-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, ErnHTCcC6aRu+IeIXKIH2P8AL9CRNWJEj1+F+zutmsTdDTqIOo/i6LDfvMpceO8Z 3tGJqU7FWMd8xC28C4nTzQ== 0000009713-00-000029.txt : 20000315 0000009713-00-000029.hdr.sgml : 20000315 ACCESSION NUMBER: 0000009713-00-000029 CONFORMED SUBMISSION TYPE: 497 PUBLIC DOCUMENT COUNT: 1 FILED AS OF DATE: 20000314 FILER: COMPANY DATA: COMPANY CONFORMED NAME: PRINCIPAL MUTUAL LIFE INSURANCE COMPANY SEPARATE ACCOUNT B CENTRAL INDEX KEY: 0000009713 STANDARD INDUSTRIAL CLASSIFICATION: [] IRS NUMBER: 420127290 FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 497 SEC ACT: SEC FILE NUMBER: 333-63401 FILM NUMBER: 568602 BUSINESS ADDRESS: STREET 1: THE PRINCIPAL FINANCIAL GROUP CITY: DES MOINES STATE: IA ZIP: 50392 BUSINESS PHONE: 5152475477 MAIL ADDRESS: STREET 1: THE PRINCIPAL FINANCIAL GROUP CITY: DES MOINES STATE: IA ZIP: 50392-0200 FORMER COMPANY: FORMER CONFORMED NAME: BANKERS LIFE CO SEPARATE ACCOUNT B DATE OF NAME CHANGE: 19870317 497 1 SUPPLEMENT TO FREEDOM VARIABLE ANNUITY PROSPECTUS SUPPLEMENT DATED MARCH 17, 2000 TO THE PRINCIPAL FREEDOMSM VARIABLE ANNUITY PROSPECTUS DATED APRIL 30, 1999 Effective March 17, 2000, the Prospectus for the Principal Freedom Variable Annuity is amended by: 1) inserting at the end of the fifth paragraph on page 19, the following: "(For Contracts sold in South Carolina the Fixed Account transfer fee is waived)." Principal FreedomSM Variable Annuity Issued by Principal Life Insurance Company (the "Company") This Prospectus is dated April 30, 1999. The individual deferred annuity contract ("Contract") described in this Prospectus is funded with the Principal Life Insurance Company Separate Account B ("Separate Account") and a fixed account ("Fixed Account"). The assets of the divisions of the Separate Account are invested in a corresponding Account of the Principal Variable Contracts Fund, Inc., the American Century Variable Portfolios, Inc. - VP Income & Growth or the Templeton Variable Products Series Fund - Templeton Stock Fund Class 2. The Fixed Account is a part of the General Account of the Company. This prospectus provides information about the Contract and the Separate Account that you ought to know before investing. It should be read and retained for future reference. Additional information about the Contract is included in the Statement of Additional Information ("SAI"), dated April 30, 1999 which has been filed with the Securities and Exchange Commission (the "Commission"). The SAI is a part of this prospectus. The table of contents of the SAI is on page 30 of this prospectus. You may obtain a free copy of the SAI by writing or telephoning: Principal FreedomSM Variable Annuity Principal Financial Group P. O. Box 9382 Des Moines, Iowa 50306-9382 Telephone: 1-800-247-9988 An investment in the Contract is not a deposit in any bank and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. These securities have not been approved or disapproved by the Securities and Exchange Commission or any state securities commission nor has the Securities and Exchange Commission or any state securities commission passed upon the accuracy or adequacy of this prospectus. Any representation to the contrary is a criminal offense. This prospectus is valid only when attached to the current prospectuses for the Principal Variable Contracts Fund, Inc., the American Century Variable Portfolios, Inc. VP Income & Growth and the Templeton Variable Products Series Fund - Templeton Stock Fund Class 2 (the "Funds"). TABLE OF CONTENTS GLOSSARY................................................................... 4 SUMMARY OF EXPENSE INFORMATION............................................. 5 SUMMARY.................................................................... 6 Investment Limitations................................................ 6 Separate Account Investment Options................................... 6 Transfers............................................................. 7 Surrenders............................................................ 7 Charges and Deductions................................................ 8 Standard Death Benefit................................................ 8 Annuity Payments Options.............................................. 8 Ten Day Examination Offer............................................. 8 THE PRINCIPAL FREEDOMSM VARIABLE ANNUITY................................... 8 THE COMPANY................................................................ 8 THE SEPARATE ACCOUNT....................................................... 9 THE FUNDS.................................................................. 9 THE CONTRACT............................................................... 11 To Buy a Contract..................................................... 11 The Accumulation Period............................................... 13 The Retirement Period................................................. 16 CHARGES AND DEDUCTIONS..................................................... 17 Morality and Expense Risks Charge..................................... 17 Transaction Fee....................................................... 17 Premium Taxes......................................................... 17 Fixed Account Surrender Charge and Transfer Fee....................... 17 Waiver of Fixed Account Surrender Charger Rider....................... 19 Administration Charge................................................. 20 Special Provisions for Group or Sponsored Arrangements................ 20 FIXED ACCOUNT.............................................................. 21 General Description................................................... 21 Fixed Account Value................................................... 21 Fixed Account Transfers, Total and Partial Surrenders................. 21 GENERAL PROVISIONS......................................................... 22 Telephone Services.................................................... 22 The Contract.......................................................... 23 Delay of Payments..................................................... 23 Misstatement of Age or Gender......................................... 23 Assignment............................................................ 23 Change of Owner....................................................... 23 Beneficiary........................................................... 24 Contract Termination.................................................. 24 RIGHTS RESERVED BY THE COMPANY............................................. 24 DISTRIBUTION OF THE CONTRACT............................................... 24 PERFORMANCE CALCULATION.................................................... 24 VOTING RIGHTS.............................................................. 25 FEDERAL TAX MATTERS........................................................ 26 Non-Qualified Contracts............................................... 26 Required Distributions for Non-Qualified Contracts.................... 26 IRA .................................................................. 27 Withholding........................................................... 27 Mutual Fund Diversification........................................... 27 STATE REGULATION........................................................... 28 LEGAL OPINIONS............................................................. 28 LEGAL PROCEEDINGS.......................................................... 28 REGISTRATION STATEMENT..................................................... 28 OTHER VARIABLE ANNUITY CONTRACTS........................................... 28 INDEPENDENT AUDITORS....................................................... 28 FINANCIAL STATEMENTS....................................................... 29 YEAR 2000 READINESS DISCLOSURE............................................. 29 CUSTOMER INQUIRIES......................................................... 30 TABLE OF CONTENTS OF THE STATEMENT OF ADDITIONAL INFORMATION............... 30 The Contract offered by this prospectus may not be available in all states. This prospectus is not an offer to sell, or solicitation of an offer to buy, the Contract in states in which the offer or solicitation may not be lawfully made. No person is authorized to give any information or to make any representation in connection with this Contract other than those contained in this prospectus. GLOSSARY account - series or portfolio of a mutual fund in which a Separate Account division invests. accumulated value - an amount equal to the Fixed Account value plus the Separate Account value. annuitant - the person, including any joint annuitant, on whose life the annuity payment is based. This person may or may not be the owner. annuity payment date - the date the owner's accumulated value is applied, under an annuity payment option, to make income payments. contract date - the date that the Contract is issued and which is used to determine contract years. contract year - the one-year period beginning on the contract date and ending one day before the Contract anniversary and any subsequent one-year period beginning on a Contract anniversary. division - a part of the Separate Account which invests in shares of an account of a mutual fund. Fixed Account - an account which earns guaranteed interest. joint annuitant - additional annuitant. Joint annuitants must be husband and wife and must be named as owner and joint owner. Any reference to the annuitant's death means the death of the last surviving annuitant. joint owner - an owner who has an undivided interest with the right of survivorship in this Contract with another owner. Joint owners must be husband and wife and must be named as annuitant and joint annuitant. Any reference to the owner's death means the death of the last surviving owner. mutual fund - a registered open-end investment company in which a division invests. owner - the person, including joint owner, who owns all the rights and privileges of this contract. purchase payments - the gross amount contributed to the contract. Fixed Account purchase payments include transfers into the Fixed Account from any Separate Account division. unit - the accounting measure used to calculate the value of the Separate Account prior to annuity payment date. unit value - a measure used to determine the value of an investment in a division. valuation date - the date as of which the net asset value of a mutual fund is determined. valuation period - the period of time between determination of net asset value on one valuation date and the next valuation date. written request - actual delivery to the Company at our home office of a written notice or request, signed and dated, on a form we supply or approve. Your notice may be mailed to: Principal FreedomSM Variable Annuity Principal Financial Group P. O. Box 9382 Des Moines, Iowa 50306-9382 SUMMARY OF EXPENSE INFORMATION The purpose of these tables is to assist you in understanding the various costs and expenses of the Contract. This information includes expenses of the Contract as well as the Accounts but does not include any premium taxes that may apply. For a more complete description of the Contract expenses, see CHARGES AND DEDUCTIONS. Contract owner Transaction Expenses: o There is no sales charge imposed on purchases. o Deferred sales charge: o No deferred sales charge applies to surrenders from the Separate Account. o The deferred sales charge (as a percentage of amounts surrendered from the Fixed Account) is as follows: number of completed contract surrender charge applied to years since each Fixed Account Fixed Account surrenders purchase* was made beyond Free Transaction Amount 0 (year of purchase payment) 6% 1 6% 2 6% 3 5% 4 4% 5 3% 6 2% 7 and later 0 * Includes amounts transferred to Fixed Account from Separate Account divisions. Each Fixed Account purchase payment begins in year 0 for purposes of calculating the percentage applied to that payment. o Transfer fees may apply to transfers from the Fixed Account to any division of the Separate Account (see Fixed Account Surrender Charge and Transfer Fee). o Transaction fee - a $30 fee is charged on: o each unscheduled transfer after the 12th unscheduled transfer, and o each unscheduled partial surrender after the 12th unscheduled partial surrender in a contract year. o There is no annual contract fee. o Separate Account annual expenses (as a percentage of average account value): o mortality and expense risks charge 0.85% o other Separate Account expenses 0 ---- o total Separate Account annual expenses 0.85% Annual expense of Accounts (as a percentage of average net assets) as of December 31, 1998.
Management Rule Other Total Account Account Fees 12(b)1 Fees Expenses Annual Expenses ------- ---------- ----------- -------- --------------- American Century VP Income & Growth 0.70% N/A 0.00% 0.70% Bond 0.49 N/A 0.02 0.51 Capital Value 0.43 N/A 0.01 0.44 International 0.73 N/A 0.04 0.77 MidCap 0.61 N/A 0.01 0.62 MidCap Growth 0.90 N/A 0.37 1.27 Money Market 0.50 N/A 0.02 0.52 SmallCap 0.85 N/A 0.13 0.98 SmallCap Growth 1.01 N/A 0.30 1.31 Templeton VP Stock 0.70 0.25% 0.19 1.14
Example The purpose of the following example is to assist you in understanding the various costs and expenses that a contract owner bears directly or indirectly. It reflects expenses of the Separate Account as well as the expenses of the Account in which the Separate Account invests, both as of the calendar year ended December 31, 1998. In certain circumstances, state premium taxes also apply. The example should not be considered a representation of past or future expenses. Actual expenses may be more or less than those shown. You would pay the following expenses on a $1,000 investment, assuming 5% annual return on assets. There is no surrender charge imposed on total or partial surrenders from divisions of the Separate Account. Division 1 Year 3 Years 5 Years 10 Years -------- ------ ------- ------- -------- American Century VP Income & Growth $16 $49 $84 $185 Blue Chip 18 55 n/a n/a Bond 14 43 74 164 Capital Value 13 41 71 156 International 16 51 88 192 LargeCap Growth 21 64 n/a n/a MidCap 15 46 80 176 MidCap Growth 18 57 98 213 MidCap Value 21 64 N/A N/A Money Market 14 43 75 165 SmallCap 19 58 99 215 SmallCap Growth 19 60 103 223 Stock Index 500 13 40 N/A N/A Templeton VP Stock 20 62 107 232 SUMMARY This prospectus describes a flexible variable annuity offered by the Company. The Contract is designed to provide individuals with retirement benefits, including plans and trusts that do not qualify for special tax treatment under the Internal Revenue Code of 1986, as amended (the "Code") and for purchase by persons participating in individual retirement annuity plans that meet the requirements of Section 408 of the Code. This is a brief summary of the Contract's features. More detailed information follows later in this prospectus. Investment Limitations o Initial purchase payment must be $10,000 or more. o Each subsequent investment must be $50 or more. o The total purchase payments made during the life of the Contract may not be greater than $2 million. Separate Account Investment Options (see THE FUNDS): You may allocate your net premium payments to divisions of the Separate Account and/or the Fixed Account. Currently there are fourteen divisions available to you. Not all divisions are available in all states. A current list of divisions available in your state may be obtained from a sales representative or our home office. Each division invests in shares of an underlying mutual fund. More detailed information about the underlying mutual funds may be found in the current prospectus for each underlying mutual fund. The underlying mutual funds are NOT available to the general public directly. The underlying mutual funds are available only as investment options in variable life insurance policies or variable annuity contracts issued by life insurance companies. Some of the underlying mutual funds have been established by investment advisers that manage publicly traded mutual funds having similar names and investment objectives. While some of the underlying mutual funds may be similar to, and may in fact be modeled after publicly traded mutual funds, you should understand that the underlying mutual funds are not otherwise directly related to any publicly traded mutual fund. Consequently, the investment performance of publicly traded mutual funds and of any underlying mutual fund may differ substantially. Division invests in: - -------- ----------- American Century Variable Portfolios, Inc. American Century VP Growth & Income VP Income & Growth Principal Variable Contracts Fund, Inc. Blue Chip Blue Chip Account Bond Bond Account Capital Value Capital Value Account International International Account LargeCap Growth LargeCap Growth Account MidCap MidCap Account MidCap Growth MidCap Growth Account MidCap Value MidCap Value Account Money Market Money Market Account SmallCap SmallCap Account SmallCap Growth SmallCap Growth Account Stock Index 500 Stock Index 500 Account Templeton Variable Products Series Fund - Templeton VP Stock Templeton Stock Fund Class 2. Transfers (see Separate Account Transfers for additional restrictions) o During the accumulation period: o from the Separate Account divisions: o dollar amount or percentage of transfer must be specified; and o transfer may occur on scheduled or unscheduled basis (a $30 fee is imposed on each unscheduled transfer after the 12th unscheduled transfer in a contract year). o from the Fixed Account: o percentage or dollar amount of transfer must be specified; and o amounts available for transfer without payment of transfer fee are limited (see Fixed Account Transfers, Total and Partial Surrenders). o During the annuity payment period, transfers are not permitted. Surrenders (total or partial) (see Separate Account Surrender and Fixed Account Transfers, Total and Partial Surrenders) o During the accumulation period: o a dollar amount must be specified; o withdrawals before age 59 1/2 may involve an income tax penalty; o full surrender permitted prior to the annuity payment date; and o partial surrender permitted prior to annuity payment date (a $30 fee is imposed on each unscheduled partial surrender after the 12th unscheduled partial surrender in a contract year). o During the annuity payment period, surrenders are not permitted. Charges and Deductions o No sales charge on purchase payment at the time of investment. o A contingent deferred surrender charge is imposed on certain total or partial surrenders from the Fixed Account. o A transfer fee applies to certain transfers from the Fixed Account to divisions of the Separate Account. o A mortality and expense risks daily charge equal to 0.85% per year applies to amounts in the Separate Account. The Company reserves the right to increase this charge but guarantees that it will not exceed 1.25% per year. o Daily Separate Account administration charge is currently zero but the Company reserves the right to assess a charge not to exceed 0.15% annually. o Certain states and local governments impose a premium tax. The Company reserves the right to deduct the amount of the tax from purchase payments or accumulated values. Standard Death Benefit o During the accumulation period: o death benefit is the greater of: o accumulated value, or o purchase payments minus partial surrenders, surrender charges and transfer fees. o You may choose to have death benefit payments made under a benefit option. o During the annuity period: o your named beneficiary receives only the continuing payments provided by the benefit option selected. Annuity Payment Options o You may choose from several fixed payment options which start on your selected annuity payment date. o Payments are made to the annuitant (or beneficiary depending on benefit option selected). Ten Day Examination Offer (Free-look period) o You may surrender the Contract during the free-look period which is generally 10 days from the date you receive your Contract. The free-look period may be longer in certain states. o We return either all purchase payments made or the accumulated value, whichever is required by applicable state law. THE PRINCIPAL FREEDOMSM VARIABLE ANNUITY The Principal FreedomSM Variable Annuity is significantly different from a fixed annuity. As the owner of a variable annuity, you assume the risk of investment gain or loss (as to amounts in the Separate Account divisions) rather than the insurance company. The amount of the annuity payment under a variable annuity is not guaranteed. Payments vary with the investment performance of the portfolio securities of the underlying Account. Based on your investment objectives, you direct the allocation of purchase payments and accumulated values. There can be no assurance that your investment objectives will be achieved. THE COMPANY The Company is a stock life insurance company with its home office at: Principal Financial Group, Des Moines, Iowa 50306-9382. It is authorized to transact life and annuity business in all of the United States and the District of Columbia. The Company is a wholly owned subsidiary of Principal Financial Services, Inc. In 1879, Principal Life Insurance Company was incorporated under Iowa law as a mutual life insurance company named Bankers Life Association. It changed its name to Bankers Life Company in 1911 and then to Principal Mutual Life Insurance Company in 1986. The name change to Principal Life Insurance Company and reorganization into a mutual holding company structure took place in 1998. THE SEPARATE ACCOUNT The Separate Account was established under Iowa law on January 12, 1970. It was registered as a unit investment trust with the Commission on July 17, 1970. This registration does not involve Commission supervision of the investments or investment policies of the Separate Account. The income, gains, and losses, whether or not realized, of the Separate Account are credited to or charged against the Separate Account without regard to other income, gains, or losses of the Company. Obligations arising from the Contract, including the promise to make annuity payments, are general corporate obligations of the Company. However, the Contract provides that the portion of the Separate Account's assets equal to the reserves and other liabilities under the Contract are not charged with any liabilities arising out of any other business of the Company. There currently are fourteen divisions in the Separate Account available to you. The assets of each division invest in a corresponding Account of a mutual fund. New Accounts may be added and made available. Accounts may also be eliminated from the Separate Account. THE FUNDS The underlying funds are mutual funds registered under the Investment Company Act of 1940 as open-end diversified management investment companies. They provide the investment vehicle for the Separate Account. A full description of the Funds, their investment objectives, policies and restrictions, charges and expenses and other operational information is contained in the attached prospectuses (which should be read carefully before investing) and the Statements of Additional Information. Additional copies of these documents are available from a sales representative or our home office. The following is a brief summary of the investment objectives of each division:
Division Division Invests in Investment Advisor - -------- ------------------- ------------------ American Century Variable Portfolios, Inc. American Century VP VP Income & Growth American Century Income & Growth Investment Management, Inc. Principal Variable Contracts Fund, Inc. Blue Chip Blue Chip Account Invista Capital Management, LLC through a sub-advisory agreement Bond Bond Account Principal Management Corporation Capital Value Capital Value Account Invista Capital Management, LLC through a sub-advisory agreement International International Account Invista Capital Management, LLC through a sub-advisory agreement LargeCap Growth LargeCap Growth Account Janus Capital Corporation through a sub-advisory agreement MidCap MidCap Account Invista Capital Management, LLC through a sub-advisory agreement MidCap Growth MidCap Growth Account Dreyfus Corporation through a sub-advisory agreement MidCap Value MidCap Value Account Neuberger & Berman Management, Inc. through a sub-advisory agreement Money Market Money Market Account Principal Management Corporation SmallCap SmallCap Account Invista Capital Management, LLC through a sub-advisory agreement SmallCap Growth SmallCap Growth Account Berger Associates through a sub-advisory agreement Stock Index 500 Stock Index 500 Account Invista Capital Management, LLC through a sub-advisory agreement Templeton Variable Products Series Fund Templeton VP Stock Templeton Stock Fund Class 2 Templeton Investment Counsel, Inc.
Division Investment Objective American Century VP Seeks dividend growth, current income and capital appreciation. The Account Income & Growth will seek to achieve its investment objective by investing in common stocks. Blue Chip Seeks to achieve growth of capital and growth of income by investing primarily in common stocks of well capitalized, established companies. Bond To provide as high a level of income as is consistent with preservation of capital and prudent investment risk. Capital Value To provide long-term capital appreciation and secondarily growth of investment income. The Account seeks to achieve its investment objectives through the purchase primarily of common stocks, but the Account may invest in other securities. International Seeks long-term growth of capital by investing in a portfolio of equity securities domiciled in any of the nations of the world. LargeCap Growth Seeks long-term growth of capital by investing primarily in equity securities of growth companies with market capitalization of greater than $10 billion. MidCap To achieve capital appreciation by investing primarily in securities of emerging and other growth-oriented companies. Division Investment Objective MidCap Growth Seeks long-term growth of capital by investing primarily in growth stocks of companies with market capitalizations in the $1 billion to $10 billion range. MidCap Value Seeks long-term growth of capital by investing primarily in equity securities of companies with value characteristics and market capitalizations in the $1 billion to $10 billion range. Money Market seeks as high a level of current income available from short-term securities as is considered consistent with preservation of principal and maintenance of liquidity by investing all of its assets in a portfolio of money market instruments. SmallCap Seeks long-term growth of capital. The Account attempts to achieve its objective by investing primarily in equity securities of both growth and value oriented companies with comparatively smaller market capitalizations. SmallCap Growth Seeks long-term growth of capital by investing primarily in equity securities of small growth companies with market capitalization of less than $1 billion. Stock Index 500 Seeks long-term growth of capital. The Account attempts to mirror the investment results of the Standard & Poors Stock Index. Templeton VP Stock Capital growth through investing primarily in common and preferred stock issued by companies, large and small, in various nations throughout the world.
