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Protective Life Corp. (NYSE:PL)

Q2 FY08 Earnings Call

August 6, 2008, 09:00 AM ET

Executives

John D. Johns - Chairman, President and CEO

Richard J. Bielen - Vice Chairman and CFO

Steven G. Walker - Sr. VP, Controller, and Chief Accounting Officer

Carl S. Thigpen - EVP and Chief Investment Officer

Analysts

Edward Spehar - Merrill Lynch

Steven Schwartz - Raymond James

Eric Berg - Lehman Brothers

Thomas Gallagher - Credit Suisse

John Fox - Fenimore Asset Management

Jukka Lipponen - Keefe, Bruyette and Woods

John Hall - Wachovia Capital Markets, Llc

Operator

Welcome to today's teleconference. At this time all participants are in a listen-only-mode. Later you will have the opportunity to ask questions during our Q&A session. At this time I would like to turn the program over to Mr. Johnny Johns, Chairman and CEO of Protective Life Corporation. Please go ahead, sir.

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

Good morning everyone. This is Johnny Johns, Protective Life Corporation. Welcome you to our second quarter conference call relating to our second quarter earnings. I'm here at our home office in Birmingham with our senior management team. I will go through sort of a high level the results for the quarter. Then I will turn it over to our Chief Financial Officer Rich Bielen who will go through our individual segments in more detail. Then Rich will give it back to me and I'll give you sort of an outlook perspective on the rest of the year and talk about our guidance for the rest of the year.

We reported yesterday operating income of $0.96 a share for the quarter. That compares to $0.88 in the same quarter of last year. In terms of net income, we reported $0.53 for the quarter. That compares to $0.91 for the second quarter of last year. The difference in the two numbers is accounted for by the fact that we realized an other than temporary impairment charge of $0.73 relating to a specific portfolio of securities. We'll talk about that in a minute. That was partially offset by $0.30 of gains in the quarter from sale of securities and mark-to-market on derivatives under FAS 133 and other items.

Just stepping back for a minute from the quarter, I can't say we were just overjoyed by the results of the quarter, but I think we're relatively pleased with our operations. Several of our segments have performed very well in the quarter. In particular, we're very pleased with the performance we're seeing from our annuities line. We made a push to become more of a player in the annuity business to broaden our distribution and our product line offerings and that is starting to bear fruit.

We're tracking a record year in terms of annuity sales and we're seeing positive fund flows in the quarter in all of our product line portfolios. Likewise, Stable Value segment performed in kind of record territory in the quarter. Spreads widened. We grew our accounts balance slightly. We've predicted that there was some pluses and minuses in the current capital markets environment. One of the pluses is that we do have the opportunity to invest in higher and higher spreads and yields and that is starting to pay off in Stable Value.

Acquisitions line also performed quite well. We replaced all aspects of our acquired portfolio at the present time.

We respect to life insurance, the reported number is a little bit light relative to our expectations, but we did not experience the favorable mortality that we have seen over the last couple of years in the quarter and that reduced earnings by $0.03 to $0.04 a share in that line. But we do think the fundamentals remain strong in our Life segment. Our plan to focus on profitability and improving returns on capital in the term business even if that means ceding some market shares is working out as expected.

Even though our sales are down, we still remain a top market share player in the term business, we're a scale player, have excellent distribution and actually seem to be gaining a little momentum there as the accounts are stabilized and it started to come up a bit lightly.

We are a little behind the curve with respect to universal life this year. We're making a nice push with respect to universal life. But we were delayed in getting new products to Street as products are now coming out, and actually have more products behind them. And we do expect to see our momentum build in universal life into this year and certainly into next and we are quite positive on our prospects with respect to universal life.

Asset Protection had a sort of a light quarter, $0.02 to $0.03 a share of legal and legal settlement expense in the quarter, a good bit of that coming from expenses associated with the final resolution of the CENTRIX matter [indiscernible] type of charge a year or so ago. That all seems to be on track.

Also we're feeling some effects from the downturn in auto sales and in boats and marine products in the United States, I think both associated with higher energy costs, but we do see APD coming up a bit from where we reported earnings in this quarter over the next couple of quarters.

With respect to Corporate and Other, we had a decent quarter there. We did see some recovery of fair value items relating to the trading account that we maintain there. We are seeing some improvement in yields, again, as we invest capital in new securities that have current market rates associated with them.

We had a fairly light quarter in terms of participating income for the quarter. We were under $4 million for the quarter. And as we indicated in the press release, we do see that number going down for the rest of the year. In fact, we are forecasting essentially no participating income for the second half of the year, very little. And that's unduly pessimistic. But we think we are going to err on the side of being too optimistic either. So as we'll talk about when we look at the outlook, we are essentially forecasting a light period of participating income.

We've seen that number in the $40 million plus range on an annual basis and we've seen it much stronger than it is this year for 10 years. And so we do forecast that will come back in the due course. We are originating some very good properties. Now this is a great time to be looking at originating new participating loans because of the credit market conditions.

Apart from the impairments, again, I'll address you in just a moment, we had very good overall credit performance from our investment portfolios. Our commercial mortgage loans continue to perform very well. Problem loan rates are at historically quite low levels. And rest of the portfolio does perform very much in line with our expectations.

With regard to the impairment charges, we did take impairments on five of bonds that we purchased in 2007. They're residential mortgage loan secured bonds, Alt A category collateral. We did see a fairly significant shift in delinquencies with respect to those bonds, even though we continue to see principal on interest on the bonds, and they are protected by credit enhancement that is still intact. Based on the very most recent information we had which we got in July, we decided to go ahead and take an impairment, which meant we had to mark-to-market which we are marketing to about $0.10 on the dollar.

