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Protective Life Corporation (NYSE:PL)

Bank of America Merrill Lynch 2012 Insurance Conference

February 16, 2012 - 12:35 a.m. ET

Executives

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

Carolyn M. Johnson – Executive Vice President and Chief Operating Officer

D. Scott Adams – Senior Vice President and Chief Human Resources Officer

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

Analysts

Edward Spehar – Bank of America Merrill Lynch

Edward Spehar – Bank of America Merrill Lynch

We have Johnny Johns, CEO of Protective Life. And Johnny was nice enough to remind me that I downgraded the stock a week or so ago. I guess right before they had their second-highest operating earnings quarter I think in the history of the company, and the highest on an adjusted basis. So, thank you. I'm going to pass it over to Johnny.

John D. Johns

Ed, thank you for what enthusiastic introduction. I appreciate it. No, actually not only what Ed just said is true, but it was also my birthday that he downgraded the stock, just to add insult to injury in. Another analyst, who had a different writing on the stock, described it was the McMuffin of quarterly earnings reports in our industry. And I had to go Google that to see that ties back to a McDonald's commercial where anything that's a McMuffin is really good. So we got kind of chucked by that.

But it is good to be with you. I am Johnny Johns. I am the CEO at Protective Life Corporation. I'm joined today -- I'd like to acknowledge my colleagues, Carolyn Johnson, who is our Chief Operations Officer; Scott Adams, our Chief HR Officer; and Carl Thigpen, our Chief Investment Officer. But I guess it's a good time to be here, it's a good time to be with you and tell you a little bit about the Protective Life story. Now here's the agenda. Just want to talk about very fundamental aspects of our business.

We want to give you some insight into how we think about the life insurance business. I want to talk some about the earnings momentum we're currently enjoying, try to give you a little explanation as to why that is happening. Even though we are operating in what I think everyone would agree is a challenging macroeconomic environment. We'll show you our financial plan for this year. It is not earnings guidance.

It is really just our internal plan, the plan we're using to benchmark our own performance, but we want to be very transparent with investors about what we're trying to achieve. I'll talk a bit more about our focus going forward. And then, I'll stop and be pleased to answer your questions. Again, we had great performance in 2011, notwithstanding 155 basis point decline in 10-year treasury, lower interest rates throughout the year, a lot of uncertainty in the regulatory environment.

And of course, the overall -- overhang on financial stocks arising from the situation in the Eurozone. We finished the year as we started it, with a very strong balance sheet. Our statutory capital at the end of year, we estimate when we file our stat statements, will be at a record level, the highest level ever. We maintain very solid risk-based capital ratios. We enhanced our already robust enterprise risk management program. And we really set ourselves up for what we think is going to be a good year in 2012.

One thing, again, we point out to investors. And again, this is an attempt to make investment in life insurance something that's more comfortable for investors. We know that there are a lot of difficulties, whether you're an expert like Ed is or not. If you're a more casual follower of the industry, to really get tour arms around the real, true underlying economics of the business, the accounting can be confusing, a little opaque, and it changes a lot.

We're in sort of a dynamic era of changes in accounting principles. So what we try to do is every year we have an Investors conference in the fall of the year, usually late November, early December. And we fully disclose our forward-looking plan, our plan. And we -- in addition to that, we tag on two more years of a model, and we are very transparent about what the assumptions are, both around the plan and the model so that investors can kind of see through to understand what we're trying to accomplish.

And we're also very pleased by the fact that even though we set for ourselves what we consider to be fairly robust kind of longer-term goals, i.e., 10% plus earnings per share growth, along with consistent improvement in return on equity. And we set kind of a target around 50 basis points a year for the next several years. And at the same time, we pledged to do our best to reduce risk throughout the enterprise.

So we're not trying to game the system, if you will, by improving performance, but by adding leverage or taking more risk on our investment portfolio or anything like that. And so we've led it out. We've done this now for three years. In 2009, we announced a plan to earn $3.25. We earned $3.97. We knew that earnings after the crisis were going to sort of come back down, so we planned for $2.60. We earned $2.7. For 2011, we planned for $3.10 and we earned $3.65.