Principal Management Corporation (the "Manager") has executed agreements with various sub-advisors. Under those sub-advisory agreements, the sub-advisor agrees to assume the obligations of the Manager to provide investment advisory services for a specific Account. For these services, each sub-advisor is paid a fee by the Manager. Accounts: Blue Chip, Capital Value, International, MidCap, SmallCap and Stock Index 500 Sub-Advisor: Invista Capital Management, LLC ("Invista"), an indirectly wholly-owned subsidiary of Principal Life Insurance Company and an affiliate of the Manger was founded in 1985. It manages investments for institutional investors, including Principal Life. Assets under management as of December 31, 1998 were approximately $31 billion. Invista's address is 1800 Hub Tower, 699 Walnut, Des Moines, Iowa 50309. Account: LargeCap Growth Sub-Advisor: Janus Capital Corporation ("Janus"), 100 Fillmore Street, Denver CO 80206-4928, was formed in 1970. Kansas City Southern Industries, Inc. owns approximately 82% of the outstanding voting stock of Janus, most of which it acquired in 1984. As of February 1, 1999, Janus managed or administered over $120 billion in assets. Account: MidCap Growth Sub-Advisor: The Dreyfus Corporation, located at 200 Park Avenue, New York, NY 10166, was formed in 1947. The Dreyfus Corporation is a wholly-owned subsidiary of Mellon Bank, N.A., which is a wholly-owned subsidiary of Mellon Bank Corporation (Mellon). As of December 31, 1998, the Dreyfus Corporation managed or administered approximately $118.5 billion in assets for approximately 1.7 million investor accounts nationwide. Account: MidCap Value Sub-Advisor: Neuberger Berman Management Inc. ("Neuberger Berman") is an affiliate of Neuberger Berman, LLC. Neuberger Berman is located at 605 Third Avenue, 2nd Floor, New York, NY 10158-0180. Together with Neuberger Berman, the firms manage more than $49 billion in total assets (as of September 30, 1998) and continue an asset management history that began in 1939. Account: SmallCap Growth Sub-Advisor: Berger Associates, Inc. Berger's address is 210 University Boulevard, Suite 900, Denver CO 80206. It serves as investment advisor, sub-advisor, administrator or sub-administrator to mutual funds and institutional investors. Berger is a wholly-owned subsidiary of Kansas City Southern Industries, Inc. (KCSI). KCSI is a publicly traded holding company with principal operations in rail transportation, through its subsidiary The Kansas City Southern Railway Company, and financial asset management businesses. Assets under management for Berger as of December 31, 1998 were approximately $3.4 billion. The Company purchases and sells Fund shares for the Separate Account at their net asset value without any sales or redemption charge. Shares of the Funds represent interests in the Accounts available for investment by the Separate Account. Each Account corresponds to one of the divisions of the Separate Account. The assets of each Account are separate from the others. An Account's performance has no effect on the investment performance of any other Account. THE CONTRACT The descriptions that follow are based on provisions of the Contract offered by this prospectus. You should refer to the actual Contract and the terms and limitations of any tax qualified plan which is to be funded by the Contract. Tax qualified plans are subject to several requirements and limitations which may affect the terms of any particular Contract or the advisability of taking certain action permitted by the Contract. To Buy a Contract If you want to buy a Contract, you must submit an application and make an initial purchase payment. If the application is complete and the Contract applied for is suitable, the Contract is issued. If the completed application is received in proper order, the initial purchase payment is credited within two valuation days after the later of receipt of the application or receipt of the initial purchase payment at the Company's home office. If the initial purchase payment is not credited within five valuation days, it is refunded unless we have received your permission to retain the purchase payment until we receive the information necessary to issue the Contract. 1. Purchase payments The initial purchase payment must be at least $10,000. Subsequent payments must be at least $50. The total of all purchase payments may not be greater than $2,000,000 without our prior approval. The Company reserves the right to: o increase the minimum amount for each purchase payment to not more than $1,000, and o terminate a Contract and distribute the accumulated value if no premiums are paid during two consecutive calendar years and the accumulated value (or total purchase payments less partial surrenders and applicable surrender charges and transfer fees) is less than $5,000. The Company will first notify you of its intent to exercise this right and give you 60 days to increase the accumulated value to at least $5,000. 2. Allocation of purchase payments and ten day examination offer Your purchase payments are allocated to the divisions of the Separate Account and/or to the Fixed Account according to your instructions. The percentage allocation for future purchase payments may be changed, without charge, at any time by sending a written request to or telephoning the Company. The allocation changes are effective at the end of the valuation period in which your new instructions are received. You may not allocate your investment to the Fixed Account if it causes the value of the Fixed Account to be more than $1,000,000 (without our prior approval). Under state law, you have the right to return the Contract for any reason during the free-look period. Some states require us to return the initial purchase payment. If your Contract is issued in one of those states, your initial purchase payments are allocated to the Money Market Division for 15 days (20 days for contracts issued in Idaho) after the contract date. After the 15-day period (20 days in Idaho), the initial purchase payment is reallocated according to your allocation instructions. The states in which purchase payments are returned are: Colorado Kentucky North Carolina Connecticut* Louisiana Oklahoma Georgia Maryland Rhode Island Hawaii Michigan South Carolina Idaho Missouri Utah Indiana Nebraska Washington *Purchase payments are refunded if the Contract is canceled prior to its delivery, otherwise accumulated value is refunded. If your Contract is issued in a state not listed above and if you return the Contract during the free-look period, you will receive the accumulated value. The free-look period is 10 days after the Contract is delivered to you in all states, unless your Contract is issued in: a. California and you are age 60 and over (your free-look period is 30 days); b. Colorado (15 day free-look period); or c. Idaho or North Dakota (20 day free-look period). You may return the Contract by sending it, and a written request to cancel the Contract, to the Company's home office or to the sales representative who sold it to you before the close of business on the last day of the free-look period. If you send your request (properly addressed and postage prepaid) to the Company, the date of the postmark is used to determine if the free-look period has expired. If the purchase of this Contract is a replacement for another annuity contract or a life insurance policy, different free-look periods may apply. The Company reserves the right to keep the initial purchase payment in the Money Market division longer than 15 days to correspond to the free-look period of a particular state's replacement requirements. The Accumulation Period 1. The value of your Contract The value of your Contract is the total of the Separate Account value plus any Fixed Account value. The Fixed Account value is described in the section titled FIXED ACCOUNT. There is no guaranteed minimum Separate Account value. Its value reflects the investment experience of the divisions of the Separate Accounts that you choose. It also reflects your purchase payments, partial surrenders and the Contract expenses deducted from the Separate Account. At the end of any valuation period, your Contract's value in a division is: o the number of units you have in a division multiplied by o the value of a unit in the division. The number of units is the total of units purchased by allocations to the division from: o your initial purchase payment; o subsequent investments; and o transfers from another division or the Fixed Account. minus units sold: o for partial surrenders from the division; o as part of a transfer to another division or the Fixed Account; and o to pay Contract charges and fees. Unit values are calculated each valuation date. To calculate the unit value of a division, the unit value from the previous valuation date is multiplied by the divisions' net investment factor for the current valuation period. The number of units does not change due to a change in unit value. The net investment factor measures the performance of each division. The net investment factor for a valuation period is calculated as follows: [{share price of the underlying mutual fund account at the end of the valuation period plus per share amount of dividend (or other distribution) made by the mutual fund account during the valuation period} divided by share price of the underlying mutual fund account at the end of the previous valuation period] subtract {an administration charge (if any) plus the mortality and expense risks charge} The administration charge (if any) and the mortality and expense risks charge are calculated by dividing the annual amount of the charge by 365 and multiplying by the number of days in the valuation period. When an investment owned by an Account pays a dividend, the dividend increases the net asset value of a share of the Account as of the date the dividend is recorded. As the net asset value of a share of an Account increases, the unit value of the corresponding division also reflects an increase. Payment of a dividend under these circumstances does not increase the number of units you own in the Account. 2. Allocation of purchase payments On your application for the Contract, you direct your purchase payments to be allocated to divisions of the Separate Account, the Fixed Account or both. Percentages must be in whole numbers and total 100%. Subsequent investments are made using the same allocation percentages unless you change the allocations. Using your allocation percentages, we will credit your purchase payments to the Separate Account divisions and/or the Fixed Account. The payments are credited to the Accounts using the unit value next calculated after we receive your payment. Changes to the allocation percentages may be made without charge. A change is effective on the next valuation period after we receive your new instructions. You can change the allocations by mailing your instructions to us, calling us at 1-800-247-9988, if telephone services apply, or faxing your instructions to us at 1-515-248-9800. 3. Separate Account Division Transfers You may request an unscheduled transfer or set up a periodic transfer by sending us a written request, calling us if telephone services apply (1-800-247-9988) or faxing your request at 1-515-248-9800. You must specify the dollar amount or percentage to transfer from each Separate Account division. In states where allowed, we reserve the right to reject transfer instructions from someone providing them for multiple Contracts for which he or she is not the owner. You may not make a transfer to the Fixed Account if: o a transfer has been made from the Fixed Account to a division within six months, or o after the transfer, the Fixed Account value would be more than $1,000,000 (without our prior approval). Unscheduled - ----------- o You may make unscheduled Separate Account division transfers from a division to another division or to the Fixed Account. o The transfer is made, and values determined, as of the end of the valuation period in which we receive your request. o The transfer amount must be equal or greater than the lesser of $50 or the value of your account(s) in the Separate Account divisions, o A $30 fee is imposed on each unscheduled transfer after the 12th unscheduled transfer in a contract year (for fee purposes, all transfers based on a single instruction are considered to be a single transfer). Scheduled - --------- o You may elect to have automatic transfers made on a periodic basis. o You select the transfer date (other than the 29th, 30th or 31st) and the transfer period. o automatic portfolio rebalancing (annually, semi-annually or quarterly) o dollar cost averaging (annually, semi-annually, quarterly or monthly) o If the selected date is not a valuation date, the transfer is completed on the next valuation date. o Transfers continue until your interest in the division is zero or we receive notice to stop them. o We reserve the right to limit the number of Separate Account divisions from which simultaneous transfers are made. In no event will it ever be less than two. 4. Separate Account Surrenders Surrenders from the Separate Account are generally paid within seven days of the effective date of the request for surrender (or earlier if required by law). However, certain delays in payment are permitted (see GENERAL PROVISIONS - Delay of Payment). Surrenders before age 59 1/2 may involve an income tax penalty (see FEDERAL TAX MATTERS). You must send us a written request for any surrender. You may specify surrender allocations percentages with each partial surrender request. If you don't provide us with specific percentages, we will use your purchase payment allocation percentages for the partial surrender. Total - ----- o You may surrender the Contract on or before the annuity payment date. o You receive the cash surrender value at the end of the valuation period during which we receive your surrender request. o The cash surrender value is the total of the values of your accounts in the Separate Account divisions plus any amount you have in the Fixed Account minus any applicable surrender charge or transaction fee. o The written consent of all collateral assignees and irrevocable beneficiaries must be obtained prior to surrender. o We reserve the right to require you to return the Contract to us prior to making any payment though this does not affect the amount of the cash surrender value. Unscheduled partial - ------------------- o Prior to the annuity payment date, you may surrender a part of the Fixed Account and/or Separate Account value by sending us a written request. o You must specify the dollar amount of the surrender which must be $50 or more. o The surrender is effective at the end of the valuation period during which we receive your written request for surrender. o The surrender is deducted from your Fixed Account value and/or your account in any Separate Account division according to the surrender allocation percentages you specify. o If surrender allocation percentages are not specified, we use your purchase payment allocation percentages. o We surrender units from the Separate Account divisions and/or Fixed Account to equal the dollar amount of the surrender request plus any applicable Fixed Account surrender charge. o The accumulated value after the unscheduled partial surrender must be equal or greater than $5,000 (we reserve the right to change the minimum remaining accumulated value but it will not be greater than $10,000). o A $30 fee is imposed on each unscheduled partial surrender after the 12th unscheduled partial surrender in a contract year. Surrenders from multiple divisions made at the same time are considered to be one surrender for purposes of calculating this fee. Scheduled partial - ----------------- o You may elect partial surrenders on a periodic basis by sending us written notice. o Your accumulated value must be at least $5,000 when the surrenders begin. o Surrenders are made from any of the Separate Account divisions and/or the Fixed Account. o You may specify monthly, quarterly, semi-annually or annually and pick a surrender date (other than the 29th, 30th or 31st). o If the selected date is not a valuation date, the transfer is completed on the next valuation date. o The surrender is deducted from your Fixed Account value and/or your account in any Separate Account division according to the surrender allocation percentages you specify. o If surrender allocation percentages are not specified, we use your purchase payment allocation percentages. o We surrender units from the Separate Account divisions and/or Fixed Account to equal the dollar amount of the surrender request plus any applicable surrender charge. o The surrenders continue until the accumulated value is zero or we receive written notice to stop them. 5. Death Benefit Before the annuity payment date, you may give us written instructions for payment under a benefit option. If we do not receive your instructions, the death benefit is paid according to instructions from the beneficiary. No surrender charge applies when a death benefit is paid. The beneficiary is the person or persons you name in the application to receive benefits upon your death. If the owner is not a natural person, death benefits are paid to the beneficiary upon the death of the annuitant. Unless you have named an irrevocable beneficiary, you may change your beneficiary by providing us with written notice. If a beneficiary dies before you, on your death we will make equal payments to the surviving beneficiaries unless you had provided us with other written instructions. If none of your beneficiaries survives you, we will pay the death benefit to your estate in a lump sum. The death benefit is usually paid within seven days of our receiving all documents (including proof of death) that we require to process the claim and the beneficiary's written instructions. Some states require this payment to be made in less than seven days. Under certain circumstances, this payment may be delayed (see GENERAL PROVISIONS - Delay of Payments). We pay interest (at least 3% or as required by state law) on the death benefit from the date we receive all required documents until payment is made or until the death benefit is applied under a benefit option. Standard Death Benefit - ---------------------- The amount of the death benefit is the greater of: o your accumulated value on the date we receive all required documents, or o the total of purchase payments minus any partial surrenders, fees and charges as of the date we receive all required documents and notice (including proof) of death. If you die before the annuitant and your beneficiary is your spouse, we will continue the Contract with your spouse as the new owner. Alternatively, within 60 days of your death, your spouse may elect to: o apply the death benefit under a benefit option, or o receive the death benefit as a single payment. If the annuitant dies before you and is not a joint owner, you may name a new annuitant. If a new annuitant is not named within 60 days of our receiving notice (including proof) of the annuitant's death, you will become the annuitant. If the owner of the contract is not a natural person, the annuitant's death is treated as the death of the owner. If your beneficiary is a natural person but not your spouse, the death benefit may be paid as: o fixed income for a period of years that is not greater than the life expectancy of the beneficiary; o life income with no minimum guaranteed period or a minimum guaranteed period that is not greater than the life expectancy of the beneficiary; o lump sum, or o an individual arrangement approved by us. NOTE: If your beneficiary is not a natural person, the death benefit must be paid out within five years of your death. If you die before the annuitant and before the annuity payment date, there may be additional requirements imposed by the Code (see FEDERAL TAX MATTERS). The Retirement Period 1. Annuity payment date You may specify an annuity payment date in your application. If the annuitant is living and the Contract is in force on that date, we will notify you to begin taking payments under the Contract. You may not select an annuity payment date which is on or after the later of the Annuitant's 85th birthday or 10 years after the contract date. Depending on the type of retirement arrangement made when a Contract is issued, payments that are made too early or too late may be subject to penalty taxes (see FEDERAL TAX MATTERS). You should consider this carefully when you select or change the annuity payment date. You may change the annuity payment date with our prior approval. The request must be in writing and approved before we issue a supplementary Contract which provides a benefit option. The new annuity payment date must be any contract anniversary on or before the maximum annuity payment date. 2. Annuity Payment Options You may choose from several fixed payment options. Payments will be made on the frequency you choose. You may elect to have your annuity payments made on a monthly, quarterly, semiannual or annual basis. The dollar amount of the payments is specified for the entire payment period according to the option selected. There is no right to make any total or partial surrender after the annuity payments start. The amount of the annuity payment depends on: o amount of accumulated value; o option selected; and o age of annuitant (unless fixed income option is selected). Annuity payments generally are higher for male annuitants than for female annuitants with an otherwise identical contract. This is because statistically females have longer life expectancies than males. In certain states, this difference may not be taken into consideration in fixing the payment amount. Additionally, contracts with no gender distinctions are made available for certain employer-sponsored plans because under most such plans, such contract provisions are prohibited by law. You may select an annuity payment option or change a previous selection by written request. We must receive the request on or before the annuity payment date. You may not change your option or make Separate Account division transfers after the annuity payment date. Payments under the annuity payment options are made as of the first day of each payment period beginning with the annuity payment date. The available annuity payment options are: o Fixed Income. Payments of a fixed amount or payments for a fixed period of at least five years but not more than 30 years. Payments stop after all guaranteed payments are made. o Life Income. Payments are made as of the first day of each payment period during the annuitant's life, starting with the annuity payment date. No payments are made after the annuitant dies. It is possible that you would only receive one payment under this option if the annuitant dies before the second payment is due. If you die after the payments begin and before the end of the minimum guaranteed period (if applicable), the remaining payments are made to the beneficiary named under your benefit option. o Joint and Survivor Life Income. Payments are made during the life of the annuitant and joint annuitant, continuing until the death of the survivor. This option includes a minimum guaranteed period of 10 years. If both persons die before the end of the minimum guaranteed period, the remaining payments are made to the beneficiary under your benefit option. o Joint and Two-thirds Survivor Life Income. Payments continue as long as either the annuitant or the joint annuitant is alive. If either the annuitant or joint annuitant dies, payments continue to the survivor at two-thirds the original amount. Payments stop when both the annuitant and joint annuitant have died. It is possible that only one payment is made under this option if both annuitants die before the second payment is due. o Other benefit options may be available with our approval. If you do not select a payment option, your accumulated value will be applied as follows to determine the annuity payment: o life income with a ten year guarantee, or o if there are joint annuitants, joint and survivor life income with a ten year guarantee. In order to avoid tax penalties, payments from at least one of your qualified contracts must start no later than April 1 following the calendar year in which you turn age 70 1/2. The required minimum payment is a distribution in equal (or substantially equal) amounts over your life or over the joint lives of you and your designated beneficiary. In addition, payments must be made at least once a year. Tax penalties may also apply at your death on certain excess accumulations. You should consider potential tax penalties with your tax advisor when selecting a benefit option or taking other distributions from the Contract. CHARGES AND DEDUCTIONS A mortality and expense risks charge and in some circumstances a transaction fee and state premium taxes are deducted under the Contract. A surrender charge (on surrenders) and a transfer fee (on transfers to divisions of the Separate Account) may also be deducted from certain withdrawals from the Fixed Account made before the annuity payment date. We reserve the right to assess a daily Separate Account administration charge. There are also deductions from and expenses paid out of the assets of the Accounts which are described in the Funds' prospectuses. Mortality and Expense Risks Charge We assess each division of the Separate Account with a daily charge for mortality and expense risks. The annual rate of the charge is 0.85% of the average daily net assets of the Separate Account. We reserve the right increase this charge but guarantee that it will not exceed 1.25% per year. This charge is assessed only prior to the annuity payment date. This charge is assessed daily when the value of an accumulation unit is calculated. We have a mortality risk in that we guarantee payment of a death benefit in a single sum or under a benefit option. No surrender charge is imposed on a death benefit payment which gives us an additional mortality risk. The expense risk that we assume is that the actual expenses incurred in issuing and administering the Contract exceed the Contract limits on administrative charges. If the mortality and expense risks charge is not enough to cover the costs, we bear the loss. If the amount of mortality and expense risks charge deducted is more than our costs, the excess is profit to the Company. We expect a profit from the mortality and expense risks charge. Transaction Fee A transaction fee of $30 applies to each unscheduled partial surrender after the twelfth unscheduled partial surrender in a contract year. A $30 transaction fee is also charged to each unscheduled transfer from a division after the twelfth such transfer in a contract year. The transaction fee is deducted from the Fixed Account and/or your interest in a Separate Account division from which the amount is surrendered or transferred, on a pro rata basis. Premium Taxes We reserve the right to deduct an amount to cover any premium taxes imposed by states or other jurisdictions. Any deduction is made from either a purchase payment when we receive it, or the accumulated value when you request a surrender (total or partial) or it is applied under an annuity payment option. Currently, premium taxes range from zero to 3.5%. Fixed Account Surrender Charge and Transfer Fee No sales charge is collected or deducted when purchase payments are applied under the Contract to provide a benefit option. A surrender charge is assessed on certain total or partial surrenders from the Fixed Account. The amounts we receive from the surrender charge are used to cover some of the expenses of the sale of the Contract (commissions and other promotional or distribution expenses). If the surrender charge collected is not enough to cover the actual costs of distribution, the costs are paid from the Company's General Account assets which will include profit, if any, from the mortality and expense risks charge. The surrender charge for any total or partial surrender is a percentage of the Fixed Account purchase payments withdrawn or surrendered which were received by us during the seven contract years prior to the withdrawal or surrender. The applicable percentage which is applied to the sum of the Fixed Account purchase payments (which includes amounts transferred to the Fixed Account from any of the Separate Account divisions) paid during each contract year is determined by the following table. The Fixed Account transfer fee is assessed on certain transfers from the Fixed Account to the Separate Account.
Table of Fixed Account Surrender Charges and Transfer Fees ---------------------------------------------------------- number of completed contract years surrender charge and transfer fee applied since each Fixed Account to Fixed Account surrenders and transfers purchase* was made beyond Free Transaction Amount ---------------------------------- ----------------------------------------- 0 (year of purchase payment) 6% 1 6% 2 6% 3 5% 4 4% 5 3% 6 2% 7 and later 0 * Includes amounts transferred to Fixed Account from Separate Account divisions. Each Fixed Account purchase payment begins in year 0 for purposes of calculating the percentage applied to that payment.
