10-Q 1 a09-15218_110q.htm 10-Q

Table of Contents

 

 

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-Q

 


 

x

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended June 30, 2009

 

OR

 

o

 

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 


 

1-16725

(Commission file number)

 

PRINCIPAL FINANCIAL GROUP, INC.

(Exact name of registrant as specified in its charter)

 

Delaware

 

42-1520346

(State or other jurisdiction of incorporation or organization)

 

(I.R.S. Employer Identification Number)

 

711 High Street, Des Moines, Iowa 50392

(Address of principal executive offices)

 

(515) 247-5111

(Registrant’s telephone number, including area code)

 


 

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.   Yes x   No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes x   No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer x

 

Accelerated filer o

Non-accelerated filer o

 

Smaller reporting company o

(Do not check if a smaller reporting company)

 

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o   No x

 

The total number of shares of the registrant’s Common Stock, $0.01 par value, outstanding as of July 29, 2009, was 318,935,780.

 

 

 



Table of Contents

 

PRINCIPAL FINANCIAL GROUP, INC.

 

TABLE OF CONTENTS

 

 

 

Page

Part I - FINANCIAL INFORMATION

 

 

 

 

Item 1.

Financial Statements

3

 

 

 

 

Consolidated Statements of Financial Position at June 30, 2009 (Unaudited) and December 31, 2008

3

 

 

 

 

Unaudited Consolidated Statements of Operations for the three and six months ended June 30, 2009 and 2008

4

 

 

 

 

Unaudited Consolidated Statements of Stockholders’ Equity for the six months ended June 30, 2009 and 2008

5

 

 

 

 

Unaudited Consolidated Statements of Cash Flows for the six months ended June 30, 2009 and 2008

6

 

 

 

 

Notes to Unaudited Consolidated Financial Statements — June 30, 2009

8

 

 

 

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

63

 

 

 

Item 3.

Quantitative and Qualitative Disclosures about Market Risk

110

 

 

 

Item 4.

Controls and Procedures

116

 

 

 

Part II — OTHER INFORMATION

 

 

 

 

Item 1.

Legal Proceedings

116

 

 

 

Item 1A.

Risk Factors

116

 

 

 

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

117

 

 

 

Item 4.

Submission of Matters to a Vote of Security Holders

117

 

 

 

Item 6.

Exhibits

119

 

 

 

Signature

 

120

 

2



Table of Contents

 

PART I — FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

Principal Financial Group, Inc.

Consolidated Statements of Financial Position

 

 

 

June 30,
2009

 

December 31,
2008

 

 

 

(Unaudited)

 

 

 

 

 

(in millions)

 

Assets

 

 

 

 

 

Fixed maturities, available-for-sale

 

$

42,298.6

 

$

40,117.2

 

Fixed maturities, trading

 

869.6

 

843.4

 

Equity securities, available-for-sale

 

212.5

 

242.7

 

Equity securities, trading

 

170.4

 

158.0

 

Mortgage loans

 

12,433.8

 

13,113.6

 

Real estate

 

974.6

 

919.4

 

Policy loans

 

902.5

 

896.4

 

Other investments

 

2,390.7

 

2,816.6

 

Total investments

 

60,252.7

 

59,107.3

 

Cash and cash equivalents

 

4,328.5

 

2,608.0

 

Accrued investment income

 

696.2

 

750.7

 

Premiums due and other receivables

 

1,046.5

 

988.1

 

Deferred policy acquisition costs

 

4,058.7

 

4,153.0

 

Property and equipment

 

506.1

 

518.2

 

Goodwill

 

384.1

 

375.5

 

Other intangibles

 

878.4

 

925.3

 

Separate account assets

 

55,998.4

 

55,142.6

 

Other assets

 

2,557.0

 

3,613.7

 

Total assets

 

$

130,706.6

 

$

128,182.4

 

Liabilities

 

 

 

 

 

Contractholder funds

 

$

41,449.8

 

$

43,086.6

 

Future policy benefits and claims

 

18,939.1

 

18,494.2

 

Other policyholder funds

 

553.4

 

536.2

 

Short-term debt

 

159.5

 

500.9

 

Long-term debt

 

2,033.3

 

1,290.5

 

Income taxes currently payable

 

2.8

 

1.9

 

Deferred income taxes

 

116.7

 

102.8

 

Separate account liabilities

 

55,998.4

 

55,142.6

 

Other liabilities

 

5,677.1

 

6,457.4

 

Total liabilities

 

124,930.1

 

125,613.1

 

Stockholders’ equity

 

 

 

 

 

Series A preferred stock, par value $.01 per share with liquidation preference of $100 per share - 3.0 million shares authorized, issued and outstanding in 2009 and 2008

 

 

 

Series B preferred stock, par value $.01 per share with liquidation preference of $25 per share - 10.0 million shares authorized, issued and outstanding in 2009 and 2008

 

0.1

 

0.1

 

Common stock, par value $.01 per share - 2,500.0 million shares authorized, 446.2 million and 387.0 million shares issued, and 318.3 million and 259.3 million shares outstanding in 2009 and 2008

 

4.5

 

3.9

 

Additional paid-in capital

 

9,459.8

 

8,376.5

 

Retained earnings

 

3,995.5

 

3,722.5

 

Accumulated other comprehensive loss

 

(3,042.4

)

(4,911.6

)

Treasury stock, at cost (127.9 million and 127.7 million shares in 2009 and 2008, respectively)

 

(4,722.3

)

(4,718.6

)

Total stockholders’ equity attributable to Principal Financial Group, Inc.

 

5,695.2

 

2,472.8

 

Noncontrolling interest

 

81.3

 

96.5

 

Total stockholders’ equity

 

5,776.5

 

2,569.3

 

Total liabilities and stockholders’ equity

 

$

130,706.6

 

$

128,182.4

 

 

See accompanying notes.

 

3



Table of Contents

 

Principal Financial Group, Inc.

Consolidated Statements of Operations

(Unaudited)

 

 

 

For the three months ended
June 30,

 

For the six months ended
June 30,

 

 

 

2009

 

2008

 

2009

 

2008

 

 

 

(in millions, except per share data)

 

Revenues

 

 

 

 

 

 

 

 

 

Premiums and other considerations

 

$

937.7

 

$

1,156.2

 

$

1,887.6

 

$

2,209.2

 

Fees and other revenues

 

515.2

 

622.5

 

988.7

 

1,235.9

 

Net investment income

 

860.1

 

990.9

 

1,688.6

 

1,951.2

 

Net realized capital gains (losses), excluding impairment losses on available-for-sale securities

 

(20.8

)

(65.6

)

11.9

 

(124.1

)

Total other-than-temporary impairment losses on available-for-sale securities

 

(200.9

)

(45.9

)

(347.5

)

(113.4

)

Portion of impairment losses on fixed maturities, available-for-sale recognized in other comprehensive income

 

66.5

 

 

117.1

 

 

Net impairment losses on available-for-sale securities

 

(134.4

)

(45.9

)

(230.4

)

(113.4

)

Net realized capital losses

 

(155.2

)

(111.5

)

(218.5

)

(237.5

)

Total revenues

 

2,157.8

 

2,658.1

 

4,346.4

 

5,158.8

 

Expenses

 

 

 

 

 

 

 

 

 

Benefits, claims and settlement expenses

 

1,334.3

 

1,634.0

 

2,640.9

 

3,106.0

 

Dividends to policyholders

 

62.9

 

69.0

 

126.4

 

139.8

 

Operating expenses

 

562.7

 

742.6

 

1,251.1

 

1,493.3

 

Total expenses

 

1,959.9

 

2,445.6

 

4,018.4

 

4,739.1

 

Income before income taxes

 

197.9

 

212.5

 

328.0

 

419.7

 

Income taxes

 

33.9

 

29.4

 

41.4

 

59.0

 

Net income

 

164.0

 

183.1

 

286.6

 

360.7

 

Net income attributable to noncontrolling interest

 

5.4

 

6.5

 

7.0

 

1.7

 

Net income attributable to Principal Financial Group, Inc.

 

158.6

 

176.6

 

279.6

 

359.0

 

Preferred stock dividends

 

8.3

 

8.3

 

16.5

 

16.5

 

Net income available to common stockholders

 

$

150.3

 

$

168.3

 

$

263.1

 

$

342.5

 

 

 

 

 

 

 

 

 

 

 

Earnings per common share

 

 

 

 

 

 

 

 

 

Basic earnings per common share

 

$

0.52

 

$

0.65

 

$

0.96

 

$

1.32

 

 

 

 

 

 

 

 

 

 

 

Diluted earnings per common share

 

$

0.52

 

$

0.64

 

$

0.95

 

$

1.31

 

 

See accompanying notes.

