Feb 5, 2008
Executives
J. Barry Griswell – Chairman, Chief Executive Officer Larry D.
Zimpleman – President, Chief Operating Officer John E. Aschenbrenner – President, Insurance and Financial Services James P.
McCaughan – President, Global Asset Management Michael H. Gersie – Executive Vice President, Chief Financial Officer Thomas J.
Graf – Senior Vice President, Investor Relations Julia M. Lawler-Johnson – Senior Vice President, Chief Investment Officer
Analysts
Tamara Kravec – Banc of America Securities Colin Devine – Citigroup Jeff Schuman – Keefe, Bruyette, and Woods Eric Berg – Lehman Brothers Ed Spehar – Merrill Lynch Suneet Kamath – Sanford C. Bernstein & Company Dan Johnson – Citadel Investments Tom Kilmokie – Goldman Sachs
Operator
Good morning and welcome to the Principal Financial Group fourth quarter 2007 conference call. There will be a question and answer period after the speakers have completed their remarks.
(Operator Instructions). I would now like to turn the conference over to Tom Graf, Senior Vice President of Investor Relations.
Thomas J. Graf
Thank you. Good morning and welcome to the Principal Financial Group’s quarterly conference call.
If you don’t already have a copy, our earnings release and financial supplement can be found on our website at www.principal.com/investor. Following a reading of the Safe Harbour Provision, CEO Barry Griswell, Chief Operating Officer Larry Zimpleman, and CFO Mike Gersie will deliver some prepared remarks.
Then we’ll open up for questions. Others available for the Q&A are: Division President John Aschenbrenner, responsible for the life and health insurance segment, and Jim McCaughan, responsible for global asset management, and Julia Lawler, Chief Investment Officer.
Some of the comments made during this conference call may contain forward looking statements within the meaning of the Private Securities Litigation Reform Act. The company does not revise or update them to reflect new information, subsequent events, or changes in strategy.
Risks and uncertainties that could cause actual results to differ materially from those expressed or implied are discussed in the company’s most recent annual report on Form 10K and quarterly report on Form 10Q filed by the company with the Securities and Exchange Commission. Barry?
J. Barry Griswell
Thanks, Tom, and welcome to everybody on the call. This morning I will continue my pattern of briefly commenting on our performance for the year and the quarter.
Mike Gersie will then provide a detailed review of our financial results. Larry Zimpleman will follow Mike with an operational overview.
As communicated our investor day, we have three key growth engines: US asset accumulation, Principal Global Investors, and Principal International. In 2007 each of these three asset management and accumulation segments delivered record operating earnings driving a 9% growth in total company earnings and a 12% growth in earnings per share.
Excluding the health division results, which we will discuss in more detail, total company earnings improved 15% from a year ago. In a year marked by adverse credit conditions and volatile equity markets, we view these results as particularly strong.
In addition to record operating earnings of $1.1 billion for the year, total company highlights include: record operating revenue of $11.2 billion, a 14% increase; record assets under management of $311 billion, an increase of 21%; and 16.4% return on equity at year end, a 110 basis point improvement from year ago. The continued strength of our growth engines was also evident in the fourth quarter.
These businesses delivered outstanding results, performance that supports our outlook for continued strong long-term growth. Highlights include: $5.6 billion of sales from our three key retirement and investment offerings, full service accumulation, Principal funds and individual annuities, a 63% increase, 20% growth in Principal Global Investors fee, mandate business earnings reflecting continued strong growth in third party assets, and a 70% increase in Principal International earnings in the fourth quarter; a tremendous finish to a breakout year.
Earnings in our other asset management and accumulation businesses were solid as well during the fourth quarter, particularly in light of spread widening and commercial securitization markets and volatile and declining equity markets. Moving to the life and health insurance businesses, the fundamentals of the specialty benefits and individual life divisions are sound.
Each delivered solid earnings in the fourth quarter. Fourth quarter earnings of the health division fell short of expectations.