We assume that surrenders and transfers are made in the following order: o first from Fixed Account purchase payments we received more than seven completed contract years prior to the surrender (or transfer); o then from the Fixed Account free transaction amount (first from the Fixed Account's earnings, then from the oldest Fixed Account purchase payments (first-in, first-out)) described below; and o then from Fixed Account purchase payments we received within the seven completed contract years before the surrender (or transfer) on a first-in, first-out basis. Where permitted by state law, we reserve the right to reduce: o the surrender charge fee for any amounts surrendered from this Contract, and/or o transfer fees on amounts transferred from the Fixed Account to the Separate These reductions would apply to Contracts that are attributable to a conversion from other products issued by the Company and its subsidiaries and as otherwise permitted by the Investment Company Act of 1940 (as amended). Waiver of Fixed Account Surrender Charge Rider The Fixed Account Surrender Charge will not apply to: o amounts applied under a benefit option; or o payment of death benefit; or o amounts distributed to satisfy the minimum distribution requirement of Section 401(a)9 of the Code (applies to qualified Contracts only) ; or o after the seventh contract year, amounts transferred from the Contract to a single premium immediate annuity issued by us; or o any amount transferred from a Contract used to fund another annuity contract issued by us to the contract owner's spouse when the distribution is made under a divorce decree; or o withdrawals made after the first Contract anniversary (if permitted by state law) if the owner or annuitant has a critical need. Waiver of the charge is available for critical need if the following conditions are met: o owner or annuitant has a critical need; o the owner or annuitant to whom the critical need applies is the original owner or annuitant; and o the critical need did not exist before the contract date. For the purposes of this section, the following definitions apply: o critical need - owner's or annuitant's confinement to a health care facility, terminal illness diagnosis or total and permanent disability. If the critical need is confinement to a health care facility, the confinement must continue for at least 60 consecutive days after the contract date and the withdrawal must occur within 90 days of the confinement's end. o health care facility - a licensed hospital or inpatient nursing facility providing daily medical treatment and keeping daily medical records for each patient (not primarily providing just residency or retirement care). This does not include a facility primarily providing drug or alcohol treatment, or a facility owned or operated by the owner, annuitant or a member of their immediate families. o terminal illness - sickness or injury that results in the owner's or annuitant's life expectancy being 12 months or less from the date notice to receive a distribution from the Contract is received by the Company. o total and permanent disability - a disability that occurs after the contract date and that qualifies the owner or annuitant to receive social security disability payments. This rider may not available in all states. Specific provisions and/or definitions may have state variations. Contact us at 1-800-247-9988 for additional information. Administration Charge We reserve the right to assess each division of the Separate Account with a daily charge at the annual rate of 0.15% of the average daily net assets of the division. This charge would only be imposed before the annuity payment date. This charge would be assessed to help cover administrative expenses. Administrative expenses include the cost of issuing the Contract, clerical, recordkeeping and bookkeeping services, keeping the required financial and accounting records, communicating with Contract owners and making regulatory filings. Special Provisions for Group or Sponsored Arrangements Where permitted by state law, Contracts may be purchased under group or sponsored arrangements as well as on an individual basis. o group arrangement - program under which a trustee, employer or similar entity purchases Contracts covering a group of individuals on a group basis. o sponsored arrangement - program under which an employer permits group solicitation of its employees or an association permits group solicitation of its members for the purchase of Contracts on an individual basis. The charges and deductions described above may be reduced for Contracts issued in connection with group or sponsored arrangements. The rules in effect at the time the application is approved will determine if reductions apply. Reductions may include Contracts without, or with reduced, Fixed Account surrender charges or transfer fees. Availability of the reduction and the size of the reduction (if any) is based factors such as: o size of group; o expected number of participants; and o anticipated purchase payments from the group. Reductions reflect the reduced sales efforts and administrative costs resulting from these arrangements. We may modify the criteria for and the amount of the reduction in the future. Modifications will not unfairly discriminate against any person, including affected Contract owners and other contract owners with contracts funded by the Separate Account. FIXED ACCOUNT You may allocate purchase payments and transfer amounts from the Separate Account to the Fixed Account. Assets in the Fixed Account are held in the General Account of the Company. Because of exemptive and exclusionary provisions, interests in the Fixed Account are not registered under the Securities Act of 1933 and the General Account is not registered as an investment company under the Investment Company Act of 1940. The Fixed Account is not subject to these Acts. The staff of the Commission does not review the prospectus disclosures relating to the Fixed Account. However, these disclosures are subject to certain generally applicable provisions of the federal securities laws relating to the accuracy and completeness of statements made in the prospectus. This prospectus is intended to serve as a disclosure document only for the Contract as it relates to the Separate Account. It only contains selected information regarding the Fixed Account. More information concerning the Fixed Account is available from our home office or from a sales representative. General Description Our obligations with respect to the Fixed Account are supported by the Company's General Account. The General Account is the assets of the Company other than those allocated to any of the Company's Separate Accounts. Subject to applicable law, the Company has sole discretion over the assets in the General Account. The Company guarantees that purchase payments allocated to the Fixed Account earn interest at a guaranteed interest rate. In no event will the guaranteed interest rate be less than 3% compounded annually. Each purchase payment allocated or amount transferred to the Fixed Account earns interest at the guaranteed rate in effect on the date it is received or transferred. This rate applies to each purchase payment or amount transferred through the end of the contract year. Each contract anniversary, we declare a renewal interest rate that is guaranteed and applies to the Fixed Account value in existence at that time. This rate applies until the end of the contract year. Interest is earned daily and compounded annually at the end of each contract year. Once credited, the interest is guaranteed and becomes part of the accumulated value in the Fixed Account from which deductions for fees and charges may be made. Fixed Account Value Your Contract's Fixed Account value on any valuation date is the sum of: o purchase payments allocated to the Fixed Account; o plus any transfers to the Fixed Account from the Separate Account; o plus interest credited to the Fixed Account; o minus any surrenders, surrender charges, or transaction fees allocated to the Fixed Account; o minus any transfers (and transfer fees) to the Separate Account. Fixed Account Transfers, Total and Partial Surrenders Transfers and surrenders from your investment in the Fixed Account are subject to certain limitations. In addition, surrenders and transfers from the Fixed Account may be subject to a charge or fee (see Fixed Account Surrender Charge and Transfer Fee). The total amount you may transfer and/or surrender from the Fixed Account may not exceed your Fixed Account value. You may transfer amounts from the Fixed Account to the Separate Account divisions before the annuity payment date and as provided below. Transfer occurs within one business day of our receiving your instructions. You may transfer amounts by making either a scheduled or unscheduled Fixed Account transfer. You may not make both a scheduled and unscheduled Fixed Account transfer in the same contract year. Fixed Account Free Transaction Amount - ------------------------------------- Each contract year, a certain portion of your Fixed Account value may be: o withdrawn free of the surrender charge, or o transferred to the Separate Account free of the transfer fee. The surrender charge and transfer fee do not apply to Fixed Account surrenders or transfers (or a combination of surrenders and transfers) which do not exceed the greater of: o your Fixed Account's earnings (Fixed Account value minus unsurrendered/non-transferred Fixed Account purchase payments still subject to a surrender charge or transfer fee), or o 10% of your total Fixed Account value recalculated as of the later of the contract date or last contract anniversary, or o any amount to satisfy the minimum distribution amount requirement of the Code. In addition, 10% of Fixed Account purchase payments during the current Contract year may be surrendered without a surrender charge or transferred without a transfer fee. Unscheduled Fixed Account Transfer - ---------------------------------- You may make an unscheduled transfer from the Fixed Account each contract year as follows: o Transfer occurs within one business day of our receiving your instructions. o You must specify the dollar amount or percentage to be transferred. o Amounts in excess of the Fixed Account Free Transaction Amount may be subject to a transfer fee. o You may transfer up to 100% of your Fixed Account value (without incurring the transfer fee) within 30 days after a contract anniversary if: o your Fixed Account value is less than $1,000, or o the renewal interest rate for your Fixed Account value for the current contract year is more than one percentage point lower than the weighted average of your Fixed Account interest rates for the preceding contract year. o If you do not meet one of the preceding conditions, transfers from the Fixed Account may be subject to a surrender charge (see Fixed Account Surrender Charge and Transfer Fee). Scheduled Fixed Account Transfer (Dollar Cost Averaging) - -------------------------------------------------------- You may make scheduled transfers on a periodic basis from the Fixed Account as follows: o Transfers occur on a date you specify (other than the 29th, 30th or 31st of any month). o If the selected date is not a valuation date, the transfer is completed on the next valuation date. o The minimum transfer amount is $50. o Transfers continue until your value in the Fixed Account is exhausted or we receive your notice to stop them. o If you stop the transfers, you may not start them again without our prior approval. GENERAL PROVISIONS Telephone Services Telephone services are permitted (unless prohibited by state law) for both changes in the allocation of future purchase payments and transfers among divisions. Telephone services may be declined on the Contract application or at any later date by providing us with written notice. Telephone service is used by calling us at 1-800-247-9988. Telephone transfer requests must be made while we are open for business. They are effective when received by us before the close of the New York Stock Exchange (generally 3 p.m. Central Time). Requests received when we are not open for business or after the New York Stock Exchange closes will be effective on the next business day. Neither the Company nor the Separate Account are responsible for the authenticity of telephone service transaction requests. We reserve the right to refuse telephone service transaction requests. You assume the risk of loss caused by fraudulent telephone service transactions we reasonably believe to be genuine. We follow procedures in an attempt to assure genuine telephone service transactions. If these procedures are not followed, then we may be liable for loss caused by unauthorized or fraudulent transactions. The procedures include recording telephone service transactions, requesting personal identification (name, daytime telephone number, social security number and/or birthdate) and sending written confirmation to your address of record. The Contract The entire Contract is made up of: applications, amendments, riders and endorsements attached to the Contract; current data page; copies of any supplemental applications, amendments, endorsements and revised Contract pages or data pages which are mailed to you. Only our corporate officers can agree to change or waive any provisions of a Contract. Any change or waiver must be in writing and signed by an officer of the Company. Delay of Payments Surrenders are generally made within seven days after we receive your instruction for a surrender in a form acceptable to us. This period may be shorter where required by law. However, payment of any amount upon total or partial surrender, death or the transfer to or from a division of the Separate Account may be deferred during any period when the right to sell Fund shares is suspended as permitted under provisions of the Investment Company Act of 1940 (as amended). The right to sell shares may be suspended during any period when: o trading on the New York Stock Exchange is restricted as determined by the Commission or when the Exchange is closed for other than weekends and holidays, or o an emergency exists, as determined by the Commission, as a result of which: o disposal by a Fund of securities owned by it is not reasonably practicable; o it is not reasonably practicable for a Fund to fairly determine the value of its net assets; or o the Commission permits suspension for the protection of security holders. If payments are delayed and your surrender (or transfer) is not canceled by your written instruction, the amount to be surrendered (or transferred) will be determined the first valuation date following the expiration of the permitted delay. The surrender will be made within seven days thereafter. In addition, payments on surrenders (or transfers) attributable to a purchase payment made by check may be delayed up to 15 days. This permits payment to be collected on the check. We may also defer payment of surrender proceeds payable out of the Fixed Account for a period of up to six months. Misstatement of Age or Gender If the age or, where applicable, gender of the annuitant has been misstated, we adjust the income payable under your Contract to reflect the amount that would have been payable at the correct age and gender. If we make any overpayment because of incorrect information about age or gender, or any error or miscalculation, we deduct the overpayment from the next payment or payments due. Underpayments are added to the next payment. Assignment You may assign your non-qualified Contract. Each assignment is subject to any payments made or action taken by the Company prior to our notification of the assignment. We assume no responsibility for the validity of any assignment. An assignment or pledge of a Contract may have adverse tax consequences. An assignment must be made in writing and filed with us at our home office. The irrevocable beneficiary(ies), if any, must authorize any assignment in writing. Your rights, as well as those of the annuitant and beneficiary, are subject to any assignment on file with us. Any amounts paid to an assignee are treated as a partial surrender and is paid in a single lump sum. Change of Owner You may change your ownership designation at any time (this does not apply to IRAs or IRA rollovers). Your request must be in writing and approved by us. After approval, the change is effective as of the date you signed the request for change. We reserve the right to require that you send us the Contract so that we can record the change. Beneficiary Before the annuity payment date, you have the right to name a beneficiary. This may be done as part of the application process or by sending us a written request. Unless you have named an irrevocable beneficiary, you may change your beneficiary designation by sending us a written request. Contract Termination We reserve the right to terminate the Contract and make a single sum payment (without imposing any charges) to you if your accumulated value at the end of the accumulation period is less than $5,000. Before the Contract is terminated, we will send you a notice to increase the accumulated value to $5,000 within 60 days. RIGHTS RESERVED BY THE COMPANY We reserve the right to make certain changes if, in our judgement, they best serve the interests of you and the annuitant or are appropriate in carrying out the purpose of the Contract. Any changes will be made only to the extent and in the manner permitted by applicable laws. Also, when required by law, we will obtain your approval of the changes and approval from any appropriate regulatory authority. Approvals may not be required in all cases. Examples of the changes the Company may make include: o transfer assets in any division to another division or to the Fixed Account; o add, combine or eliminate divisions in the Separate Account; or o substitute the shares of an Account for the Account shares in any division: o if shares of an Account are no longer available for investment; or o if in our judgement, investment in an Account becomes inappropriate considering the purposes of the Separate Account. DISTRIBUTION OF THE CONTRACT The individuals who sell the Contract are authorized to sell life and other forms of personal insurance and variable annuities. Though it is sold primarily by insurance agents who are employees of the Company, the Contract may also be offered by insurance agents or brokers who are not our employees but who are appointed by us to sell variable annuities. Our employees who sell the Contract are also registered representatives of Princor Financial Services Corporation, Principal Financial Group, Des Moines, Iowa 50392-0200. Princor is a broker-dealer registered under the Securities Exchange Act of 1934 and a member of the National Association of Securities Dealers, Inc. When the Contract is sold by our employees, as the principal underwriter, Princor is paid 1.35% of purchase payments by the Company for the distribution of the Contract. Princor is also the principal underwriter for various registered investment companies organized by the Company. Princor is an indirectly wholly-owned subsidiary of the Company. In addition to being sold by our employees, the Contract may be offered through other registered representatives of Princor and registered representatives of other selected broker-dealers. Such broker-dealers are either registered under the Securities Exchanges Act of 1934 or are exempt from such registration. When the Contract is sold by other than our employees, as the principal underwriter, Princor is paid 1.50% of purchase payments by the Company for the distribution of the Contract. PERFORMANCE CALCULATION The Separate Account may publish advertisements containing information (including graphs, charts, tables and examples) about the performance of one or more of its divisions. The Contract was not offered prior to April 30, 1999. However, shares of Accounts in which the Bond, Capital Value, International, MidCap, MidCap Growth, Money Market, SmallCap and SmallCap Growth divisions of the Separate Account invest were offered prior to that date. The Separate Account may publish advertisements containing information about the hypothetical performance of one or more of its divisions for this Contract as if the Contract had been issued on or after the date the Account in which the division invests was first offered. The hypothetical performance from the date of the inception of the Account in which the division invests is calculated by reducing the actual performance of the underlying Account by the fees and charges of this Contract as if it had been in existence. The American Century VP Income & Growth, Blue Chip, LargeCap Growth, MidCap Value, Stock Index 500, and Templeton VP Stock divisions of the Separate Account were not offered until April 30, 1999. Performance data for these divisions are calculated utilizing standardized performance formulas and shows performance since the inception date of the division. The yield and total return figures described below vary depending upon market conditions, composition of the underlying Account's portfolios and operating expenses. These factors and possible differences in the methods used in calculating yield and total return should be considered when comparing the Separate Account performance figures to performance figures published for other investment vehicles. The Separate Account may also quote rankings, yields or returns as published by independent statistical services or publishers and information regarding performance of certain market indices. Any performance data quoted for the Separate Account represents only historical performance and is not intended to indicate future performance. For further information on how the Separate Account calculates yield and total return figures, see the SAI. From time to time the Separate Account advertises its Money Market division's "yield" and "effective yield" for these Contracts. Both yield figures are based on historical earnings and are not intended to indicate future performance. The "yield" of the division refers to the income generated by an investment in the division over a 7-day period (which period is stated in the advertisement). This income is then "annualized." That is, the amount of income generated by the investment during that week is assumed to be generated each week over a 52-week period and is shown as a percentage of the investment. The "effective yield" is calculated similarly but, when annualized, the income earned by an investment in the division is assumed to be reinvested. The "effective yield" is slightly higher than the "yield" because of the compounding effect of the assumed reinvestment. In addition, the Separate Account advertises the "yield" for other divisions for the Contract. The "yield" of a division is determined by annualizing the net investment income per unit for a specific, historical 30-day period and dividing the result by the ending maximum offering price of the unit for the same period. The Separate Account also advertises the average annual total return of its various divisions. The average annual total return for any of the divisions is computed by calculating the average annual compounded rate of return over the stated period that would equate an initial $1,000 investment to the ending redeemable Contract value. VOTING RIGHTS The Company votes Account shares of the Principal Variable Contracts Fund, Inc. held in the Separate Account at meetings of shareholders of those Accounts. It follows your voting instructions if you have an investment in the corresponding division of the Separate Account. The number of Account shares in which you have a voting interest is determined by the Company as of a date not more than 90 days before the meeting of the shareholders of the Account. Your voting instructions are solicited by written communication at least ten days prior to the meeting. The number of Account shares held in Separate Account B attributable to your interest in each division is determined by dividing the value of your interest in that division by the net asset value of one share of the underlying Account. Account shares for which owners are entitled to give voting instructions, but for which none are received, and shares of the Account owned by the Company are voted in the same proportion as the total shares for which voting instructions have been received. Proxy materials are provided to you along with an appropriate form that may be used to give voting instructions to the Company. If the Company determines pursuant to applicable law that Account shares held in Separate Account B need not be voted pursuant to instructions received from owners, then the Company may vote Account shares held in Separate Account B in its own right. FEDERAL TAX MATTERS The following description is a general summary of the tax rules, primarily related to federal income taxes, which in our opinion are currently in effect. These rules are based on laws, regulations and interpretations which are subject to change at any time. This summary is not comprehensive and is not intended as tax advice. Federal estate and gift tax considerations, as well as state and local taxes, may also be material. You should consult a qualified tax adviser about the tax implications of taking action under a Contract or related retirement plan. Non-Qualified Contracts Section 72 of the Code governs the taxation of annuities in general. o Purchase payments made under non-qualified Contracts are not excludible or deductible from your gross income or any other person's gross income. o An increase in the accumulated value of a non-qualified Contract resulting from the investment performance of the Separate Account or interest credit to the Fixed Account is generally not taxable until paid out as surrender proceeds, death benefit proceeds, or otherwise. o Generally, owners who are not natural persons are immediately taxed on any increase in the accumulated value. The following discussion applies generally to Contracts owned by natural persons. o Surrenders or partial surrenders are taxed as ordinary income to the extent of the accumulated income or gain under the Contract. o The value of the Contract pledged or assigned is taxed as ordinary income to the same extent as a partial withdrawal. o Annuity payments: o The investment in the Contract is generally the total of the purchase payments made. o The portion of the annuity payment that represents the amount by which the accumulated value exceeds the investment in the Contract is taxed as ordinary income. The remainder of each annuity payment is not taxed. o After the investment in the Contract is paid out, the full amount of any annuity payment is taxable. For purposes of determining the amount of taxable income resulting from distributions, all Contracts and other annuity contracts issued by us or our affiliates to the same owner within the same calendar year are treated as if they are a single contract. A transfer of ownership of a Contract, or designation of an annuitant or other payee who is not also the owner, may result in a certain income or gift tax consequences to the owner. If you are contemplating any transfer or assignment of a Contract, you should contact a competent tax advisor with respect to the potential tax effects of such transactions. Required Distributions for Non-Qualified Contracts In order for a non-qualified Contract to be treated as an annuity contract for federal income tax purposes, the Code requires: o If the person receiving payments dies on or after the annuity payment date but prior to the time the entire interest in the Contract has been distributed, the remaining portion of the interest is distributed at least as rapidly as under the method of distribution being used as of the date of that person's death. o If you die prior to the annuity payment date, the entire interest in the Contract will be distributed: o within five years after the date of your death, or o as annuity payments which begin within one year of your death and which are made over the life of your designated beneficiary or over a period not extending beyond the life expectancy of that beneficiary. o If you take a distribution from the Contract before you are 59 1/2, you may incur an income tax penalty. If your designated beneficiary is your surviving spouse, the Contract may be continued with your spouse deemed to be the new owner for purposes of the Code. Where the owner or other person receiving payments is not a natural person, the required distributions provided for in the Code apply upon the death of the primary annuitant. Generally, unless the beneficiary elects otherwise, the above requirements are satisfied prior to the annuity payment date by paying the death benefit in a single sum, subject to proof of your death. The beneficiary may elect by written request to receive a benefit option instead of a lump sum payment. However, if the election is not made within 60 days of the date the single sum death benefit otherwise becomes payable, the IRS may disregard the election for tax purposes and tax the beneficiary as if a single sum payment had been made. IRA The Contract may be used to fund IRAs. The tax rules applicable to owners, annuitants and other payees vary according to the type of plan and the terms and conditions of the plan itself. In general, purchase payments made under a retirement program recognized under the Code are excluded from the participant's gross income for tax purposes prior to the annuity payment date. The portion, if any, of any purchase payment made that is not excluded from their gross income is their investment in the Contract. Aggregate deferrals under all plans at the employee's option may be subject to limitations. The tax implications of these plans are further discussed in the SAI under the heading Taxation Under Certain Retirement Plans. Check with your tax advisor for the rules which apply to your specific situation. With respect to IRAs or 3 rollovers, there is a 10% penalty under the Code on the taxable portion of a "premature distribution." Generally, an amount is a "premature distribution" unless the distribution is: o made on or after you reach age 59 1/2, o made to a beneficiary on or after your death, o made upon your disability, o part of a series of substantially equal periodic payments for the life or life expectancy of you or you and the beneficiary, o made to pay medical expenses, o for certain unemployment expenses, o for first home purchases (up to $10,000), or o for higher education expenses. Rollover IRAs. If you receive a lump-sum distribution from a pension or profit sharing plan, to maintain the tax deferred status of the money it may be rolled into a "Rollover Individual Retirement Account." You have 60 days from receipt of the money to complete this transaction. If you choose not to reinvest or go beyond the 60 day limit and are under age 59 1/2, you will incur a 10% IRS penalty as well as income tax expenses. Withholding Annuity payments and other amounts received under the Contract are subject to income tax withholding unless the recipient elects not to have taxes withheld. The amounts withheld vary among recipients depending on the tax status of the individual and the type of payments from which taxes are withheld. Notwithstanding the recipient's election, withholding may be required on payments delivered outside the United States. Moreover, special "backup withholding" rules may require us to disregard the recipient's election if the recipient fails to supply us with a "TIN" or taxpayer identification number (social security number for individuals), or if the Internal Revenue Service notifies us that the TIN provided by the recipient is incorrect. Mutual Fund Diversification The United States Treasury Department has adopted regulations under Section 817(h) of the Code which establishes standards of diversification for the investments underlying the Contracts. Under this Code Section, Separate Account investments must be adequately diversified in order for the increase in the value of non-qualified Contracts to receive tax-deferred treatment. In order to be adequately diversified, the portfolio of each underlying Account must, as of the end of each calendar quarter or within 30 days thereafter, have no more than 55% of its assets invested in any one investment, 70% in any two investments, 80% in any three investments and 90% in any four investments. Failure of an Account to meet the diversification requirements could result in tax liability to non-qualified Contract holders. The investment opportunities of the Accounts could conceivably be limited by adhering to the above diversification requirements. This would affect all owners, including owners of Contracts for whom diversification is not a requirement for tax-deferred treatment. STATE REGULATION The Company is subject to the laws of the State of Iowa governing insurance companies and to regulation by the Insurance Department of the State of Iowa. An annual statement in a prescribed form must be filed by March 1 in each year covering our operations for the preceding year and our financial condition on December 31 of the prior year. Our books and assets are subject to examination by the Commissioner of Insurance of the State of Iowa or her representatives at all times. A full examination of our operations is conducted periodically by the National Association of Insurance Commissioners. Iowa law and regulations also prescribe permissible investments, but this does not involve supervision of the investment management or policy of the Company. In addition, we are subject to the insurance laws and regulations of other states and jurisdictions where we are licensed to operate. Generally, the insurance departments of these states and jurisdictions apply the laws of the state of domicile in determining the field of permissible investments. LEGAL OPINIONS Legal matters applicable to the issue and sale of the Contracts, including our right to issue Contracts under Iowa Insurance Law, have been passed upon by Gregg R. Narber, Senior Vice President and General Counsel. LEGAL PROCEEDINGS There are no legal proceedings pending to which Separate Account B is a party or which would materially affect Separate Account B. REGISTRATION STATEMENT This Prospectus omits some information contained in the SAI (Part B of the Registration Statement) and Part C of the Registration Statement which the Company has filed with the Commission. The SAI is a part of this Prospectus. You may request a free copy of the SAI by writing or telephoning Princor. You may obtain a copy of Part C of the Registration Statement from the Commission, Washington, D.C. by paying the prescribed fees. OTHER VARIABLE ANNUITY CONTRACTS The Company currently offers other variable annuity contracts that participate in Separate Account B. In the future, we may designate additional group or individual variable annuity contracts as participating in Separate Account B. INDEPENDENT AUDITORS The financial statements of Principal Life Insurance Company Separate Account B and the financial statements of Principal Life Insurance Company are included in the SAI. Those statements have been audited by Ernst & Young LLP, independent auditors, for the periods indicated in their reports which also appear in the SAI. FINANCIAL STATEMENTS The financial statements of the Principal Life Insurance Company which are included in the SAI should be considered only as it relates to our ability to meet our obligations under the Contract. They do not relate to investment performance of the assets held in the Separate Account. YEAR 2000 READINESS DISCLOSURE Starting in early 1995, as a corporate effort, the Company recognized the Year 2000 could have a significant impact on our operations. With the strong commitment from the Board of Directors, Chief Executive Officer and Chief Information Officer, we initiated a comprehensive plan to ensure our systems and facilities would function correctly regardless of the date on the calendar. Assessments of our computer systems were completed in 1996. We identified 35,000 programs comprising 40 million lines of mainframe code, 1,300 PC software packages, and 400,000+ end-user PC applications that could be affected by the Year 2000. Our analysis didn't stop there. We requested Year 2000 compliance status information from hardware and software vendors of over 1,000 PC systems and 450 mainframe systems. New purchase agreements, along with renewal agreements, have included a "Year 2000" warranty clause since 1997. In 1997, we contacted critical service and product suppliers such as banks and utility companies regarding their Year 2000 readiness. To further assess the stability of our external supply chain, we conducted another survey in 1998, and a third evaluation of our most critical suppliers will take place in 1999. As of December 31, 1998, 100 percent of our identified mission critical system renovations were completed, tested and in production. We expect to complete the remaining identified changes by June 30, 1999 (when we receive and install updated software releases from our outside vendors). Full-scale testing of our systems began in March 1998 using an in-house, isolated testing facility. We include "system date manipulation" and "file aging" processes to verify a wide variety of dates before, on, and after January 1, 2000, including February 29, 2000 (leap day). Our objective is to complete full-scale testing of all identified mission critical systems in second quarter 1999, with significant attentions to year-end and leap-year processing. Verification will continue through 1999, and into the early part of 2000, to ensure no new date related problems are introduced into previously tested or newly developed systems. We believe our thorough systems testing process should eliminate significant date related problems that could affect our systems. We will have staff onsite during critical times to ensure a timely and accurate response to unforeseen issues which may arise. Contingency plan development began July 1998. The methodology was documented in November 1998. We expect initial plans to be completed by March 31, 1999. These plans are being developed to address external systems and non-systems events that could affect our operations. Many of those scenarios are beyond our control, so we are identifying possible options, which will minimize their impact. We are also communicating with other entities involved to encourage their Year 2000 preparedness. We will reevaluate our contingency plans throughout the Year 2000 experience. The cost associated with completing our Year 2000 readiness for the business unit of the Company which issues the Policy is estimated to be $1.3 - $1.6 million. Additional corporate Y2K information can be found on our website at www.principal.com/general/faqy2k.htm. CUSTOMER INQUIRIES Your questions should be directed to: Principal FreedomSM Variable Annuity, Principal Financial Group, P.O. Box 9382, Des Moines, Iowa 50306-9382, 1-800-247-9988. TABLE OF CONTENTS OF THE STATEMENT OF ADDITIONAL INFORMATION General Information and History............................................. 4 Independent Auditors ...................................................... 4 Calculation of Yield and Total Return ...................................... 4 Taxation Under Certain Retirement Plans..................................... 6 Principal Life Insurance Company Separate Account B Report of Independent Auditors......................................... 9 Financial Statements................................................... 10 Principal Life Insurance Company Report of Independent Auditors......................................... 33 Financial Statements................................................... 34 To obtain a free copy of the SAI write or telephone: Principal FreedomSM Variable Annuity Principal Financial Group P.O. Box 9382 Des Moines, Iowa 50306-9382 Telephone: 1-800-247-9988 PART B STATEMENT OF ADDITIONAL INFORMATION PRINCIPAL FREEDOMSM VARIABLE ANNUITY CONTRACT dated April 30, 1999 The Statement of Additional Information provides information about the Principal Freedom Variable Annuity sponsored by Principal Life Insurance Company. This Statement of Additional Information is not a prospectus but does provide information that supplements the Contract's Prospectus dated April 30, 1999. It should be read with that Prospectus which is available without charge. To request a copy of the Prospectus, please contact us at: Principal FreedomSM Variable Annuity Principal Financial Group P.O. Box 9382 Des Moines, Iowa 50306-9382 Telephone: 1-800-247-9988 TABLE OF CONTENTS General Information and History............................................ 4 Independent Auditors ..................................................... 4 Calculation of Yield and Total Return ..................................... 4 Taxation Under Certain Retirement Plans.................................... 6 Principal Life Insurance Company Separate Account B Report of Independent Auditors........................................ 9 Financial Statements.................................................. 10 Principal Life Insurance Company Report of Independent Auditors........................................ 33 Financial Statements.................................................. 34 GENERAL INFORMATION AND HISTORY Principal Life Insurance Company is the issuer of the Principal Freedom Variable Annuity (the "Contract"). In 1879, it was incorporated under the laws of the State of Iowa as a mutual life insurance company named Bankers Life Association. It changed its name to Bankers Life Company in 1911 and then to Principal Mutual Life Insurance Company in 1986. The name change to Principal Life Insurance Company and reorganization into a mutual holding company structure was effective July 1, 1998. INDEPENDENT AUDITORS Ernst & Young LLP, 801 Grand, Des Moines, Iowa, serves as independent auditors for Principal Life Insurance Company Separate Account B and the Principal Life Insurance Company. The firm performs audit and accounting services for Separate Account B and the Principal Life Insurance Company. CALCULATION OF YIELD AND TOTAL RETURN The Separate Account may publish advertisements containing information (including graphs, charts, tables and examples) about the performance of one or more of its divisions. The Contract was not offered prior to April 30, 1999. Each division of the Separate Account which is available for investment through the Contract invests in an Account of the Principal Variable Contracts Fund, Inc., the American Century Variable Portfolios, Inc. - VP Income & Growth or the Templeton Variable Products Series Fund - Templeton Stock Fund Class 2. Certain of the Accounts of the Principal Variable Contracts Fund, Inc. correspond to open-end investment companies ("mutual funds") which, effective January 1, 1998, were reorganized into the Accounts of the Principal Variable Contracts Fund, Inc. as follows: Account Name Old Mutual Fund Name ------------ -------------------- Bond Account Principal Bond Fund, Inc. Capital Value Account Principal Capital Accumulation Fund, Inc. MidCap Account Principal Emerging Growth Fund, Inc. Money Market Account Principal Money Market Fund, Inc. International Account Principal World Fund, Inc. These Accounts (under their former names), the MidCap Growth Account, SmallCap Growth Account as well as the American Century Variable Portfolios, Inc. - VP Income & Growth, and the Templeton Variable Products Series Fund - Templeton Stock Fund Class 2 were offered prior to the date the Contract was available. The Separate Account may publish advertisements containing information about the hypothetical performance of one or more of its divisions for this Contract as if the contract had been issued on or after the date the Account in which such division invests was first offered. The hypothetical performance from the date of the inception of the Account is derived by reducing the actual performance of the underlying Account by the fees and charges of the Contract as if it had been in existence. The yield and total return figures described below vary depending upon market conditions, the composition of the underlying Account's portfolios and operating expenses. These factors and possible differences in the methods used in calculating yield and total return should be considered when comparing the Separate Account performance figures to performance figures published for other investment vehicles. The Separate Account may also quote rankings, yields or returns published by independent statistical services or publishers and information regarding performance of certain market indices. Any performance data quoted for the Separate Account represents historical performance and is not intended to indicate future performance. From time to time the Account advertises its Money Market division's "yield" and "effective yield" for the Contract. Both yield figures are based on historical earnings and are not intended to indicate future performance. The "yield" of the division refers to the income generated by an investment under the contract in the division over a seven-day period (the period will be stated in the advertisement). This income is then "annualized." That is, the amount of income generated by the investment during that week is assumed to be generated each week over a 52-week period and is shown as a percentage of the investment. The "effective yield" is calculated similarly but, when annualized, the income earned by an investment in the division is assumed to be reinvested. The "effective yield" is slightly higher than the "yield" because of the compounding effect of this assumed reinvestment. Neither yield quotation reflects a sales load deducted from purchase payments which, if included, would reduce the "yield" and "effective yield." In addition, the Separate Account advertises the "yield" for certain other divisions for the Contract. The "yield" of a division is determined by annualizing the net investment income per unit for a specific, historical 30-day period and dividing the result by the ending maximum offering price of the unit for the same period. This yield quotation does not reflect a contingent deferred sales charge which, if included, would reduce the "yield." No contingent deferred sales charge is assessed on investments in the divisions of the Separate Account of the Contract. The Separate Account also advertises the average annual total return of its various divisions. The average annual total return for any of the divisions is computed by calculating the average annual compounded rate of return over the stated period that would equate an initial $1,000 investment to the ending redeemable contract value. Following are the hypothetical average annual total returns for the period ended December 31, 1998 assuming the contract had been offered as of the effective dates of the underlying Accounts in which the Divisions invest:
Division One Year Five Year Ten Year -------- -------- --------- -------- American Century Variable Portfolios, Inc. - VP Income & Growth 25.80% 28.93%(2) N/A Principal Variable Contracts Fund, Inc. Bond 6.78 6.75 8.54% Capital Value 12.62 18.04 14.18 International 9.05 11.50(4) N/A MidCap 2.80 13.95 15.25 MidCap Growth -3.96(1) N/A N/A Money Market 4.32 4.06 4.48 SmallCap -20.98(1) N/A N/A SmallCap Growth 2.37(1) N/A N/A Templeton Variable Products Series Fund Templeton Stock Fund Class 2. -32.16 -17.71(3) N/A (1) Period from May 1, 1998 through December 31, 1998. (2) Period from October 30, 1997 through December 31, 1998. (3) Period from May 1, 1997 through December 31, 1998. (4) Period from May 1, 1994 through December 31, 1998.