 

4



Table of Contents

 

Principal Financial Group, Inc.

Consolidated Statements of Stockholders’ Equity

(Unaudited)

 

 

 

Series A
preferred
stock

 

Series B
preferred
stock

 

Common
stock

 

Additional
paid-in
capital

 

Retained
earnings

 

Accumulated
other
comprehensive
income (loss)

 

Treasury
stock

 

Noncontrolling interest

 

Total
stockholders’
equity

 

 

 

(in millions)

 

Balances at January 1, 2008

 

$

 

$

0.1

 

$

3.9

 

$

8,295.4

 

$

3,414.3

 

$

420.2

 

$

(4,712.2

)

$

97.6

 

$

7,519.3

 

Common stock issued

 

 

 

 

23.6

 

 

 

 

 

23.6

 

Capital transactions of equity method investee, net of related income taxes

 

 

 

 

0.2

 

 

 

 

 

0.2

 

Stock-based compensation and additional related tax benefits

 

 

 

 

31.2

 

 

 

 

 

31.2

 

Treasury stock acquired, common

 

 

 

 

 

 

 

(6.1

)

 

(6.1

)

Dividends to preferred stockholders

 

 

 

 

 

(16.5

)

 

 

 

(16.5

)

Dividends to noncontrolling interest

 

 

 

 

 

 

 

 

(8.8

)

(8.8

)

Capital received from noncontrolling interest

 

 

 

 

 

 

 

 

9.7

 

9.7

 

Effects of changing post-retirement benefit plan measurement date, net of related income taxes

 

 

 

 

 

0.9

 

(2.0

)

 

 

(1.1

)

Comprehensive loss:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

 

 

 

359.0

 

 

 

1.7

 

360.7

 

Net unrealized losses, net

 

 

 

 

 

 

(1,220.9

)

 

 

(1,220.9

)

Foreign currency translation adjustment, net of related income taxes

 

 

 

 

 

 

32.8

 

 

(0.6

)

32.2

 

Unrecognized post-retirement benefit obligation, net of related income taxes

 

 

 

 

 

 

(4.0

)

 

 

(4.0

)

Comprehensive loss

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(832.0

)

Balances at June 30, 2008

 

$

 

$

0.1

 

$

3.9

 

$

8,350.4

 

$

3,757.7

 

$

(773.9

)

$

(4,718.3

)

$

99.6

 

$

6,719.5

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balances at January 1, 2009

 

$

 

$

0.1

 

$

3.9

 

$

8,376.5

 

$

3,722.5

 

$

(4,911.6

)

$

(4,718.6

)

$

96.5

 

$

2,569.3

 

Common stock issued

 

 

 

0.6

 

1,112.4

 

 

 

 

 

1,113.0

 

Stock-based compensation and additional related tax benefits

 

 

 

 

16.8

 

 

 

 

 

16.8

 

Treasury stock acquired, common

 

 

 

 

 

 

 

(3.7

)

 

(3.7

)

Dividends to preferred stockholders

 

 

 

 

 

(16.5

)

 

 

 

(16.5

)

Dividends to noncontrolling interest

 

 

 

 

 

 

 

 

(4.2

)

(4.2

)

Purchase of subsidiary shares from noncontrolling interest

 

 

 

 

(45.9

)

 

 

 

0.2

 

(45.7

)

Capital paid to noncontrolling interest

 

 

 

 

 

 

 

 

(18.2

)

(18.2

)

Effects of reclassifying noncredit component of previously recognized impairment losses on fixed maturities, available-for-sale, net

 

 

 

 

 

9.9

 

(9.9

)

 

 

 

Comprehensive income:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

 

 

 

279.6

 

 

 

7.0

 

286.6

 

Net unrealized gains, net

 

 

 

 

 

 

1,806.8

 

 

 

1,806.8

 

Noncredit component of impairment losses on fixed maturities, available-for-sale, net

 

 

 

 

 

 

(68.4

)

 

 

(68.4

)

Foreign currency translation adjustment, net of related income taxes

 

 

 

 

 

 

110.8

 

 

 

110.8

 

Unrecognized post-retirement benefit obligation, net of related income taxes

 

 

 

 

 

 

29.9

 

 

 

29.9

 

Comprehensive income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2,165.7

 

Balances at June 30, 2009

 

$

 

$

0.1

 

$

4.5

 

$

9,459.8

 

$

3,995.5

 

$

(3,042.4

)

$

(4,722.3

)

$

81.3

 

$

5,776.5

 

 

See accompanying notes.

 

5



Table of Contents

 

Principal Financial Group, Inc.

Consolidated Statements of Cash Flows

(Unaudited)

 

 

 

For the six months ended
June 30,

 

 

 

2009

 

2008

 

 

 

(in millions)

 

Operating activities

 

 

 

 

 

Net income

 

$

286.6

 

$

360.7

 

Adjustments to reconcile net income to net cash provided by operating activities:

 

 

 

 

 

Amortization of deferred policy acquisition costs

 

36.2

 

126.4

 

Additions to deferred policy acquisition costs

 

(253.3

)

(373.8

)

Accrued investment income

 

54.5

 

30.1

 

Net cash flows from trading securities

 

38.0

 

(409.8

)

Premiums due and other receivables

 

(55.3

)

23.0

 

Contractholder and policyholder liabilities and dividends

 

820.1

 

1,083.9

 

Current and deferred income taxes

 

149.0

 

(20.1

)

Net realized capital losses

 

218.5

 

237.5

 

Depreciation and amortization expense

 

68.8

 

69.8

 

Mortgage loans held for sale, acquired or originated

 

(21.2

)

(27.4

)

Mortgage loans held for sale, sold or repaid, net of gain

 

26.0

 

28.8

 

Real estate acquired through operating activities

 

(16.6

)

(29.9

)

Real estate sold through operating activities

 

0.3

 

7.2

 

Stock-based compensation

 

16.5

 

26.4

 

Other

 

46.8

 

(59.7

)

Net adjustments

 

1,128.3

 

712.4

 

Net cash provided by operating activities

 

1,414.9

 

1,073.1

 

Investing activities

 

 

 

 

 

Available-for-sale securities:

 

 

 

 

 

Purchases

 

(2,968.0

)

(4,360.4

)

Sales

 

1,623.7

 

434.2

 

Maturities

 

2,049.6

 

1,799.4

 

Mortgage loans acquired or originated

 

(181.1

)

(753.4

)

Mortgage loans sold or repaid

 

862.2

 

613.8

 

Real estate acquired

 

(42.1

)

(11.2

)

Real estate sold

 

1.3

 

46.0

 

Net purchases of property and equipment

 

(16.5

)

(49.5

)

Purchases of interest in subsidiaries, net of cash acquired

 

(45.7

)

(20.3

)

Net change in other investments

 

(50.6

)

(25.3

)

Net cash provided by (used in) investing activities

 

$

1,232.8

 

$

(2,326.7

)

 

6



Table of Contents

 

Principal Financial Group, Inc.

Consolidated Statements of Cash Flows (continued)

(Unaudited)

 

 

 

For the six months ended,
June 30,

 

 

 

2009

 

2008

 

 

 

(in millions)

 

Financing activities

 

 

 

 

 

Issuance of common stock

 

$

1,154.4

 

$

23.6

 

Acquisition of treasury stock

 

(3.7

)

(6.1

)

Proceeds from financing element derivatives

 

77.9

 

83.3

 

Payments for financing element derivatives

 

(43.7

)

(61.1

)

Excess tax benefits from share-based payment arrangements

 

0.2

 

2.8

 

Dividends to preferred stockholders

 

(16.5

)

(16.5

)

Issuance of long-term debt

 

750.0

 

3.1

 

Principal repayments of long-term debt

 

(21.7

)

(12.7

)

Net repayments of short-term borrowings

 

(345.7

)

(72.7

)

Investment contract deposits

 

2,681.1

 

6,792.5

 

Investment contract withdrawals

 

(5,224.4

)

(5,531.7

)

Net increase in banking operation deposits

 

68.1

 

232.3

 

Other

 

(3.2

)

(3.1

)

Net cash provided by (used in) financing activities

 

(927.2

)

1,433.7

 

Net increase in cash and cash equivalents

 

1,720.5

 

180.1

 

Cash and cash equivalents at beginning of period

 

2,608.0

 

1,344.4

 

Cash and cash equivalents at end of period

 

$

4,328.5

 

$

1,524.5

 

 

See accompanying notes.