In terms of the outlook for those without [ph] that portfolio, we really don't... it's about... originally it was about $230 million of bonds that we purchased. We have stress test the entire portfolio from where we are now using the Fitch models. When we run it through Fitch's high-stress scenario, the result we get is that the impairment with respect to the entire portfolio are adequate to cover expected losses. When we run it through Fitch's more moderate stress scenario, we actually would show a recovery of the impairments that we've taken in this quarter. So, that would give you some feel for the prospects for that portfolio, although time will tell in terms of how that really plays out.

Again, I am going to now step back and turn it over to Rich and let Rich take you through a more detailed discussion of various segments. Rich?

Richard J. Bielen - Vice Chairman and Chief Financial Officer

Thank you, Johnny, and good morning to everybody. I would first point out that in addition to the information continued in our press release, we have certain supplemental financial information available via our website www.protective.com. Also, this conference call discussion includes forward-looking statements which express expectations of future events and/or results. Actual events and results may differ materially from these expectations. Please refer to our press release and to Exhibit 99 of the company's most recent 10-K, 10-Q for more information about factors which may affect future results.

This discussion may also contain non-GAAP financial information. Please see our website for additional information and reconciliation to GAAP financial measures.

What I'd like to do is first start out with talking about operating earning. Operating earnings for the quarter were $0.96 per share as compared to $0.88 in the second quarter of last year. Our net income was $0.53 this quarter. And as we mentioned, what we did in the quarter was we took an impairment loss of $0.73 related to five Alt-A Securities. But offsetting that were approximately $0.16 of items related to derivatives and fair value items and then $0.14 of other kinds of gains that we took in the portfolio.

One thing that we are experiencing just as a general focus as you listened to Johnny's comments is we're in just an economic cycle and what we're now starting to experience here in the numbers and we are reflecting is the turns in that cycle. One of the things I'd point out to we are disappointed by taking any kind of impairment in the quarter. But if you go back and look at our history over the last decade, even with these impairments, our cumulative net income continues to exceed our operating income during that period. So, we've had some good times in the past where we've been able to benefit from a lot of gains. In light of what's going on in the market, we are taking some impairments, but they don't even come close to what we've taken on the gains side historically.

What I would like to do now is turn to our divisions. On the Life Marketing side, the Life Marketing pre-tax operating income was $38 million compared to $37.8 million in the second quarter of last year. Now, when you compare year-over-year, I'd just like to remind everybody that in the second quarter of '07, there was approximately $4 million of investment income that is now sitting incorporate another as a result of the AXXX securitization last year.

We also saw sales in the second quarter were about $41.1 million compared to $43.3 million in the first quarter or a decrease of 4.9%. As planned, we brought down our term sales year-over-year and our term sales seem to be stabilizing at about $27 million. As Johnny mentioned, we continue to update our universal life portfolio. We've released a new product here in July and have more plans for products as the year goes on.

We are seeing an uptick in our app count although slow at this point. So we are hoping that those UL sales start to pick up as all these new product introductions work their way through.

The other item, when we went through kind of our expectations as far as earnings, we expected to see positive mortality in the quarter in this line of business and actually in this quarter we saw a negative $0.8 million or $800,000, that's $3.2 million less favorable sequentially than compared to the first quarter of this year. And year-to-date, our mortality is favorable $1.9 million, but in our original earnings estimate, we had expected a number closer to $6 million. So, we are getting held down a little bit by not seeing as favorable mortality as we previously expected.

We did see in the morning notes, there were some questions regarding the earnings in Life Marketing going forward. What we expect currently in the earnings estimate is about $42 million a quarter for the balance of the year. And one of the things that we are seeing is even with a lower sales, we've been very focused on our expense management and we have been bringing those expenses down in order to try and improve profitability for future years in this line.

Now turning to Acquisitions, our pretax operating income for the Acquisitions segment was $34.5 million, up 12% compared to $30.8 million in the same period last year. The improvement is primarily the decreased operating expenses in the Chase Insurance block and some good mortality results.

As you recall, we've been in the process of converting that. It took us until the middle of last year to complete those conversions. So we had elevated expenses and now we are benefiting from the lower expenses now that we completed the conversions.

Those improvements though were obviously being offset somewhat by the normal run-off pattern in the block of business. When we look at the future, we see this business kind of running off at about 6% a year. So, that's something that will generate capital for us and we will have to look for future acquisitions to benefit.

We continue to be pleased with all the financial performance of the Chase Insurance Group block. And then the remaining core acquisitions block, that's the more legacy block, continues to perform as expectations.

Moving on to the Annuity business, the Annuity business had pretax operating earnings of $9.5 million, which was a 42% increase compared to the $6.7 million in the same period last. The results for the second quarter were positively impacted by the effect of $1.7 million of fair value charges, net of any DAC amortization. That's $7.4 million more favorable than in the first quarter.

And one of the things that we picked up in Chase that we've mentioned was we picked up a marketing opportunity to be able to sell single premium deferred annuities through the Chase Bank channel. In the quarter, that was $185 million of sales. That's a very positive there. We had some nice momentum from the first quarter where we only had about $82 million of sales. And we are now seeing that line of business begin to contribute to earnings in this business, it was about $1.3 million in the quarter.