TAXATION UNDER CERTAIN RETIREMENT PLANS Individual Retirement Annuities Purchase Payments. Individuals may make contributions for individual retirement annuity ("IRA") Contracts. Deductible contributions for any year may be made up to the lesser of $2,000 or 100% of compensation for individuals who (1) are not active participants in another retirement plan, (2) are unmarried and have adjusted gross income of $40,000 or less, or (3) are married and have adjusted gross income of $60,000 or less. Such individuals may establish an IRA for a spouse who makes no contribution to an IRA for the tax year. The annual purchase payments for both spouses' Contracts cannot exceed the lesser of $4,000 or 100% of the working spouse's earned income, and no more than $2,000 may be contributed to either spouse's IRA for any year. Individuals who are active participants in other retirement plans and whose adjusted gross income (with certain special adjustments) exceeds the cut-off point ($40,000 for unmarried, $60,000 for married persons filing jointly, and $0 for married persons filing a separate return) by less than $10,000 are entitled to make deductible IRA contributions in proportionately reduced amounts. For example, a married individual who is an active participant in another retirement plan and files a separate tax return is entitled to a partial IRA deduction if the individual's adjusted gross income is less than $10,000, and no IRA deduction if his or her adjusted gross income is equal to or greater than $10,000. Individuals whose spouse is an active participant in other retirement plans and whose combined adjusted gross income exceeds the cutoff point of $150,000 by less than $10,000 are entitled to make deductible IRA contributions in proportionately reduced amounts. An individual may make non-deductible IRA contributions to the extent of the excess of (1) the lesser of $2,000 ($4,000 in the case of a spousal IRA) or 100% of compensation over (2) the IRA deductible contributions made with respect to the individual. An individual may not make any contribution to his/her own IRA for the year in which he/she reaches age 70 1/2 or for any year thereafter. Taxation of Distributions. Distributions from IRA Contracts are taxed as ordinary income to the recipient, although special rules exist for the tax-free return of non-deductible contributions. In addition, taxable distributions received under an IRA Contract prior to age 59 1/2 are subject to a 10% penalty tax in addition to regular income tax. Certain distributions are exempted from this penalty tax, including distributions following the owner's death or disability if the distribution is paid as part of a series of substantially equal periodic payments made for the life (or life expectancy) of the Owner or the joint lives (or joint life expectancies) of Owner and the Owner's designated Beneficiary; distributions to pay medical expenses; distributions for certain unemployment expenses; distributions for first home purchases (up to $10,000) and distributions for higher education expenses. Required Distributions. Generally, distributions from IRA Contracts must commence not later than April 1 of the calendar year following the calendar year in which the employee attains age 70 1/2, and such distributions must be made over a period that does not exceed the life expectancy of the employee (or the employee and Beneficiary). A penalty tax of 50% would be imposed on any amount by which the minimum required distribution in any year exceeded the amount actually distributed in that year. In addition, in the event that the employee dies before his or her entire interest in the Contract has been distributed, the employee's entire interest must be distributed in accordance with rules similar to those applicable upon the death of the Contract Owner in the case of a non-qualified contract, as described in the Prospectus. Tax-Free Rollovers. The Code permits the taxable portion of funds to be transferred in a tax-free rollover from a qualified employer pension, profit-sharing, annuity, bond purchase or tax-deferred annuity plan to an IRA Contract if certain conditions are met, and if the rollover of assets is completed within 60 days after the distribution from the qualified plan is received. A direct rollover of funds may avoid a 20% federal tax withholding generally applicable to qualified plans or tax-deferred annuity plan distributions. In addition, not more frequently than once every twelve months, amounts may be rolled over tax-free from one IRA to another, subject to the 60-day limitation and other requirements. The once-per-year limitation on rollovers does not apply to direct transfers of funds between IRA custodians or trustees. Simplified Employee Pension Plans and Salary Reduction Simplified Employee Pension Plans Purchase Payments. Under Section 408(k) of the Code, employers may establish a type of IRA plan referred to as a simplified employee pension plan (SEP). Employer contributions to a SEP cannot exceed the lesser of $24,000 or 15% or the employee's earned income. Employees of certain small employers may have contributions made to the salary reduction simplified employee pension plan ("SAR/SEP") on their behalf on a salary reduction basis. These salary reduction contributions may not exceed $10,000 in 1999, which is indexed for inflation. Employees of tax-exempt organizations and state and local government agencies are not eligible for SAR/SEPs. SAR/SEPs may not be established after December 31, 1996. Taxation of Distributions. Generally, distribution payments from SEPs and SAR/SEPs are subject to the same distribution rules described above for IRAs. Required Distributions. SEPs and SAR/SEPs are subject to the same minimum required distribution rules described above for IRAs. Tax-Free Rollovers. Generally, rollovers and direct transfers may be made to and from SEPs and SAR/SEPs in the same manner as described above for IRAs, subject to the same conditions and limitations. Savings Incentive Match Plans for Employees (Simple Ira) Purchase Payments. Under Section 408(p) of the Code, employers may establish a type of IRA plan known as a Simple IRA. Employees may have contributions made to the SIMPLE IRA on a salary reduction basis. These salary reduction contributions may not exceed $6,000 in 1999, which is indexed for inflation. Total salary reduction contributions are limited to $10,000 per year for any employee who makes salary reduction contributions to more than one plan. Employers are required to contribute to the SIMPLE IRA, which contributions may not exceed the lesser of: (1) The amount of salary deferred by the employee, (2) 3% of the employee's compensation, or (3) $6,000, if the employer contributes on a matching basis; or the lesser of: (1) 2% of the employee's compensation, or (2) $3,200, if the employer makes non-elective contributions. An employer may not make contributions to both a SIMPLE IRA and another retirement plan for the same calendar year. Taxation of Distributions. Generally, distribution payments from SIMPLE IRAs are subject to the same distribution rules described above for IRAs, except that distributions made within two years of the date of an employee's first participation in a SIMPLE IRA of an employer are subject to a 25% penalty tax instead of the 10% penalty tax discussed previously. Required Distributions. SIMPLE IRAs are subject to the same minimum required distribution rules described above for IRAs. Tax-Free Rollovers. Direct transfers may be made among SIMPLE IRAs in the same manner as described above for IRAs, subject to the same conditions and limitations. Rollovers from SIMPLE IRAs are permitted after two years have elapsed from the date of an employee's first participation in a SIMPLE IRA of the employer. Rollovers to SIMPLE IRAs from other plans are not permitted. Report of Independent Auditors Board of Directors and Participants Principal Life Insurance Company We have audited the accompanying statement of net assets of Principal Life Insurance Company Separate Account B (comprising, respectively, the Aggressive Growth, Asset Allocation, Balanced, Bond, Capital Value [formerly Capital Accumulation], Government Securities, Growth, International [formerly World], MidCap [formerly Emerging Growth], and Money Market Divisions; and, beginning May 1, 1998 [date operations commenced], the International SmallCap, MicroCap, MidCap Growth, Real Estate, SmallCap, SmallCap Growth, SmallCap Value, and Utilities Divisions) as of December 31, 1998, and the related statements of operations for the year then ended, and changes in net assets for each of the two years in the period then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. Our procedures included confirmation of securities owned as of December 31, 1998, by correspondence with the transfer agent. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Principal Life Insurance Company Separate Account B at December 31, 1998, and the results of its operations for the year then ended, and the changes in its net assets for each of the two years in the period then ended, in conformity with generally accepted accounting principles. /s/ Ernst & Young LLP Des Moines, Iowa January 29, 1999 Principal Life Insurance Company Separate Account B Statement of Net Assets December 31, 1998 Assets Investments: Aggressive Growth Division: Aggressive Growth Account - 11,371,446 shares at net asset value of $18.33 per share (cost - $178,267,259) $ 208,438,611 Asset Allocation Division: Asset Allocation Account - 5,104,252 shares at net asset value of $12.30 per share (cost - $60,233,970) 62,782,299 Balanced Division: Balanced Account - 11,546,085 shares at net asset value of $16.25 per share (cost - $174,579,287) 187,623,872 Bond Division: Bond Account - 9,732,261 shares at net asset value of $12.02 per share (cost -$115,148,744) 116,981,771 Capital Value Division: Capital Value Account - 9,635,914 shares at net asset value of $37.19 per share (cost - $302,231,124) 358,359,614 Government Securities Division: Government Securities Account - 12,410,577 shares at net asset value of $11.01 per share (cost - $132,699,642) 136,640,443 Growth Division: Growth Account - 12,388,261 shares at net asset value of $20.46 per share (cost - $183,113,548) 253,463,838 International Division: International Account - 9,965,227 shares at net asset value of $14.51 per share (cost - $128,347,758) 144,595,446 International SmallCap Division: International SmallCap Account - 417,619 shares at net asset value of $9.00 per share (cost - $3,801,982) 3,758,570 MicroCap Division: MicroCap Account - 140,266 shares at net asset value of $8.17 per share (cost - $1,225,445) 1,145,974 MidCap Division: MidCap Account - 6,771,410 shares at net asset value of $34.37 per share (cost - $198,836,712) 232,733,374 MidCap Growth Division: MidCap Growth Account - 351,189 shares at net asset value of $9.65 per share (cost - $3,104,721) 3,388,971 Money Market Division: Money Market Account - 73,597,012 shares at net asset value of $1.00 per share (cost - $73,597,012) 73,597,012 See accompanying notes. Assets (continued) Real Estate Division: Real Estate Account - 199,858 shares at net asset value of $9.07 per share (cost - $1,857,915) $ 1,812,711 SmallCap Division: SmallCap Account - 442,796 shares at net asset value of $8.21 per share (cost - $3,515,041) 3,635,355 SmallCap Growth Division: SmallCap Growth Account - 316,865 shares at net asset value of $10.10 per share (cost - $2,744,450) 3,200,338 SmallCap Value Division: SmallCap Value Account - 309,231 shares at net asset value of $8.34 per share (cost - $2,559,608) 2,578,984 Utilities Division: Utilities Account - 670,534 shares at net asset value of $10.93 per share (cost - $6,711,416) 7,328,933 ====================== Net assets $1,802,066,116 ====================== Principal Life Insurance Company Separate Account B Statement of Net Assets (continued) December 31, 1998
Unit Units Value ------------------------ Net assets are represented by: Aggressive Growth Division: Contracts in accumulation period: The Principal Variable Annuity 7,485,637 $27.85 $208,438,611 Asset Allocation Division: Contracts in accumulation period: The Principal Variable Annuity 3,761,735 16.69 62,782,299 Balanced Division: Contracts in accumulation period: Personal Variable 2,321,229 1.77 4,109,836 Premier Variable 14,770,828 1.79 26,396,964 The Principal Variable Annuity 8,903,277 17.65 157,117,072 ------------ ------------ 187,623,872 Bond Division: Contracts in accumulation period: Personal Variable 765,780 1.47 1,126,185 Premier Variable 6,013,799 1.48 8,926,784 The Principal Variable Annuity 7,498,613 14.26 106,928,802 ------------ ------------ 116,981,771 Capital Value Division: Currently payable annuity contracts: Bankers Flexible Annuity 4,299 31.50 135,398 Pension Builder Plus - Rollover IRA 54,872 6.51 357,449 ------------ 492,847 Contracts in accumulation period: Bankers Flexible Annuity 221,262 31.50 6,970,904 Pension Builder Plus 1,288,464 5.88 7,572,342 Pension Builder Plus - Rollover IRA 293,222 6.51 1,907,883 Personal Variable 3,764,848 2.65 9,982,371 Premier Variable 22,328,019 2.69 60,046,505 The Principal Variable Annuity 11,720,185 23.16 271,386,762 ------------ 357,866,767 ------------ 358,359,614 Government Securities Division: Contracts in accumulation period: Pension Builder Plus 488,033 2.17 1,061,229 Pension Builder Plus - Rollover IRA 151,353 2.31 348,924 Personal Variable 1,953,940 1.52 2,973,074 Premier Variable 8,358,244 1.54 12,899,067 The Principal Variable Annuity 8,553,946 13.95 119,358,149 ------------ 136,640,443 Growth Division: Contracts in accumulation period: Personal Variable 2,232,330 2.13 4,744,796 Premier Variable 16,370,833 2.15 35,121,256 The Principal Variable Annuity 9,862,571 21.66 213,597,786 ------------ 253,463,838 See accompanying notes.
Unit Units Value ---------------------------- ---------------------------- Net assets are represented by: International Division: Contracts in accumulation period: Personal Variable 1,510,915 $1.65 $ 2,488,857 Premier Variable 9,442,447 1.66 15,699,547 The Principal Variable Annuity 7,865,745 16.07 126,407,042 -------------- 144,595,446 International SmallCap Division: Contracts in accumulation period: The Principal Variable Annuity 418,654 8.98 3,758,570 MicroCap Division: Contracts in accumulation period: The Principal Variable Annuity 141,369 8.11 1,145,974 MidCap Division: Contracts in accumulation period: Personal Variable 1,917,499 1.92 3,685,468 Premier Variable 12,204,415 1.94 23,677,140 The Principal Variable Annuity 10,738,428 19.12 205,370,766 -------------- 232,733,374 MidCap Growth Division: Contracts in accumulation period: The Principal Variable Annuity 352,022 9.63 3,388,971 Money Market Division: Contracts in accumulation period: Pension Builder Plus 369,783 1.96 723,423 Pension Builder Plus - Rollover IRA 10,667 2.05 21,829 Personal Variable 1,329,920 1.28 1,695,975 Premier Variable 9,868,681 1.30 12,764,651 The Principal Variable Annuity 4,904,753 11.91 58,391,134 -------------- 73,597,012 Real Estate Division: Contracts in accumulation period: The Principal Variable Annuity 195,435 9.28 1,812,711 SmallCap Division: Contracts in accumulation period: The Principal Variable Annuity 458,539 7.93 3,635,355 SmallCap Growth Division: Contracts in accumulation period: The Principal Variable Annuity 314,420 10.18 3,200,338 SmallCap Value Division: Contracts in accumulation period: The Principal Variable Annuity 305,572 8.44 2,578,984 Utilities Division: Contracts in accumulation period: The Principal Variable Annuity 639,299 11.46 7,328,933 ============== Net assets $1,802,066,116 ==============
Principal Life Insurance Company Separate Account B Statement of Operations Year ended December 31, 1998
Aggressive Asset Allocation Growth Division Division Combined -------------------------------------------------------- -------------------------------------------------------- Investment income Income: Dividends $ 35,563,154 $ 386,909 $1,492,404 Capital gains distributions 50,235,913 10,088,357 1,853,405 -------------------------------------------------------- -------------------------------------------------------- Total income 85,799,067 10,475,266 3,345,809 Expenses: Mortality and expense risks 17,696,159 2,218,045 702,097 Administration charges 552,069 116,130 7,655 Contingent sales charges 1,597,700 206,988 72,030 -------------------------------------------------------- -------------------------------------------------------- 19,845,928 2,541,163 781,782 -------------------------------------------------------- -------------------------------------------------------- Net investment income (loss) 65,953,139 7,934,103 2,564,027 Realized and unrealized gains (losses) on investments Net realized gains (losses) on investments 12,416,637 2,390,605 109,943 Change in net unrealized appreciation/ depreciation of investments 69,585,710 16,690,371 1,193,914 -------------------------------------------------------- ======================================================== Net increase (decrease) in net assets resulting from operations $147,955,486 $27,015,079 $3,867,884 ======================================================== See accompanying notes.
Capital Government Balanced Bond Value Securities Division Division Division Division ------------------------------------------------------------------------- ------------------------------------------------------------------------- Investment income Income: Dividends $ 5,238,471 $5,971,195 $ 6,429,904 $6,927,074 Capital gains distributions 5,863,051 62,033 12,255,065 - ------------------------------------------------------------------------- ------------------------------------------------------------------------- Total income 11,101,522 6,033,228 18,684,969 6,927,074 Expenses: Mortality and expense risks 1,755,460 1,099,671 3,396,860 1,319,686 Administration charges 38,695 15,794 174,201 29,797 Contingent sales charges 142,069 98,023 248,388 119,994 ------------------------------------------------------------------------- ------------------------------------------------------------------------- 1,936,224 1,213,488 3,819,449 1,469,477 ------------------------------------------------------------------------- ------------------------------------------------------------------------- Net investment income (loss) 9,165,298 4,819,740 14,865,520 5,457,597 Realized and unrealized gains (losses) on investments Net realized gains (losses) on investments 612,459 256,093 3,370,612 519,217 Change in net unrealized appreciation/ depreciation of investments 5,916,307 403,378 16,709,725 1,581,620 ------------------------------------------------------------------------- ------------------------------------------------------------------------- Net increase (decrease) in net assets resulting from operations $15,694,064 $5,479,211 $34,945,857 $7,558,434 =========================================================================
Growth International Division Division --------------------------------------- --------------------------------------- Investment income Income: Dividends $ 2,527,666 $2,324,284 Capital gains distributions 2,405,834 4,824,427 --------------------------------------- --------------------------------------- Total income 4,933,500 7,148,711 Expenses: Mortality and expense risks 2,326,505 1,572,370 Administration charges 70,201 22,222 Contingent sales charges 181,708 133,172 --------------------------------------- --------------------------------------- 2,578,414 1,727,764 --------------------------------------- --------------------------------------- Net investment income (loss) 2,355,086 5,420,947 Realized and unrealized gains (losses) on investments Net realized gains (losses) on investments 2,312,393 1,240,861 Change in net unrealized appreciation/ depreciation of investments 32,170,680 3,163,616 --------------------------------------- --------------------------------------- Net increase (decrease) in net assets resulting from operations $36,838,159 $9,825,424 =======================================
Principal Life Insurance Company Separate Account B Statement of Operations (continued) Year ended December 31, 1998
International MidCap SmallCap Division* MicroCap MidCap Growth Division* Division Division* ---------------------------------------------------------------------------- ---------------------------------------------------------------------------- Investment income Income: Dividends $ 9,794 $ 4,786 $ 1,368,645 $ - Capital gains distributions - - 12,883,741 - ---------------------------------------------------------------------------- ---------------------------------------------------------------------------- Total income 9,794 4,786 14,252,386 - Expenses: Mortality and expense risks 16,991 6,089 2,595,067 12,207 Administration charges 210 126 59,714 245 Contingent sales charges 87 378 249,206 1,273 ---------------------------------------------------------------------------- ---------------------------------------------------------------------------- 17,288 6,593 2,903,987 13,725 ---------------------------------------------------------------------------- ---------------------------------------------------------------------------- Net investment income (loss) (7,494) (1,807) 11,348,399 (13,725) Realized and unrealized gains (losses) on investments Net realized gains (losses) on investments (34,310) (30,669) 1,666,097 (8,805) Change in net unrealized appreciation/depreciation of investments (43,412) (79,471) (9,573,159) 284,250 ---------------------------------------------------------------------------- ============================================================================ Net increase (decrease) in net assets resulting from operations $(85,216) $(111,947) $ 3,441,337 $261,720 ============================================================================
Money SmallCap Growth SmallCap Value Market Division Real Estate SmallCap Division* Division* Division* Division* --------------------------------------------------------------------------------------------- --------------------------------------------------------------------------------------------- Investment income Income: Dividends $2,711,098 $53,265 $ 338 $ - $ 9,921 Capital gains distributions - - - - - --------------------------------------------------------------------------------------------- --------------------------------------------------------------------------------------------- Total income 2,711,098 53,265 338 - 9,921 Expenses: Mortality and expense risks 607,616 7,997 13,571 11,177 10,196 Administration charges 15,992 131 228 166 159 Contingent sales charges 142,955 193 87 338 303 --------------------------------------------------------------------------------------------- --------------------------------------------------------------------------------------------- 766,563 8,321 13,886 11,681 10,658 --------------------------------------------------------------------------------------------- --------------------------------------------------------------------------------------------- Net investment income (loss) 1,944,535 44,944 (13,548) (11,681) (737) Realized and unrealized gains (losses) on investments Net realized gains (losses) on investments - (1,854) (4,971) 1,417 (6,817) Change in net unrealized appreciation/depreciation of investments - (45,204) 120,314 455,888 19,376 --------------------------------------------------------------------------------------------- --------------------------------------------------------------------------------------------- Net increase (decrease) in net assets resulting from operations $1,944,535 $(2,114) $101,795 $445,624 $11,822 =============================================================================================
Utilities Division* ---------------- ---------------- Investment income Income: Dividends $107,400 Capital gains distributions - ---------------- ---------------- Total income 107,400 Expenses: Mortality and expense risks 24,554 Administration charges 403 Contingent sales charges 508 ---------------- ---------------- 25,465 ---------------- ---------------- Net investment income (loss) 81,935 Realized and unrealized gains (losses) on investments Net realized gains (losses) on investments 24,366 Change in net unrealized appreciation/depreciation of investments 617,517 ---------------- ---------------- Net increase (decrease) in net assets resulting from operations $723,818 ================ * Commenced operations May 1, 1998. See accompanying notes. Principal Life Insurance Company Separate Account B Statements of Changes in Net Assets
Aggressive Asset Growth Allocation Balanced Combined Division Division Division ------------------------------------------------------------------ Net assets at January 1, 1997 $ 806,097,603 $72,827,189 $30,022,679 $75,478,532 Increase (decrease) in net assets Operations: Net investment income 70,282,286 16,875,413 4,939,230 9,943,711 Net realized gains on investments 5,671,902 464,006 63,749 453,888 Change in net unrealized appreciation/ depreciation of investments 102,587,382 9,210,372 744,626 4,610,751 ------------------------------------------------------------------ ------------------------------------------------------------------ Net increase in net assets resulting from 178,541,570 26,549,791 5,747,605 15,008,350 operations Changes from principal transactions: Purchase payments, less sales charges, per payment fees and applicable premium taxes 627,937,841 59,917,348 16,705,667 53,714,866 Contract terminations (55,874,169) (3,178,242) (1,163,611) (4,281,984) Death benefit payments (4,316,597) (405,803) (51,804) (958,828) Flexible withdrawal option payments (7,524,649) (555,143) (424,697) (1,011,471) Transfer payments to other contracts (256,636,172) (11,197,324) (2,323,881) (10,850,210) Annuity payments (42,217) - - - ------------------------------------------------------------------ ------------------------------------------------------------------ Increase (decrease) in net assets from principal transactions 303,544,037 44,580,836 12,741,674 36,612,373 ------------------------------------------------------------------ ------------------------------------------------------------------ Total increase 482,085,607 71,130,627 18,489,279 51,620,723 ------------------------------------------------------------------ ------------------------------------------------------------------ Net assets at December 31, 1997 1,288,183,210 143,957,816 48,511,958 127,099,255 Increase (decrease) in net assets Operations: Net investment income (loss) 65,953,139 7,934,103 2,564,027 9,165,298 Net realized gains (losses) on investments 12,416,637 2,390,605 109,943 612,459 Change in net unrealized appreciation/ depreciation of investments 69,585,710 16,690,371 1,193,914 5,916,307 ------------------------------------------------------------------ Net increase (decrease) in net assets resulting from operations 147,955,486 27,015,079 3,867,884 15,694,064 Changes from principal transactions: Purchase payments, less sales charges, per payment fees and applicable premium taxes 880,179,184 89,426,487 20,700,753 75,135,480 Contract terminations (82,987,332) (7,493,332) (2,607,601) (7,275,303) Death benefit payments (6,720,662) (574,590) (356,750) (782,491) Flexible withdrawal option payments (13,530,855) (1,052,669) (647,508) (2,009,052) Transfer payments to other contracts (410,965,015) (42,840,180) (6,686,437) (20,238,081) Annuity payments (47,900) - - - ------------------------------------------------------------------ Increase (decrease) in net assets from principal transactions 365,927,420 37,465,716 10,402,457 44,830,553 ------------------------------------------------------------------ Total increase 513,882,906 64,480,795 14,270,341 60,524,617 ================================================================== Net assets at December 31, 1998 $1,802,066,116 $208,438,611 $62,782,299 $187,623,872 ================================================================== * Commenced operations May 1, 1998. See accompanying notes.
