified and we are monitoring it, modeling it, and looking at the portfolio with a fine view.

Larry Zimpleman

So, I think our expectation going forward, Darin, is we probably lots of all that portfolio probably in the range of 8 to 10 million a quarter, which would be offset by operating earnings for the bank. So, we expect that to be about a breakeven situation going forward.

Darin Arita – Deutsche Bank

Okay, that’s helpful. If I could just follow-up on that, do you have the total reserves and write-downs in that portfolio?

Terrance Lillis

Yes. Darin, this is Terry. The reserve that we have set against that portfolio is about $32 million after against the HELOC loans. In total we have about $40 million of reserves against the entire portfolio, but we think that that 4%, we feel that that’s an appropriate reserve at this point.

Darin Arita – Deutsche Bank

All right. Thanks very much.

Larry Zimpleman

Thanks, Darin.

Operator

Your next question is from Thomas Gallagher with Credit Suisse.

Thomas Gallagher – Credit Suisse AG

Good morning. First question I had is on that you’d mentioned on full service accumulation flows. You lost a large plan, can you comment on the AUM associated with the plan and broadly speaking, are you seeing intensive price competition particularly in the larger end of the market?

Larry Zimpleman

I’ll just kick that off and have Dan comment on. First of all, in terms of overall price competition, again this is a business that has always been competitive and as I’ve said to many of you, our responsibility really is to manage the business in such a way that it produces a desired profitability. And I think again you’re seeing in terms of the profitability both in the second quarter and sort of on a rolling basis that it continues to perform very much in line with our expectations.

So, again, that’s part of the thing that we manage and I don’t know that I would necessarily say that large cases or somehow more price competitive than small cases. It really just – every part of the market is competitive, but I think we’ve demonstrated we have the ability to manage through that and I’ll let Dan comment on the one particular case.

Daniel Houston

Sure. The one case was roughly a quarter of a billion dollars, $250 to 300 million. This is a piece of business that actually had come over in one of our endorse transfers, five years ago. It’s been a very price sensitive sort of customer during that entire period of time that finally reached a point – if we look at it from a profitability perspective, we weren’t pleased with it from a profitability perspective – took it out to bid and they went with who I would’ve describe as a very low cost, no frills provider of the marketplace. There wasn’t [inaudible] you placed on a total retirement sweep approach, it was a standalone 401-K and they certainly wouldn’t have put value on the Retire Secure Worksite sort of solution. So, again, not a good match post-acquisition some five years ago.

Larry Zimpleman

Just a couple of final comments, Tom. If we look at the lapse rates on full service accumulation through midyear, they run on a little bit under 3.5%, and if you look at 2009, they run about 7.4% for the year. So, again, these are – it’s actually running a little bit better than it did in 2009 and what is interesting is that the larger case end of that – the lapse rates are closer to 2% instead of that 3.5, so that differential really reflects more plan terminations and very small employers going out of business. So, the lapse rates here continue to be very much under control.

Thomas Gallagher – Credit Suisse AG

And Larry or Dan, just to follow-up. So, as we look to the back half of the year, do you expect flows to turn positive n FSA for both 3 and 4Q or is it going to be lumpy or how should we be thinking about that?

Daniel Houston

I think the best way to think of it is it always could be lumpy, but we anticipate by year end, we will be positive. We’re positive today and we fully intend that we’ll finish positive for the year. And again, just maybe to reiterate maybe my confidence around the full service line, when you go back and adjust for the one large plan that we had in the first quarter of 2009, which again was $1.4 billion. If you look at our increased closed ratios, if you look at the average size plan excluding that large one, large plan a year ago, and the average size plan is up 45%.

If we look at sales with plans of less than 10 million, so kind of that back to that core sweet spot of small to medium size business year-to-date that business is up 38% and as Larry cited earlier, our created pipeline is 12%. So, we go into this cautiously optimistic around the second half of the year, feel good about the quality of the pipeline and feel good that we can reach our stated objectives.

Thomas Gallagher – Credit Suisse AG

Okay. And then just one for Julia, on the – I noticed the CMBS delinquencies continue to move up and just a question on I think your stress, your moderate stress scenario for CMBS and CMBS CDOs is now 387 million. Can you talk about what you have already taken on those and the way, and I guess it breaks out over what period of time, you would expect to recognize those, but how much have you already taken of that 387?