 

7



Table of Contents

 

Principal Financial Group, Inc.

Notes to Consolidated Financial Statements

June 30, 2009

(Unaudited)

 

1. Nature of Operations and Significant Accounting Policies

 

Basis of Presentation

 

The accompanying unaudited consolidated financial statements of Principal Financial Group, Inc. (“PFG”), its majority-owned subsidiaries and its consolidated variable interest entities (“VIEs”), have been prepared in conformity with accounting principles generally accepted in the U.S. (“U.S. GAAP”) for interim financial statements and with the instructions to Form 10-Q and Article 10 of Regulation S-X. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and six months ended June 30, 2009, are not necessarily indicative of the results that may be expected for the year ended December 31, 2009. These interim unaudited consolidated financial statements should be read in conjunction with our annual audited financial statements as of December 31, 2008, included in our Form 10-K for the year ended December 31, 2008, filed with the United States Securities and Exchange Commission (“SEC”). The accompanying consolidated statement of financial position as of December 31, 2008, has been derived from the audited consolidated statement of financial position but does not include all of the information and footnotes required by U.S. GAAP for complete financial statements.

 

We have evaluated subsequent events through August 5, 2009, which was the date our consolidated financial statements were issued.

 

Reclassifications have been made to prior period financial statements to conform to the June 30, 2009, presentation. See Recent Accounting Pronouncements for impact of new accounting guidance on prior period financial statements.

 

Recent Accounting Pronouncements

 

On June 30, 2009, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 168, The FASB Accounting Standards CodificationTM and the Hierarchy of Generally Accepted Accounting Principles, a replacement of FASB Statement No. 162 (“SFAS 168”). This statement replaces SFAS No. 162, The Hierarchy of Generally Accepted Accounting Principles, and establishes the FASB Accounting Standards CodificationTM (“Codification”) as the source of authoritative accounting principles recognized by the FASB to be applied by nongovernmental entities in the preparation of financial statements in conformity with U.S. GAAP. Rules and interpretive releases of the SEC under federal securities laws are also sources of authoritative U.S. GAAP for SEC registrants. All guidance contained in the Codification carries an equal level of authority. SFAS 168 is effective for financial statements issued for interim and annual periods ending after September 15, 2009. We do not anticipate that SFAS 168 will have a material impact on our consolidated financial statements.

 

On June 12, 2009, the FASB issued SFAS No. 166, Accounting for Transfers of Financial Assets, an amendment of FASB Statement No. 140 (“SFAS 166”). The objective of SFAS 166 is to improve the relevance, representational faithfulness, and comparability of the information that a reporting entity provides in its financial reports about a transfer of financial assets; the effects of a transfer on its financial position, financial performance, and cash flows; and a transferor’s continuing involvement in transferred financial assets. The most significant change is the elimination of the concept of a qualifying special-purpose entity. Therefore, formerly qualifying special-purpose entities (as defined under previous accounting standards) should be evaluated for consolidation by reporting entities on and after the effective date in accordance with the applicable consolidation guidance. SFAS 166 will be effective for us on January 1, 2010. Earlier adoption is prohibited. We are still evaluating the impact this guidance will have on our consolidated financial statements.

 

Also on June 12, 2009, the FASB issued SFAS No. 167, Amendments to FASB Interpretation No. 46(R) (“SFAS 167”). SFAS 167 amends FASB Interpretation No. 46(R), to require an enterprise to perform an analysis to determine whether the enterprise’s variable interest or interests give it a controlling financial interest in a VIE. This analysis identifies the primary beneficiary of a VIE as the enterprise that (1) has the power to direct the activities of a VIE that most significantly impact the entity’s economic performance and (2) the obligation to absorb losses of the entity that could potentially be significant to the VIE or the right to receive benefits from the entity that could potentially be significant to the VIE. SFAS 167 requires ongoing reassessments of whether an enterprise is the primary beneficiary of a VIE. In addition, SFAS 167 requires enhanced disclosures that will provide users of financial statements with more transparent information about an enterprise’s involvement in a VIE. The enhanced disclosures are required for any enterprise that holds a variable interest in a VIE. SFAS 167 will be effective for us on January 1, 2010. Earlier adoption is prohibited. We are still evaluating the impact this guidance will have on our consolidated financial statements.

 

8



Table of Contents

 

Principal Financial Group, Inc.
Notes to Consolidated Financial Statements (continued)
June 30, 2009
(Unaudited)

 

1. Nature of Operations and Significant Accounting Policies (continued)

 

On April 9, 2009, the FASB issued FASB Staff Position (“FSP”) FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments (“FSP FAS 115-2”). FSP FAS 115-2 provides new guidance on the recognition and presentation of an other-than-temporary impairment (“OTTI”) and requires additional disclosures. The recognition provisions within FSP FAS 115-2 apply only to debt securities classified as available-for-sale and held-to-maturity, while the presentation and disclosure requirements of FSP FAS 115-2 apply to both debt and equity securities. An impaired debt security will be considered other-than-temporarily impaired if a holder has the intent to sell, or it more likely than not will be required to sell prior to recovery of the amortized cost. If a holder of a debt security does not expect recovery of the entire cost basis, even if there is no intention to sell the security, it will be considered an OTTI as well. FSP FAS 115-2 also changes how an entity recognizes an OTTI for a debt security by separating the loss between the amount representing the credit loss and the amount relating to other factors, if a holder does not have the intent to sell or it more likely than not will not be required to sell prior to recovery of the amortized cost less any current period credit loss. Credit losses will be recognized in net income and losses relating to other factors will be recognized in other comprehensive income (“OCI”). If the holder has the intent to sell or it more likely than not will be required to sell before its recovery of amortized cost less any current period credit loss, the entire OTTI will continue to be recognized in net income. FSP FAS 115-2 requires a cumulative effect adjustment to the opening balance of retained earnings in the period of adoption with a corresponding adjustment to accumulated OCI. We adopted FSP FAS 115-2 effective January 1, 2009. The cumulative change in accounting principle from adopting this guidance resulted in a net $9.9 million increase to retained earnings and a corresponding decrease to accumulated OCI. The required disclosures have been included in our consolidated financial statements.

 

On April 9, 2009, the FASB issued FSP FAS 157-4, Determining Fair Value When Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly (“FSP FAS 157-4”). FSP FAS 157-4 amends SFAS No. 157, Fair Value Measurements (“SFAS 157”), to provide additional guidance on estimating fair value when the volume and level of activity for an asset or liability have significantly decreased in relation to normal market activity for the asset or liability and clarifies that the use of multiple valuation techniques may be appropriate. FSP FAS 157-4 also provides additional guidance on circumstances that may indicate a transaction is not orderly. Further, this FSP requires additional disclosures about fair value measurements in annual and interim reporting periods and supersedes FSP FAS 157-3, Determining the Fair Value of a Financial Asset in a Market That Is Not Active. We adopted FSP FAS 157-4 effective January 1, 2009, and this guidance did not have a material impact on our consolidated financial statements. See Note 9, Fair Value of Financial Instruments, for further details.

 

Also on April 9, 2009, the FASB issued FSP FAS 107-1 and APB 28-1, Interim Disclosures About Fair Value of Financial Instruments (“FSP FAS 107-1”). FSP FAS 107-1 extends the annual disclosure requirements of SFAS No. 107, Disclosures about Fair Value of Financial Instruments (“SFAS 107”), to interim financial statements of public companies. We adopted FSP FAS 107-1 effective April 1, 2009. The required disclosures have been included in Note 9, Fair Value of Financial Instruments.

 

On March 19, 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities — an amendment of FASB Statement No. 133 (“SFAS 161”). This statement requires (1) qualitative disclosures about objectives and strategies for using derivatives, (2) quantitative disclosures about fair value amounts of gains and losses on derivative instruments and related hedged items and (3) disclosures about credit-risk-related contingent features in derivative instruments. The disclosures are intended to provide users of financial statements with an enhanced understanding of how and why derivative instruments are used, how they are accounted for and the financial statement impacts. We adopted SFAS 161 on January 1, 2009. See Note 3, Derivative Financial Instruments, for further details.

 

On December 4, 2007, the FASB issued SFAS No. 141(R), Business Combinations (“SFAS 141(R)”). Among the changes, the standard requires that the acquiring entity in a business combination establish the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed, including any noncontrolling interests, and requires the acquirer to disclose to investors and other users all of the information they need to evaluate and understand the nature and financial effect of the business combination. In addition, SFAS 141(R) requires direct acquisition costs to be expensed. We adopted SFAS 141(R) on January 1, 2009. All requirements of SFAS 141(R) are applied prospectively.