Government Capital Value Securities Growth Bond Division Division Division Division ------------------------------------------------------------------ Net assets at January 1, 1997 $ 51,156,727 $164,206,061 $ 80,421,152 $ 98,430,386 Increase (decrease) in net assets Operations: Net investment income 3,568,462 20,413,652 4,278,724 1,112,338 Net realized gains on investments 110,974 2,848,843 274,681 452,453 Change in net unrealized appreciation/ depreciation of investments 1,830,541 27,562,078 2,797,737 27,128,828 ------------------------------------------------------------------ Net increase in net assets resulting from operations 5,509,977 50,824,573 7,351,142 28,693,619 Changes from principal transactions: Purchase payments, less sales charges, per payment fees and applicable premium taxes 29,283,340 88,457,676 25,613,735 53,502,269 Contract terminations (2,130,683) (18,056,258) (5,656,444) (4,866,079) Death benefit payments (265,662) (501,663) (615,089) (543,121) Flexible withdrawal option payments (880,841) (965,075) (1,128,199) (731,944) Transfer payments to other contracts (9,182,990) (14,671,351) (13,132,281) (8,671,205) Annuity payments - (42,217) - - ------------------------------------------------------------------ ------------------------------------------------------------------ Increase (decrease) in net assets from principal transactions 16,823,164 54,221,112 5,081,722 38,689,920 ------------------------------------------------------------------ ------------------------------------------------------------------ Total increase 22,333,141 105,045,685 12,432,864 67,383,539 ------------------------------------------------------------------ ------------------------------------------------------------------ Net assets at December 31, 1997 73,489,868 269,251,746 92,854,016 165,813,925 Increase (decrease) in net assets Operations: Net investment income (loss) 4,819,740 14,865,520 5,457,597 2,355,086 Net realized gains (losses) on investments 256,093 3,370,612 519,217 2,312,393 Change in net unrealized appreciation/ depreciation of investments 403,378 16,709,725 1,581,620 32,170,680 ------------------------------------------------------------------ Net increase (decrease) in net assets resulting from operations 5,479,211 34,945,857 7,558,434 36,838,159 Changes from principal transactions: Purchase payments, less sales charges, per payment fees and applicable premium taxes 58,231,814 104,873,017 63,571,935 84,755,953 Contract terminations (4,182,861) (20,291,443) (6,906,897) (9,260,589) Death benefit payments (501,389) (1,069,753) (712,491) (806,053) Flexible withdrawal option payments (1,522,331) (2,067,909) (1,740,621) (1,381,999) Transfer payments to other contracts (14,012,541) (27,234,001) (17,983,933) (22,495,558) Annuity payments - (47,900) - - ------------------------------------------------------------------ Increase (decrease) in net assets from principal transactions 38,012,692 54,162,011 36,227,993 50,811,754 ------------------------------------------------------------------ Total increase 43,491,903 89,107,868 43,786,427 87,649,913 ------------------------------------------------------------------ Net assets at December 31, 1998 $116,981,771 $358,359,614 $136,640,443 $253,463,838 ================================================================== * Commenced operations May 1, 1998. See accompanying notes.
International International SmallCap Divisional Division* ------------------------------- Net assets at January 1, 1997 $ 70,528,972 $ - Increase (decrease) in net assets Operations: Net investment income 4,371,904 - Net realized gains on investments 495,943 - Change in net unrealized appreciation/ depreciation of investments 2,593,492 - ------------------------------- Net increase in net assets resulting from operations 7,461,339 - Changes from principal transactions: Purchase payments, less sales charges, per payment fees and applicable premium taxes 57,394,881 - Contract terminations (3,938,573) - Death benefit payments (333,151) - Flexible withdrawal option payments (438,591) - Transfer payments to other contracts (9,238,723) - Annuity payments - - ------------------------------- ------------------------------- Increase (decrease) in net assets from principal transactions 43,445,843 - ------------------------------- ------------------------------- Total increase 50,907,182 ------------------------------- ------------------------------- Net assets at December 31, 1997 121,436,154 - Increase (decrease) in net assets Operations: Net investment income (loss) 5,420,947 (7,494) Net realized gains (losses) on investments 1,240,861 (34,310) Change in net unrealized appreciation/ depreciation of investments 3,163,616 (43,412) ------------------------------- Net increase (decrease) in net assets resulting from operations 9,825,424 (85,216) Changes from principal transactions: Purchase payments, less sales charges, per payment fees and applicable premium taxes 43,354,442 4,389,570 Contract terminations (6,288,874) (3,166) Death benefit payments (361,156) - Flexible withdrawal option payments (842,431) (8,380) Transfer payments to other contracts (22,528,113) (534,238) Annuity payments - - ------------------------------- Increase (decrease) in net assets from principal transactions 13,333,868 3,843,786 ------------------------------- Total increase 23,159,292 3,758,570 ------------------------------- Net assets at December 31, 1998 $144,595,446 $3,758,570 =============================== * Commenced operations May 1, 1998. See accompanying notes.
Principal Life Insurance Company Separate Account B Statements of Changes in Net Assets (continued)
MidCap Money MicroCap MidCap Growth Market Division* Division Division* Division ----------------------------------------------------------------- Net assets at January 1, 1997 $ $122,287,543 $ $40,738,362 Increase (decrease) in net assets Operations: Net investment income - 3,233,729 - 1,545,123 Net realized gains on investments - 507,365 - - Change in net unrealized appreciation/ depreciation of investments - 26,108,957 - - ----------------------------------------------------------------- ----------------------------------------------------------------- Net increase in net assets resulting from - 29,850,051 - 1,545,123 operations Changes from principal transactions: Purchase payments, less sales charges, per payment fees and applicable premium taxes - 71,186,197 - 172,161,862 Contract terminations - (6,477,064) - (6,125,231) Death benefit payments - (451,603) - (189,873) Flexible withdrawal option payments - (790,604) - (598,084) Transfer payments to other contracts - (11,516,457) - (165,851,750) Annuity payments - - - - ----------------------------------------------------------------- ----------------------------------------------------------------- Increase (decrease) in net assets from principal transactions - 51,950,469 - (603,076) ------------------------------------------------------------------ ------------------------------------------------------------------ Total increase - 81,800,520 - 942,047 ------------------------------------------------------------------ ------------------------------------------------------------------ Net assets at December 31, 1997 - 204,088,063 - 41,680,409 Increase (decrease) in net assets Operations: Net investment income (loss) (1,807) 11,348,399 (13,725) 1,944,535 Net realized gains (losses) on investments (30,669) 1,666,097 (8,805) - Change in net unrealized appreciation/ depreciation of investments (79,471) (9,573,159) 284,250 - ------------------------------------------------------------------ Net increase (decrease) in net assets resulting from operations (111,947) 3,441,337 261,720 1,944,535 Changes from principal transactions: Purchase payments, less sales charges, per payment fees and applicable premium taxes 1,525,355 66,169,872 3,381,739 245,196,048 Contract terminations (13,672) (11,333,222) (46,096) (7,232,550) Death benefit payments - (893,824) - (658,257) Flexible withdrawal option payments (764) (1,395,916) (5,134) (797,929) Transfer payments to other contracts (252,998) (27,342,936) (203,258) (206,535,244) ------------------------------------------------------------------ Increase (decrease) in net assets from principal transactions 1,257,921 25,203,974 3,127,251 29,972,068 ------------------------------------------------------------------ Total increase 1,145,974 28,645,311 3,388,971 31,916,603 ================================================================== Net assets at December 31, 1998 $1,145,974 $232,733,374 $3,388,971 $73,597,012 ================================================================== * Commenced operations May 1, 1998. See accompanying notes.
SmallCap Real Estate SmallCap Growth SmallCap Value Division* Division* Division* Division* ------------------------------------------------------------------------ Net assets at January 1, 1997 $ - $ - $ - $ - Increase (decrease) in net assets Operations: Net investment income - - - - Net realized gains on investments - - - - Change in net unrealized appreciation/ depreciation of investments - - - - Net increase in net assets resulting from operations - - - - Changes from principal transactions: Purchase payments, less sales charges, per payment fees and applicable premium taxes - - - - Contract terminations - - - - Death benefit payments - - - - Flexible withdrawal option payments - - - - Transfer payments to other contracts - - - - Annuity payments - - - - ------------------------------------------------------------------------ Increase (decrease) in net assets from principal transactions - - - - ------------------------------------------------------------------------ Total increase - - - - ------------------------------------------------------------------------ Net assets at December 31, 1997 - - - - Increase (decrease) in net assets Operations: Net investment income (loss) 44,944 (13,548) (11,681) (737) Net realized gains (losses) on investments (1,854) (4,971) 1,417 (6,817) Change in net unrealized appreciation/ depreciation of investments (45,204) 120,314 455,888 19,376 ------------------------------------------------------------------------ Net increase (decrease) in net assets resulting from operations (2,114) 101,795 445,624 11,822 Changes from principal transactions: Purchase payments, less sales charges, per payment fees and applicable premium taxes 1,979,207 3,787,231 3,229,155 2,802,830 Contract terminations (6,972) (3,155) (12,246) (10,976) Death benefit payments - - (3,908) - Flexible withdrawal option payments (4,598) (9,905) (1,997) (9,311) Transfer payments to other contracts (152,812) (240,611) (456,290) (215,381) ------------------------------------------------------------------------ Increase (decrease) in net assets from principal transactions 1,814,825 3,533,560 2,754,714 2,567,162 ------------------------------------------------------------------------ Total increase 1,812,711 3,635,355 3,200,338 2,578,984 ------------------------------------------------------------------------ Net assets at December 31, 1998 $1,812,711 $3,635,355 $3,200,338 $2,578,984 ======================================================================== * Commenced operations May 1, 1998. See accompanying notes.
Utilities Division* ------------------- Net assets at January 1, 1997 $ - Increase (decrease) in net assets Operations: Net investment income - Net realized gains on investments - Change in net unrealized appreciation/ depreciation of investments - Net increase in net assets resulting from operations - Changes from principal transactions: Purchase payments, less sales charges, per payment fees and applicable premium taxes - Contract terminations - Death benefit payments - Flexible withdrawal option payments - Transfer payments to other contracts - Annuity payments - ------------------- Increase (decrease) in net assets from principal transactions - ------------------- Total increase - ------------------- Net assets at December 31, 1997 - Increase (decrease) in net assets Operations: Net investment income (loss) 81,935 Net realized gains (losses) on investments 24,366 Change in net unrealized appreciation/ depreciation of investments 617,517 ------------------- Net increase (decrease) in net assets resulting from operations 723,818 Changes from principal transactions: Purchase payments, less sales charges, per payment fees and applicable premium taxes 7,668,296 Contract terminations (18,377) Death benefit payments - Flexible withdrawal option payments (32,401) Transfer payments to other contracts (1,012,403) ------------------- Increase (decrease) in net assets from principal transactions 6,605,115 ------------------- Total increase 7,328,933 ------------------- Net assets at December 31, 1998 $7,328,933 =================== * Commenced operations May 1, 1998. See accompanying notes. Principal Life Insurance Company Separate Account B Notes to Financial Statements December 31, 1998 1. Investment and Accounting Policies Principal Life Insurance Company Separate Account B (Separate Account B) is a segregated investment account of Principal Life Insurance Company (Principal Life, formerly Principal Mutual Life Insurance Company) and is registered under the Investment Company Act of 1940 as a unit investment trust, with no stated limitations on the number of authorized units. As directed by eligible contractholders, each division of Separate Account B invests exclusively in shares representing interests in a corresponding investment option. As of December 31, 1998, contractholder investment options include the following accounts of Principal Variable Contracts Fund, Inc., a diversified open-end management investment company, organized by Principal Life: Aggressive Growth Account, Asset Allocation Account, Balanced Account, Bond Account, Capital Value Account, Government Securities Account, Growth Account, International Account, International SmallCap Account, MicroCap Account, MidCap Account, MidCap Growth Account, Money Market Account, Real Estate Account, SmallCap Account, SmallCap Growth Account, SmallCap Value Account, and Utilities Account. Investments are stated at the closing net asset values per share on December 31, 1998. The Principal Variable Contracts Fund, Inc. (the Fund) was formed on January 1, 1998. Prior to that date, the accounts of the Fund were reported as separate mutual funds. This reorganization resulted in changes to the names of the following investment options:
Former Name Name Subsequent to Reorganization - -------------------------------------------- --------------------------------- Principal Aggressive Growth Fund, Inc. Aggressive Growth Account Principal Asset Allocation Fund, Inc. Asset Allocation Account Principal Balanced Fund, Inc. Balanced Account Principal Bond Fund, Inc. Bond Account Principal Capital Accumulation Fund, Inc. Capital Accumulation Account Principal Emerging Growth Fund, Inc. Emerging Growth Account Principal Government Securities Fund, Inc. Government Securities Account Principal Growth Fund, Inc. Growth Account Principal High Yield Fund, Inc. High Yield Account Principal Money Market Fund, Inc. Money Market Account Principal World Fund, Inc. World Account Effective May 1, 1998, the following names within the Principal Variable Contracts Fund, Inc. were changed:
Former Name Name as Changed - -------------------------------------------- --------------------------------- Capital Accumulation Account Capital Value Account Emerging Growth Account MidCap Account World Account International Account
Principal Life Insurance Company Separate Account B Notes to Financial Statements (continued) 1. Investment and Accounting Policies (continued) On May 1, 1998, Principal Life increased contractholder investment options to include: Principal Variable Contracts Fund, Inc. International SmallCap Account, MicroCap Account, MidCap Growth Account, Real Estate Account, SmallCap Account, SmallCap Growth Account, SmallCap Value Account and Utilities Account. Contributions to the Personal Variable contracts are no longer accepted from new customers, only from existing customers beginning January 1, 1998. Effective July 1, 1998, Principal Mutual Life Insurance Company (the Company) formed a mutual insurance holding company and converted to a stock life insurance company. With the conversion, the Company's name was changed to Principal Life Insurance Company. The average cost method is used to determine realized gains and losses on investments. Dividends are taken into income on an accrual basis as of the ex-dividend date. Use of Estimates in the Preparation of Financial Statements The preparation of Separate Account B's financial statements and accompanying notes requires management to make estimates and assumptions that affect the amounts reported and disclosed. These estimates and assumptions could change in the future as more information becomes known, which could impact the amounts reported and disclosed in the financial statements and accompanying notes. 2. Expenses Principal Life is compensated for the following expenses: Bankers Flexible Annuity Contracts - Mortality and expense risks assumed by Principal Life are compensated for by a charge equivalent to an annual rate of 0.48% of the asset value of each contract. An annual administration charge of $7 for each participant's account is deducted as compensation for administrative expenses. The mortality and expense risk and annual administration charges amounted to $35,161 and $1,092, respectively, during the year ended December 31, 1998. Pension Builder Plus and Pension Builder Plus - Rollover IRA Contracts - Mortality and expense risks assumed by Principal Life are compensated for by a charge equivalent to an annual rate of 1.4965% (1.0001% for a Rollover Individual Retirement Annuity) of the asset value of each contract. A contingent sales charge of up to 7% may be deducted from withdrawals made during the first 10 years of a contract, except for death or permanent disability. An annual administration charge will be deducted ranging from a minimum of $25 to a maximum of $275 depending upon a participant's investment account values and the number of participants under the retirement plan and their participant investment account value. The charges for mortality and expense risks, contingent sales, and annual administration amounted to $180,477, $1,389, and $58,703, respectively, during the year ended December 31, 1998. Personal Variable Contracts - Mortality and expense risks assumed by Principal Life are compensated for by a charge equivalent to an annual rate of 0.64% of the asset value of each contract. A contingent sales charge of up to 5% may be deducted from withdrawals from an investment account during the first seven years from the date the first contribution which relates to such participant is accepted by Principal Life. This charge does not apply to withdrawals made from investment accounts which correlate to a plan participant as a result of the plan participant's death or permanent disability. An annual administration charge of $31 for each participant's account plus 0.35% of the annual average balance of investment account values which correlate to a plan participant will be deducted on a quarterly basis. The charges for mortality and expense risks, contingent sales and annual administration amounted to $170,640, $46,976, and $59,111, respectively, during the year ended December 31, 1998. Premier Variable Contracts - Mortality and expense risks assumed by Principal Life are compensated for by a charge equivalent to an annual rate of 0.42% of the asset value of each contract. An annual administration charge of $300 for each contract account plus .35% of the annual average balance of investment account values under the contract will be billed or deducted on a quarterly basis. The charges for mortality expense risks and annual administration amounted to $722,455 and $16,533, respectively, during the year ended December 31, 1998. There were no contingent sales charges provided for in these contracts. The Principal Variable Annuity - Mortality and expense risks assumed by Principal Life are compensated for by a charge equivalent to an annual rate of 1.25% of the asset value of each contract. A contingent sales charge of up to 6% may be deducted from the withdrawals made during the first six years of a contract, except for death, annuitization, permanent disability, confinement in a health care facility, or terminal illness. An annual administration charge of the lessor of two percent of the accumulated value or $30 is deducted at the end of the contract year. Principal Life reserves the right to charge an additional administrative fee of up to 0.15% of the asset value of each Division. This fee is currently being waived. The mortality expense risks, contingent sales, and annual administration amounted to $16,587,426, $1,549,335, and $416,630, respectively, during the year ended December 31, 1998. 3. Federal Income Taxes The operations of Separate Account B are a part of the operations of Principal Life. Under current practice, no federal income taxes are allocated by Principal Life to the operations of Separate Account B. 4. Purchases and Sales of Investment Securities The aggregate units and cost of purchases and proceeds from sales of investments were as follows:
Year ended December 31, 1998 -------------------------------------------------------------------------- Units Amount Units Amount Purchased Purchased Redeemed Redeemed -------------------------------------------------------------------------- Aggressive Growth Division: The Principal Variable Annuity 3,499,221 $99,901,754 2,090,432 $54,501,935 Asset Allocation Division: The Principal Variable Annuity 1,282,525 24,046,561 654,896 11,080,077 Balanced Division: Personal Variable 1,004,328 1,912,930 457,683 780,708 Premier Variable 10,422,806 19,013,537 6,268,556 10,551,964 The Principal Variable Annuity 3,344,124 65,310,536 1,158,043 20,908,480 -------------------------------------------------------------------------- 14,771,258 86,237,003 7,884,282 32,241,152 Bond Division: Personal Variable 483,609 749,413 204,963 298,308 Premier Variable 3,340,901 5,252,870 1,335,734 1,947,955 The Principal Variable Annuity 3,782,130 58,262,756 1,300,729 19,186,344 -------------------------------------------------------------------------- 7,606,640 64,265,039 2,841,426 21,432,607 Capital Value Division: Bankers Flexible Annuity - 378,745 33,142 1,019,158 Pension Builder Plus 12,400 489,669 347,496 2,079,127 Pension Builder - Rollover 13,394 206,030 61,664 413,253 Personal Variable 1,028,159 3,098,635 706,659 1,805,819 Premier Variable 6,692,409 20,064,223 5,703,586 14,753,134 The Principal Variable Annuity 3,851,690 99,320,683 1,451,484 34,459,963 -------------------------------------------------------------------------- 11,598,052 123,557,985 8,304,031 54,530,454 Government Securities Division: Pension Builder Plus 2,440 59,890 144,796 323,157 Pension Builder - Rollover 6,075 31,150 46,361 105,763 Personal Variable 533,981 932,430 395,901 592,463 Premier Variable 3,808,301 6,299,202 3,136,542 4,703,918 The Principal Variable Annuity 4,224,663 63,176,336 1,616,290 23,088,117 -------------------------------------------------------------------------- 8,575,460 70,499,008 5,339,890 28,813,418 Growth Division: Personal Variable 1,056,605 $ 2,120,837 399,346 $ 785,794 Premier Variable 9,492,310 19,278,673 4,562,959 9,075,786 The Principal Variable Annuity 3,220,065 68,289,943 1,255,802 26,661,033 -------------------------------------------------------------------------- 13,768,980 89,689,453 6,218,107 36,522,613 International Division: Personal Variable 805,432 1,415,902 308,660 500,015 Premier Variable 4,733,201 8,515,990 2,974,704 4,950,251 The Principal Variable Annuity 2,153,106 40,571,261 1,603,148 26,298,072 -------------------------------------------------------------------------- 7,691,739 50,503,153 4,886,512 31,748,338 International SmallCap Division: The Principal Variable Annuity 483,237 4,399,364 64,583 563,072 MicroCap Division: The Principal Variable Annuity 175,619 1,530,140 34,250 274,026 MidCap Division: Personal Variable 879,026 1,880,837 439,232 851,883 Premier Variable 5,642,259 12,250,222 2,973,492 5,798,868 The Principal Variable Annuity 2,793,284 66,291,200 1,875,347 37,219,135 -------------------------------------------------------------------------- 9,314,569 80,422,259 5,288,071 43,869,886 MidCap Growth Division: The Principal Variable Annuity 381,976 3,381,739 29,954 268,213 Money Market Division: Pension Builder Plus 53,479 135,725 102,745 203,381 Pension Builder - Rollover 1,336 3,925 6,405 13,015 Personal Variable 3,575,718 4,528,715 3,302,133 4,121,381 Premier Variable 48,477,115 61,598,188 45,123,308 56,876,964 The Principal Variable Annuity 15,337,299 181,640,592 13,184,712 154,775,801 -------------------------------------------------------------------------- 67,444,947 247,907,145 61,719,303 215,990,542 Real Estate Division: The Principal Variable Annuity 213,750 2,032,472 18,315 172,703 SmallCap Division: The Principal Variable Annuity 492,217 $ 3,787,569 33,678 $ 267,557 SmallCap Growth Division: The Principal Variable Annuity 368,419 3,229,155 53,999 486,122 SmallCap Value Division: The Principal Variable Annuity 334,867 2,812,751 29,295 246,326 Utilities Division: The Principal Variable Annuity 741,204 7,775,696 101,905 1,088,646 --------------------------------------------------------------------------- =========================================================================== 148,744,680 $965,978,246 105,592,929 $534,097,687 ===========================================================================
Year ended December 31, 1997 -------------------------------------------------------------------------- Units Amount Units Amount Purchased Purchased Redeemed Redeemed -------------------------------------------------------------------------- Aggressive Growth Division: The Principal Variable Annuity 2,866,842 $ 78,258,746 760,825 $ 16,802,497 Asset Allocation Division: The Principal Variable Annuity 1,151,186 22,167,226 281,079 4,486,322 Balanced Division: Personal Variable 1,121,294 1,881,609 362,119 541,564 Premier Variable 6,824,153 11,562,751 3,674,287 5,395,069 The Principal Variable Annuity 2,815,600 51,420,018 759,885 12,371,661 --------------------------------------------------------------------------- 10,761,047 64,864,378 4,796,291 18,308,294 Bond Division: Personal Variable 345,135 485,073 132,143 174,058 Premier Variable 2,547,619 3,651,845 1,151,236 1,516,914 The Principal Variable Annuity 2,004,124 29,486,187 858,968 11,540,507 --------------------------------------------------------------------------- 4,896,878 33,623,105 2,142,347 13,231,479 Capital Value Division: Bankers Flexible Annuity - 683,529 29,544 773,974 Pension Builder Plus 68,140 1,235,130 1,982,927 8,819,318 Pension Builder Plus - Rollover IRA 1,995 221,006 181,779 925,026 Personal Variable 1,387,651 3,539,847 858,885 1,776,616 Premier Variable 8,035,489 21,108,357 4,658,141 9,954,051 The Principal Variable Annuity 3,744,285 84,607,543 691,613 14,511,663 --------------------------------------------------------------------------- 13,237,560 111,395,412 8,402,889 36,760,648 Government Securities Division: Pension Builder Plus 23,169 $ 118,925 570,707 $ 1,099,325 Pension Builder Plus - Rollover IRA 617 24,244 208,339 426,973 Personal Variable 633,713 990,854 754,202 1,021,076 Premier Variable 2,966,089 4,655,507 2,792,797 3,804,557 The Principal Variable Annuity 1,669,224 25,164,798 1,166,357 15,241,951 -------------------------------------------------------------------------- 5,292,812 30,954,328 5,492,402 21,593,882 Growth Division: Personal Variable 1,072,567 1,734,898 311,356 500,397 Premier Variable 7,226,323 11,858,111 2,587,048 4,197,408 The Principal Variable Annuity 2,442,934 42,661,389 633,196 11,754,335 -------------------------------------------------------------------------- 10,741,824 56,254,398 3,531,600 16,452,140 International Division: Personal Variable 759,933 1,208,340 233,106 354,907 Premier Variable 5,217,093 8,423,719 1,831,269 2,787,221 The Principal Variable Annuity 3,256,925 53,417,398 738,451 12,089,582 -------------------------------------------------------------------------- 9,233,951 63,049,457 2,802,826 15,231,710 MidCap Division: Personal Variable 979,972 1,752,787 332,091 581,993 Premier Variable 6,044,928 10,752,356 2,231,491 3,852,324 The Principal Variable Annuity 3,406,355 64,056,027 870,634 16,942,655 -------------------------------------------------------------------------- 10,431,255 76,561,170 3,434,216 21,376,972 Money Market Division: Pension Builder Plus 285,405 558,229 456,641 845,039 Pension Builder Plus - Rollover IRA 2,628 7,254 13,813 27,122 Personal Variable 6,785,344 8,146,664 6,570,220 7,839,434 Premier Variable 32,145,080 39,119,749 31,009,540 37,413,932 The Principal Variable Annuity 11,093,609 126,422,118 11,270,301 127,186,440 -------------------------------------------------------------------------- 50,312,066 174,254,014 49,320,515 173,311,967 -------------------------------------------------------------------------- 118,925,421 $711,382,234 80,964,990 $337,555,911 ==========================================================================
Purchases include reinvested dividends and capital gains. Mortality adjustments are included in purchases and redemptions, as applicable. Money Market purchases include transactions where investment allocations are not known at the time of the deposit. Redemptions reflect subsequent allocations to directed investment divisions. Principal Life Insurance Company Separate Account B Notes to Financial Statements (continued) 5. Net Assets Net assets at December 31, 1998 consisted of the following:
Net Unrealized Accumulated Appreciation Unit Net Investment (Depreciation) Combined Transactions Income of Investments ---------------------------------------------------------------------- Aggressive Growth Division: The Principal Variable Annuity $ 208,438,611 $ 154,950,165 $ 23,317,094 $30,171,352 Asset Allocation Division: The Principal Variable Annuity 62,782,299 52,071,898 8,162,072 2,548,329 Balanced Division: Personal Variable 4,109,836 3,683,235 176,085 250,516 Premier Variable 26,396,964 23,899,032 1,049,822 1,448,110 The Principal Variable Annuity 157,117,072 128,451,709 17,319,404 11,345,959 ---------------------------------------------------------------------- 187,623,872 156,033,976 18,545,311 13,044,585 Bond Division: Personal Variable 1,126,185 1,087,120 38,350 715 Premier Variable 8,926,784 8,466,508 345,446 114,830 The Principal Variable Annuity 106,928,802 96,980,945 8,230,375 1,717,482 ---------------------------------------------------------------------- 116,981,771 106,534,573 8,614,171 1,833,027 Capital Value Division: Bankers Flexible Annuity 7,106,302 4,287,364 302,409 2,516,529 Pension Builder Plus 7,572,342 5,238,165 203,355 2,130,822 Pension Builder Plus - Rollover IRA 2,265,332 1,545,362 77,147 642,823 Personal Variable 9,982,371 7,863,505 364,464 1,754,402 Premier Variable 60,046,505 46,288,705 2,283,433 11,474,367 The Principal Variable Annuity 271,386,762 202,044,892 31,732,323 37,609,547 ---------------------------------------------------------------------- 358,359,614 267,267,993 34,963,131 56,128,490 Government Securities Division: Pension Builder Plus 1,061,229 972,846 24,160 64,223 Pension Builder Plus - Rollover IRA 348,924 320,834 10,126 17,964 Personal Variable 2,973,074 2,765,554 103,654 103,866 Premier Variable 12,899,067 12,039,838 443,589 415,640 The Principal Variable Annuity 119,358,149 106,682,124 9,336,917 3,339,108 ---------------------------------------------------------------------- 136,640,443 122,781,196 9,918,446 3,940,801 Growth Division: Personal Variable 4,744,796 3,647,573 44,149 1,053,074 Premier Variable 35,121,256 27,146,937 433,857 7,540,462 The Principal Variable Annuity 213,597,786 148,732,392 3,108,640 61,756,754 ---------------------------------------------------------------------- 253,463,838 179,526,902 3,586,646 70,350,290 International Division: Personal Variable $ 2,488,857 $ 2,290,386 $ 84,381 $ 114,090 Premier Variable 15,699,547 14,099,541 531,420 1,068,586 The Principal Variable Annuity 126,407,042 103,577,125 7,764,905 15,065,012 ---------------------------------------------------------------------- 144,595,446 119,967,052 8,380,706 16,247,688 International SmallCap Division The Principal Variable Annuity 3,758,570 3,808,226 (6,244) (43,412) MicroCap Division The Principal Variable Annuity 1,145,974 1,226,493 (1,048) (79,471) MidCap Division: Personal Variable 3,685,468 3,250,816 155,802 278,850 Premier Variable 23,677,140 20,357,568 1,066,985 2,252,587 The Principal Variable Annuity 205,370,766 161,654,058 12,351,483 31,365,225 ---------------------------------------------------------------------- 232,733,374 185,262,442 13,574,270 33,896,662 MidCap Growth Division The Principal Variable Annuity 3,388,971 3,115,968 (11,247) 284,250 Money Market Division: Pension Builder Plus 723,423 704,183 19,240 - Pension Builder Plus - Rollover IRA 21,829 21,296 533 - Personal Variable 1,695,975 1,678,764 17,211 - Premier Variable 12,764,651 12,678,626 86,025 - The Principal Variable Annuity 58,391,134 57,893,036 498,098 - ---------------------------------------------------------------------- 73,597,012 72,975,905 621,107 - Real Estate Division: The Principal Variable Annuity 1,812,711 1,816,371 41,544 (45,204) SmallCap Division: The Principal Variable Annuity 3,635,355 3,527,366 (12,325) 120,314 SmallCap Growth Division The Principal Variable Annuity 3,200,338 2,753,982 (9,532) 455,888 SmallCap Value Division The Principal Variable Annuity 2,578,984 2,559,859 (251) 19,376 Utilities Division The Principal Variable Annuity 7,328,933 6,639,682 71,734 617,517 ====================================================================== $1,802,066,116 $1,442,820,049 $129,755,585 $229,490,482 ======================================================================
Principal Life Insurance Company Separate Account B Notes to Financial Statements (continued) 6. Year 2000 Issues (Unaudited) Like other investment funds, financial and business organizations and individuals around the world, Separate Account B could be adversely affected if the computer systems used by Principal Life and other service providers do not properly process and calculate date-related information and data from and after January 1, 2000. In 1995, Principal Life began investigating the potential impact of the Year 2000 on its systems, procedures, customers and business processes. The Year 2000 assessment that was completed in 1996 provided information used to determine what system components must be changed or replaced to minimize the impact of the calendar change from 1999 to 2000. Principal Life will continue to use internal and external resources to modify, replace and test its systems. Management estimates 100% of the identified modifications to mission critical systems and 99% of the identified modifications to other systems have been completed for its Year 2000 project. The project completion is scheduled to occur prior to any anticipated impact on Principal Life's operations. Principal Life and Separate Account B face the risk that one or more of its critical suppliers or customers (external relationships) will not be able to interact with them due to the third party's inability to resolve its own Year 2000 issues. Principal Life has completed its inventory of external relationships and is attempting to determine the overall Year 2000 readiness of its external relationships. Principal Life is engaged in discussions with the third parties and is requesting information as to those parties' Year 2000 plans and state of readiness. Principal Life, however, does not have sufficient information at the current time to predict whether all of its external relationships will be Year 2000 ready. While Principal Life believes that it has addressed its Year 2000 concerns, Principal Life has begun to develop contingency/recovery plans aimed at ensuring the continuity of critical business functions before, on and after December 31, 1999. Principal Life expects contingency/recovery planning to be substantially complete by April 1, 1999. The Year 2000 contingency plans will be reviewed periodically throughout 1999 and revised as needed. Principal Life believes its Year 2000 contingency plans coupled with existing "disaster recovery" and "business resumption" plans minimize the impact Year 2000 issues may have on the organization. Report of Independent Auditors The Board of Directors Principal Life Insurance Company We have audited the accompanying consolidated statements of financial position of Principal Life Insurance Company (the Company, an indirect wholly-owned subsidiary of Principal Mutual Holding Company), formerly Principal Mutual Life Insurance Company, as of December 31, 1998 and 1997, and the related consolidated statements of operations, stockholder's equity and cash flows for each of the three years in the period ended December 31, 1998. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Principal Life Insurance Company at December 31, 1998 and 1997, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1998, in conformity with generally accepted accounting principles. /s/ Ernst & Young LLP Des Moines, Iowa January 29, 1999 Principal Life Insurance Company Consolidated Statements of Operations Year ended December 31 1998 1997 1996 --------------------------------------- (In Millions) Revenue Premiums and annuity and other considerations $3,409 $4,668 $5,121 Policy and contract charges 780 682 572 Net investment income 2,821 2,948 2,905 Net realized capital gains 466 176 388 Commissions and other income 208 199 150 Contribution from the closed block 13 - - --------------------------------------- Total revenue 7,697 8,673 9,136 Expenses Benefits, claims and settlement expenses 4,777 5,632 6,087 Dividends to policyholders 155 299 299 Operating expenses 2,026 2,047 1,920 --------------------------------------- --------------------------------------- Total expenses 6,958 7,978 8,306 --------------------------------------- Income before income taxes 739 695 830 Income taxes 44 241 304 --------------------------------------- ======================================= Net income $ 695 $ 454 $ 526 ======================================= See accompanying notes. Principal Life Insurance Company Consolidated Statements of Financial Position December 31 1998 1997 --------------------------- --------------------------- (In Millions) Assets Fixed maturities, available-for-sale $21,006 $21,546 Equity securities, available-for-sale 1,102 1,273 Mortgage loans 12,091 13,286 Real estate 2,691 2,632 Policy loans 25 749 Other investments 349 130 Cash and cash equivalents 461 546 Accrued investment income 375 457 Deferred policy acquisition costs 456 1,057 Property held for Company use 246 232 Closed block assets 4,251 - Separate account assets 29,009 23,627 Other assets 1,881 1,519 --------------------------- =========================== Total assets $73,943 $67,054 =========================== =========================== Liabilities Contractholder funds $23,339 $23,179 Future policy benefits and claims 7,082 11,239 Other policyholder funds 249 314 Policyholder dividends payable 44 444 Debt 671 459 Income taxes currently payable 27 298 Deferred income taxes 497 803 Closed block liabilities 5,299 - Separate account liabilities 29,009 23,560 Other liabilities 2,257 1,474 --------------------------- --------------------------- Total liabilities 68,474 61,770 Stockholder's equity Common stock, par value $1 per share - authorized 5,000,000 shares, issued and outstanding 2,500,000 shares (wholly owned indirectly by Principal Mutual Holding Company) 3 - Retained earnings 4,749 4,257 Accumulated other comprehensive income: Net unrealized gains on available-for-sale securities 746 1,038 Net foreign currency translation adjustment (29) (11) ----------------------- ----------------------- Total stockholder's equity 5,469 5,284 ----------------------- ======================= Total liabilities and stockholder's equity $73,943 $67,054 ======================= See accompanying notes. Principal Life Insurance Company Consolidated Statements of Stockholder's Equity
Net Unrealized Net Foreign Gains on Currency Total Common Retained Available-for-Sale Translation Stockholder's Stock Earnings Securities Adjustment Equity ---------------------------------------------------------------------------- (In Millions) Balances at January 1, 1996 $ - $3,277 $1,336 $ (7) $4,606 Comprehensive income: Net income - 526 - - 526 Decrease in unrealized appreciation on fixed maturities, - - (543) - (543) available-for-sale Decrease in unrealized appreciation on equity securities, - - (262) - (262) available-for-sale Adjustments for assumed changes in amortization patterns: Deferred policy acquisition costs - - 83 - 83 Unearned revenue reserves - - (11) - (11) Provision for deferred income tax - - 257 - 257 benefit Change in net foreign currency translation adjustment - - - (2) (2) ------------ Comprehensive income - 48 ---------------------------------------------------------------------------- Balances at December 31, 1996 - 3,803 860 (9) 4,654 Comprehensive income: Net income - 454 - - 454 Increase in unrealized appreciation on fixed maturities, - - 197 - 197 available-for-sale Increase in unrealized appreciation on equity securities, - - 118 - 118 available-for-sale Adjustments for assumed changes in amortization patterns: - Deferred policy acquisition costs - - (44) - (44) Unearned revenue reserves - - 4 - 4 Provision for deferred income taxes - - (97) - (97) Change in net foreign currency translation adjustment - - - (2) (2) ------------ Comprehensive income 630 ---------------------------------------------------------------------------- Balances at December 31, 1997 - 4,257 1,038 (11) 5,284
Principal Life Insurance Company Consolidated Statements of Stockholder's Equity (continued)
Net Unrealized Net Foreign Gains on Currency Total Common Retained Available-for-Sale Translation Stockholder's Stock Earnings Securities Adjustment Equity ------------------------------------------------------------------------------- (In Millions) Balances at January 1, 1998 $ - $4,257 $1,038 $(11) $5,284 Comprehensive income: Net income - 695 - - 695 Decrease in unrealized appreciation on fixed maturities, - - (203) - (203) available-for-sale Decrease in unrealized appreciation on equity securities, available-for-sale, including seed money in separate accounts - - (292) - (292) Adjustments for assumed changes in amortization patterns: Deferred policy acquisition costs - - 37 - 37 Unearned revenue reserves - - (4) - (4) Provision for deferred income tax - - 170 - 170 benefit Change in net foreign currency translation adjustment - - - (18) (18) Issuance of 2,500,000 shares of common stock to parent holding 3 (3) - - - company Dividend to parent holding company - (200) - - (200) ---------- Comprehensive income 185 =============================================================================== Balances at December 31, 1998 $ 3 $4,749 $746 $(29) $5,469 =============================================================================== See accompanying notes.
Principal Life Insurance Company Consolidated Statements of Cash Flows
Year ended December 31 1998 1997 1996 --------------------------------------- (In Millions) Operating activities Net income $ 695 $ 454 $ 526 Adjustments to reconcile net income to net cash provided by operating activities: Amortization of deferred policy acquisition costs 114 170 178 Additions to deferred policy acquisition costs (173) (213) (215) Gain on sales of subsidiaries (6) (14) - Accrued investment income 24 7 15 Contractholder and policyholder liabilities and dividends 1,538 1,401 1,667 Current and deferred income taxes (265) 96 20 Net realized capital gains (466) (176) (388) Depreciation and amortization expense 133 117 112 Other (197) (403) (253) Change in closed block operating assets and liabilities, net 230 - - --------------------------------------- --------------------------------------- Net adjustments 932 985 1,136 --------------------------------------- Net cash provided by operating activities 1,627 1,439 1,662 Investing activities Available-for-sale securities: Purchases (7,141) (7,478) (11,876) Sales 5,684 7,475 9,089 Maturities 1,377 1,204 2,796 Mortgage loans acquired or originated (14,162) (9,925) (2,955) Mortgage loans sold or repaid 14,414 8,977 1,619 Real estate acquired (436) (309) (166) Real estate sold 662 198 253 Proceeds from sales of subsidiaries 96 35 - Purchases of interest in subsidiaries, net of cash acquired (218) (99) (51) Net change in policy loans (12) (13) (25) Net change in property held for Company use (57) (11) (18) Net change in other investments (270) (68) (74) Change in closed block investments, net (201) - - --------------------------------------- Net cash used in investing activities (264) (14) (1,408)
Principal Life Insurance Company Consolidated Statements of Cash Flows (continued)
Year ended December 31 1998 1997 1996 --------------------------------------- (In Millions) Financing activities Issuance of debt $ 243 $ 75 $ 43 Principal repayments of debt (51) (28) (29) Proceeds of short-term borrowings 8,628 5,089 1,451 Repayment of short-term borrowings (8,924) (4,974) (1,282) Dividend paid to parent holding company (140) - - Investment contract deposits 5,854 4,134 4,221 Investment contract withdrawals (7,058) (5,446) (4,682) --------------------------------------- Net cash used in financing activities (1,448) (1,150) (278) --------------------------------------- Net increase (decrease) in cash and cash equivalents (85) 275 (24) Cash and cash equivalents at beginning of year 546 271 295 ======================================= Cash and cash equivalents at end of year $ 461 $ 546 $ 271 =======================================
Schedule of noncash operating and investing activities The following noncash assets and liabilities were transferred to the Closed Block as a result of the July 1, 1998 mutual holding company formation: Operating activities: Accrued investment income $ 59 Deferred policy acquisition costs 697 Other assets 12 Future policy benefits and claims (4,545) Other policyholder funds (7) Policyholder dividends payable (388) Other liabilities (173) ------------ Total noncash operating activities (4,345) Investing activities: Fixed maturities, available-for-sale 1,562 Mortgage loans 1,027 Policy loans 736 Other investments 1 ------------ Total noncash investing activities 3,326 ============ Total noncash operating and investing activities $(1,019) ============= Net transfer of noncash assets and liabilities of Principal Health Care Inc. on April 1, 1998 in exchange for common shares of Coventry Health Care, Inc. $ (160) ============= See accompanying notes. Principal Life Insurance Company Notes to Consolidated Financial Statements December 31, 1998 1. Nature of Operations and Significant Accounting Policies Reorganization Effective July 1, 1998, Principal Mutual Life Insurance Company formed a mutual insurance holding company (Principal Mutual Holding Company) and converted to a stock life insurance company (Principal Life Insurance Company). All of the shares of Principal Life Insurance Company (the Company) were issued to Principal Mutual Holding Company through two newly formed intermediate holding companies, Principal Financial Group, Inc. and Principal Financial Services, Inc. The reorganization itself did not have a material financial impact on the Company. Description of Business The Company is a diversified financial services organization engaged in the marketing and management of life insurance, annuity, health, pension and other financial products and services, primarily in the United States. Basis of Presentation The accompanying consolidated financial statements of the Company and its majority-owned subsidiaries have been prepared in conformity with generally accepted accounting principles (GAAP). Less than majority-owned entities in which the Company has at least a 20% interest are reported on the equity basis in the consolidated statements of financial position as other investments. All significant intercompany accounts and transactions have been eliminated. Total assets of the unconsolidated entities amounted to $2.2 billion at December 31, 1998 and $1.1 billion at December 31, 1997. Total revenues of the unconsolidated entities were $1.8 billion in 1998, $294 million in 1997 and $349 million in 1996. During 1998, 1997 and 1996, the Company included $18 million, $19 million and $(3) million, respectively, in net investment income representing the Company's share of current year net income (loss) of the unconsolidated entities. Closed Block In conjunction with the formation of the mutual insurance holding company, the Company established a Closed Block for the benefit of certain classes of individual participating and dividend-paying policies in force on that date. The Closed Block was designed to provide reasonable assurance to owners of insurance policies included therein that, after the reorganization, assets would be available to maintain the aggregate dividend scales in effect for 1997 if the experience underlying such scales continued. Assets were allocated to the Closed Block in amounts which, together with premiums from policies included in the Closed Block, were reasonably expected to be sufficient to support such policies, including provisions for payment of claims, certain expenses, charges and taxes, and for continuation of dividend scales payable in 1997 in the aggregate, assuming the experience underlying such scales continued. Assets allocated to the Closed Block inure to the benefits of the holders of policies included in the Closed Block. Closed Block assets and liabilities are carried on the same basis as similar assets and liabilities held by the Company. The contribution to the operating income of the Company from the Closed Block is reported as a single line item in the statement of operations. Accordingly, premiums, net investment income, realized capital gains (losses), policyowner benefits and dividends attributable to the Closed Block, less certain expenses and charges and the amortization of deferred policy acquisition costs, are shown as a net number under the caption "Contribution from the Closed Block." This results in material reductions in the respective line items in the statement of operations while having no effect on net income. All assets allocated to the Closed Block are grouped together and shown as a separate item entitled "Closed Block assets"; and all liabilities attributable to the Closed Block are combined and disclosed as the "Closed Block liabilities." The excess of Closed Block liabilities over Closed Block assets represents the expected future post-tax contribution from the Closed Block which would be recognized in income over the period the policies and contracts in the Closed Block remain in force. The Contribution from the Closed Block does not represent the total profitability attributable to the policies included in the Closed Block. Certain expenses attributable to the policies included in the Closed Block and commissions on these policies are not included in the reported Contribution from the Closed Block, but rather are included in operating expenses consistent with the initial regulatory funding of the Closed Block. Consequently, the assets needed to fund the Closed Block are less than the total accumulated assets attributable to the policies included in the Closed Block. Income on the assets held outside of the Closed Block is included in net investment income and not included in the Contribution from the Closed Block. Use of Estimates in the Preparation of Financial Statements The preparation of the Company's consolidated financial statements and accompanying notes requires management to make estimates and assumptions that affect the amounts reported and disclosed. These estimates and assumptions could change in the future as more information becomes known, which could impact the amounts reported and disclosed in the consolidated financial statements and accompanying notes. Significant Risks The following is a description of the most significant risks facing diversified financial service organizations and how the Company mitigates those risks: Legal or regulatory risk is the risk that changes in the legal or regulatory environment in which an insurer operates will create additional expenses not anticipated by the insurer in pricing its products. The Company mitigates this risk by offering a wide range of products and operating throughout the United States and the world, thus reducing its exposure to any single product or jurisdiction, and also by employing underwriting practices which identify and minimize the adverse impact of this risk. Credit risk is the risk that issuers of securities owned by the Company or borrowers through mortgage loans on real estate will default or that other parties that owe the Company money, will not pay. The Company minimizes this risk by adhering to a conservative investment strategy, by maintaining sound credit and collection policies and by providing for any amounts deemed uncollectible. Interest rate risk is the risk that interest rates will change and cause a decrease in the value of the Company's investments. This change in rates may also cause certain interest-sensitive products to become uncompetitive or may cause disintermediation. The Company mitigates this risk by charging fees for policyowners' contract terminations, by offering products that transfer this risk to the purchaser and by attempting to match the maturity schedule of its assets with the expected payout of its liabilities. To the extent that liabilities come due more quickly than assets mature, an insurer would have to borrow funds or sell assets prior to maturity and potentially recognize a gain or loss. Cash and Cash Equivalents Cash and cash equivalents include cash on hand, money market instruments and other debt issues with a maturity date of three months or less when purchased. Investments Investments in fixed maturities and equity securities are classified as available-for-sale and, accordingly, are carried at fair value. (See Note 12 for policies related to the determination of fair value.) The cost of fixed maturities is adjusted for amortization of premiums and accrual of discounts, both computed using the interest method. The cost of fixed maturities and equity securities is adjusted for declines in value that are other than temporary. For the loan-backed and structured securities included in the bond portfolio, the Company recognizes income using a constant effective yield based on currently anticipated prepayments as determined by broker-dealer surveys or internal estimates and the estimated lives of the securities. Real estate investments are reported at cost less accumulated depreciation. The initial cost bases of properties acquired through loan foreclosures are the lower of the loan balances or fair market values of the properties at the time of foreclosure. Buildings and land improvements are generally depreciated on the straight-line method over the estimated useful life of improvements, and tenant improvement costs are depreciated on the straight-line method over the term of the related lease. The Company recognizes impairment losses for its properties when indicators of impairment are present and a property's expected undiscounted cash flows are not sufficient to recover the property's carrying value. In such cases, the cost bases of the properties are reduced accordingly. Real estate expected to be disposed is carried at the lower of cost or fair value, less cost to sell, with valuation allowances established accordingly and depreciation no longer recognized. Any impairment losses and any changes in valuation allowances are reported as net realized capital losses. Commercial and residential mortgage loans are reported at cost adjusted for amortization of premiums and accrual of discounts, computed using the interest method, and net of valuation allowances. Any changes in the valuation allowances are reported as net realized capital gains (losses). The Company measures impairment based upon the present value of expected cash flows discounted at the loan's effective interest rate. If foreclosure is probable, the measurement of any valuation allowance is based upon the fair value of the collateral. The Company includes residential mortgage loans held for sale in the amount of $802 million and $512 million at December 31, 1998 and 1997, respectively, which are carried at lower of cost or fair value and reported as mortgage loans in the statements of financial position. Net realized capital gains and losses on investments are determined using the specific identification basis. Policy loans and other investments are primarily reported at cost. Derivatives Derivatives are generally held for purposes other than trading and are primarily used to hedge or reduce exposure to interest rate and foreign currency risks associated with assets held or expected to be purchased or sold, and liabilities incurred or expected to be incurred. Additionally, derivatives are used to change the characteristics of the Company's asset/liability mix consistent with the Company's risk management activities. The Company's use of derivatives is further described in Note 4. The net interest effect of interest rate and currency swap transactions is recorded as an adjustment to net investment income or interest expense, as appropriate, over the periods covered by the agreements. The cost of other derivative contracts is amortized over the life of the contracts and classified with the results of the underlying hedged item. Certain contracts are designated as hedges of specific assets and, to the extent those assets are marked to market, the hedge contracts are also marked to market and included as an adjustment of the underlying asset value. Other contracts are designated and accounted for as hedges of certain liabilities and are not marked to market. Hedge accounting is used for derivatives that are specifically designated in advance as hedges and that reduce the Company's exposure to an indicated risk by having a high correlation between changes in the value of the derivatives and the items being hedged at both the inception of the hedge and throughout the hedge period. Should such criteria not be met or if the hedged items are sold, terminated or matured, the changes in value of the derivatives are included in net income. Contractholder and Policyholder Liabilities Contractholder and policyholder liabilities (contractholder funds, future policy benefits and claims and other policyholder funds) include reserves for investment contracts and reserves for universal life, limited payment, participating and traditional life insurance policies. Investment contracts are contractholders' funds on deposit with the Company and generally include reserves for pension and annuity contracts. Reserves on investment contracts are equal to the cumulative deposits less any applicable charges plus credited interest. Reserves for universal life insurance contracts are equal to cumulative premiums less charges plus credited interest which represents the account balances that accrue to the benefit of the policyowners. Reserves for non-participating term life insurance contracts are computed on a basis of assumed investment yield, mortality, morbidity and expenses, including a provision for adverse deviation, which generally vary by plan, year of issue and policy duration. Investment yield is based on the Company's experience. Mortality, morbidity and withdrawal rate assumptions are based on experience of the Company and are periodically reviewed against both industry standards and experience. Reserves for participating life insurance contracts are based on the net level premium reserve for death and endowment policy benefits. This net level premium reserve is calculated based on dividend fund interest rate and mortality rates guaranteed in calculating the cash surrender values described in the contract. Some of the Company's policies and contracts require payment of fees in advance for services that will be rendered over the estimated lives of the policies and contracts. These payments are established as unearned revenue reserves upon receipt and included in other policyowner funds in the consolidated statements of financial position. These unearned revenue reserves are amortized to operations over the estimated lives of these policies and contracts. The liability for unpaid accident and health claims is an estimate of the ultimate net cost of reported and unreported losses not yet settled. This liability is estimated using actuarial analyses and case basis evaluations. Although considerable variability is inherent in such estimates, the Company believes that the liability for unpaid claims is adequate. These estimates are continually reviewed and, as adjustments to this liability become necessary, such adjustments are reflected in current operations. Recognition of Premiums, Fees and Benefits Traditional individual life and health insurance products include those products with fixed and guaranteed premiums and benefits, and consist principally of whole life and term life insurance policies and certain immediate annuities with life contingencies. Premiums from these products are recognized as premium revenue when due. Group life and health insurance premiums are generally recorded as premium revenue over the term of the coverage. Some group contracts allow for premiums to be adjusted to reflect emerging experience. Such adjusted premiums are recognized in the period that the related experience emerges. Fees for contracts providing claim processing or other administrative services are recorded over the period the service is provided. Related policy benefits and expenses for individual and group life and health insurance products are associated with earned premiums and result in the recognition of profits over the expected lives of the policies and contracts. Universal life-type policies are insurance contracts with terms that are not fixed and guaranteed. Amounts received as payments for such contracts are not reported as premium revenues. Revenues for universal life-type insurance contracts consist of policy charges for the cost of