So we were able to, in each of those years, to lay out a plan, disclose our assumptions and then meet or exceed the plan. The question is, well, how do you manage this business? And it's extremely simple. We try to be brutally honest and rational with our sales and with investors about how we allocate capital. We really think that's the key to managing your way through this business. You can see from this chart that we basically have four different kind of buckets to which we can allocate capital within our three retail businesses; life insurance, annuities and asset protection.

We can park capital more on a short-term basis into stable value, our stable value business, which is guaranteed investment contracts that we sell to 401(k) problems or funding agreements, which are more wholesale type funding agreements that we sell to institutional investors. I'll speak in a minute to what we believe is a demonstrable competitive strength we have, which is we think we are the best in our industry doing small company and block of business acquisitions.

And we've got a track record to back up that statement. Or we can repurchase shares or debt. And we've done all of that. During this three-year period of our plan, we've invested a good bit of capital in our life annuity and asset protection businesses through our retail sales. We've -- though stable value has been sort of declining segment for us because the returns at some points have not been very attractive to us on new marginal business, but we've been able to kind of hold our own in that business, while increasing returns and spreads.

We've done two major acquisitions. We acquired from Torchmark, United Investors, in a transaction that I believe was of success for them and was a success for us. It was a true win-win situation. And we bought the life insurance business of Liberty Life Insurance Company in Greenville, South Carolina. At the same time, we've restarted our share repurchase program in the spring of last year. And I'll speak to that more in a minute.

But we've also been able opportunistically to repurchase some debt, some non-recourse funding debt that has supported some securitization structures that we have in the marketplace that with the collapse of the financial guarantors who wrapped that paper, the market value of the paper has declined. And so, we've been able to scoop in opportunistically and occasionally, and repurchase that. But it's been quite a nice generator of bottom line profit, and the returns have been extremely good on those transactions.

We're very serious about enterprise risk management. We think that's the cornerstone of running any financial institutions. We've made great strides over the last few years. We've really brought in a whole new team of people a few years ago, who were successful in that field at MetLife and have joined our team and doing a really good job. We're very focused on the risk characteristics, risk management in the variable annuity product line.

That gets a lot of focus and attention from investors, rating agencies and regulators. It probably should. We think we've got that under really good control. But also, we focus on risk more broadly across the entire enterprise. In the investment portfolio, I will tell you that we've determined and really truly believe that this should not be a place where a life insurance company attempts to really outperform the competition. We do not invest in hedge funds, private equity or other alternative investments.

We have a very traditional portfolio. We've seen a good deal of improvement in the credit quality of the portfolio. Post the financial crisis, if you use the criteria of our regulators for putting a rating on credit, about 5% of our portfolio currently would be rated below investment grade. And we think that's even going to improve a bit as we go forward. Again, we are very disciplined in terms of asset liability management. We're frequently asking in our Investors presentation from this fall.

We laid out in lot of detail how carefully we are cash flow matched. And we indicated then that we don't think that even the current level of interest rates is going to have a material effect on our earnings over the next several years because of the close-matching of cash flows. We take a lot of pride in the relationships we maintain with distributors of our retail products. We do not try to cover the world. We only distribute through distributors that we think are high-quality, high value-added to the end customer distributors.

We want to be in a situation where we're important to every distributor we do business with and they're very important to us, so that we treat each other in very mutually respectful way and we're value-added to each other's business models. This is beyond the scope of this investor presentation, but we're very actively involved in rethinking our whole strategic orientation now. We think that the industry has really underperformed in recent year, and it truly has.

You can index it against whatever you want to, but save it, life insurance companies have not been star performers individually or as a group. We think a lot of the problem is the industry doesn't understand customers very well. The need for life insurance and annuities in the U.S. right now is at all-time high. Baby boomers are nearing retirement, grossly underprepared for it. And yet, the percentage of all retirement savings that are attributable to variable annuities is declining.