We’re working hard on the turnaround of the division, but it will take time to implement the pricing adjustments and network discount modifications needed to bring the health business to desired profitability levels. However, we’ve made good progress in managing expenses to the current level of membership and we will continue to manage that appropriately.
We remain committed to the success of all of our insurance businesses. Each contributes to the strength of our small and medium business franchise; each provides earnings diversification for the organization, an extremely important benefit in times of difficult equity and credit markets; and each can contribute to the organization’s long-term profitable growth.
Before closing my remarks I’ll comment on net income and our outlook going forward. While we had a significant drop in net income in the fourth quarter, which Mike will discuss, much of the decline reflects market conditions.
As market conditions improve we would expect to recover a meaningful portion of the losses recognized in the fourth quarter. Let me also comment on total company outlook given the current environment.
Two-thousand-eight will be a challenging year. After dropping nearly 4% in the fourth quarter, the S&P dropped another 6% in the month of January.
This directly impacts our level of assets under management and, therefore, operating revenues and earnings. We most recently provided estimates of the impact of equity markets on earnings at our investor day.
In addition, continued adverse credit conditions translate into lost revenues and earnings from commercial mortgage loan, origination, and securitization. That said, our fundamentals remain very strong.
We remain committed to and confident in our ability to achieve our longer-term performance goals, 11% to 13% average annual growth in EPS, and roughly 50 basis points average annual improvement and return on equity. Mike?
Michael H. Gersie
Thanks, Barry. This morning I’ll spend a few minutes providing financial detail for each of our four operating segments, but before I do, a brief overview at the total company level.
While reported earnings were down from the year-ago quarter, after isolating the sources of the decline – primarily health division results in the impact of falling equity markets – we see a much better picture with a continued strong underlying performance in our asset management and accumulation businesses. Before I begin the operating segment discussion I’ll highlight a change in our reporting format.
US asset management and accumulation is now separated into two segments: US asset accumulation, which includes our US-based accumulation and guaranteed businesses, and global asset management, which houses Principal Global Investors. Let me start with US asset accumulation.
Segment account values are up $17.5 billion or 11% from a year ago to $181 billion at year end. For the full year segment earnings increased 21%, 16% excluding the net benefit of $28 million disclosed last quarter for full service accumulation.
In fourth quarter 2007 segment earnings increase 2% from a year ago to $150 million. Three items dampened the comparison.
With the S&P down nearly 4% in the fourth quarter 2007 and up more than 6% in fourth quarter 2006 there was a meaningful impact on the quarterly variance from deferred policy acquisition cost, or DAC (sic) true-ups. We true-up amortization expense quarterly for actual experience, including equity market performance.
Between full-service accumulation and individual annuities, true-ups dampened the comparison by $6.5 million after tax, about $4 million and about $2.5 million respectively. Full-service accumulation earnings were also dampened in fourth quarter 2007 by about $2 million for refinement to capitalizations and full-service pay-out earnings were reduced $3.5 million for our settlement with the Connecticut attorney general.
Adjusting for these items, segment earnings improved about $15 million or 10% in line with the comp failure growth. Let me now offer some additional business-specific detail starting with full-service accumulation.
As I mentioned, DAC amortization expense and a refinement to capitalizations dampened the quarterly comparison by about $6 million in total, or about $8.5 million on a pre-tax basis. Adjusting for these items, pre-tax earnings were up about 19% as compared to 17% growth in average account values.
Moving to Principal funds and $11 million, earnings are up 77% from a year ago as our mutual funds business continue to achieve good organic growth and solid post-merger performance. Principal funds earnings did decline $2 million on a sequential basis.
This reflects normal expense fluctuations as well as the impact of poor equity markets, which resulted in a $1.2 billion or 3% sequential decline in mutual fund account values. At $15 million individual annuity earnings were down 24% from a year ago and a 23% increase in average account values.
The decline primarily relates to the impact of market volatility on our DAC true-ups as discussed. As well as the net market-to-market of our guaranteed minimum withdrawal benefit liability, which we currently account for in operating earnings.
As markets stabilize we’d expect individual annuity earnings to again grow in line with account values. At $27 million in fourth quarter 2007, Principal Global Investors' earnings declined $5 million from a year ago.