insurance, policy initiation and administration, surrender charges and other fees that have been assessed against policy account values. Policy benefits and claims that are charged to expense include interest credited to contracts and benefit claims incurred in the period in excess of related policy account balances. Investment contracts do not subject the Company to risks arising from policyowner mortality or morbidity, and consist primarily of Guaranteed Investment Contracts (GICs) and certain deferred annuities. Amounts received as payments for investment contracts are established as investment contract liability balances and are not reported as premium revenues. Revenues for investment contracts consist of investment income and policy administration charges. Investment contract benefits that are charged to expense include benefit claims incurred in the period in excess of related investment contract liability balances and interest credited to investment contract liability balances. Deferred Policy Acquisition Costs Commissions and other costs (underwriting, issuance and agency expenses) that vary with and are primarily related to the acquisition of new and renewal insurance policies and investment contract business are capitalized to the extent recoverable. Acquisition costs that are not deferrable and maintenance costs are charged to operations as incurred. Deferred policy acquisition costs for universal life-type insurance contracts and participating life insurance policies and investment contracts are being amortized over the lives of the policies and contracts in relation to the emergence of estimated gross profit margins. This amortization is adjusted retrospectively when estimates of current or future gross profits and margins to be realized from a group of products and contracts are revised. The deferred policy acquisition costs of non-participating term life insurance policies are being amortized over the premium-paying period of the related policies using assumptions consistent with those used in computing policyowner liabilities. Deferred policy acquisition costs are subject to recoverability testing at the time of policy issue and loss recognition testing at the end of each accounting period. Deferred policy acquisition costs would be written off to the extent that it is determined that future policy premiums and investment income or gross profit margins would not be adequate to cover related losses and expenses. Reinsurance The Company enters into reinsurance agreements with other companies in the normal course of business. The Company may assume reinsurance from or cede reinsurance to other companies. Premiums and expenses are reported net of reinsurance ceded. The Company is contingently liable with respect to reinsurance ceded to other companies in the event the reinsurer is unable to meet the obligations it has assumed. Guaranty-fund Assessments Guaranty-fund assessments are accrued when the Company receives notice that an amount is payable to a guaranty fund. The Company also accrues for anticipated assessments which are estimated using data available from various industry sources that monitor the current status of open and closed insolvencies. The Company has also established an other asset for assessments expected to be recovered through future premium tax offsets. Separate Accounts The separate account assets and liabilities presented in the consolidated financial statements represent the fair market value of funds that are separately administered by the Company for contracts with equity, real estate and fixed-income investments. Generally, the separate account contract owner, rather than the Company, bears the investment risk of these funds. The separate account assets are legally segregated and are not subject to claims that arise out of any other business of the Company. The Company receives a fee for administrative, maintenance and investment advisory services that is included in the consolidated statements of operations. Deposits, net investment income and realized and unrealized capital gains and losses on the separate accounts are not reflected in the consolidated statements of operations. Income Taxes Principal Mutual Holding Company files a consolidated income tax return that includes the Company and all of its qualifying subsidiaries and has a policy of allocating income tax expenses and benefits to companies in the group based upon pro rata contribution of taxable income or operating losses. The Company is taxed at corporate rates on taxable income based on existing tax laws. Current income taxes are charged or credited to operations based upon amounts estimated to be payable or recoverable as a result of taxable operations for the current year. Deferred income taxes are provided for the tax effect of temporary differences in the financial reporting and income tax bases of assets and liabilities and net operating losses using enacted income tax rates and laws. The effect on deferred tax assets and deferred tax liabilities of a change in tax rates is recognized in operations in the period in which the change is enacted. Foreign Exchange The Company's foreign subsidiaries' statements of financial position and operations are translated at the current exchange rates and average exchange rates for the year, respectively. Resulting translation adjustments for foreign subsidiaries and certain other transactions are reported as a component of equity. Other translation adjustments for foreign currency transactions that affect cash flows are reported in current operations. Pension and Postretirement Benefits The Company accounts for its pension benefits and postretirement benefits other than pension (medical, life insurance and long-term care) using the full accrual method. Property Held for Company Use Property held for Company use includes home office properties and related leasehold improvements. Property held for Company use is shown in the consolidated statements of financial position at cost less allowances for accumulated depreciation. Provisions for depreciation of property held for Company use are computed principally on the straight-line method over the estimated useful lives of the assets. Property held for Company use and related accumulated depreciation are as follows (in millions): December 31 1998 1997 ----------------------------- Property held for Company use $328 $302 Accumulated depreciation (82) (70) ============================= Property held for Company use, net $246 $232 ============================= Other Assets Intangible assets are included in other assets in the consolidated statements of financial position. The cost of acquired subsidiaries in excess of the fair value of the net assets (i.e., goodwill) and other intangible assets have been recorded in connection with acquisitions. These assets are amortized on a straight-line basis generally over 10 to 15 years. The carrying amount of goodwill and other intangible assets is reviewed periodically for indicators of impairment in value. Intangible assets and related accumulated amortization are as follows (in millions): December 31 1998 1997 --------------------------- Goodwill $185 $165 Accumulated amortization (40) (16) --------------------------- Goodwill, net 145 149 Other intangible assets, net 16 74 --------------------------- Total intangible assets $161 $223 =========================== Mortgage servicing rights of $778 million and $432 million at December 31, 1998 and 1997, respectively, are included in other assets in the consolidated statements of financial position and represent the cost of purchasing or originating the right to service mortgage loans. These costs are capitalized and amortized to operations over the estimated remaining lives of the underlying loans using the interest method and taking into account appropriate prepayment assumptions. Capitalized mortgage servicing rights are periodically assessed for impairment, which is recognized in the consolidated statements of operations during the period in which impairment occurs by establishing a corresponding valuation allowance. Other assets are reported primarily at cost. Pooled Investment Fund The Company has an arrangement whereby short-term funds of Principal Financial Services, Inc. are pooled with funds of the Company's subsidiaries and invested by the Company. The Company credits Principal Financial Services, Inc. with interest approximating the yield earned by the Company's Separate Account LI, which invests in commercial paper. At December 31, 1998, the Company reported $137 million in other liabilities in the statements of financial position related to this arrangement with Principal Financial Services, Inc. The Company's pooled funds are also made available to Principal Financial Services, Inc. for short-term borrowings up to $1 million, with interest approximating the yield earned by Separate Account LI. At December 31, 1998, there were no such borrowings outstanding under this arrangement. Comprehensive Income On January 1, 1998, the Company adopted Statement of Financial Accounting Standards No. 130, Reporting Comprehensive Income ("SFAS 130"), and restated prior years' financial statements to conform to the reporting standard. SFAS 130 establishes standards for reporting and displaying comprehensive income and its components in a full set of general-purpose financial statements. Comprehensive income includes all changes in equity during a period except those resulting from investments by shareholders and distributions to shareholders. The adoption of SFAS No. 130 resulted in revised and additional disclosures but had no effect on the financial position, results of operations, or liquidity of the Company. Other comprehensive income excludes net realized capital gains (losses) included in net income of $344 million in 1998, $113 million in 1997 and $256 million in 1996. These amounts are net of income taxes and adjustments to deferred policy acquisition costs and unearned revenue reserves of $122 million in 1998, $63 million in 1997 and $132 million in 1996. Reclassifications Certain reclassifications have been made to the 1996 and 1997 consolidated financial statements to conform to the 1998 presentation. Pending Accounting Change In June 1998, the Financial Accounting Standards Board (the "FASB") issued Statement No. 133, Accounting for Derivative Instruments and Hedging Activities ("SFAS 133"), which the Company is required to adopt January 1, 2000. SFAS 133 will require the Company to include all derivatives in the statement of financial position at fair value. Changes in derivative fair values will either be recognized in earnings as offsets to the changes in fair value of related hedged assets, liabilities and firm commitments or, for forecasted transactions, deferred and recorded as a component of equity until the hedged transactions occur and are recognized in earnings. The ineffective portion of a hedging derivative's change in fair value will be immediately recognized in earnings. The impact of SFAS 133 on the Company's financial statements will depend on a variety of factors, including future interpretive guidance from the FASB, the future level of forecasted and actual foreign currency transactions, the extent of the Company's hedging activities, the types of hedging instruments used and the effectiveness of such instruments. However, the Company does not believe the effect of adopting SFAS 133 will be material to its financial position. 2. Mergers, Acquisitions and Divestitures Effective April 1, 1998, the Company merged substantially all of its managed care operations with Coventry Corporation in exchange for a share of ownership in the resulting entity, Coventry Health Care, Inc. At December 31, 1998, the Company held a 42% share of Coventry Health Care, Inc. The Company's investment in Coventry Health Care, Inc. is accounted for using the equity method. Net equity of the transferred business on April 1, 1998 was $170 million. Consolidated financial results for 1997 included total assets at December 31, 1997, and total revenues and pretax loss for the year then ended of approximately $419 million, $883 million and $(26) million, respectively, for the transferred business. During 1998, various acquisitions were made by the Company's subsidiaries at purchase prices aggregating $224 million. The acquisitions were all accounted for using the purchase method and the results of operations of the acquired businesses have been included in the financial statements of the subsidiaries from the dates of acquisition. Such acquired companies had total assets at December 31, 1998 and total 1998 revenue of $459 million and $58 million, respectively. During 1998, various divestitures were made by certain of the Company's subsidiaries at selling prices aggregating $118 million and $15 million in net realized capital gains were realized as a result of these divestitures. In 1997, the financial statements included $152 million in assets, $206 million in revenues and $20 million of pretax losses related to these subsidiaries. Beginning in 1998, the Company did not renew medical business in 14 states where it does not believe it can effectively compete. The Company continues to offer non-medical coverage and administrative services only products in these states. Annual medical premium in these states was approximately $230 million in 1997. During 1997, various acquisitions were made by certain of the Company's subsidiaries at purchase prices aggregating $101 million. The acquisitions were all accounted for using the purchase method and the results of operations of the acquired businesses have been included in the financial statements of the subsidiaries from the dates of acquisition. Such acquired companies had total assets at December 31, 1997 and total 1997 revenue of $459 million and $86 million, respectively. During 1997, the Company terminated a portion of its group medical business and helped insureds find replacement coverage. The Company has retained responsibility for the payment of claims incurred on this business prior to the effective date of the termination and has included an estimate of the ultimate liability for these claims in its financial statements. Annual premiums related to this business were approximately $380 million at date of transfer. 3. Investments Under SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, securities are generally classified as available-for-sale, held-to-maturity, or trading. The Company has classified its entire fixed maturities portfolio as available-for-sale, although it is generally the Company's intent to hold these securities to maturity. The Company has also classified all equity securities as available-for-sale. Securities classified as available-for-sale are reported at fair value in the consolidated statements of financial position with the related unrealized holding gains and losses on such available-for-sale securities reported as a separate component of equity after adjustments for related changes in deferred policy acquisition costs, unearned revenue reserves and deferred income taxes. The cost, gross unrealized gains and losses and fair value of fixed maturities and equity securities available-for-sale as of December 31, 1998 and 1997, are as follows (in millions):
Gross Gross Unrealized Unrealized Fair Cost Gains Losses Value --------------------------------------------------------------- --------------------------------------------------------------- December 31, 1998 Fixed maturities: United States Government and agencies $ 611 $ - $ 10 $ 601 Foreign governments 57 21 1 77 States and political subdivisions 428 19 4 443 Corporate - public 4,470 264 88 4,646 Corporate - private 11,935 653 97 12,491 Mortgage-backed securities 2,661 92 5 2,748 --------------------------------------------------------------- Total fixed maturities $20,162 $1,049 $205 $21,006 =============================================================== Total equity securities $ 760 $ 395 $ 53 $ 1,102 =============================================================== December 31, 1997 Fixed maturities: United States Government and agencies $ 337 $ 1 $ - $ 338 Foreign governments 217 - - 217 States and political subdivisions 232 15 2 245 Corporate - public 4,014 224 18 4,220 Corporate - private 12,478 856 30 13,304 Mortgage-backed securities 3,124 99 3 3,220 --------------------------------------------------------------- --------------------------------------------------------------- 20,402 1,195 53 21,544 Redeemable preferred stocks 2 - - 2 =============================================================== Total fixed maturities $20,404 $1,195 $ 53 $21,546 =============================================================== Total equity securities $ 639 $ 664 $ 30 $ 1,273 ===============================================================
The cost and fair value of fixed maturities available-for-sale at December 31, 1998, by expected maturity, are as follows (in millions): Cost Fair Value -------------------------- -------------------------- Due in one year or less $ 1,043 $ 1,061 Due after one year through five years 6,922 7,012 Due after five years through ten years 5,283 5,590 Due after ten years 4,234 4,577 -------------------------- -------------------------- 17,482 18,240 Mortgage-backed and other securities without a single maturity date 2,680 2,766 -------------------------- ========================== Total $20,162 $21,006 ========================== The above summarized activity is based on expected maturities. Actual maturities may differ because borrowers may have the right to call or pre-pay obligations. Major categories of net investment income are summarized as follows (in millions): Year ended December 31 1998 1997 1996 ------------------------------------ Fixed maturities, available-for-sale $1,525 $1,620 $1,649 Equity securities, available-for-sale 32 39 33 Mortgage loans 1,171 1,150 1,085 Real estate 525 501 486 Policy loans 27 50 49 Cash and cash equivalents 9 9 15 Other 49 92 48 ------------------------------------ ------------------------------------ 3,338 3,461 3,365 Less investment expenses (517) (513) (460) ------------------------------------ ==================================== Net investment income $2,821 $2,948 $2,905 ==================================== The major components of net realized capital gains (losses) on investments are summarized as follows (in millions): Year ended December 31 1998 1997 1996 ---------------------------------- Fixed maturities, available-for-sale: Gross gains $ 67 $ 51 $ 80 Gross losses (31) (43) (73) Equity securities, available-for-sale: Gross gains 329 132 451 Gross losses (40) (26) (5) Mortgage loans 8 (6) (11) Real estate 126 64 14 Other 7 4 (68) ================================== Net realized capital gains $466 $176 $388 ================================== Proceeds from sales of investments (excluding call and maturity proceeds) in fixed maturities were $2.8 billion, $5.0 billion and $7.8 billion in 1998, 1997 and 1996 respectively. Of the 1998, 1997 and 1996 proceeds, $2.2 billion, $4.0 billion and $7.2 billion, respectively, relates to sales of mortgage-backed securities. The Company actively manages its mortgage-backed securities portfolio to control prepayment risk. Gross gains of $23 million, $29 million and $64 million and gross losses of $7 million, $10 million and $53 million in 1998, 1997 and 1996, respectively, were realized on sales of mortgage-backed securities. At December 31, 1998, the Company had security purchases payable totaling $576 million relating to the purchases of mortgage-backed securities at forward dates. Prior to 1996, the Company entered into short-term equity swap agreements to mitigate its exposure to declines in the value of about one-half of its marketable common stock portfolio. Under the agreements, the return on that portion of the Company's marketable common stock portfolio was swapped for a fixed short-term interest rate. The equity swaps were terminated during 1996 and a realized loss of $81 million recorded. Common stocks of $633 million associated with these equity swaps were sold during 1996 and a gain of $402 million recorded, resulting in a net realized gain of $321 million. The unrealized appreciation on investments in fixed maturities and equity securities available-for-sale is reported as a separate component of equity, reduced by adjustments to deferred policy acquisition costs and unearned revenue reserves that would have been required as a charge or credit to operations had such amounts been realized and a provision for deferred income taxes. The cumulative amount of net unrealized gains on available-for-sale securities, including the net unrealized gains on the Closed Block available-for-sale securities, is as follows (in millions):
December 31 1998 1997 ----------------------------- Unrealized appreciation on fixed maturities, available-for-sale $939 $1,142 Unrealized appreciation on equity securities, available-for-sale, including seed money in separate accounts 347 639 Adjustments for assumed changes in amortization patterns: Deferred policy acquisition costs (167) (204) Unearned revenue reserves 17 21 Provision for deferred income taxes (390) (560) ============================= Net unrealized gains on available-for-sale securities $746 $1,038 =============================
The 1998 decrease in unrealized appreciation on fixed maturities, available-for-sale, includes the effect of a change in the method of estimating the fair value of certain corporate bonds, net of related adjustments for assumed changes in amortization patterns and deferred income taxes, of $116 million. Commercial mortgage loans and corporate private placement bonds originated or acquired by the Company represent its primary areas of credit risk exposure. At December 31, 1998 and 1997, the commercial mortgage portfolio is diversified by geographic region and specific collateral property type as follows: Geographic Distribution Property Type Distribution December 31 December 31 1998 1997 1998 1997 ---------------------- -------------------- ---------------------- -------------------- Pacific 28% 28% Industrial 33% 33% South Atlantic 24 24 Retail 33 33 North Central 15 16 Office 29 29 Mid Atlantic 14 14 Other 5 5 South Central 9 9 New England 5 5 Mountain 5 4 Mortgage loans on real estate are considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to contractual terms of the loan agreement. When the Company determines that a loan is impaired, a provision for loss is established for the difference between the carrying amount of the mortgage loan and the estimated value. Estimated value is based on either the present value of the expected future cash flows discounted at the loan's effective interest rate, the loan's observable market price or fair value of the collateral. The provision for losses is reported as a net realized capital loss. Mortgage loans deemed to be uncollectible are charged against the allowance for losses and subsequent recoveries are credited to the allowance for losses. The allowance for losses is maintained at a level believed adequate by management to absorb estimated probable credit losses. Management's periodic evaluation of the adequacy of the allowance for losses is based on the Company's past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower's ability to repay, the estimated value of the underlying collateral, composition of the loan portfolio, current economic conditions and other relevant factors. The evaluation is inherently subjective as it requires estimating the amounts and timing of future cash flows expected to be received on impaired loans that may change. A summary of the changes in the mortgage loan allowance for losses is as follows (in millions): December 31 1998 1997 1996 ------------------------------------ Balance at beginning of year $121 $121 $115 Provision for losses 4 8 16 Releases due to write-downs, sales and foreclosures (12) (8) (10) ==================================== Balance at end of year $113 $121 $121 ==================================== The corporate private placement bond portfolio is diversified by issuer and industry. Restrictive bond covenants are monitored by the Company to regulate the activities of issuers and control their leveraging capabilities. The Company was servicing approximately 484,000 and 371,000 residential mortgage loans with aggregate principal balances of approximately $42.1 billion and $29.1 billion at December 31, 1998 and 1997, respectively. In connection with these mortgage servicing activities, the Company held funds in trust for others totaling approximately $284 million and $210 million at December 31, 1998 and 1997, respectively. In connection with its loan administration activities, the Company advances payments of property taxes and insurance premiums and also advances principal and interest payments to investors in advance of collecting funds from specific mortgagors. In addition, the Company makes certain payments of attorney fees and other costs related to loans in foreclosure. These amounts receivable are recorded, at cost, as advances on serviced loans. Amounts advanced are considered in management's evaluation of the adequacy of the mortgage loan allowance for losses. Real estate holdings and related accumulated depreciation are as follows (in millions): December 31 1998 1997 ----------------------------- Properties held for sale $1,043 $ 360 Investment real estate 2,007 2,625 ----------------------------- 3,050 2,985 Accumulated depreciation (359) (353) ============================= Real estate, net $2,691 $2,632 ============================= Other investments include properties owned jointly with venture partners and operated by the partners. Joint ventures in which the Company has an interest have mortgage loans with the Company of $0.9 billion and $1.2 billion at December 31, 1998 and 1997, respectively. The Company is committed to providing additional mortgage financing for such joint ventures aggregating $85 million at December 31, 1998. 4. Derivatives Held or Issued for Purposes Other Than Trading The Company uses exchange-traded interest rate futures and forward contracts to hedge against interest rate risks. The Company attempts to match the timing of when interest rates are committed on insurance products and on new investments. However, timing differences do occur and can expose the Company to fluctuating interest rates. Interest rate futures and forward contracts are used to minimize these risks. In these contracts, the Company is subject to the risk that the counterparties will fail to perform and to the risks associated with changes in the value of the underlying securities; however, such changes in value generally are offset by opposite changes in the value of the hedged items. Futures contracts are marked to market and settled daily, which minimizes the counterparty risk. The notional amounts of futures contracts ($140 million at December 31, 1998, and $36 million at December 31, 1997) represent the extent of the Company's involvement but not the risk of loss. The Company had no forward contracts at December 31, 1998 and 1997. The Company enters into interest rate swaps to minimize its exposure to fluctuations in interest rates. Swaps are used in asset and liability management to modify duration and match cash flows. The notional principal amounts of the swaps outstanding at December 31, 1998 and 1997, were $1.6 billion and $1.0 billion, respectively, and the credit exposure at December 31, 1998 and 1997 was $19 million and $21 million, respectively. The Company is exposed to credit loss in the event of nonperformance of the counterparties. This credit risk is minimized by purchasing such agreements from financial institutions with superior performance records. The Company's current credit exposure on swaps is limited to the value of interest rate swaps that have become favorable to the Company. The average unexpired terms of the swaps were approximately six years at both December 31, 1998 and 1997. The net amount payable or receivable from interest rate swaps is accrued as an adjustment to interest income. The Company's interest rate swap agreements include cross-default provisions when two or more swaps are transacted with a given counterparty. The Company manages risk on its mortgage loan pipeline by buying and selling mortgage-backed securities in the forward markets, over-the-counter options on mortgage-backed securities, U. S. Treasury futures contracts and options on Treasury futures contracts. The Company entered into mandatory forward, option and futures contracts totaling approximately $2.4 billion and $1.2 billion at December 31, 1998 and 1997, respectively, to reduce interest rate risk on certain mortgage loans held for sale and other commitments. The forward contracts provide for the delivery of securities at a specified future date at a specified price or yield. In the event the counterparty is unable to meet its contractual obligations, the Company may be exposed to the risk of selling mortgage loans at prevailing market prices. The effect of these contracts was considered in the lower of cost or market calculation of mortgage loans held for sale. The Company has committed to originate approximately $1.1 billion and $612 million of mortgage loans at December 31, 1998 and 1997, respectively, subject to borrowers meeting the Company's underwriting guidelines. These commitments call for the Company to fund such loans at a future date with a specified rate at a specified price. Because the borrowers are not obligated to close the loans, the Company is exposed to risks that it may not have sufficient mortgage loans to deliver to its mandatory forward contracts and, thus, would be obligated to purchase mortgage loans at prevailing market rates to meet such commitments. Conversely, the Company is exposed to the risk that more loans than expected will close, and the loans would then be sold at current market prices. The Company uses interest rate floors and options on futures contracts in hedging a portion of its portfolio of mortgage servicing rights from prepayment risk associated with changes in interest rates. The Company had entered into interest rate floor and option contracts with a notional value of $6.3 billion and $3.1 billion at December 31, 1998 and 1997, respectively. The floors and contracts provide for the receipt of payments when interest rates are below predetermined interest rate levels. The premiums paid for floors are included in other assets in the Company's consolidated statements of financial position. The Company enters into currency exchange swap agreements to convert certain foreign denominated fixed rate assets into U.S. dollar denominated fixed rate assets and eliminate the exposure to future currency volatility on those securities. At December 31, 1998, the Company had various foreign currency exchange agreements with maturities ranging from 1999 to 2018, with an aggregate notional amount involved of approximately $486 million and the credit exposure was $35 million. At December 31, 1997, such maturities ranged from 1998 to 2018 with an aggregate notional amount of approximately $410 million and a credit exposure of $17 million. The average unexpired term of the swaps was approximately seven years at both December 31, 1998 and 1997. 