So if you look at all of the things people are buying to prepare for retirement, putting money in 401(k)'s IRA's, whatever, we're not gaining share there. And Americas is not ready. We're not doing our job to help people get ready. Same is true of life insurance. So if you look at data that LIMRA, which is the Life Insurance and Marketing Research Organization and Trade Association, does every year shows that the penetration of American households by the individual life product is as low as it's been in recorded history, which goes back 30, 40 years.

And it continues to decline life sales. The premium is essentially flat. And there's a huge market in the middle of a sort of underserved right now, I think as everyone would admit. But we're really trying to rethink how we can play differently in the game. We have a lot of initiatives going on to better understand and engage with our customers to simplify the experience of buying our products, to reduce product complexity, and probably most importantly, to redevelop some trust between end consumers and our company.

I think that's a huge problem right now for banks and insurance companies kind of globally, is that that trust relationship has been broken. I talked a bit about our acquisitions. Again, I won't go into this in too much detail, but we have a wealth of experience. We've been doing acquisitions for decades. We've done -- we've invested billions of dollars. We've done dozens of acquisitions. The kind of acquisition we typically do is we buy a block of business or we buy a small company that is somehow impaired, there's something wrong with it for its current owner.

It may not be -- it may have good mortality or whatever, but it may have an expense structure, that's usually the problem, that's not working for the current owner. And so, we can buy business, convert it to our systems, which is extremely hard to do efficiently in our business. It takes a whole lot of knowledge and experience to do that. We can very efficiently do that. And by filliping over to our unit costs, which are typically much, much lower than they were on the part of the seller, we can create value for the seller and for our company.

And another thing I like about it, and yet I think this is something that you've picked up on, is that the kind of liabilities that we're acquiring, they're products that were manufactured 10 or 15 years ago when there was far less volatility in the products. There were many fewer embedded derivatives in the products. Again, we're very fortunate to be able to do business with Torchmark. So we picked up a couple hundred thousand customers from them, and we picked up products that they manufactured their way, which is a very solid, value proposition both ways.

Unlike products that are being sold today at retail, which would have a lot of interest guarantees and a lot of gotchas for the insurance companies. It's a very high-quality book of business because it's an old school kind of product chassis typically in the products. And other thing about it, we're picking up a lot of new customers. Our company now has about 6 million customers, and that's more than a lot of regional banks have. And in the Liberty acquisition, we picked up about 1 million customers, new customers, new to Protective.

And we didn't pay anything for that. All we bought were the cash flows. We didn't pay anything for the customer relationships. So this is a real solid part of our company, and we think there'll be more opportunities for that in the future. Costs are very important, and this chart shows you that we participate annually in a benchmarking survey that the Deloitte firm has sponsored for a number of years. And what it shows you in both life insurance and annuity, we're in the best quartile in terms of lowest expense against all the companies.

Most of the major competitors we have participate in the benchmarking study, but our expense structure is as good as any, even though we're a smaller player than most. We still are able to manage expenses to a very competitive level. Again, this chart would just give you a snapshot of our earnings pattern over the last few years. You can see that we did actually reach our operating earnings watermark in 2009. But that was because we had a very substantial gain from repurchase of these non-recourse funding agreements.

If you adjust it and normalize the earnings pattern, we really have had reached high watermark on an adjusted basis. In terms of net income, it was absolutely the record year for us. We had the highest level of net income in our company's history. And kind of what I take away from that is though the financial was challenging, we're back and we've restored the earnings power of the franchise to the pre-crisis levels.

And you can see -- if you look through this, you can see we definitely do have some momentum in terms of forward earnings power. I mentioned that our capital base is extremely strong. To me, this is probably the most powerful chart in this slide deck, which is in 2007, before the financial crisis, we had $2 billion of statutory capital. Now, we have about $3 billion of statutory capital. And along the way, we've been steadily investing away in our retail businesses, and we've spent over $500 million of stacked capital doing those two acquisitions that I just mentioned.