The sales growth continued to be very strong in the period with in total a 28.8% increase over the same period last year. Sales were $552 million in this quarter versus $428 million in the prior year's quarter. Our fixed annuity sales showed strong growth in the quarter, up 42.9% to $436 million. We are beginning to benefit, with the fed having cut rates, what we are finding is the annuity products are becoming more competitive in the marketplace. Now that there is somewhat of a yield curve, we can be very competitive against CD rates. While when the curve was inverted, we were struggling with attractive CD rates competing against our longer term annuity product.

Our variable annuity sales were down somewhat, about 6.3% from $123 million last year to $115 million in this year. But in light of the market volatility in the equity performance, we actually think that's doing pretty well. We see some good momentum there. We continue to implement some new sales growth programs with our annuity wholesalers to continue the momentum.

And the other thing that I think is important is we've seen a lot of people in the industry struggling with outflows in their annuity lines. And our account values here at the end of the second quarter increased 14.1% to $8.1 billion versus the second quarter of last year. So, we see some good momentum there and we are on track to hit our sales goal of $2 billion for calendar year 2008, which we thought was a little bit of a stretch, but we see that momentum continuing.

Now turning to the Stable Value Products division. Stable Value Products delivered just outstanding results in the second quarter. The segment reported $17.5 million of pre-tax operating income. That's a 42% increase over the same period last year. The improvement is due both to higher account balances and improved operating spreads.

Operating spreads in the quarter were 134 basis points versus 104 last year and up from the 126 in the first quarter. We do expect spreads to remain in the triple-digits through the remainder of the year. We actually may see some slight improvement here in the third quarter. And then as a result of some low cost liabilities and some high yielding assets maturing in the third quarter, we will probably see a decline from a peak level in the third quarter in terms of spread into the fourth quarter.

One thing that's interesting about this line, we keep talking about the yields available in the marketplace, but the benefit we are actually seeing is that we're able to fund our liability at cheaper cost than historically and it's not so much that the yields are going up, the yields are kind of holding steady, even declining slightly, but our liability costs have been able to come down, which is attributing to the increase spreads. We did end our balance at approximately $5.4 billion at the end of the second quarter.

Now turning to Asset Protection, the Asset Protection segment reported pre-tax operating income in the second quarter of $6.7 million compared to $11.5 million in the same period last year. Basically what we're seeing is the cyclical impact of auto and marine sales or our service contract income was down, because we picked up some admin fees at the point of sales. And with sales down, we lose those admin fees that we recognized in the beginning.

Also impacting our results is that last year we had a program where we covered some inventory protection. We lost a significant customer there. That's probably costing us about $1 million of income year-over-year. We also saw an increase in our legal expenses that Johnny referred to in the second quarter this year as we were settling up some kind of legacy losses.

We do continue to see the economic conditions provide challenges for this division. We obviously see marine sales being very low. We see both manufacturing plants being closed. You can see all the headlines you see in the auto industry. So what we've seen is total sales this year were $120 million versus $150 million from last year. Some of that was by design. We reduced our emphasis on credit sales. We've reduced our emphasis on some other product sales, but our main service product contract business is down about 9% year-over-year for about $90 million.... $82 million. And what we're actively doing is trying to find new distributors to offset the impact of the lower sales volumes that our current ones that we're experiencing.

Now turning to Corporate and Other. Corporate and Other, as you know, includes net investment income and expenses not attributable to the business segments. It also has some legacy kind of non-strategic or discontinued lines of business.

In the second quarter, we reported a pre-tax operating loss of $2.1 million. What I'll do is kind of walk through a couple of major items. The first one is participating income this year in the second quarter was $3.7 million versus $7 million in the second quarter of '07, and $3.6 million in the first quarter of this year. That is our gross participating income. And as you may recall, we allocate $2 million of that to the lines of business. So Corporate and Other had a $1.7 million contribution there.

We also see in the times when things are slower, we are also seeing a reduction in our pre-payment fees and make-whole fees. We saw a $2.6 million decrease this quarter versus a year ago. And that just relates to the fact that there was no refinancing activity. There is no bond calls going on in these kind of distressed times.

The trading portfolio did contribute approximately $5.3 million in the second quarter of positive earnings. That was some of the recovery that we expected from the mark-to-market loss that we took in the first quarter of this year. That was kind of consistent with slightly short of what we originally expected. What we actually saw in April and May was on track or a little ahead and then we've seen some kind of stress time again in June and July and now pulled that back a little bit.

And what we are now projecting is rather than the full kind of $19 million to $20 million recovering this year, when we kind of reforecast and re-projected the movements in that portfolio. We now see that being closer to about $15 million for the year versus the original recovery expectation.

I'm going to turn to the investment portfolio a little bit just to hit some high issues and then we'll take some questions there during the Q&A. We continue to see opportunities to purchase higher yielding assets. Our new money investments are higher than our portfolio yields. So we think that's a very good trend. We are keeping our high yield portfolio currently at less than 6% of our invested assets. That's to provide us some cushion and some capacity if there are opportunities there. But reflective of the times, we know there may be some downgrades. So we want to make sure that we manage our risk assets appropriately.

On the commercial mortgage side, the portfolio was performing incredibly well. Our problem loans and foreclosed properties are less than 0.2% of the mortgage loan portfolio. So our current delinquencies are approximately $7 million.

To hit some of the other high kind of high focus categories. In our subprime portfolio, we hold about $73 million of assets or 0.2% of invested assets. Approximately half of those are currently rated AAA. One thing that we do on all of these securitized assets, anything that is in, what we call a high risk category, we review monthly remittance reports. We look at the delinquencies. We look at the subordination in order to access whether there are any issues there. And in the subprime portfolio, what we see is that although the actual delinquencies are extremely high, because of all of the bonds we purchased were effectively AAA at the time we bought them, we see substantial subordination levels, and therefore we don't see any issues related to that portfolio at this time.