5. Closed Block Summarized financial information of the Closed Block as of and for the six-month period from formation to December 31, 1998, is as follows (in millions): Assets Fixed maturities, available-for-sale $1,722 Mortgage loans 1,063 Policy loans 741 Other investments 1 Accrued investment income 60 Deferred policy acquisition costs 649 Other assets 15 =========== $4,251 =========== Liabilities Future policy benefits and claims $4,668 Other policyholder funds 6 Policyholder dividends payable 393 Other liabilities 232 =========== $5,299 =========== Revenues and expenses Premiums $ 390 Net investment income 127 Other income 1 Benefits, claims and settlement expenses (306) Dividends to policyholders (143) Operating expenses (56) =========== Contribution from the Closed Block (before income taxes) $ 13 =========== 6. Accident and Health Reserves Activity in the liability for unpaid accident and health claims, which is included with future policy benefits and claims in the consolidated statements of financial position, is summarized as follows (in millions): Year ended December 31 1998 1997 1996 ------------------------------------ Balance at beginning of year $ 770 $ 800 $ 810 Incurred: Current year 1,922 2,723 3,051 Prior years (14) (21) (29) ------------------------------------ ------------------------------------ Total incurred 1,908 2,702 3,022 Reclassification for subsidiary merger (see Note 2) 155 - - Payments: Current year 1,523 2,235 2,535 Prior years 359 497 497 ------------------------------------ Total payments 2,037 2,732 3,032 ------------------------------------ Balance at end of year: Current year 349 476 516 Prior years 292 294 284 ------------------------------------ ==================================== Total balance at end of year $ 641 $ 770 $ 800 ==================================== The activity summary in the liability for unpaid accident and health claims shows a decrease of $14 million, $21 million and $29 million to the December 31, 1997, 1996 and 1995 liability for unpaid accident and health claims, respectively, arising in prior years. Such liability adjustments, which affected current operations during 1998, 1997 and 1996, respectively, resulted from developed claims for prior years being different than were anticipated when the liabilities for unpaid accident and health claims were originally estimated. These trends have been considered in establishing the current year liability for unpaid accident and health claims. 7. Debt The components of debt as of December 31, 1998 and December 31, 1997 are as follows (in millions): December 31 1998 1997 ------------------------------ 7.875% notes payable, due 2024 $199 $199 8% notes payable, due 2044 99 99 Mortgages and other notes payable 373 161 ============================== Total debt $671 $459 ============================== On March 10, 1994, the Company issued $300 million of surplus notes, including $200 million due March 1, 2024 at a 7.875% annual interest rate and the remaining $100 million due March 1, 2044 at an 8% annual interest rate. No affiliates of the Company hold any portion of the notes. The discount and direct costs associated with issuing these notes are being amortized to expense over their respective terms using the interest method. Each payment of interest and principal on the notes, however, may be made only with the prior approval of the Commissioner of Insurance of the State of Iowa (the Commissioner) and only to the extent that the Company has sufficient surplus earnings to make such payments. For each of the years ended December 31, 1998, 1997 and 1996, interest of $24 million was approved by the Commissioner, paid and charged to expense. Subject to Commissioner approval, the surplus notes due March 1, 2024 may be redeemed at the Company's election on or after March 1, 2004 in whole or in part at a redemption price of approximately 103.6% of par. The approximate 3.6% premium is scheduled to gradually diminish over the following ten years. These surplus notes may then be redeemed on or after March 1, 2014, at a redemption price of 100% of the principal amount plus interest accrued to the date of redemption. In addition, subject to Commissioner approval, the notes due March 1, 2044 may be redeemed at the Company's election on or after March 1, 2014, in whole or in part at a redemption price of approximately 102.3% of par. The approximate 2.3% premium is scheduled to gradually diminish over the following ten years. These notes may be redeemed on or after March 1, 2024, at a redemption price of 100% of the principal amount plus interest accrued to the date of redemption. The mortgages and other notes payable are financings for real estate developments. The Company has obtained loans with various lenders to finance these developments. Outstanding principal balances as of December 31, 1998 range from $1 million to $39.1 million per development with interest rates generally ranging from 6.6% to 9.3%. Outstanding principal balances as of December 31, 1997 range from $1 million to $10.7 million per development with interest rates generally ranging from 6.6% to 8.0%. At December 31, 1998, future annual maturities of debt are as follows (in millions): 1999 $150 2000 9 2001 8 2002 8 2003 9 Thereafter 487 ---------- ========== Total future maturities of debt $671 ========== Cash paid for interest for 1998, 1997 and 1996 was $97 million, $67 million and $79 million, respectively. The Company issues commercial paper periodically to meet its short-term financing needs and also has credit facilities with various banks. The Company had outstanding credit borrowings of $200 million and $225 million at December 31, 1998 and 1997, respectively. These outstanding borrowings are included in other liabilities in the consolidated statements of financial position. 8. Income Taxes The Company's income tax expense (benefit) is as follows (in millions): Year ended December 31 1998 1997 1996 --------------------------------------- Current income taxes: Federal $ (80) $144 $145 State and foreign 10 3 (1) Net realized capital gains 107 11 210 --------------------------------------- Total current income taxes 37 158 354 Deferred income taxes 7 83 (50) ======================================= Total income taxes $44 $241 $304 ======================================= The Company's provision for income taxes may not have the customary relationship of taxes to income. Differences between the prevailing corporate income tax rate of 35% times the pre-tax income and the Company's effective tax rate on pre-tax income are generally due to inherent differences between income for financial reporting purposes and income for tax purposes, and the establishment of adequate provisions for any challenges of the tax filings and tax payments to the various taxing jurisdictions. A reconciliation between the corporate income tax rate and the effective tax rate is as follows (in millions): Year ended December 31 1998 1997 1996 ----------------------------------- Statutory corporate tax rate 35% 35% 35% Dividends received deduction (4) (2) (1) Interest exclusion from taxable income (1) (1) (1) Resolution of prior year tax issues (20) - - Other (4) 3 4 ----------------------------------- Effective tax rate 6% 35% 37% =================================== Significant components of the Company's net deferred income taxes are as follows (in millions): December 31 1998 1997 ------------------- Deferred income tax assets (liabilities): Insurance liabilities $ 171 $ 179 Deferred policy acquisition costs (331) (341) Net unrealized gains on available for sale securities (390) (560) Other 53 (81) =================== $(497) $(803) =================== The Internal Revenue Service (the Service) has completed examination of the consolidated federal income tax returns of the Company and affiliated companies through 1992. The Service is completing their examination of the Company's returns for 1993 and 1994. The Service has also begun to examine returns for 1995 and 1996. The Company believes that there are adequate defenses against or sufficient provisions for any challenges. Undistributed earnings of certain foreign subsidiaries are considered indefinitely reinvested by the Company. A tax liability will be recognized when the Company expects distribution of earnings in the form of dividends, sale of the investment or otherwise. Cash paid for income taxes was $309 million in 1998, $143 million in 1997 and $285 million in 1996. 9. Employee and Agent Benefits The Company has defined benefit pension plans covering substantially all of its employees and certain agents. The employees and agents are generally first eligible for the pension plans when they reach age 21. The pension benefits are based on the years of service and generally the employee's or agent's average annual compensation during the last five years of employment. Partial benefit accrual of pension benefits is recognized from first eligibility until retirement based on attained service divided by potential service to age 65 with a minimum of 35 years of potential service. The Company's policy is to fund the cost of providing pension benefits in the years that the employees and agents are providing service to the Company. The Company's funding policy is to deposit the actuarial normal cost and any change in unfunded accrued liability over a 30-year period as a percentage of compensation. The Company also provides certain health care, life insurance and long-term care benefits for retired employees. Substantially all employees are first eligible for these postretirement benefits when they reach age 57 and have completed ten years of service with the Company. Partial benefit accrual of these health, life and long-term care benefits is recognized from the employee's date of hire until retirement based on attained service divided by potential service to age 65 with a minimum of 35 years of potential service. The Company's policy is to fund the cost of providing retiree benefits in the years that the employees are providing service to the Company. The Company's funding policy is to deposit the actuarial normal cost and an accrued liability over a 30-year period as a percentage of compensation. The plans' combined funded status, reconciled to amounts recognized in the consolidated statements of financial position and consolidated statements of operations, is as follows (in millions):
Other Postretirement Benefits Pension Benefits ---------------------------------- ------------------------------- Year ended December 31 Year ended December 31 1998 1997 1996 1998 1997 1996 --------- ----------- ------------ ---------- ---------- --------- Change in benefit obligation Benefit obligation at beginning $(700) $(732) $(670) $(214) $(218) $(212) of year Service cost (34) (41) (38) (12) (12) (12) Interest cost (50) (52) (46) (15) (16) (15) Plan amendment - - (16) - - - Actuarial gain (loss) (79) 97 19 22 22 14 Curtailment adjustment - 7 - - - - Benefits paid 36 21 19 13 10 7 ========= =========== ============ ========== ========== ========= Benefit obligation at end of year $(827) $(700) $(732) $(206) $(214) $(218) ========= =========== ============ ========== ========== =========
Other Postretirement Benefits Pension Benefits -------------------------------------- ------------------------------ Year ended December 31 Year ended December 31 1998 1997 1996 1998 1997 1996 ----------- ------------ ------------- ---------- ---------- ---------- Change in plan assets Fair value of plan assets at beginning of year $980 $841 $723 $300 $247 $208 Actual return on plan assets 23 130 118 15 41 32 Employer contribution 26 26 20 26 25 17 Benefits paid (36) (17) (20) (15) (13) (10) ----------- ------------ ------------- ---------- ---------- ---------- Fair value of plan assets at end of $993 $980 $841 $326 $300 $247 year =========== ============ ============= ========== ========== ========== Funded status $166 $280 $109 $120 $ 86 $ 29 Unrecognized net actuarial gain (38) (182) (29) (71) (53) (10) Unrecognized prior service cost 12 14 17 - - - Unamortized transition obligation (37) (49) (60) 8 12 17 ----------- ------------ ------------- ---------- ---------- ---------- Prepaid benefit cost $103 $ 63 $ 37 $ 57 $ 45 $ 36 =========== ============ ============= ========== ========== ========== Weighted-average assumptions as of December 31 Discount rate 6.75% 7.25% 7.25% 6.75% 7.25% 7.25% Components of net periodic benefit cost Service cost $ 34 $ 41 $ 38 $ 12 $ 12 $ 12 Interest cost 50 52 46 15 16 15 Expected return on plan assets (75) (80) (119) (16) (16) (13) Amortization of prior service cost 1 1 1 - - - Amortization of transition (asset) obligation (11) (11) (11) 4 4 4 Recognized net actuarial loss (gain) (8) 2 52 (1) - - ----------- ------------ ------------- ---------- ---------- ---------- Net periodic benefit cost (income) $ (9) $ 5 $ 7 $ 14 $ 16 $ 18 =========== ============ ============= ========== ========== ==========
For 1998, 1997 and 1996, the expected long-term rates of return on plan assets for pension benefits were approximately 5%, 5% and 6.2%, respectively (after estimated income taxes) for those trusts subject to income taxes. For trusts not subject to income taxes, the expected long-term rates of return on plan assets were approximately 8.1%, 8.1% and 9.6% for 1998, 1997 and 1996, respectively. The assumed rate of increase in future compensation levels varies by age for both the qualified and non-qualified pension plans. For 1998, 1997 and 1996, the expected long-term rates of return on plan assets for other post-retirement benefits were approximately 5%, 5% and 6.2%, respectively (after estimated income taxes) for those trusts subject to income taxes. For trusts not subject to income taxes, the expected long-term rates of return on plan assets were approximately 8.1%, 8.2% and 9.5% for 1998, 1997 and 1996, respectively. These rates of return on plan assets vary by benefit type and employee group. The assumed health care cost trend rate used in measuring the accumulated postretirement benefit obligations starts at 8.75% in 1998 and declines to an ultimate rate of 6% in 2025. Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. A one-percentage-point change in assumed health care cost trend rates would have the following effects (in millions): 1-Percentage- 1-Percentage- Point Increase Point Decrease --------------- --------------- Effect on total of service and interest cost components $ 9 $ (6) Effect on accumulated postretirement benefit obligation $43 $(34) In addition, the Company has defined contribution plans that are generally available to all employees and agents who are age 21 or older. Eligible participants may contribute up to 20% of their compensation, to a maximum of $10,000 annually to the plans in 1998. Eligible participants were able to contribute up to 15% of their compensation, to a maximum of $9,500 annually to the plans in 1997 and 1996. The Company matches the participant's contribution at a 50% contribution rate up to a maximum Company contribution of 2% of the participant's compensation. The Company contributed $11 million in 1998, $15 million in 1997 and $13 million in 1996 to these defined contribution plans. 10. Reinsurance Reinsurance contracts do not relieve the Company from its obligations to policyowners. Failure of reinsurers to honor their obligations could result in losses to the Company. To minimize the possibility of losses, the Company evaluates the financial condition of its reinsurers and continually monitors concentrations of credit risk. The effect of reinsurance on premiums and annuity and other considerations and benefits, claims and settlement expenses is as follows (in millions): Year ended December 31 1998 1997 1996 ----------------------------------- ----------------------------------- Premiums and annuity and other considerations: Direct $3,380 $4,601 $5,034 Assumed 59 106 116 Ceded (30) (39) (29) =================================== Net premiums and annuity and other considerations $3,409 $4,668 $5,121 =================================== =================================== Benefits, claims and settlement expenses: Direct $4,739 $5,596 $6,003 Assumed 66 102 109 Ceded (28) (66) (25) =================================== Net benefits, claims and settlement expenses $4,777 $5,632 $6,087 =================================== Effective July 1, 1998, the Company no longer participates in reinsurance pools related to the Federal Employee Group Life Insurance and Service Group Life Insurance programs. In 1997, the premium assumed from these arrangements was approximately $85 million. 11. Other Commitments and Contingencies The Company, as a lessor, leases industrial, office, retail and other wholly owned investment real estate properties under various operating leases. Rental income for all operating leases totaled $362 million in 1998, $344 million in 1997 and $310 million in 1996. At December 31, 1998, future minimum annual rental commitments under these noncancelable operating leases are as follows (in millions): Held for Sale Held for Total Rental Investment Commitments ------------------------------------------- 1999 $150 $ 172 $ 322 2000 127 162 289 2001 103 140 243 2002 77 117 194 2003 49 99 148 Thereafter 152 758 910 =========================================== Total future minimum lease receipts $658 $1,448 $2,106 =========================================== The Company, as a lessee, leases office space, data processing equipment, corporate aircraft and office furniture and equipment under various operating leases. Rental expense for all operating leases totaled $60 million in 1998 and $84 million in both 1997 and 1996. At December 31, 1998, future minimum annual rental commitments under these noncancelable operating leases are as follows (in millions): 1999 $ 44 2000 38 2001 28 2002 22 2003 14 Thereafter 17 ----------- 163 Less future sublease rental income on these noncancelable leases 6 =========== Total future minimum lease payments $157 =========== The Company is a defendant in various legal actions arising in the normal course of its investment and insurance operations. In the opinion of management, any losses resulting from the resolution of such actions would not have a material effect on the Company's consolidated financial statements. The Company is also subject to insurance guarantee laws in the states in which it writes business. These laws provide for assessments against insurance companies for the benefit of policyowners and claimants in the event of insolvency of other insurance companies. The assessments may be partially recovered through a reduction in future premium taxes in some states. At December 31, 1998 and 1997, approximately $9 million and $6 million, respectively, is accrued in other liabilities in the consolidated statements of financial position for possible guarantee fund assessments for which notices have not been received and the Company does not anticipate receiving a premium tax credit. 12. Fair Value of Financial Instruments The following discussion describes the methods and assumptions utilized by the Company in estimating its fair value disclosures for financial instruments. Certain financial instruments, particularly policyowner liabilities other than investment contracts, are excluded from these fair value disclosure requirements. The techniques utilized in estimating the fair values of financial instruments are affected by the assumptions used, including discount rates and estimates of the amount and timing of future cash flows. Care should be exercised in deriving conclusions about the Company's business, its value or financial position based on the fair value information of financial instruments presented below. The estimates shown are not necessarily indicative of the amounts that would be realized in a one-time, current market exchange of all of the Company's financial instruments. The Company defines fair value as the quoted market prices for those instruments that are actively traded in financial markets. In cases where quoted market prices are not available, fair values are estimated using present value or other valuation techniques. The fair value estimates are made at a specific point in time, based on available market information and judgments about the financial instrument, including estimates of timing, amount of expected future cash flows and the credit standing of counterparties. Such estimates do not consider the tax impact of the realization of unrealized gains or losses. In many cases, the fair value estimates cannot be substantiated by comparison to independent markets. In addition, the disclosed fair value may not be realized in the immediate settlement of the financial instrument. Fair values of public debt and equity securities have been determined by the Company from public quotations, when available. Private placement securities and other fixed maturities and equity securities are valued by discounting the expected total cash flows. Market rates used are applicable to the yield, credit quality and average maturity of each security. Fair values of commercial mortgage loans are determined by discounting the expected total cash flows using market rates that are applicable to the yield, credit quality and maturity of each loan. Fair values of residential mortgage loans are determined by a pricing and servicing model using market rates that are applicable to the yield, rate structure, credit quality, size and maturity of each loan. The fair values for assets classified as policy loans, other investments, cash and cash equivalents and accrued investment income in the accompanying consolidated statements of financial position approximate their carrying amounts. The fair values of the Company's reserves and liabilities for investment-type insurance contracts (insurance, annuity and other policy contracts that do not involve significant mortality or morbidity risk and that are only a portion of the policyowner liabilities appearing in the consolidated statements of financial position) are estimated using discounted cash flow analyses (based on current interest rates being offered for similar contracts with maturities consistent with those remaining for the investment-type contracts being valued). The fair values for the Company's insurance contracts (insurance, annuity and other policy contracts that do involve significant mortality or morbidity risk), other than investment-type contracts, are not required to be disclosed. The Company does consider, however, the various insurance and investment risks in choosing investments for both insurance and investment-type contracts. Fair values for debt issues are estimated using discounted cash flow analysis based on the Company's incremental borrowing rate for similar borrowing arrangements. The carrying amounts and estimated fair values of the Company's financial instruments at December 31, 1998 and 1997, are as follows (in millions):
1998 1997 --------------------------- ---------------------------- Carrying Fair Carrying Fair Amount Value Amount Value --------------------------- ---------------------------- Assets (liabilities) Fixed maturities (see Note 3) $21,006 $21,006 $21,546 $21,546 Equity securities (see Note 3) 1,102 1,102 1,273 1,273 Mortgage loans 12,091 12,711 13,286 14,010 Policy loans 25 25 749 749 Other investments 349 349 130 130 Cash and cash equivalents 461 461 546 546 Accrued investment income 375 375 457 457 Financial instruments included in Closed Block (see Note 5) 3,587 3,652 - - Investment-type insurance contracts (22,127) (21,606) (22,115) (22,637) Debt (671) (708) (459) (486)
13. Statutory Insurance Financial Information The Company prepares statutory financial statements in accordance with the accounting practices prescribed or permitted by the Insurance Division of the Department of Commerce of the State of Iowa. Currently "prescribed" statutory accounting practices include a variety of publications of the National Association of Insurance Commissioners (NAIC) as well as state laws, regulations and general administrative rules. "Permitted" statutory accounting practices encompass all accounting practices not so prescribed. The impact of any permitted accounting practices on statutory surplus is not material. The accounting practices used to prepare statutory financial statements for regulatory filings differ in certain instances from GAAP. Prescribed or permitted statutory accounting practices are used by state insurance departments to regulate the Company. The NAIC has adopted the Codification of Statutory Accounting Principles (Codification), the result of which is expected to constitute the primary source of "prescribed" statutory accounting practices assuming formal adoption by Iowa regulatory authorities. If adopted as proposed, the codification will likely change, to some extent, prescribed statutory accounting practices and may result in changes to the accounting practices that the Company uses to prepare its statutory-basis financial statements. Codification will require adoption by the various states before it becomes the prescribed statutory basis of accounting for insurance companies domiciled within those states. The impact on the Company's statutory financial statements has not been determined at this time. Life/Health insurance companies are subject to certain risk-based capital (RBC) requirements as specified by the NAIC. Under those requirements, the amount of capital and surplus maintained by a life/health insurance company is to be determined based on the various risk factors related to it. At December 31, 1998, the Company meets the RBC requirements. The following summary reconciles the assets and stockholder's equity at December 31, 1998, 1997 and 1996, and net income for the years ended December 31, 1998, 1997 and 1996, in accordance with statutory reporting practices prescribed or permitted by the Insurance Division of the Department of Commerce of the State of Iowa with that reported in these consolidated GAAP financial statements (in millions):
Stockholder's Assets Equity Net Income --------------------------------------------- --------------------------------------------- December 31, 1998 As reported in accordance with statutory accounting practices - unconsolidated $70,096 $3,032 $511 Additions (deductions): Unrealized gain on fixed maturities available-for-sale 997 997 - Other investment adjustments 1,620 1,081 176 Adjustments to insurance reserves and dividends (169) (192) (56) Deferral of policy acquisition costs 1,105 1,105 - Surplus note reclassification as debt - (298) - Provision for deferred federal income taxes and other tax reclassifications - (475) 165 Other - net 294 219 (101) ============================================= As reported in these consolidated GAAP financial statements $73,943 $5,469 $695 ============================================= December 31, 1997 As reported in accordance with statutory accounting practices - unconsolidated $63,957 $2,811 $432 Additions (deductions): Unrealized gain on fixed maturities available-for-sale 1,176 1,176 - Other investment adjustments 853 1,141 27 Adjustments to insurance reserves and dividends (173) (131) (41) Deferral of policy acquisition costs 1,057 1,057 43 Surplus note reclassification as debt - (298) - Provision for deferred federal income taxes and other tax reclassifications - (643) 7 Other - net 184 171 (14) --------------------------------------------- ============================================= As reported in these consolidated GAAP financial statements $67,054 $5,284 $454 ============================================= Stockholder's Assets Equity Net Income --------------------------------------------- December 31, 1996 As reported in accordance with statutory accounting practices - unconsolidated $56,837 $2,504 $415 Additions (deductions): Unrealized gain on fixed maturities available-for-sale 964 964 - Other investment adjustments 355 901 53 Adjustments to insurance reserves and dividends (156) (115) (41) Deferral of policy acquisition costs 1,058 1,058 38 Surplus note reclassification as debt - (298) - Provision for deferred federal income taxes and other tax reclassifications (6) (493) 60 Other - net 90 133 1 ============================================= As reported in these consolidated GAAP financial statements $59,142 $4,654 $526 =============================================
14. Dividends On December 1, 1998, the Company's Board of Directors declared dividends comprising cash and other assets totaling $200 million to its sole shareholder, Principal Financial Services, Inc. At December 31, 1998, $140 million of the dividends have been paid and the remaining balance is reported in other liabilities. 15. Year 2000 Issues (Unaudited) In 1995, the Company began investigating the potential impact of the Year 2000 on its systems, procedures, customers and business processes. The Year 2000 assessment provided information used to determine what system components must be changed or replaced to minimize the impact of the calendar change from 1999 to 2000. The Company will continue to use internal and external resources to modify, replace, and test its systems. Management estimates 100% of the identified modifications to mission critical systems and 99% of the identified modifications to other systems have been completed for its Year 2000 project. The project completion is scheduled to occur prior to any anticipated impact on the Company operations. The total cost for the project is estimated to be $20 million, with the costs being expensed as incurred until completion. The Company faces the risk that one or more of its critical suppliers or customers (external relationships) will not be able to interact with the Company due to the third party's inability to resolve its own Year 2000 issues. The Company has completed its inventory of external relationships and is attempting to determine the overall Year 2000 readiness of its external relationships. The Company is engaged in discussions with the third parties and is requesting information as to those parties' Year 2000 plans and state of readiness. The Company, however, does not have sufficient information at the current time to predict whether all of its external relationships will be Year 2000 ready. While the Company believes that it has addressed its Year 2000 concerns, the Company has begun to develop contingency/recovery plans aimed at ensuring the continuity of critical business functions before, on and after December 31, 1999. The Company expects contingency/recovery planning to be substantially complete by April 1, 1999. The Year 2000 contingency plans will be reviewed periodically throughout 1999 and revised as needed. The Company believes its Year 2000 contingency plans coupled with existing "disaster recovery" and "business resumption" plans minimize the impact Year 2000 issues may have on the organization. The process the Company is using encourages the developers of the contingency plans to look beyond traditional systems problems which may include supply chain issues, economic conditions, social changes, political aspects and other factors which could influence the success of the business and customers. -----END PRIVACY-ENHANCED MESSAGE-----