We did that without any external financing. So you can see that we're in good shape in terms of capital, and we're actually tracking ahead of our planned RBC levels, as you'll see in this chart. This is what we presented at our fall Investors Conference this year. This is our plan and our model; our plan for 2012, our model for the next two years. This particular iteration of it assumes that we will spend about $100 million a year annually in share repurchase.

During the last two quarters of last year, that tracks the level at which we repurchase shares, about 25 million of shares per quarter. It also assumes that we'll have a dividend payout to shareowners of about $50 million. So we roughly earn about $300 million after-tax, GAAP; return 50% of that to shareowners, while continuing to maintain robust RBC ratios, above 400%, improving our ROE and continuing to invest steadily in our retail businesses. So that's sort of the plan we're operating under.

I will point out that this particular chart does not reflect the effect of a change in accounting principle that the insurance industry adopted, will adopt for this year. EITF-9g was basically a new approach to DAC accounting, deferred acquisition cost accounting. The impact on us is a reduction in earnings of about $0.30 a share per year. So when I show you -- but there is some ROE enhancement, as well. I'm sorry -- this chart does reflect the effects of the RITF-9g.

You can see though we reported $3.65 last year, this year the plan is $3.28 but there's a $0.30 reduction based on the adoption of the accounting principle, but there is ROE improvement. But I'll also tell you, and we pre-announced this along with our earnings, is that we've already in this quarter closed a repurchase of notes, these funding agreement notes. That's generating about $35 million of operating pre-tax earnings this quarter. It completes -- a budget ago, we had $15 million of that in the 2012 plan.

But it's incremental about $0.15 a share of earnings. So our adjusted plan for this year would be $3.28, plus $0.15 that we know that we already have in the bank in the terms of a gain on that transaction. But again, you see, we're forecasting -- we're not forecasting but we're planning for and our models indicate very robust earnings per share accretion, along with very steady ROE improvement over the next three years, and also very, very comfortable debt-to-total capital ratio as well.

Looking forward, what's our focus? It's really very simple. We're going to be absolutely disciplined about allocating capital in ways that make sense. We are not going to chase market share. We're going to price our products rationally. We've done that. Interest rates have come down. We've re-priced our products in a very disciplined way to reflect that. We think at our size and given the way we manage expenses and infrastructure, we can definitely do that.

We are expecting, though, improvements. In our life insurance sales, we expect to see some growth there in sales this year. I'd say we do expect double-digit growth in earnings share and continuation of the pattern of ROE improvement. I know one question that gets asked and you may ask, and I'll go ahead an answer it, is tell me how the share repurchase program interplays with acquisitions. What are you intentions there?

And I can say that there's a trade-off, and that we will continue to repurchase shares so long as our calculations would indicate that the implied return on share repurchase is superior risk-adjusted to an acquisition. If you reach a point where we see a very compelling return on an acquisition, we will reenter that market, because we think that's the best use of capital. But if we don't, our plan, our intention, our hope and expectation is that we'll continue to repurchase shares at a very healthy clear-up and kind of stick to this model of about 50% of our after-tax earnings being returned to shareowners.

So in conclusion, we feel very good about our company. We're very optimistic about our prospects, and we think we're extremely well positioned to continue to execute on our plans and deliver very satisfactory results to our shareowners. So with that, Ed, I'm going to pause and open the floor for questions. So, are there any? Well, I hope that's not from the lack of interest. I hope it's from completeness of coverage of the subject matter.

Question-and-Answer Session

Edward Spehar – Bank of America Merrill Lynch

Well, I'll start it off.

John D. Johns

Okay.

Edward Spehar – Bank of America Merrill Lynch

You talk about the acquisition and a favorable risk profile on the liabilities. And if you look at your company and the growth that you've had in the annuity business, and variable annuity specifically, how do you balance the desire to grow in that product line with the risk of that product line, both the actual risk but then maybe more importantly the perceived risk? Is there a point where you -- that you pass, where suddenly rating agencies begin to hold the overall company to a much higher capital standard because of the variable annuity business?