 

9



Table of Contents

 

Principal Financial Group, Inc.
Notes to Consolidated Financial Statements (continued)
June 30, 2009
(Unaudited)

 

1. Nature of Operations and Significant Accounting Policies (continued)

 

Also on December 4, 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements — an Amendment of Accounting Research Bulletin No. 51 (“SFAS 160”). Under this statement, noncontrolling interests are to be treated as a separate component of equity, rather than as a liability or other item outside of equity. In addition, SFAS 160 changes the way the consolidated income statement is presented. Under this statement, net income includes the total income of all consolidated subsidiaries, with separate disclosures on the face of the income statement of the income attributable to controlling and noncontrolling interests. Previously, net income attributable to the noncontrolling interest was reported as an operating expense in arriving at consolidated net income. Finally, SFAS 160 revises the accounting requirements for changes in a parent’s ownership interest when the parent retains control and for changes in a parent’s ownership interest that results in deconsolidation. We adopted SFAS 160 on January 1, 2009. Presentation and disclosure requirements have been applied retrospectively for all periods presented. All other requirements of SFAS 160 should be applied prospectively. Certain separate account arrangements involve ownership of mutual funds to support the investment objective of the separate account. It is possible that, through a separate account arrangement, greater than 50% of the mutual fund shares could be owned. The accounting guidance for this circumstance is not well defined, but we, like many other insurers, do not consolidate the mutual fund as we believe the arrangement qualifies for the exemption afforded investment companies. In January 2009, the FASB asked the Emerging Issues Task Force (“EITF”) to consider a topic entitled “Consideration of an Insurer’s Accounting for Majority Owned Investments When the Ownership is through a Separate Account.” It is anticipated that the EITF will consider the issue in 2009. It is not possible to predict the outcome of the deliberations with any certainty; however, one outcome could be the recognition of the portion of the mutual fund not held via the separate account arrangement as a noncontrolling interest in equity.

 

Separate Accounts

 

As of June 30, 2009, and December 31, 2008, the separate accounts include a separate account valued at $159.9 million and $207.4 million, respectively, which primarily includes shares of our stock that were allocated and issued to eligible participants of qualified employee benefit plans administered by us as part of the policy credits issued under our 2001 demutualization. These shares are included in both basic and diluted earnings per share calculations. The separate account shares are recorded at fair value and are reported as separate account assets and separate account liabilities in the consolidated statements of financial position. Changes in fair value of the separate account shares are reflected in both the separate account assets and separate account liabilities and do not impact our results of operations.

 

10



Table of Contents

 

Principal Financial Group, Inc.
Notes to Consolidated Financial Statements (continued)
June 30, 2009
(Unaudited)

 

2. Investments

 

Fixed Maturities and Equity Securities

 

Fixed maturity securities include bonds, mortgage-backed securities, redeemable preferred stock and certain nonredeemable preferred stock. Equity securities include mutual funds, common stock and nonredeemable preferred stock. We classify fixed maturity securities and equity securities as either available-for-sale or trading at the time of the purchase and, accordingly, carry them at fair value. See Note 9, Fair Value of Financial Instruments, for methodologies related to the determination of fair value. Unrealized gains and losses related to available-for-sale securities, excluding those in fair value hedging relationships, are reflected in stockholders’ equity, net of adjustments related to deferred policy acquisition costs (“DPAC”), sales inducements, unearned revenue reserves, derivatives in cash flow hedge relationships and applicable income taxes. Unrealized gains and losses related to trading securities and hedged portions of available-for-sale securities in fair value hedging relationships are reflected in net income as net realized capital gains (losses).

 

The cost of fixed maturity securities is adjusted for amortization of premiums and accrual of discounts, both computed using the interest method. The cost of fixed maturity securities and equity securities is adjusted for other-than-temporary impairments recognized in net income. For loan-backed and structured securities, we recognize income using a constant effective yield based on currently anticipated prepayments using a tool that models the prepayment behavior of the underlying collateral based on the current interest rate environment.

 

The amortized cost, gross unrealized gains and losses, other-than-temporary impairments in OCI and fair value of fixed maturities and equity securities available-for-sale as of June 30, 2009, are summarized as follows:

 

 

 

Amortized
cost

 

Gross
unrealized
gains

 

Gross
unrealized
losses

 

Other-than-temporary impairments
in OCI

 

Fair value

 

 

 

 

 

 

 

(in millions)

 

 

 

 

 

Fixed maturities, available-for-sale:

 

 

 

 

 

 

 

 

 

 

 

U.S. government and agencies

 

$

570.2

 

$

4.8

 

$

0.8

 

$

 

$

574.2

 

Non-U.S. governments

 

708.1

 

82.7

 

5.8

 

 

785.0

 

States and political subdivisions

 

1,968.4

 

33.9

 

40.4

 

 

1,961.9

 

Corporate

 

33,176.7

 

679.0

 

2,890.9

 

28.0

 

30,936.8

 

Residential mortgage-backed securities

 

2,187.7

 

64.3

 

1.7

 

 

2,250.3

 

Commercial mortgage-backed securities

 

5,355.3

 

8.6

 

1,825.8

 

31.7

 

3,506.4

 

Collateralized debt obligations

 

641.7

 

3.0

 

316.0

 

34.1

 

294.6

 

Other debt obligations

 

2,436.3

 

19.2

 

425.3

 

40.8

 

1,989.4

 

Total fixed maturities, available-for-sale

 

$

47,044.4

 

$

895.5

 

$

5,506.7

 

$

134.6

 

$

42,298.6

 

Total equity securities, available-for-sale

 

$

294.2

 

$

12.0

 

$

93.7

 

$

 

$

212.5

 

 

The amortized cost and fair value of fixed maturities available-for-sale as of June 30, 2009, by contractual maturity, were as follows:

 

 

 

Amortized cost

 

Fair value

 

 

 

(in millions)

 

Due in one year or less

 

$

1,446.5

 

$

1,425.7

 

Due after one year through five years

 

13,367.7

 

13,205.0

 

Due after five years through ten years

 

9,725.9

 

9,086.6

 

Due after ten years

 

11,883.3

 

10,540.6

 

 

 

36,423.4

 

34,257.9

 

Mortgage-backed and other asset-backed securities

 

10,621.0

 

8,040.7

 

Total

 

$

47,044.4

 

$

42,298.6

 

 

Actual maturities may differ because issuers may have the right to call or prepay obligations.

 

11



Table of Contents

 

Principal Financial Group, Inc.
Notes to Consolidated Financial Statements (continued)
June 30, 2009
(Unaudited)

2. Investments (continued)

 

Our portfolio is diversified by industry, issuer and asset class. Credit concentrations are managed to established limits.

 

Net Realized Capital Gains and Losses

 

Net realized capital gains and losses on sales of investments are determined on the basis of specific identification. In general, in addition to realized capital gains and losses on investment sales and periodic settlements on derivatives not designated as hedges, gains and losses related to other than temporary impairments, trading securities, certain seed money investments, fair value hedge and cash flow hedge ineffectiveness, mark-to-market adjustments on derivatives not designated as hedges, changes in the mortgage loan valuation allowance and impairments of real estate held for investment are reported as net realized capital gains (losses). Investment gains and losses on sales of certain real estate held for sale, which do not meet the criteria for classification as a discontinued operation, are reported as net investment income and are excluded from net realized capital gains (losses). The major components of net realized capital gains (losses) on investments are summarized as follows:

 

 

 

For the three months
ended June 30, 2009

 

For the six months
ended June 30, 2009

 

 

 

(in millions)

 

Fixed maturities, available-for-sale:

 

 

 

 

 

Gross gains

 

$

14.2

 

$

63.6

 

Gross losses

 

(193.6

)

(350.4

)

Portion of impairment losses recognized in other comprehensive income

 

66.5

 

117.1

 

Hedging, net

 

(180.2

)

(233.6

)

Fixed maturities, trading

 

18.2

 

41.8

 

Equity securities, available-for-sale:

 

 

 

 

 

Gross gains

 

5.7

 

12.5

 

Gross losses

 

(13.5

)

(14.1

)

Equity securities, trading

 

20.3

 

10.7

 

Mortgage loans

 

(41.1

)

(76.6

)

Derivatives

 

193.9

 

262.1

 

Other

 

(45.6

)

(51.6

)

Net realized capital losses

 

$

(155.2

)

$

(218.5

)

 

Proceeds from sales of investments (excluding call and maturity proceeds) in fixed maturities, available-for-sale were $0.7 billion and $1.6 billion for the three and six months ended June 30, 2009, respectively.