With respect to the Alt A securities, we own approximately $755 million of those securities as of the end of the second quarter. That's about 2.5% of invested assets. 92.5% of those are rated AAA. So they originally purchased this AAA, they continue to be AAA. We reviewed all of those AAA remittance reports to make sure that we don't see any impact on our contractual cash flows and we do not at this point in anyway.

We did take an $80 million gross impairment on five Alt A bonds. Those bonds were originally part of a pool bonds of 16 bonds we bought in 2007. They were all AA rated at the time we purchased them. We've gone in and looked at them on a bond-by-bond basis and what we found was approximately five of the bonds have seen delinquency rates which we had originally expected to be probably in the 4% to 6% range exceed 10%. We also expected loss severities on those originally to probably be between 15% to 25%, we've now seen them exceed 30%. And as a result of all that analysis, we determined that we were not going to get back all of our contractible cash flows and we went ahead and impaired them to market.

And as all of you know, kind of a liquidation prices out there and then the headlines are extremely low and market values on those securities are currently estimated to be about $0.10 on the dollar. So we just went ahead and dealt with it. We did that through July remittance reports. We've seen some comments out there where people are expecting may be some impairments in the third quarter. We went ahead given our reporting cycle to not just look through June to go ahead and look through July to assess whether anything needed to being impaired. So at this point we looked at the bonds, we don't see any need for impairment on anything else that would come up in the third quarter. But the other thing or caveat is in light of this economic environment, I'm not trying to forecast the future. We're just looking at what we have and what we're seeing in the remittance reports.

Just turn... the last thing that I probably want to address is FAS 115. We continue to see our market value basis, our portfolio decline as a result of the massive spread widening we've seen. And in the second quarter... I think I need to remind everybody... we actually saw an uptick in treasury rates. And so, we don't benchmark ourselves to an index, but to give you some idea of how we think the portfolio performed in the second quarter. If you'd looked at the Lehman Aggregate Index, you would have found the price performance of that index to have been down in excess of 2%. And if you look at our portfolio for the quarter, even including the impact of the impairments and say that was a mark-to-market loss, you would have come to a number that was less than 2%. So, we think our portfolio overall performed consistently with the market price movements in the marketplace.

And now with that, I will turn it back over to Johnny for the outlook.

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

Yes, thanks, Rich. As we look out over the next two quarters to the end of the year, we see some positives, we see continued improvement in the profitability and the sales of Life Insurance segment. Term we think will tickup somewhat gradually, but we do expect to see a nice improvement in UL business to get our new products to the Street and we do think that we expect to see some improvement in profitability as well.

We think Stable Value is positioned to perform very well in the second half of the year as well, fundamentals there are very good. As Rich indicated, we do expect to achieve a record level of sales in our Annuity line. Our expectation is that sales will be in excess of $2 billion for the year and we think that line will continue to perform well.

We see no reason that our Acquisitions segment shouldn't also continue to perform well in the second half of the year. And I will say that we have been pretty active over the last quarter looking at acquisition opportunities. We looked at one that was more traditional, kind of block transaction. Unfortunately we didn't get it. But we are very much in the hunt for it and there are other things out there that we are continuing to explore as we speak.

We do think that the capital markets environment is kind of a mixed blessing right now. It is giving us the opportunity to continue to invest cash and earnings in higher yields, which is good. But it is raising liability costs a bit as well.

With respect to the mark-to-market at fair value items, we do expect to see some continued recovery there, although not quite as much as we would have expected a quarter ago.

In terms of guidance for the rest of the year, we are bringing our guidance down for the rest of year. We are lowering our range from where it currently sits at $3.80 to $4.15. We are lowering that to $3.60 to $3.80 with $3.70 being our best estimate.

We have several specific items that we have taken into account in bringing down the guidance. The first is, as I mentioned, we are not optimistic about our ability to generate participating income in the second half of the year. We started the year with a forecast that we would generate about $20 million of participating income for the year. We're now dropping that to $10 million, which is $0.09 or $0.10 a share. And it's just based on the lack of visibility in terms of the transactions in the pipeline for the rest of the year.

In terms of Asset Protection division, we are looking now for earnings for the year to be about $10 million less than we would have thought when we started the year. That's due mainly to the increased expenses that we've talked about, as well as to the impact of the auto and marine markets nationally on our business.

And then lastly, while we do expect some recovery... some continued recovery in these fair value items, we'd recently hoped to pick up about $20 million over the last three quarters of the year and now we are thinking that number more likely to be in the range of $15 million or so. So when you run those of items sort of through our models, it would suggest that $3.70 is just about a good number, best estimate number for our earnings guidance for the rest of the year.

Again, we think we are in very solid right now, our balance sheet is solid. We feel good about our capital position, our liquidity is strong, we are building some real momentum in terms of the annuities and we are very pleased with our life footprint and we are hopeful to see some acquisitions down there as well as we go forward.

With that, I am going to stop with our prepared comments and turn it over to you for questions.

Question And Answer

Operator

[Operator Instructions]. And we'll take our first question from Edward Spehar with Merrill Lynch. Please go ahead.

Edward Spehar - Merrill Lynch

Thank you, good morning. I had a couple of questions. I guess, first on the Life Marketing side, the prior couple of quarters I think we had earnings that were in the sort of $46 million range and even if we adjust for the mortality and I think your expectation is staying it maybe be in the low 40s to $42 million range. Could you talk a little bit about how we should think about the earnings trajectory there? Obviously that's the one business where we have some difficulty in terms of forecasting given what's going on in the business model and the mix shift.