Julia Lawler

Okay. Good morning, Tom. We have taken about 30%. And remember when we started doing these stress analysis and scenarios, we said this is how actual losses were more likely to emerge and when I tell you what we’ve done, it’s more an impairment basis. So, we haven’t actually experienced the actual losses yet, but we have impaired about 30 to 40% of this total.

Thomas Gallagher – Credit Suisse AG

And Julia of those that you compared, how much have you actually absorbed in terms of real losses versus impairment accounting recognition?

Julia Lawler

Virtually none.

Larry Zimpleman

Right. And I think this is a key point, Tom, and something that does sometimes kind of get loss in the understanding around this particular issue. Again, Julia and her team do continuous stress modeling, looking for future losses and then are taking impairments against that. So, we’re already taking impairments for losses that won’t occur in many cases for another one or two years.

And I think in the case of many investors, they get confused between the timing for impairment as compared to when the actual the bond losses occur and by the time the bond losses occur, we’ve done our work well and Julia’s team is as good as it gets. We’ve already taken those impairments, so that’s have already been front loaded into our financials, and I think investors need to have a sort of better understanding and appreciation for that.

Thomas Gallagher – Credit Suisse AG

Okay, but –

Julia Lawler

And Tom, if you want to comment on the delinquencies because as you mentioned, they have increased quarter over quarter that was anticipated. That’s really in our stress modeling scenarios, so all of it is in line with what we expected and we’re actually seeing a slowdown in the increase. So, again, all in line with our expectations toward scenarios.

Thomas Gallagher – Credit Suisse AG

Okay, thanks.

Larry Zimpleman

Thanks, Tom.

Operator

Your next question is from Randy Binner with FBR Capital.

Randy Binner – FBR Capital Markets & Co.

Hi, thanks. I guess I’m following up on Tom Gallagher’s questions on – a little bit different, but back to FSA on fees. So, fee is the total fund value, we’re a little bit better than they have been running. So, I guess Larry from your commentary, it doesn’t sound like there’s too much competition that’s destructive there. So, can we expect kind of stabilization on fees relative to account values and maybe another way to hit this is could we think about Principal being able to maintain kind of 30% ROA in the FSA business going forward?

Larry Zimpleman

Well, a couple of comments, Randy. Again, I think its 30 basis points ROA, which has been sort of the historical range that we’ve talked about, and I would say sort of yes with one caveat and then I’ll let Dan comment as well.

The one caveat is that again as we have said before, Randy, there is a mix of business issue that’s involved here. So, for example, on our ESOP [ph] business, employer securities provide little if any in the way of fee revenue. Our proprietary investment options generate a higher degree of fee revenue. So, there is very much a mix of business issue here. And so the caveat, in terms of maintaining fees, the answer is yes with the caveat that we’re assuming there’s not a substantial shift or change in mix of business, so that will be the only thing that you’ll need to watch and you can see that in the financial supplement. You can track that quarter by quarter and kind of see how does various buckets are trending and I’ll let Dan add his comments.

Daniel Houston

Yes, that’s exactly right. And the only other comment I’d make about fees and fee disclosures, the Department of Labor has handed down a requirement that by July of next year 2011, we’ll have to comply with the standard approach in terms of disclosing fees for recordkeeping, administration, asset management fee, trust fees and advisory fees were already – feel very good about our current disclosure. We’ve been at it for many years and so to the extent that it’s raised out there in the marketplace we feel like ours, we will compete very well with the competition.

Randy Binner – FBR Capital Markets & Co.

Okay, great. And then there’s one more if I could, also just on the CMBS. I guess maybe this is for Terry or Julia, but would you characterized the CMBS charges, this quarter is kind of a catch up. I mean certainly it seems that way for the home equity products, but I mean it was a little bit higher than the run rate has been and so was there something in the squirt [ph] that cause you to kind of take out a lump of impairments that may not be recurring going forward.

Larry Zimpleman

Well, I think certainly – this is Larry, Randy. On the home equity piece, so it’s definitely. I mean when I say catch up, what I mean is that we started to see delinquencies and severities increase in the last quarter or two. So, I don’t know if that’s catch up, but certainly we felt it was appropriate to increase the loss recognition around that portfolio. I think on the CMBS, I’ll let Julia comment on that.