 

Other-Than-Temporary Impairments

 

We have a process in place to identify fixed maturity and equity securities that could potentially have a credit impairment that is other than temporary. This process involves monitoring market events that could impact issuers’ credit ratings, business climate, management changes, litigation and government actions and other similar factors. This process also involves monitoring late payments, pricing levels, downgrades by rating agencies, key financial ratios, financial statements, revenue forecasts and cash flow projections as indicators of credit issues.

 

Every month, all securities are reviewed to determine whether an other-than-temporary decline in value exists and whether losses should be recognized. We consider relevant facts and circumstances in evaluating whether a credit or interest rate-related impairment of a security is other than temporary. Relevant facts and circumstances considered include: (1) the extent and length of time the fair value has been below cost; (2) the reasons for the decline in value; (3) the financial position and access to capital of the issuer, including the current and future impact of any specific events and (4) for fixed maturity securities, our intent to sell a security or whether it is more likely than not we will be required to sell the security before the recovery of its amortized cost which, in some cases, may extend to maturity and for equity securities, our ability and intent to hold the security for a period of time that allows for the recovery in value. To the extent we determine that a security is deemed to be other than temporarily impaired, an impairment loss is recognized.

 

12



Table of Contents

 

Principal Financial Group, Inc.
Notes to Consolidated Financial Statements (continued)
June 30, 2009
(Unaudited)

 

2. Investments (continued)

 

During first quarter 2009 we adopted FSP FAS 115-2, which changes the recognition and presentation of other-than-temporary impairments. See further discussion of the adoption in Note 1, Nature of Operations and Significant Accounting Policies. The recognition provisions within FSP FAS 115-2 apply only to debt securities classified as available-for-sale and held-to-maturity, while the presentation and disclosure requirements of FSP FAS 115-2 apply to both debt and equity securities.

 

Impairment losses on equity securities are recognized in net income. The way in which impairment losses on debt securities are recognized in the financial statements is dependent on the facts and circumstances related to the specific security. If we intend to sell a security or it is more likely than not that we would be required to sell a security before the recovery of its amortized cost, less any current period credit loss, we recognize an other-than-temporary impairment in net income for the difference between amortized cost and fair value. If we do not expect to recover the amortized cost basis, we do not plan to sell the security and if it is not more likely than not that we would be required to sell a security before the recovery of its amortized cost, less any current period credit loss, the recognition of the other-than-temporary impairment is bifurcated. We recognize the credit loss portion in net income and the noncredit loss portion in OCI.

 

We estimate the amount of the credit loss component of a debt security impairment as the difference between amortized cost and the present value of the expected cash flows of the security. The present value is determined using the best estimate cash flows discounted at the effective interest rate implicit to the security at the date of purchase or the current yield to accrete an asset-backed or floating rate security. The methodology and assumptions for establishing the best estimate cash flows vary depending on the type of security. The asset-backed securities cash flow estimates are based on bond specific facts and circumstances that may include collateral characteristics, expectations of delinquency and default rates, loss severity and prepayment speeds and structural support, including subordination and guarantees. The corporate bond cash flow estimates are derived from scenario-based outcomes of expected corporate restructurings or liquidations using bond specific facts and circumstances including timing, security interests and loss severity.

 

Total other-than-temporary impairment losses, net of recoveries from the sale of previously impaired securities, on fixed maturity securities were $193.1 million and $345.8 million for the three and six months ended June 30, 2009, respectively. Total other-than-temporary impairment losses, net of recoveries from the sale of previously impaired securities, on equity securities were $7.8 million and $1.7 million for the three and six months ended June 30, 2009, respectively.

 

The other-than-temporary impairments on fixed maturity securities for which an amount related to credit losses was recognized in net realized capital gains (losses) and an amount related to noncredit losses was recognized in OCI is summarized as follows:

 

 

 

For the three months
ended June 30, 2009

 

For the six months
ended June 30, 2009

 

 

 

(in millions)

 

Total other-than-temporary impairments on fixed maturity securities for which an amount related to noncredit losses was recognized in OCI (1)

 

$

(100.1

)

$

(199.3

)

Noncredit loss recognized in OCI

 

66.5

 

117.1

 

Credit loss impairment recognized in net realized capital losses

 

$

(33.6

)

$

(82.2

)

 


(1)   For the three and six months ended June 30, 2009, total other-than-temporary impairment losses on available-for-sale securities reported in the consolidated statements of operations also include $93.0 million and $146.5 million, respectively, of impairment losses, net of recoveries from the sale of previously impaired securities, on fixed maturity securities and $7.8 million and $1.7 million, respectively, of impairment losses, net of recoveries from the sale of previously impaired securities, on equity securities for which total impairment losses are recognized in net income.

 

The following table provides a rollforward of credit losses on fixed maturity securities recognized in net income (“bifurcated credit losses”) for which a portion of an other-than-temporary impairment was recognized in OCI. The purpose of the table is to provide detail of (1) additions to the bifurcated credit loss amounts recognized for the period and (2) decrements for previously recognized bifurcated credit losses where the loss is no longer bifurcated and/or there has been a positive change in expected cash flows or accretion of the bifurcated credit loss amount.

 

13



Table of Contents

 

Principal Financial Group, Inc.
Notes to Consolidated Financial Statements (continued)

June 30, 2009
(Unaudited)

 

2. Investments (continued)

 

 

 

For the three months
ended June 30, 2009

 

For the six months
ended June 30, 2009

 

 

 

(in millions)

 

Beginning balance

 

$

(67.1

)

$

(18.5

)

Credit losses for which an other-than-temporary impairment was not previously recognized

 

(24.3

)

(72.3

)

Credit losses for which an other-than-temporary impairment was previously recognized

 

(9.6

)

(10.2

)

Reduction for credit losses previously recognized on securities now sold or intended to be sold

 

0.3

 

0.3

 

Reduction for positive changes in cash flows expected to be collected and amortization (1)

 

0.1

 

0.1

 

Ending balance

 

$

(100.6

)

$

(100.6

)

 


(1) Amounts are recognized in net investment income.

 

Gross Unrealized Losses for Fixed Maturities and Equity Securities

 

For fixed maturities and equity securities available-for-sale with unrealized losses, including other-than-temporary impairment losses reported in OCI, as of June 30, 2009, the gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position are summarized as follows:

 

 

 

Less than
twelve months

 

Greater than or
equal to twelve months

 

Total

 

 

 

Carrying
value

 

Gross
unrealized
losses

 

Carrying
value

 

Gross
unrealized
losses

 

Carrying
value

 

Gross
unrealized
losses

 

 

 

(in millions)

 

Fixed maturities, available-for-sale:

 

 

 

 

 

 

 

 

 

 

 

 

 

U.S. government and agencies

 

$

48.8

 

$

0.8

 

$

 

$

 

$

48.8

 

$

0.8

 

Non-U.S. governments

 

59.3

 

3.6

 

61.7

 

2.2

 

121.0

 

5.8

 

States and political subdivisions

 

297.2

 

4.7

 

567.3

 

35.7

 

864.5

 

40.4

 

Corporate

 

3,975.7

 

370.0

 

13,066.1

 

2,548.9

 

17,041.8

 

2,918.9

 

Residential mortgage-backed securities

 

328.1

 

1.6

 

1.9

 

0.1

 

330.0

 

1.7

 

Commercial mortgage-backed securities

 

821.8

 

121.4

 

2,447.2

 

1,736.1

 

3,269.0

 

1,857.5

 

Collateralized debt obligations

 

12.0

 

6.6

 

277.8

 

343.5

 

289.8

 

350.1

 

Other debt obligations

 

264.7

 

60.3

 

1,094.0

 

405.8

 

1,358.7

 

466.1

 

Total fixed maturities, available-for-sale

 

$

5,807.6

 

$

569.0

 

$

17,516.0

 

$

5,072.3

 

$

23,323.6

 

$

5,641.3

 

Total equity securities, available-for-sale

 

$

86.1

 

$

42.6

 

$

65.9

 

$

51.1

 

$

152.0

 

$

93.7

 

 

Of the total amounts, Principal Life’s consolidated portfolio represented $22,381.1 million in available-for-sale fixed maturity securities with gross unrealized losses of $5,544.2 million. Principal Life’s consolidated portfolio consists of fixed maturity securities where 86% are investment grade (rated AAA through BBB-) with an average price of 80 (carrying value/amortized cost) at June 30, 2009. Due to the credit disruption that began in the last half of 2007 and continued into 2009, which reduced liquidity and led to wider credit spreads, we saw an increase in unrealized losses in our securities portfolio. The unrealized losses were more pronounced in the Corporate sector and in structured products, such as commercial mortgage-backed securities, collateralized debt obligations and asset-backed securities (included in other debt obligations). During the second quarter of 2009, a narrowing of credit spreads and some improvement in liquidity resulted in a decrease in the unrealized losses in our securities portfolio relative to the period ended March 31, 2009.