And then, Rich, I was wondering if you could talk a little bit more about the comment you made on Stable Value and the sort of cheaper funding. I guess there's sort of an element here in both Stable Value and Annuities where we're getting a benefit of wider quality spreads, but also may be liability costs are lower than what we thought they were going to be. So, if you could talk a little bit more about that it would be helpful. Thanks.

Richard J. Bielen - Vice Chairman and Chief Financial Officer

Ed, let's deal with Life Marketing first. The last two quarters were a little higher than what we previously... what we were seeing this quarter and for the balance of the year. As a reminder, we thought this was kind of our final transition year on Life Marketing earnings roughly in the 40 million dollarish range a quarter. What we saw is we do get a little cyclicality in the fourth quarter in this business just related to the way reinsurance premiums come in. So, it tends to be a little bit higher.

The other thing in the first quarter we just had some one-time items that helped boost that to $46 million. The other thing that we didn't mention is that we are seeing some increased securitization costs that we did not see in the first quarter. The way we had originally projected we'd able to refinance our XXX facility and move that out. That's got some increasing costs over time in light of the capital markets that we see right now. What is happening is that we don't see us getting that out and that's causing us to increase those costs by about $2 million a quarter. So, that's partially in our forecast here, and why we're trying to say the rest of the year is about $42 million on average.

With respect to Stable Value, we've just seen some opportunities. We actually went into this cycle with a position where we had more floating rate assets than we had floating rate liabilities as a result of the inverted yield curve. We've got into this cycle actually short duration. While we've been doing now that the fed's cut and moved... and you now have short rates being much lower than longer rates, we've been issuing more contracts that have floating rate components to it and that's the reason I have been able to drive down my liability cost. But my net LIBOR exposure is in organization now. It's taken me the first six months to really get it back to kind of a zero effect where at one time earlier in the year we had more floating rate assets than we had floating rate liabilities. Ed?

Edward Spehar - Merrill Lynch

Okay, thank you.

Richard J. Bielen - Vice Chairman and Chief Financial Officer

Thank you.

Operator

And our next question comes from Steven Schwartz with Raymond James. Please go ahead.

Steven Schwartz - Raymond James

Hey, good morning everybody. If I can follow up on the... number of things, but on the... immediately on the securitization and the plan to redo that, that obviously did not happen in the quarter, are we to assume that it's going happen in the third quarter and were those costs included in you guidance, Johnny?

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

Yes, we'll refinance our securitization facility in the third quarter. And we are including our expectation for the cost of financing the reserves in the outlook for the rest of the year.

Steven Schwartz - Raymond James

Okay. So, we don't have the extinguishment cost in Corporate and Other, and where does the cost of the... what line item in Life Marketing does the cost of the financing go through?

Richard J. Bielen - Vice Chairman and Chief Financial Officer

It actually goes through investment income. So we'd hope down the investment income that we allocate to the line of business or the profitability of it.

Steven Schwartz - Raymond James

And, Rich, you had $2 million of the extra in there in 2Q? Is that what you were saying?

Richard J. Bielen - Vice Chairman and Chief Financial Officer

That is correct.

Steven Schwartz - Raymond James

And does it go up by $2 million a quarter or does it just stay with this 2 million run rate?

Richard J. Bielen - Vice Chairman and Chief Financial Officer

It's a $2 million run rate. So we expect that $2 million to be for the balance of the year.

Steven Schwartz - Raymond James

Okay. Just moving on here, just a couple of quickies. Rich, Stable Value, you mentioned that the spread might be up a little bit in the third quarter, down in 4Q. Can you give us some guidance on what you might think 4Q might be?

Richard J. Bielen - Vice Chairman and Chief Financial Officer

It will still be in... it will still be in the triple digits, but probably lower than where the second quarter is. But we expect to see healthy spreads there. It's really a function of what are the new investment opportunities, what are the new liabilities that we will see as we put on the books for a balance of the year. But as we just kind of forecasted, we expect some improvement in spread in the third quarter and then a decline, probably a little less than where we are in the second right now.

Steven Schwartz - Raymond James

Okay. The... and last one, the original guidance assumed continued favorable mortality on Life Marketing. We didn't get it in the second quarter, obviously, although it's been still positive for the first six months. And in the second six months, are we assuming mortality at pricing or we assuming a return to favorable mortality?

Richard J. Bielen - Vice Chairman and Chief Financial Officer

We're assuming a return to favorable mortality, but no kind of recovery from the first half of the year. So we kind of built into our original forecast about $3 million of favorable mortality, which was consistent with our '07 results. And we've left that in for the last two quarters, but no catch up from the first two quarters.

Steven Schwartz - Raymond James

Okay, got you. Thanks a lot.

Operator

And our next question comes from the site of Eric Berg with Lehman Brothers. Go ahead

Eric Berg - Lehman Brothers

Thanks very much and good morning to everyone. First off, on the investment portfolio with respect to the AAA rated, a great bulk of the Alt A portfolio, 92%, I think you said rated AAA or in the neighborhood as 92%. What is its fair value at present relative to its amortized cost?

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

It's very close to a par.

Richard J. Bielen - Vice Chairman and Chief Financial Officer

Yes, it was... the difference between par and book and it is probably somewhere in the table in the Q when we release it tomorrow, but I think the difference was about $10 million... less than $10 million

Eric Berg - Lehman Brothers

Okay. Thank you. Next I had a question about the annuity business and in general, this concept of fair value adjustment, I know that one of the fair value adjustments or I should say I believe that one of the fair value adjustments is the marking to market of the trading portfolio. I think that is one of the fair value adjustments. But in the news release you referred more than one to two fair value adjustments. What specifically are we referencing here if you could just sort of list them for us?