Julia Lawler

Yes. No, actually what we’re seeing is from third quarter ‘09, really second quarter ‘09, we started to see impairments because we actually started to see forecast for a loss of that point in time. So, again, remember we’re impairing long before the losses actually emerge.

First quarter was the peak. We’ve actually seen it trends down on CMBS losses impairment. The first quarter was really our peak number and we’re trending downward. So, no, I guess the answer is no. There’s no catch up. We’re really impairing as we see in forecast losses and severity of those losses and we’re seeing the trends sort of play out as we would have anticipated and first quarter was kind of our peak.

Randy Binner – FBR Capital Markets & Co.

All right, very good. Thank you.

Larry Zimpleman

Thank you, Randy.

Operator

Your next question is from Ed Spehar with Bank of America.

Edward Spehar – BofA Merrill Lynch

Thank you. Good morning, everyone.

Larry Zimpleman

Hi, Ed.

Edward Spehar – BofA Merrill Lynch

I have two questions. The first is on capital, when you talk about the $2 billion excess number and you talk about you want to hold $1 billion cushion, so I think you’re saying there’s a billion dollars that you could do something with in the near-term, is that a correct interpretation?

Larry Zimpleman

Well, I think, Ed – this is Larry, Ed. I mean I think – generally speaking, but I’ll say it back to you. We again have, if you use the 350 RBC and we could – people might have different lines, but just to have a common measuring stick, there’s about $2 billion of excess capital. And our thinking right now is that as we look both to higher capital requirements that I alluded to in my remarks, plus we’re very sensitive also around sort of near-term obligations of the holding company. We probably be of a mind today, that we would want to hold somewhere around $1 to 1.2 billion.

The higher amount does not necessarily mean, however, that we have a desire to go out in the next quarter or two and spend down the remaining amount. As I said, I think that the rating agencies, two of the four have moved the industry to neutral, so there are some again some signs that are positive. And so I think as we go forward, as we keep adding to our excess capital position, as the economy and the markets normalize, I think that sort of 750 million number will grow and we will and we’re currently working on lots of plans and ideas around ways to deploy it.

Edward Spehar – BofA Merrill Lynch

Yes. I guess, Larry, just a follow-up on that. I mean I understand the desire to hold a cushion, but I guess the question is you’re stock is below book value and I think when you think about the prospects for this business and when you think about the marginal return on capital that you expect, I find it hard to see any other alternative use for capital being compelling other than buying your stock. And when you talk about funding growth for me, it doesn’t seem like you need to hold capital fund growth at least significant amounts considering the mixed shift.

When you talk about M&A, it’s again it seems impossible, almost impossible to find something that’s more compelling than your stock below book. So, can you just give us some sense of how you’re thinking about timing, of deploying capital because this is – I’m not so sure that this is an opportunity that stays forever?

Larry Zimpleman

Right. I mean I think there’s a general agreement with many of the points, Ed, that you were talking about and it’s really more I would say a matter of timing more than anything else. As you said and again you’ve written and commented on this, which I appreciate, we have made conscious decisions here to pullback on some of the more capital intensive businesses particularly the IO business and that has very positive implications going forward.

We used to talk about needing 50% of operating earnings to support the growth of the businesses. We haven’t really retested that in detail to give you a new number today, but clearly because of the pullback of IO, we would need less than that sort of that 50% number going forward. So, we will be generating higher amounts of free cash flow. We will be adding to our excess capital position. And again as we go forward and through the rest of 2010 into 2011, we will need to have and we have been working and continue to have a plan for capital deployment, but again I think it’s a little bit early to be pulling the trigger on that.

So, for now, it’s a very nice position to be in. we want to continue to watch the things that are going on. We have the opportunity to be very opportunistic both in global asset management, in international and U.S. retirement that’s where the capital will go to, and so we just like the position we’re in and we’ll see how it works out over the next quarter or two.

Edward Spehar – BofA Merrill Lynch

Okay, and then one quick follow-up, just for some clarification on International. The $35 million that you earned this quarter, there was about a $3 or 4 million impact from the change in the JV ownership. When we’re thinking forward over the next couple quarters, we have earnings that should come down from that level by something in the neighborhood of $9 million. Is that correct?