 

14



Table of Contents

 

Principal Financial Group, Inc.
Notes to Consolidated Financial Statements (continued)
June 30, 2009
(Unaudited)

2. Investments (continued)

 

For those securities that have been in a loss position for less than twelve months, Principal Life’s consolidated portfolio holds 619 securities with a carrying value of $5,284.5 million and unrealized losses of $537.0 million reflecting an average price of 91 at June 30, 2009. Of this portfolio, 87% was investment grade (rated AAA through BBB-) at June 30, 2009, with associated unrealized losses of $444.2 million. The losses on these securities can primarily be attributed to changes in market interest rates and changes in credit spreads since the securities were acquired.

 

For those securities that have been in a continuous loss position greater than or equal to twelve months, Principal Life’s consolidated portfolio holds 2,202 securities with a carrying value of $17,096.6 million and unrealized losses of $5,007.2 million. The average rating of this portfolio is A- with an average price of 77 at June 30, 2009. Of the $5,007.2 million in unrealized losses, the Corporate sector accounts for $2,484.0 million in unrealized losses with an average price of 84 and an average credit rating of BBB. The remaining unrealized losses consist primarily of $1,736.0 million within the commercial mortgage-backed securities sector at June 30, 2009. The average price of the commercial mortgage-backed securities sector is 59 and the average credit rating is AA. The losses on these securities can primarily be attributed to changes in market interest rates and changes in credit spreads since the securities were acquired.

 

Because it is not our intent to sell the fixed maturity available-for-sale securities with unrealized losses and it is not more likely than not that we would be required to sell these securities before recovery of the amortized cost, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at June 30, 2009.

 

Net Unrealized Gains and Losses on Available-for-Sale Securities and Derivative Instruments

 

The net unrealized gains and losses on investments in fixed maturities available-for-sale, equity securities available-for-sale and derivative instruments are reported as a separate component of stockholders’ equity. The cumulative amount of net unrealized gains and losses on available-for-sale securities and derivative instruments net of adjustments related to DPAC, sales inducements, unearned revenue reserves, changes in policyholder benefits and claims and applicable income taxes was as follows:

 

 

 

June 30, 2009

 

 

 

(in millions)

 

Net unrealized losses on fixed maturities, available-for-sale (1)

 

$

(4,611.2

)

Noncredit component of impairment losses on fixed maturities, available-for-sale

 

(117.1

)

Net unrealized losses on equity securities, available-for-sale

 

(81.7

)

Adjustments for assumed changes in amortization patterns

 

814.8

 

Adjustments for assumed changes in liability for policyholder benefits and claims

 

(36.8

)

Net unrealized gains on derivative instruments

 

29.1

 

Net unrealized gains on equity method subsidiaries and noncontrolling interest adjustments

 

223.8

 

Provision for deferred income tax benefits

 

1,346.7

 

Effect of reclassifying noncredit component of previously recognized impairment losses on fixed maturities, available-for-sale, net

 

(9.9

)

Net unrealized losses on available-for-sale securities and derivative instruments

 

$

(2,442.3

)

 


(1)                                Excludes net unrealized gains (losses) on hedged portions of fixed maturities, available-for-sale included in fair value hedging relationships.

 

Securities Posted as Collateral

 

We posted $804.6 million in fixed maturity securities as of June 30, 2009, to satisfy collateral requirements primarily associated with our derivative credit support annex (collateral) agreements and a reinsurance arrangement. In addition, we posted $1,681.2 million in commercial mortgage loans as of June 30, 2009, to satisfy collateral requirements associated with our obligation under funding agreements with the Federal Home Loan Bank of Des Moines.

 

15



Table of Contents

 

Principal Financial Group, Inc.
Notes to Consolidated Financial Statements (continued)
June 30, 2009
(Unaudited)

 

3. Derivative Financial Instruments

 

Derivatives are generally used to hedge or reduce exposure to market risks associated with assets held or expected to be purchased or sold and liabilities incurred or expected to be incurred. Derivatives are used to change the characteristics of our asset/liability mix consistent with our risk management activities. Derivatives are also used in asset replication strategies. We do not buy, sell or hold these investments for trading purposes.

 

Types of Derivative Instruments

 

Interest Rate Contracts

 

Interest rate risk is the risk that we will incur economic losses due to adverse changes in interest rates. Sources of interest rate risk include the difference between the maturity and interest rate changes of assets with the liabilities they support, timing differences between the pricing of liabilities and the purchase or procurement of assets and changing cash flow profiles from original projections due to prepayment options embedded within asset and liability contracts. We use various derivatives to manage our exposure to fluctuations in interest rates.

 

Interest rate swaps are contracts in which we agree with other parties to exchange, at specified intervals, the difference between fixed rate and floating rate interest amounts based upon designated market rates or rate indices and an agreed upon notional principal amount. Generally, no cash is exchanged at the outset of the contract and no principal payments are made by either party. Cash is paid or received based on the terms of the swap. These transactions are entered into pursuant to master agreements that provide for a single net payment to be made by one counterparty at each due date. We use interest rate swaps primarily to more closely match the interest rate characteristics of assets and liabilities arising from timing mismatches between assets and liabilities (including duration mismatches). We also use interest rate swaps to hedge against changes in the value of assets we anticipate acquiring and other anticipated transactions and commitments. Interest rate swaps are used to hedge against changes in the value of the guaranteed minimum withdrawal benefit (“GMWB”) liability. The GMWB rider on our variable annuity products provides for guaranteed minimum withdrawal benefits regardless of the actual performance of various equity and/or fixed income funds available with the product.

 

A swaption is an option to enter into an interest rate swap at a future date. We have written these options and received a premium in order to transform our callable liabilities into fixed term liabilities. Swaptions provide us the benefit of the agreed-upon strike rate if the market rates for liabilities are higher, with the flexibility to enter into the current market rate swap if the market rates for liabilities are lower. Swaptions not only hedge against the downside risk, but also allow us to take advantage of any upside benefits.

 

In exchange-traded futures transactions, we agree to purchase or sell a specified number of contracts, the values of which are determined by the values of designated classes of securities, and to post variation margin on a daily basis in an amount equal to the difference in the daily market values of those contracts. We enter into exchange-traded futures with regulated futures commissions merchants who are members of a trading exchange. We have used exchange-traded futures to reduce market risks from changes in interest rates and to alter mismatches between the assets in a portfolio and the liabilities supported by those assets.

 

A treasury lock is an agreement that allows the holder to lock in an interest rate. If the interest rate increases, the holder is entitled to receive a payment from the counterparty to the agreement equal to the present value of the difference in the current interest rate and the locked-in interest rate. If the interest rate decreases, the holder must pay the counterparty to the agreement an amount equal to the present value of the difference in the current interest rate and the locked-in interest rate. We have used treasury lock agreements to hedge against changes in the value of anticipated transactions and commitments.

 

Foreign Exchange Contracts

 

Foreign currency risk is the risk that we will incur economic losses due to adverse fluctuations in foreign currency exchange rates. This risk arises from foreign currency-denominated funding agreements we issue, foreign currency-denominated fixed maturity securities we invest in and our investment in and net income of our international operations. We may use currency swaps and currency forwards to hedge foreign currency risk.

 

16



Table of Contents

 

Principal Financial Group, Inc.
Notes to Consolidated Financial Statements (continued)

June 30, 2009
(Unaudited)

3. Derivative Financial Instruments (continued)

 

Currency swaps are contracts in which we agree with other parties to exchange, at specified intervals, a series of principal and interest payments in one currency for that of another currency. Generally, the principal amount of each currency is exchanged at the beginning and termination of the currency swap by each party. The interest payments are primarily fixed-to-fixed rate; however, may also be fixed-to-floating rate or floating-to-fixed rate. These transactions are entered into pursuant to master agreements that provide for a single net payment to be made by one counterparty for payments made in the same currency at each due date. We use currency swaps to reduce market risks from changes in currency exchange rates with respect to investments or liabilities denominated in foreign currencies that we either hold or intend to acquire or sell.

 

Currency forwards are contracts in which we agree with other parties to deliver a specified amount of an identified currency at a specified future date. Typically, the price is agreed upon at the time of the contract and payment for such a contract is made at the specified future date. We use currency forwards to reduce market risks from changes in currency exchange rates with respect to investments or liabilities denominated in foreign currencies that we either hold or intend to acquire or sell. We have also used currency forwards to hedge the currency risk associated with net investments in foreign operations.