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

This is Steve Walker, our Chief Accountant.

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

In our Annuities line, you have two fair value adjustments, one is related to an embedded derivative on our Guaranteed Minimum Withdrawal Benefit and that's just under FAS 133. And then in our equity index annuity product, we have fair value in our liability under FAS 155.

Eric Berg - Lehman Brothers

Okay. And then finally with respect to the Asset Protection segment, I just wanted to sort of make sure, check my understanding of sort of what's in there these days, and in particular, the names of the businesses. Because I know over the years you've had different businesses. You had your business of sort of indemnifying lenders against losses on automobiles, if they were repossessed. And I guess that would have been called the lenders indemnity business and then you have this business of insuring the value of cars at the end of car leases. I think that was called the residual value business. But in today's news release, you used... you referred to other businesses or you're using other titles to talk about them, inventory protection and guaranteed asset protection. Can you just sort of lay out what the businesses are called today and what remains in that asset protection business in addition to, of course, your main service contract business?

Richard J. Bielen - Vice Chairman and Chief Financial Officer

Okay. There are really only three true businesses in there currently. One is the service contract business, both on marine products and on auto. There is also credit insurance in there, which at one time we used to sell through financial institutions. We have discontinued selling through financial institutions.

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

Credit life and disability, yes

Eric Berg - Lehman Brothers

Right, right.

Richard J. Bielen - Vice Chairman and Chief Financial Officer

We only sell that now through auto dealers as part of the package of suite of products there. And then the third product is what we call the gap product, which is if a car is totaled and then we will cover the difference between the long value and kind of the net blue book value of the car in terms of that product, and primarily that's in other and that's something we sold some off. We've actually increased prices. It's one of the reasons that the other is down. We have some really tiny things. We still have some inventory protection going on, but that's a line of business when we lost our large customer. The sales are not very significant.

With respect to your other items, the CENTRIX item is basically behind us. We still are trying to resolve all of the litigation regarding it, but we think we're well reserved there. And we are seeing those litigation expenses still flowing through this line of business even though we are not selling it any longer.

And then your last item is residual value. Residual value, we actually moved to Corporate and Other. And that's something we probably just need to address for everybody. In the first quarter, we had may be about $1 million of reserve in Corporate and Other there. In the second quarter we didn't really have any. We just had about $400,000 of expenses. And the current contracts as of the end of June were less than 2600 remaining contracts. So we're now down to the tail end of that and although that was a disappointment that we had to deal with that in the past. That is effectively gone in this environment.

Eric Berg - Lehman Brothers

So, Rich, this will be my final question. Obviously GM was in the news to be taking a write-down or charge in connection with the residual values on leased cars and [indiscernible] higher price of gas and the collapse of SUV prices. This is really not an issue for Protective?

Richard J. Bielen - Vice Chairman and Chief Financial Officer

That is correct. That's why I mentioned we're down to less than 2600 contracts at the end of June. So, that is fortunately behind us in light of the current environment.

Eric Berg - Lehman Brothers

Thank you.

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

Thank you.

Operator

Our next question comes from Tom Gallagher with Credit Suisse. Please go ahead.

Thomas Gallagher - Credit Suisse

Good morning. Just wanted to talk about plans for capital management for the next year for you guys. I guess in lieu with the fact that you've seen very good spreads and growth on the fixed annuity side and on the GIC side, should we assume that there is going to be more capital now moving towards just to support the general account businesses? And also combining that with a more cautious outlook on what's going on in the credit side, can you talk a little bit about expectations for free cash flow and overall capital positioning for the year?

Richard J. Bielen - Vice Chairman and Chief Financial Officer

Tom, I think you're... when we look at capital, and we've looked at what our capital generation is. We'll always first start and say we'd like to grow our organic businesses first in terms of capital deployment. And so, I think your observation is right. We expect to deploy... with an increasing balance in both Annuities and Stable Value, we expect to deploy more capital in those businesses as those sales continue to perform well. In light of the environment, we are just being very careful to make sure that we can weather all capital strains that potentially can occur. You've obviously seen people in the bank and brokerage sector who've had to come to the capital markets in distress. We are going to make sure that we don't do that. And so we are being a little conservative in terms of how we deploy our capital. We do see, as Johnny mentioned, some acquisition opportunities that we kicked the tires on one, but we think there may be some other ones out there at the same time. And so we're looking to deploy that capital. But in light of the environment, the stress on assets, the stress on securitization, we're making sure that we always weather everything about the core franchise first and then look forward to that.

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

Tom, I'll just chime in on that that. I think you will recall that through the balance of this year, we were carrying some extra RBC charges as a result of a slight pick-up, a very slight pick-up a year or so ago in our mortgage factor. That comes off this year and then we will see a pretty significant jump in our RBC ratios into next year, it's almost mechanical. It'll just happens. But at the same time, the securitization markets are very expensive right now and our preference would be not to go out and securitize now, So our business plan has always been to be able to sell finance these redundant reserves on our own balance sheet until the timing is good for us to go out and securitize. We think that's only prudent to operate that way. So that's a further constraint on having a lot of excess capital, but we want to be sure that we've got plenty of capital to support reserving requirements on our products and have these redundant reserves.

Thomas Gallagher - Credit Suisse

Okay. And how much excess do you have today if you just measure it by excess RBC? And where do you think that moves to by year-end, Johnny, when that change kicks in?