Norman Sorensen

Well, on a quarterly – this is Norman. On a quarterly basis, we have indicated that we expect earnings to drop by about between $10 and 12 million per quarter after tax.

Larry Zimpleman

But given we have one quarter, we should be in the 27 to 28 million per quarter basically, Ed.

Norman Sorensen

That’s right.

Edward Spehar – BofA Merrill Lynch

And then how quickly – now, is it going to grow still off of that as the start of your 15% or is there a faster growth rate recovery because of what you see as sort of near-term opportunities.

Jim McCaughan

We anticipate growth between 15 and 20%. Obviously, the 23-year agreement with Banco do Brasil gives us tremendous opportunity in that market as well as the other market, so roughly between 15 and 20% growth going forward. Okay?

Edward Spehar – BofA Merrill Lynch

Thank you.

Larry Zimpleman

Thanks, Ed.

Operator

Your next question is from Colin Devine with Citi.

Colin Devine – Citigroup Inc

Good morning.

Larry Zimpleman

Hey, Colin.

Colin Devine – Citigroup Inc

I just got a couple of quick questions just to make sure that I’m sort of getting the message that I think you’re trying to convey. And first is in terms of capital redeployment, the way that Principal used to do it, buybacks and such, but nobody should be holding their breath for awhile, and that the ROE that we’re looking at today in this sort of 10.5% range is going to be here for awhile or actually maybe go down as you continue to build [inaudible], so that’s question number one.

Question number two, as I look at the FSA business again, the number of plans your managing continues to decline and is that just really a reflection of the overall shrinkage you alluded to in the 401-K market more than a problem at Principal?

And then three, can you just confirm the home equity lines and the bank are those loans you originated yourselves, right, or portfolios that you purchased?

Then finally, if you could just confirm – one more time for me at least on the DAC with the life business, exactly what happened there with this sort of what gen [ph] worth ad where there’s sort of been because of lower rates, some of them are more permanent impairment or against their original pricing assumptions or was it more market driven? I know you’ve written a bunch secondary guarantee, Universal Life and I didn’t know if we were seeing somebody as [inaudible] class experience come through.

Larry Zimpleman

Okay. I’ll try to take them quickly, Colin, and Terry will want to comment on a couple of these as well. But in terms of ROE growth, the fact that we’re holding higher capital, we think probably impacts ROE around 56 to 60 basis points. But having said that, I think our current ROE of about 10.6, I think is still reasonably competitive within the industry.

Having said that, I guess we still believe that we have the opportunity to grow that ROE even at these higher levels of capital, we’ll continue to grow that ROE about 50 basis points a year, so there’s really been no change around that because of the fee nature of our growth businesses. We see opportunities to continue to grow from this kind of 10.5 to 10.6% levels.

In terms of numbers of plans, that’s really a combination of two things. Number one, there’s fewer startup plans, so we’re not writing quite as many plans in this kind of an environment and number two, of course, there are a few more terminations of plans meaning very small employers who go out of business. So, again, we think those are trends that will normalize and reverse themselves overtime.

Quickly on the HELOC, I would just comment that is basically a portfolio that was purchased through a few different sources, but basically those are all correspondents. We don’t necessarily have a basis to originate those, and again that activity was ceased as of a number of years ago, so we’re not having to be adding any of those home equity loans in the portfolio over the last couple of last years. And I’ll let Terry comment very quickly on the Individual Life DAC issue.

Terrance Lillis

Yes, Colin. As we had two large claims that generated losses in the current period, they were offset by reinsurance. So, the economic impact of it, this quarter was about $2 million. However, accounting practice does not allow you to recognize the reinsurance reimbursement during the current period and you have to spread that over the life of the portfolio, which could be 75 years plus and so there’s going to be very little impact. The net effect of this in several different lines through geography was a $5 million tax impact of the underwriting of the reinsurance amortization or impact.

As a result, we said that at $2 million economic impact versus a $5 million gap impact generated lower earnings in the life line by about $3 million after tax this quarter. Therefore, we feel that that was an appropriate adjustment to make to our EPS in the current period.

Colin Devine – Citigroup Inc

Thank you very much.