John D. Johns

We like the variable annuity business, and we like the product. We like our distribution of the product. We sell a fair amount of product that has no -- it has no roll-up feature. Most of what we sell has a 5% kind of roll-up feature. So the product is not necessarily a bad product. If it's well distributed and is carefully managed, and you keep a real close eye on how it's priced.

But most importantly, you have an appropriate hedging program to ensure that you've got all your bases covered in terms of your optical EPS performance, as well as any adverse effect on statutory capital. What I personally think is going to happen is I really see the VA business continue to evolve. It's evolved a lot in the last 24 months.

We were not even in the living benefit side of the VA business four, five years ago because we didn't think the products made a whole lot of sense. And I think unfortunately, a lot of companies that sold that vintage of product would now agree with us. And also, the hedging technology, which is probably not as well advanced as it should have been.

But we think with all the de-risking that's going on in the business, including on our products. Our products have been de-risked materially. They were good products in there, but they're much better products today because of a lot of the changes we've made in the product features that I think that the perceived risk of the product would probably start to catch up with the actual risk of the modern vintage products.

But I also think -- we think more as kind of portfolio of annuity products, fixed annuity sales have been pretty more abundant recently because the interest rate environment is so low, it's very hard to sell fixed annuities right now. We see that coming back, maybe with stability of the equity markets, or a trend of improvement. People will be less willing to pay the fees they have to pay for the guarantees.

And so, there probably is going to be some natural kind of pullback in the VA space. But we do have our own internal risk management guidelines and understand it. It's very important for us to keep a nice balance between the equity market exposure we have, the interest rate exposure we have, and the steady cash flows that we have. So we do expect -- this year, we're forecasting variable annuity sales to be lower than they were last year as we have kind of a glide path into more of a sustainable world.

Edward Spehar – Bank of America Merrill Lynch

Is there a percentage of the balance sheet that you think about of earnings from VA but where you think you've maxed out?

John D. Johns

I wouldn't say maxed out but we are trending. It's kind of both sides of the equation are moving. But I think maybe something, a fifth or roughly that, depending on the product type and how we measure the risk of it, would be something that we might kind of gravitate toward. But that's not a written in stone kind of rule. That's just sort of a conceptual thought. It depends a lot on the product, the risk characteristics of the product. You'd be comfortable if more -- if less volatility in it, less riskier product.

Edward Spehar – Bank of America Merrill Lynch

How about in terms of pricing product within the current rate environment? I think you've talked about pricing life products based on current interest rates and on a forward curve. But if you look at the VA products, why is it -- then looks like Pru rolled out 5% or lower there. Their roll-up went from 6% to 5%, I don't know, and that was a year and a half ago or something. And obviously, rates are a lot lower now. Why isn't 5% as kind of an industry standard? Why doesn't 5% come down to 4%, considering where rates are?

John D. Johns

I can't comment on other company's pricing decisions or strategies. But we do run our return analysis around different interest rate scenarios, and we certainly use it as a benchmark of kind of current new money yields. And again, I think that's important, I think it's important to understand about sort of maybe our conservative stance. And again, this is based on what we're hearing from consulting actuaries.

But there are a lot of ways, different ways, people look at product design. And one approach is to assume that interest rates revert to mean. If you look and take a 10-year rolling average of the 10-year treasury, you might assume over the next five years that even though 10-year is hovering in the 2% range today, that it's going to revert back to 3% or 4% and you're going to see some wins.

If we're more pessimistic than that, I hope that happens. That would be a good thing for our industry, and we'd be off in terms of our pricing assumptions, but that would be too conservative. We'll make more money that we think. But we do use kind of a market consistent approach in terms of pricing our products.

And Ed, it's hard to say what other product designs companies, what the interest rate sensitivity really is in their product. It may look like you were making 18% interest rates or 200%, and now you're making 12%. So you say, I can take 12% and live with that. It's not as good as 18%. But I don't know, it's really hard for me to speculate and I shouldn't on other companies.

It's been my pleasure. Thank you very much.

Edward Spehar – Bank of America Merrill Lynch

Thank you, Johnny.

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