While the decline reflects commercial mortgage back securitization spread widening and increased spread hedging cost, the impact of adverse credit conditions has clearly been minimized by our shift to the US bank joint venture in our hedging program. In spite of market conditions, Principal Global Investor earnings are up 6% for the year.
This reflects continued strong fee mandate business earnings, which increased 20% in the fourth quarter and 44% for the full year. The breakdown between PGI’s fee earnings and their spread and securitization earnings is a new financial supplement display.
It reflects our efforts to give investors greater visibility into our new segmentation. Moving to international asset management and accumulation, fourth quarter earnings were $25 million, up 70% from a year ago.
The earnings increase reflects solid growth from a year ago in Brazil, Hong Kong, Chile and China. Based on normalized earnings, segment ROE was 8.8% at year end.
While US equity markets were down in the fourth quarter, Principal International experienced positive investment market performance of more than $800 million or 3% of beginning of quarter assets under management. Clearly Principal International provides another important source of earnings diversification for the company.
Moving to the life and health segment, at $42 million fourth quarter earnings were down $23 million from a year ago. Especially benefits delivered earnings of $26 million during the fourth quarter, a 19% improvement from a year ago with the division growing premiums and fees by 12% while holding growth and operating expenses to 2%.
Individual life earnings were $26 million in the fourth quarter compared to $30 million a year ago. Adjusting fourth quarter 2006 results for investment earnings on a higher capital base and lower-than-normal DAC amortization expense, division earnings improved modestly from a year ago.
Health division had a loss of $9 million in fourth quarter 2007. This compared to $2 million of losses in fourth quarter 2006 after adjusting that period for the development of year end 2006 claims as previously communicated.
Due to seasonality of claims experience in our plans with higher deductibles, we expected negligible earnings in fourth quarter 2007. However, at 89% for the quarter, the group medical incurred loss ratio was about 300 basis points higher than we had expected as actual experience continues to run above pricing.
Larry will discuss the work we’re doing to address this issue. Let me now comment on fourth quarter’s $212 million of realized/unrealized capital losses.
This includes unrealized capital losses of $26 million, primarily from the market to market of interest rate and credit defaults loss. It also includes $21 million of realized capital losses related to derivative positions, $135 million of losses related to impairment of fixed maturity securities, and $34 million on impairments on equity securities.
Between the fixed maturity and equity security impairments, $85 million relates to certain structured assets. Structured asset values have generally been hit hard by recent market turmoil.
Because these assets have equity-like characteristics we took the conservative position and permanently impaired them. However, we continue to believe the fundamental outlook for these securities remains strong and that they will ultimately recover.
With market illiquidity reducing fair values, at year end we also conservatively valued our collateralized debt obligations which generated $49 million of losses. We believe the current fair value is significantly below the value we will ultimately recover on these assets, as well.
Combined structured assets and CDOs made up approximately two-thirds of our losses in fourth quarter and, again, we believe we will see substantial recovery. The remaining losses were in line with expectations given market conditions overall, including spread widening.
We remain very positive about the quality and diversification of our portfolio and about our ability to effectively manage exposures. Before handing off to Larry I’ll cover capital and provide more colour on our growth expectations.
We had some internal capital movements during fourth quarter. Reflecting a change in our capital formula, health division returned about $100 million to corporate and specialty benefits returned about $60 million.
This was partially offset by roughly $130 million of higher capital requirements in our other segments. In terms of the external view of our capital position, we’re basically at the level required by the rating agencies and have a modest amount of debt capacity.
In terms of uses of capital, organic growth and strategic acquisitions remain our top two priorities. We also continue to return capital to share holders through share repurchases.
As previously communicated, we completed the remaining (inaudible) of the board’s May 2007 authorization in October. We also completed half of the board’s $500 million November 2007 authorization.
This was accomplished through an accelerated program under which we received 2.9 million shares in November 2007 and an additional 900,000 shares upon completion of the contract in January 2008. We also returned $236 million to shareholders in the fourth quarter through our annual common stock dividend.