Larry Zimpleman

Thanks, Colin.

Operator

Your next question is from Mark Finkelstein with Macquarie.

Mark Finkelstein – Macquarie Research

Hi, good morning. Just to talk a little bit about the health business. Premium continues to go down at a fairly rapid clip. I guess what is your premium outlook and when do we start to really kind of have more meaningful expense ratio issues, particularly when we start thinking about healthcare reform and minimum loss ratios, that’s my first question.

Larry Zimpleman

Okay. Well, this is Larry. I’ll make a quick comment on that, Dan may want to comment as well. I don’t that there’s necessarily such as thin as bright line, Mark, where that becomes an issue and clearly we’re well aware of the membership decline, which again is a combination of in plans shrink as well as lapses exceeding new sales. And again, you see these across most of the commercial blocks of pretty much of all the carrier, so there’s not a magic point.

I would say that we are looking at in regard to minimum loss ratios, we are looking at the potential impact of that and again, that’s just something that we’ll have to manage towards. But I don’t know Danny, do you have any comment?

Daniel Houston

Yes, maybe just two real quick ones. As you know we’ve talked about previously the build out of our Pen [ph] networks, which are our proprietary network development going on and roughly six or seven cities around the country to get better discounts from hospitals and physicians and clinics et cetera. So, it does require some investment to build out that capability.

We’re also making a modest investment in distribution as well as back office to comply with healthcare reforms. So, we’re going to have some pressure on expenses, we continue to manage that very aggressively and at the same time, you can see a nice improvement in overall loss ratios, and again, those two areas are certainly driving cost up for our overhead administrative expenses.

Mark Finkelstein – Macquarie Research

Okay. And then just secondly on the PGI unaffiliated flow, I think you attributed some of the issues in the quarter to a rebalancing where you’re not as competitive in those strategies or even have them in some instances. I guess one has that rebalancing essentially ended and did I hear you correctly in suggesting that you expect those – that particular area to show positive flows in the third and fourth quarters.

Larry Zimpleman

Sure. I’ll have Jim comment on that. Jim?

Jim McCaughan

Yes. I mean it’s so much differs by client that it’s hard to generalize. You can point or one can point to two or three clients who rebalance in particular ways and therefore that cost us flows during the quarter. But it’s very hard to generalize about a process that goes across a lot of client, and I will not hesitate to do that.

I think really is the way to look at is that not only as Larry mentioned quoting Siruly [ph] the DC industry in an outflow, but the DB industry also industry also is or the DB funds across the country are also in that outflows. So to have – was it 1.6 billion of net outflow, 2% of the total non-affiliate book of business, it’s actually not a particularly bad result given the influence of the economy on the funds.

And really the key towards turning positive is that clients start allocating both U.S. and international clients to the active strategies we’re in, and we see signs of that as coming and we’d be disappointed to see continued negative flows through the next two quarters, but it’s very difficult to predict client movement. We do have participation in quite few searches at the moment and our search competitive in the number of popular investment choices, but I do think that it’s very hard to predict at this point whether it will actually turn positive in the next two quarters. So, for the next two or three years, it will remain very positive.

Mark Finkelstein – Macquarie Research

Okay. Thanks, Jim.

Larry Zimpleman

Thanks, Mark.

Operator

We have reached the end of our Q&A. Mr. Zimpleman, your closing comments please.

Larry Zimpleman

Well, again, I want to thank all of you for joining us this morning and for your continuing interest in the Principal.

As we’ve mentioned in our call today, we do see increasing evidence that the economy in the small and medium sector are now at the beginning of what we hope to be a growth cycle going forward. Although we’re going to focus on challenges that remain, we also believe we are well-positioned as we go forward for the next few quarters, and we look forward to speaking with many of you about the opportunities that we believe will continue to differentiate Principal Financial Group from our peers.

Thank you and have a great day.

Operator

Thank you for participating in today’s conference call. This call will be available for reply, beginning at approximately 8 p.m. Eastern Time until end of day, August 10th, 2010. 4587874 is the access code for the replay. The number to dial for the replay is 800-642-1687, U.S. and Canadian callers or 706-645-9291, international callers.

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Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

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Source: Principal Financial Group, Inc. Q2 2010 Earnings Call Transcript
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