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

Don't know, we haven't really closed our statutory books at the present of time. But I would say by year-end we expect to have a modest amount of excess capital, if we don't securitize, if we just continue to build. But finances [ph] done reserves without any kind of relief from after a securitization... we do securitize, we will have a lot of redundant capital, hundreds of millions of dollars, I would guess. And then next year we again... the forecast is when these RBC charges come off, we have a considerable amount of capacity, all other things being equal.

Thomas Gallagher - Credit Suisse

Okay. And then just one final question. Rich, on the... when you'd mentioned, you also incorporated what has happened in the market the... I guess, the fact that pricing had also gone down further in July. Now, if you mark this stuff down to $0.10 using sort of more current pricing, what would that have been had you used June? Just out of curiosity, was it a fairly big delta or was it modest?

Richard J. Bielen - Vice Chairman and Chief Financial Officer

On the impaired... on the five bonds we impaired, the difference in price, we actually use the June month-end price, and there has really been no change there, just because they are down $0.10 on the dollar.

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

We use July remittance reports, but we use end of the quarter pricing, but [indiscernible] on the dollar, that's kind of a bottom.

Richard J. Bielen - Vice Chairman and Chief Financial Officer

And one thing to clarify in the remittance report, we went in and looked at the underlying performance of the deals. Had we stopped at June, we would have seen a more modest number, but we wanted to try and capture everything all at once and just kind of flush it through so that we didn't have to keep talking about it.

Thomas Gallagher - Credit Suisse

Okay, I got you. So, you were looking at the cash flow impairment side you were using data through the end of July, but on pricing end of June?

Richard J. Bielen - Vice Chairman and Chief Financial Officer

Yes.

Thomas Gallagher - Credit Suisse

Thanks a lot.

Operator

And our next question will come from John Fox with Fenimore Asset Management. Please go ahead.

John Fox - Fenimore Asset Management

Hi, good morning everybody. I have a couple of questions. First, a quick one in Asset Protection, you said there were some legal expenses. Do you have the pre-tax amount and do you consider those one-time?

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

I think there were about $3 million and I'd say about half of that has been kind of a recurring as we fall through some of these litigations issues we have, I'd say, about half of that was probably one-time or higher than we would have expected. Over time we think that that number is going to come down because we are kind of... we are spending on various matters we have, but that's the break down of it.

John Fox - Fenimore Asset Management

Okay, thank you. And can you talk about your confidence level as kind of gone though this period where Life profits were at level and then you talked about the profit emergence in the future. Can you just talk about how you feel given interest rates, sales levels et cetera, how you feel about that profit emergence going into '09?

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

I think we feel pretty bullish about our ability to improve our position in universal life. We really don't have the profit emergence issue on universal life to the degree we have it on terms. The fact that term is down in UL, we think will help on that.

It just... again to rehash a little bit what's already been said, we think that mortality was against us this quarter and the sense it wasn't as favorable as it's been in past quarters, $3 million, $0.03 a share, we say an elevated securitization cost of couple of million dollar. So if you run that back in and then you go back and compare this quarter, this year to last year without the excess allocated income there, which was about $4 million, you actually see home loss, all that, the trends are not too bad we think.

We can't forecast the sales, that just will be where it will be. But we do think we are going to have a very competitive positioning, it's very attractive products in UL space as we go forward and that's the basis of our optimism that we are going to see some improvement there.

John Fox - Fenimore Asset Management

Okay. And the Alt A securities you hold now and the ones that are written down, I guess for Rich, what are the main differences? I know you mentioned the ones you still hold to AAA. But can you just talk about the differences between those securities?

Richard J. Bielen - Vice Chairman and Chief Financial Officer

The ones that we've written down were part of the pool of AAs that we bought last year. And therefore they were subordinate to the AAAs in the structure.

John Fox - Fenimore Asset Management

Right.

Richard J. Bielen - Vice Chairman and Chief Financial Officer

When we bought them, we thought that the subordination levels of about 4% would be able to withstand the deteriorating housing market. We had FICO scores of 700 plus, loan to values of 75%. And what we've actually seen is the consumer behavior on these has been far worst than anything we would have expected. And so we went in... there were a total of 16 securities that we originally purchased. We knew when we bought them one or two of them may go bad, but we had bought them at about a $65 million discount to par when we looked at the entire pool. We've monitored every one of the 16 and what we saw is that in these five, four them were actually issued or originated by ResCap, which we thought was interestingly. We thought they were somewhat reputable originator in this marketplace. And what we saw is a lot of deterioration in those particular bonds and we've recognize that we weren't going to get back all of our cost. And we went ahead and just dealt with it now. Even though the actual deals today have seen actual losses of less than 1%, they still have subordination levels of probably around 3% on all of them. We continue to receive our coupon payments and in fact, we get a little trickle of principal on each one of those bonds, but looking at the future in the current delinquencies, we recognize that given where they were, we may not get back all of our principal. And so we went ahead and impaired them.

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

John's question too, Rich, is what's the difference between that portfolio of AA rated Alt As versus the AAAs, and the answer is just materially more subordinated.

Richard J. Bielen - Vice Chairman and Chief Financial Officer

Right.

John Fox - Fenimore Asset Management

Right.

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

So they are performing better.

Richard J. Bielen - Vice Chairman and Chief Financial Officer

And they're performing better. Actually the other Alt As are primarily... we bought some here where there is some repackage because of labels and things, but a lot of those were also older deals and they are shorter sequentials in the deal. So we actually see amortization on those... on all of those bonds as we speak, which lets you get out of the positions faster.