 

Equity Contracts

 

Equity risk is the risk that we will incur economic losses due to adverse fluctuations in common stock. We use various derivatives to manage our exposure to equity risk, which arises from products in which the interest we credit is tied to an external equity index as well as products subject to minimum contractual guarantees.

 

We may sell an investment-type insurance contract with attributes tied to market indices (an embedded derivative as noted below), in which case we write an equity call option to convert the overall contract into a fixed-rate liability, essentially eliminating the equity component altogether. We purchase equity call spreads to hedge the equity participation rates promised to contractholders in conjunction with our fixed deferred annuity products that credit interest based on changes in an external equity index. We use exchange-traded futures and equity put options to hedge against changes in the value of the GMWB liability related to the GMWB rider on our variable annuity product, as previously explained.

 

Credit Contracts

 

Credit risk relates to the uncertainty associated with the continued ability of a given obligor to make timely payments of principal and interest. We use credit default swaps to enhance the return on our investment portfolio by providing comparable exposure to fixed income securities that might not be available in the primary market. They are also occasionally used to hedge credit exposures in our investment portfolio. Credit derivatives are used to sell or buy credit protection on an identified name or names on an unfunded or synthetic basis in return for receiving or paying a quarterly premium. The premium generally corresponds to a referenced name’s credit spread at the time the agreement is executed. In cases where we sell protection, at the same time we enter into these synthetic transactions, we buy a quality cash bond to match against the credit default swap. When selling protection, if there is an event of default by the referenced name, as defined by the agreement, we are obligated to pay the counterparty the referenced amount of the contract and receive in return the referenced security in a principal amount equal to the notional value of the credit default swap.

 

Other Contracts

 

Commodity Swaps. Commodity swaps are used to sell or buy protection on commodity prices in return for receiving or paying a quarterly premium. We purchased AAA rated secured limited recourse notes from VIEs that are consolidated in our financial results. These VIEs use a commodity swap to enhance the return on an investment portfolio by selling protection on a static portfolio of commodity trigger swaps, each referencing a base or precious metal. The portfolio of commodity trigger swaps is a portfolio of deep out-of-the-money European puts on various base or precious metals. The VIEs provide mezzanine protection that the average spot rate will not fall below a certain trigger price on each commodity trigger swap in the portfolio and receive guaranteed quarterly premiums in return until maturity. At the same time the VIEs enter into this synthetic transaction, they buy a quality cash bond to match against the commodity swaps.

 

17



Table of Contents

 

Principal Financial Group, Inc.
Notes to Consolidated Financial Statements (continued)

June 30, 2009
(Unaudited)

3. Derivative Financial Instruments (continued)

 

Embedded Derivatives. We purchase or issue certain financial instruments or products that contain a derivative instrument that is embedded in the financial instrument or product. When it is determined that the embedded derivative possesses economic characteristics that are not clearly or closely related to the economic characteristics of the host contract and a separate instrument with the same terms would qualify as a derivative instrument, the embedded derivative is bifurcated from the host for measurement purposes. The embedded derivative, which is reported with the host instrument in the consolidated statements of financial position, is carried at fair value.

 

We sell investment-type insurance contracts in which the return is tied to an external equity index, a leveraged inflation index or leveraged reference swap. We economically hedge the risk associated with these investment-type insurance contracts.

 

We offer group benefit plan contracts that have guaranteed separate accounts as an investment option. We also offer a guaranteed fund as an investment option in our defined contribution plans in Hong Kong.

 

We have structured investment relationships with trusts we have determined to be VIEs, which are consolidated in our financial statements. The notes issued by these trusts include obligations to deliver an underlying security to residual interest holders and the obligations contain an embedded derivative of the forecasted transaction to deliver the underlying security.

 

We offer a fixed deferred annuity product that credits interest based on changes in an external equity index. We also offer certain variable annuity products with a GMWB rider, which provides that the contractholder will receive at least their principal deposit back through withdrawals of up to a specified annual amount, even if the account value is reduced to zero. Declines in the equity market may increase our exposure to benefits under contracts with the GMWB. We economically hedge the exposure in these annuity contracts.

 

Exposure

 

Our risk of loss is typically limited to the fair value of our derivative instruments and not to the notional or contractual amounts of these derivatives. Risk arises from changes in the fair value of the underlying instruments. We are also exposed to credit losses in the event of nonperformance of the counterparties. Our current credit exposure is limited to the value of derivatives that have become favorable to us. This credit risk is minimized by purchasing such agreements from financial institutions with high credit ratings and by establishing and monitoring exposure limits. We also utilize various credit enhancements, including collateral and credit triggers to reduce the credit exposure to our derivative instruments.

 

Our derivative transactions are generally documented under International Swaps and Derivatives Association, Inc. Master Agreements. Management believes that such agreements provide for legally enforceable set-off and close-out netting of exposures to specific counterparties. Under such agreements, in connection with an early termination of a transaction, we are permitted to set off our receivable from a counterparty against our payables to the same counterparty arising out of all included transactions. For reporting purposes, we do not offset fair value amounts recognized for the right to reclaim cash collateral or the obligation to return cash collateral against fair value amounts recognized for derivative instruments executed with the same counterparties under master netting agreements.

 

We posted $236.9 million and $372.8 million in cash and securities under collateral arrangements as of June 30, 2009, and December 31, 2008, respectively, to satisfy collateral requirements associated with our derivative credit support agreements.

 

Certain of our derivative instruments contain provisions that require us to maintain an investment grade rating from each of the major credit rating agencies on our debt. If our debt were to fall below investment grade, it would be in violation of these provisions and the counterparties to the derivative instruments could request immediate payment or demand immediate and ongoing full overnight collateralization on derivative instruments in net liability positions. The aggregate fair value of all derivative instruments with credit-risk-related contingent features that were in a liability position as of June 30, 2009, and December 31, 2008, was $1,244.7 million and $2,100.0 million, respectively, for which we posted collateral of $236.9 million and $372.8 million, respectively, in the normal course of business. If the credit-risk-related contingent features underlying these agreements were triggered on June 30, 2009, we would be required to post an additional $47.6 million of collateral to our counterparties.

 

18



Table of Contents

 

Principal Financial Group, Inc.
Notes to Consolidated Financial Statements (continued)

June 30, 2009
(Unaudited)

3. Derivative Financial Instruments (continued)

 

As of June 30, 2009, and December 31, 2008, we had received $271.2 million and $262.9 million, respectively, of cash collateral associated with our derivative credit support annex agreements. The cash collateral is included in other assets on the consolidated statements of financial position, with a corresponding liability reflecting our obligation to return the collateral recorded in other liabilities.

 

Notional amounts are used to express the extent of our involvement in derivative transactions and represent a standard measurement of the volume of our derivative activity. Notional amounts represent those amounts used to calculate contractual flows to be exchanged and are not paid or received, except for contracts such as currency swaps. Credit exposure represents the gross amount owed to us under derivative contracts as of the valuation date. The notional amounts and credit exposure of our derivative financial instruments by type were as follows:

 

 

 

June 30, 2009

 

December 31, 2008

 

 

 

(in millions)

 

Notional amounts of derivative instruments

 

 

 

 

 

Interest rate contracts:

 

 

 

 

 

Interest rate swaps

 

$

23,651.7

 

$

24,148.6

 

Futures

 

51.1

 

97.3

 

Swaptions

 

 

94.8

 

Foreign exchange contracts:

 

 

 

 

 

Foreign currency swaps

 

5,456.3

 

6,298.7

 

Currency forwards

 

60.9

 

52.1

 

Equity contracts:

 

 

 

 

 

Options

 

846.6

 

797.5

 

Futures

 

60.3

 

63.6

 

Credit contracts:

 

 

 

 

 

Credit default swaps

 

1,857.2

 

1,948.9

 

Other contracts:

 

 

 

 

 

Embedded derivative financial instruments

 

3,114.6

 

2,938.6

 

Commodity swaps

 

40.0

 

40.0

 

Total notional amounts at end of period

 

$

35,138.7

 

$

36,480.1

 

 

 

 

 

 

 

Credit exposure of derivative instruments

 

 

 

 

 

Interest rate contracts:

 

 

 

 

 

Interest rate swaps

 

$

694.2

 

$

1,105.1

 

Foreign exchange contracts:

 

 

 

 

 

Foreign currency swaps

 

487.5

 

562.5

 