Moving to our growth expectations, some important items to keep in mind. Growth targets should be applied to normalized results.
As we discussed throughout the year, we’ve had a number of items impacting 2007 operating earnings, which on a net basis totalled $39 million after tax. The breakdown is net benefits of $28 million for full-service accumulation, $19 million for Principal International, and $10 million for corporate and other.
These benefits were partially offset by $15 million for the development of year-end 2006 claims in the health division and $3 million of charges for full-service payout. Regarding our outlook for 2008, markets continue to perform below our equity market performance assumption of roughly 2% per quarter.
As previously communicated, a 10% immediate decline in markets followed by a 2% per quarter increase generates a reduction in total company earnings of roughly 4% to 6%. As Barry communicated, after a meaningful drop in the fourth quarter the S&P declined another 6% in January.
Three other noteworthy impacts on our outlook: We expect very little improvement in credit market conditions in 2008 and, therefore, a delay before Principal Global Investors’ spread and securitization businesses again contribute to profitability. We now expect results from the spread and securitization business to range from break even to a modest loss for the year.
This compares to the $14 million PGI earned from that business in 2007. We now expect run rate earnings for the health division of approximately $35 million to $40 million for 2008, which compares to a $50 million run rate for 2007.
This change reflects expected declines in the size of the black of business, as well as a $4 million after-tax impact on 2008 earnings from the division’s fourth quarter 2007 return of capital. We now expect $60 million to $70 million of losses in the corporate and other segment for 2008.
This reflects lower yields and a lower level of invested assets, interest expense on $250 million of short term debt issued in the fourth quarter of 2007, and lower projected earnings from joint venture real estate. This compares to segment losses of just under $40 million in 2007.
Larry?
Larry D. Zimpleman
Thanks, Mike. As indicated, I will now provide an overview of operations covering our ongoing focus on three areas: continuing growth in our asset accumulation businesses, leveraging our global asset management expertise, and profitably growing our insurance businesses.
Let me start with life and health. It was another strong year for specialty benefits.
Premium and fees are up 12% for the year marking the fourth consecutive year of double-digit growth in the business. This combined with a 230 basis point improvement in operating expenses as a percent of premium and fees lead to a record operating earnings of 6% over a strong 2006.
In the individual life division we continue to build sales momentum across a broad spectrum of products including double-digit growth for our non-qualified offerings. For the year, total premium and deposits are up 17% for the division with particularly strong growth in first year and single premiums and deposits.
Our sales success reflects good performance and increasing momentum with independent distribution. It also reflects continued strong performance from our career channel with both Asian productivity and four-year retention running significantly ahead of LIMRA (sic) industry averages.
The strength of our career channel is not only benefiting the individual life division, but also the full-service accumulation, mutual funds, individual annuities, and individual disability businesses. While we were disappointed in the health division’s fourth quarter results, we know what the issues are and we are working diligently to fix them.
In addition to pricing adjustments and tightening our underwriting guidelines, we’re taking a number of other actions. These include entering into more Principal-specific network contracts so we can gain greater control of our claims costs and moving toward more fixed fee arrangements in our existing network contracts.
We’ve also evaluated our claim payment practices and are making appropriate changes. And to improve the health of our members and drive down costs we offer our wellness product as an integral part of our health care offerings.
As discussed throughout the year, diligent expense management remains a key focus. In 2007 we improved operating expenses as a percentage of premium and fees by 60 basis points for insured medical and 550 basis points for the fee-for-service business.
We’ll continue to align expenses with expected membership levels going forward. All this said, a return to membership growth and a sustainable return on equity of 15% will be a multi-year process.
We continue to experience a net decline in health division covered members in the fourth quarter and we do expect further declines in membership in 2008. The decline is the result of implementing the necessary pricing adjustments to bring the business to desired profitability.
I’ll close the health discussion with a reminder of the longer-term opportunities for the division. Opportunities created by increasing market interest in consumer-driven health care, health savings accounts, and wellness.