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

Carl Thigpen, our Chief Investment Officer, do you the data on how the AAA portfolio is marked at the end of the second quarter?

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

Yes, of the $715 million, it was only marked down about $9 million. And those, as Rich said, are short sequential pays, they are paying back principal at a fairly rapid rate.

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

So their market value is about 99% of the cost.

John Fox - Fenimore Asset Management

Okay. Thank you.

Richard J. Bielen - Vice Chairman and Chief Financial Officer

Thank you.

Operator

And our next question comes from Jukka Lipponen with KBW. Please go ahead.

Jukka Lipponen - Keefe, Bruyette and Woods

Follow-up question on capital. Given the current outlook and your capital levels, it sounds like you don't expect capital to restrict or limit your annuity or stable value sales.

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

Not at all.

Jukka Lipponen - Keefe, Bruyette and Woods

And Rich, you made a comment that in the Life Marketing that there is some cyclicality the way the reinsurance premiums work, can you give us a little more detail and color on that?

Unidentified Company Representative

It's really a function of the reinsurance mode versus the mode of the direct policies. We've recognize with little allowances that come in on the reinsurance based on a slug of business we wrote in December of, I believe, '99. And that really... because we were 90% reinsured at that point on a coinsurance basis, we recognized those allowances and that creates some earnings boost in the fourth quarter every year.

Jukka Lipponen - Keefe, Bruyette and Woods

And Last question. And sorry if I missed it, if you'd touched on this initially earlier on the call, but how do you yourselves look at again some of these items, what would you look at and consider as sort of the non-recurring or one-time?

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

Rich, I want to cast [ph] that. We kind of go through the quarter and it's really hard sometimes to say, particularly you get down to these smaller items, but we would say that... what we would consider things that we expect to come back or non-recurring kind of the wash quarter, Rich, do you want to elaborate on that?

Richard J. Bielen - Vice Chairman and Chief Financial Officer

Yes, I think, actually looking at both the first and the second quarter, we would have thought the run rate was inconsistent with this kind of $0.96-$0.97 when we take out all the fair value items. This quarter we had some fair value items on the trading account and the annuity business, which totaled about $0.06. But offsetting that was the increased litigation in APD, which was about a penny or so. The mortality did not run unfavorable, as expected. That was about $0.03 to $0.04. We also had some minor items in Corporate and Other that kind of flowed around, but they're not worth talking about. But they are this last penny or two that we see. So, the $0.96 we reported is actually kind of what we think is a pretty decent run rate in terms of what is going on.

Jukka Lipponen - Keefe, Bruyette and Woods

Thank you.

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

We are just approaching the end of the hour. Let's take another question or two and then, as always, we are happy to fill in any of the details offline. So, let's take another question or two.

Operator

And our next question comes from John Hall with Wachovia. Please go ahead.

John Hall - Wachovia Capital Markets, Llc

Thank you very much. Good morning.

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

Hey, John.

John Hall - Wachovia Capital Markets, Llc

Hey, in your comments, Rich, you mentioned that the acquisition area was running off at 6%. I was just wondering if you could offer some clarity on what the 6% is referencing? Are you talking about in force, are you talking about profitability? And as that 6% of whatever it is running off, what amount of capital is being freed up at the same time?

Richard J. Bielen - Vice Chairman and Chief Financial Officer

Well, I'll answer you first question. The 6% is really looking at the in force of the business. We moderate the in force all the time to kind of know how that's flowing off. And we believe earnings track along with the run off of the in-force. We'll have to get back to you on the amount of capital that gets thrown off by that process. We know it's substantial, but I don't have that number in front of us.

John Hall - Wachovia Capital Markets, Llc

Great. And is there sort of a direct line between the 6% in force run off and the profit run off?

Richard J. Bielen - Vice Chairman and Chief Financial Officer

Give or take, yes. So, I mean, you've got some mortality variance. We have to manage our expenses against that, but basic level, the two kind of run off at line.

John Hall - Wachovia Capital Markets, Llc

Great. And then just I have quick question on the annuity business, particularly those being sold through the Chase system, is the sales surge there a function of a rising tide or is it... is there a special hook that you got in that system, be a product or special placement?

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

It's our sense and it's not just in that system, but it is in other systems that there has been a rising tide, if you will, of fixed annuity sales volatility and the equity markets. I think distributors have found consumers more amenable to buying fixed rate kind of products. And so we are actually seeing that kind of broadly right now.

John Hall - Wachovia Capital Markets, Llc

Thanks very much, Johnny.

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

Okay, thank you, one more please.

Operator

And our final question comes from Edward Spehar with Merrill Lynch. Please go ahead.

Edward Spehar - Merrill Lynch

Thank you. Just one quick follow-up. Johnny, did you say that the... I think you said the new guidance no longer assumes the $0.07 per share charge, debt extinguishing charge, is that correct?

Richard J. Bielen - Vice Chairman and Chief Financial Officer

That is correct, but it's showing off indirectly because we have these elevated securitization costs. So we experienced $0.02 in the second quarter and we think we're going to see $0.02 a quarter in the last two. So the two kind of washed in our guidance thoughts.

Edward Spehar - Merrill Lynch

Okay, thank you.

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

Okay. Well, thanks everyone. Again, thanks for your participation in the call today. And if there are any kind of fill in the gap kind of items we can cover, we are always glad to do that. Please contact Rich or any of our people. Thank you very much.

Operator

This concludes today's teleconference. You may disconnect your lines. Thank you and have a great day.

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Source: Protective Life Corp. Q2 2008 Earnings Call Transcript
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