Currency forwards

 

6.6

 

0.2

 

Equity contracts:

 

 

 

 

 

Options

 

180.1

 

222.1

 

Credit contracts:

 

 

 

 

 

Credit default swaps

 

30.8

 

70.7

 

Total gross credit exposure

 

1,399.2

 

1,960.6

 

Less: collateral received

 

312.3

 

284.2

 

Net credit exposure

 

$

1,086.9

 

$

1,676.4

 

 

19



Table of Contents

 

Principal Financial Group, Inc.
Notes to Consolidated Financial Statements (continued)

June 30, 2009
(Unaudited)

3. Derivative Financial Instruments (continued)

 

The fair value of our derivative instruments classified as assets and liabilities were as follows:

 

 

 

Derivative assets (1)

 

Derivative liabilities (2)

 

 

 

June 30, 2009

 

December 31, 2008

 

June 30, 2009

 

December 31, 2008

 

 

 

(in millions)

 

Derivatives designated as hedging instruments

 

 

 

 

 

 

 

 

 

Interest rate contracts

 

$

119.7

 

$

250.8

 

$

378.0

 

$

819.2

 

Foreign exchange contracts

 

374.1

 

410.8

 

214.0

 

300.4

 

Total derivatives designated as hedging instruments

 

$

493.8

 

$

661.6

 

$

592.0

 

$

1,119.6

 

 

 

 

 

 

 

 

 

 

 

Derivatives not designated as hedging instruments

 

 

 

 

 

 

 

 

 

Interest rate contracts

 

$

507.9

 

$

802.1

 

$

388.3

 

$

621.5

 

Foreign exchange contracts

 

101.7

 

121.3

 

59.4

 

155.1

 

Equity contracts

 

180.1

 

222.1

 

0.1

 

 

Credit contracts

 

31.1

 

70.7

 

143.2

 

227.2

 

Other contracts

 

 

 

73.8

 

185.2

 

Total derivatives not designated as hedging instruments

 

$

820.8

 

$

1,216.2

 

$

664.8

 

$

1,189.0

 

 

 

 

 

 

 

 

 

 

 

Total derivative instruments

 

$

1,314.6

 

$

1,877.8

 

$

1,256.8

 

$

2,308.6

 

 


(1)         The fair value of derivative assets is reported with other investments on the consolidated statements of financial position.

(2)        The fair value of derivative liabilities is reported with other liabilities on the consolidated statements of financial position, with the exception of certain embedded derivative liabilities. Embedded derivative liabilities with a fair value of $31.2 million and $60.2 million as of June 30, 2009, and December 31, 2008, respectively, are reported with contractholder funds on the consolidated statements of financial position.

 

Credit Derivatives Sold

 

When we sell credit protection, we are exposed to the underlying credit risk similar to purchasing a fixed maturity security instrument. The majority of our credit derivative contracts sold reference a single name or reference security (referred to as “single name credit default swaps”). The remainder of our credit derivatives reference either a basket or index of securities. These instruments are either referenced in an over-the-counter credit derivative transaction, or embedded within an investment structure that has been fully consolidated into our financial statements.

 

These credit derivative transactions are subject to events of default defined within the terms of the contract, which normally consist of bankruptcy, failure to pay, or modified restructuring of the reference entity and/or issue. If a default event occurs for a reference name or security, we are obligated to pay the counterparty an amount equal to the notional amount of the credit derivative transaction. As a result, our maximum future payment is equal to the notional amount of the credit derivative. In certain cases, we also have purchased credit protection with identical underlyings to certain of our sold protection transactions. The effect of this purchased protection would reduce our total maximum future payments by $60.8 million as of both June 30, 2009, and December 31, 2008. These credit derivative transactions had a net fair value of $10.8 million and $21.2 million as of June 30, 2009, and December 31, 2008, respectively. Our potential loss could also be reduced by any amount recovered in the default proceedings of the underlying credit name.

 

We purchased certain investment structures with embedded credit features that are fully consolidated into our financial statements. This consolidation results in recognition of the underlying credit derivatives and collateral within the structure, typically high quality fixed maturity securities that are owned by a special purpose vehicle. These credit derivatives reference a single name or several names in a basket structure. In the event of default, the collateral within the structure would typically be liquidated to pay the claims of the credit derivative counterparty.

 

20



Table of Contents

 

Principal Financial Group, Inc.
Notes to Consolidated Financial Statements (continued)

June 30, 2009
(Unaudited)

3. Derivative Financial Instruments (continued)

 

The following tables show our credit default swap protection sold by types of contract, types of referenced/underlying asset class and external agency rating for the underlying reference security as of June 30, 2009, and December 31, 2008. The maximum future payments are undiscounted and have not been reduced by the effect of any offsetting transactions, collateral or recourse features described above.

 

 

 

June 30, 2009

 

 

 

 

 

 

 

 

 

Weighted

 

 

 

 

 

 

 

Maximum

 

average

 

 

 

Notional

 

Fair

 

future

 

expected life

 

 

 

amount

 

value

 

payments

 

(in years)

 

 

 

 

 

(in millions)

 

 

 

 

 

Single name credit default swaps

 

 

 

 

 

 

 

 

 

Corporate debt

 

 

 

 

 

 

 

 

 

AA

 

$

140.0

 

$

(4.3

)

$

140.0

 

4.7

 

A

 

514.0

 

(5.7

)

514.0

 

4.4

 

BBB

 

330.0

 

(10.0

)

330.0

 

2.4

 

BB

 

18.0

 

(0.3

)

18.0

 

0.2

 

Structured finance

 

 

 

 

 

 

 

 

 

BBB

 

16.0

 

(15.4

)

16.0

 

21.7

 

BB

 

22.0

 

(20.2

)

22.0

 

6.5

 

B

 

9.9

 

(5.6

)

9.9

 

3.0

 

Total single name credit default swaps

 

1,049.9

 

(61.5

)

1,049.9

 

4.0

 

 

 

 

 

 

 

 

 

 

 

Basket and index credit default swaps

 

 

 

 

 

 

 

 

 

Corporate debt

 

 

 

 

 

 

 

 

 

AAA

 

35.0

 

0.3

 

35.0

 

0.5

 

A

 

20.0

 

(0.5

)

20.0

 

1.1

 

BBB

 

20.0

 

(0.7

)

20.0

 

1.0

 

CCC

 

145.0

 

(24.3

)

145.0

 

1.2

 

Near default

 

20.0

 

(20.0

)

20.0

 

2.5

 

Government/municipalities

 

 

 

 

 

 

 

 

 

AA

 

50.0

 

(15.5

)

50.0

 

5.6

 

Structured finance

 

 

 

 

 

 

 

 

 

AA

 

20.0

 

(7.8

)

20.0

 

5.9

 

BBB

 

5.0

 

(1.7

)

5.0

 

16.4

 

Total basket and index credit default swaps

 

315.0

 

(70.2

)

315.0

 

2.4

 

Total credit default swap protection sold

 

$

1,364.9

 

$

(131.7

)

$

1,364.9

 

3.7

 

 

21



Table of Contents

 

Principal Financial Group, Inc.
Notes to Consolidated Financial Statements (continued)
June 30, 2009
(Unaudited)

 

3. Derivative Financial Instruments (continued)

 

 

 

December 31, 2008

 

 

 

 

 

 

 

 

 

Weighted

 

 

 

 

 

 

 

Maximum

 

average

 

 

 

Notional

 

Fair

 

future

 

expected life

 

 

 

amount

 

value

 

payments

 

(in years)

 

 

 

(in millions)

 

 

 

Single name credit default swaps

 

 

 

 

 

 

 

 

 

Corporate debt

 

 

 

 

 

 

 

 

 

AAA

 

$

10.0

 

$

(1.0

)

$

10.0

 

4.5

 

AA

 

135.0

 

(4.6

)

135.0

 

5.4

 

A

 

554.0

 

(25.8

)

554.0

 

4.8

 

BBB

 

305.0

 

(24.4

)

305.0

 

2.7

 

BB

 

33.0

 

(1.4

)

33.0

 

0.5

 

Structured finance

 

 

 

 

 

 

 

 

 

A

 

9.9

 

(7.9

)

9.9

 

3.5

 

BBB

 

16.0

 

(15.0

)

16.0

 

22.5

 

BB

 

22.0

 

(18.1

)

22.0

 

7.1

 

Total single name credit default swaps

 

1,084.9

 

(98.2

)

1,084.9

 

4.4

 

 

 

 

 

 

 

 

 

 

 

Basket and index credit default swaps

 

 

 

 

 

 

 

 

 

Corporate debt