We continue to believe we have the expertise to capitalize on these trends in both our insured medical and fee-for-service businesses. Let me now comment on our US retirement businesses.
I’ll start with full-service accumulation where account value growth, sales, and net cash flow continue to reflect the business’ underlying strength. At quarter end full-service accumulation account values were $103 billion, an increase of $11 billion or 12% from a year ago, which compares to a 3.5% increase in the S&P 500.
That strong increase reflects good growth in deposits from existing retirement plan investors, strong plan and participant level retention, and outstanding sales. In the fourth quarter full-service accumulation delivered $2.4 billion of sales, up 30% from a year ago.
At $9.5 billion for 2007 we achieved our best sales year on record, improving $2.3 billion or 31% for the year and breaking through the $9 billion mark two years ahead of plan. Alliances continue to be an increasingly important element of our sales growth making up 40% of 2007 sales and improving 94% from a year ago to $3.8 billion for the year.
Total retirement suite remains a key driver, as well, as 61% of 2007 sales based on assets. After delivering 31% growth in 2007, achieving sales growth of 10% to 12% in 2008 will clearly be challenging.
That said, we remain optimistic we can do so, reflecting our strong and improving sales infrastructure, the momentum of our alliance strategy, and the competitiveness of our total retirement suite offering. Moving to net cash flows, after achieving $1.6 billion for the first half of 2007, full-service accumulation delivered $3.1 billion in the second half.
At $4.7 billion for the year that translates into 5.1% of beginning of year account values. One final point on full-service accumulation.
We continue to make meaningful investments in this business and those investments are paying off. A couple of examples of some incremental gains: our investment in expanding our large-case capabilities has driven up our 1,000-and-above employee plan count by 14% from a year ago.
Our investment in enhancing our asset retention capabilities generated our first billion-dollar year of additional asset capture, a 29% improvement, and our investment in retire secure is driving better planned economics with 13% higher participation rates and 9% higher salary deferrals. Moving to principal funds, post-merger earnings for the year were in line with our expectations given market conditions, as were account values.
Mutual fund sales were up 130% for the year with our new third-party distribution contributing about 85% of that gain and our existing channels contributing about 15%. While we did experience additional outflows in the fourth quarter, flows improved from the third quarter and our lapses as a percent of beginning of period account values remained in line with published industry rates.
Importantly, we’re optimistic we can deliver solid ongoing improvement in mutual fund flows throughout 2008. We expect to have about 33% more wholesalers in place in average in 2008 than we did in 2007.
And going into 2008 we have 65% more funds approved for sales on advisors top tier platforms than we did going into 2007. We also have a great line-up of asset allocation funds which play very well in volatile environments where investors seek safety.
In the fourth quarter Lipper Research recognized us as one of three fund firms whose target date funds showed the greatest consistency over the past three years. Moving to global asset management, Principal Global Investors continues to leverage and expand its expertise.
Compared to a year ago, Principal Global Investors’ assets under management is up $45 billion or 23% to a record $236 billion. This includes a record $87 billion of third party assets, an increase of 48% from a year ago, 24% on an organic basis.
At $4.5 billion for the quarter and nearly $16 billion for the year we remain extremely pleased with Principal Global Investors’ net cash flows. Investment performance remains strong as well with 53% of PGIs retirement plans separate accounts and the top two Morningstar quartiles for the one-year period, 76% for the three-year period, and 75% for the five-year period.
That track record includes continued strong equity investment performance, which has driven equity assets under management up 30% from a year ago to nearly $70 billion. PGI continues to experience increasing success with institutional and sub-advisory clients both in the US and internationally.
This reflects strong investment performance over a broad range of assets, innovative fund and mandate structures, and strong build-up of the global sales force. Net cash flows from these two sources were $11.5 billion in 2007 or 19% of beginning-of-year assets; strong growth from $8.3 billion of net flows in 2006 and $5 billion in 2005.
In 2007 Principal International again made exceptional progress accelerating growth and profitability. Segment assets under management are up 50% from a year ago to a record $29 billion, up 38% excluding merger and acquisition.
This growth includes net cash flows of $2.1 billion for the year, which translates into 11% of beginning-of-year assets. With over a billion dollars of net cash flows over that period, Brazil has been the key contributor to organic growth in assets under management as well as earnings growth.
But I’d also point to solid net cash flows and earnings growth in each of our operations and to China in particular. Reported assets under management does not include assets under management in China, which have increased from approximately $1.6 billion a year ago to $3.7 billion at year-end 2007.
While we did experience a significant decline in assets under management in China from third quarter, this was due to market declines and a tendency for investors to withdraw from older funds to invest in new offerings. A couple final points.
Principal International continues to do a tremendous job transitioning to more fee-based businesses. Last quarter we began disclosing some additional breakdowns for our equity method or unconsolidated subsidiaries, including fee revenues.
On a GAAP basis fee revenues are up $22 million year to date or 20%. However, including our equity methods subsidiaries fee revenues were up $159 million or 72% for the year.
In light of our continued strong outlook for Principal International, we’re updating our return on equity goals for the segment. We’re now targeting 11% return on equity by 2010, up from our previous target of 10%.
This higher target is in line with our goal to increase segment return on equity by roughly 75 basis points per year on average on a normalized basis. In closing, we remain sharply focused on executing our growth strategy.
As always, we’ll continue working hard to extend our leadership in the industry to meet the needs of growing businesses and their employees and to deliver superior long-term results for our share holders. This concludes our prepared remarks.
I would now ask the conference call operator to open the call to questions.
Operator
(Operator Instructions). Your first question comes from Suneet Kamath of Sanford Bernstein.
Suneet Kamath – Sanford C. Bernstein & Company
Thanks and good morning. A question on the health business.
Barry, you said many times in the past that all of your businesses have to perform well to remain in the business portfolio and based on your comments now we’re looking at flat earnings in 2008 and, per your comment, the multi-year turnaround. So my question is, how much longer or how much runway are you going to give this business to turn around before you consider other options?
J. Barry Griswell
Good morning, Suneet. I appreciate the question.
You know, I do stay, we stay committed to all of our businesses having to perform solidly and that continues to be true for health. It is a little more complicated when you’re dealing with a business that has a significant amount of renewals on an annual basis.
It takes a longer amount of time to know if your turn around is being effective. I just continue to believe that the best thing we can do for long-term shareholder value is to turn the business around.
We’re focused on that. I think we’ve said and I would say it’s on a short leash.
We have to prove that it is going to turn around and we have some internal metrics that we look at to make sure that’s true and we’ll continue to do so. We’re not just sitting here letting the business deteriorate.
We’re working very hard on turning it around and I think we’re going to see some signs of that in 2008. As I say, we have some metrics we’re looking at and we’ll do the appropriate thing over time.
Suneet Kamath – Sanford C. Bernstein & Company
Okay. Thanks.
Operator
Your next question will be from Tamara Kravec of Banc of America.
Tamara Kravec – Banc of America Securities
Thank you. Good morning.
A couple of questions. First, in terms of your investment portfolio, at your investor day you talked about your sub-prime exposure and I think it was around $700 million or around 1% of your invested assets and you’ve currently realized losses on $49 million of it roughly in the fixed maturity security category.
How comfortable are you feeling now given no real improvement in the credit environment this year that you’re not going to have additional issues with your sub-prime exposure? And the second question is, I know you touched on this in your comments, but you talked about your hedging program and I wanted to delve more into that in terms of how it’s working across your segments and what you would expect to change this year given the environment.
Thanks.
J. Barry Griswell
Thanks, Tamara. I think I’ll ask Julia Lawler, our chief investment officer, to handle the first and maybe the second as well.
Julia M. Lawler-Johnson
Yes. Good morning, Tamara.
On the sub-prime portfolio you’ll recall from investor day – and we’re going to put out a, re-file the 8K and update all the numbers, but you can see on the supplement that our home equity loan for about $557 million. And that is the category, you’ll recall, we said is our higher quality older (inaudible).
That remains high quality and it would take a tremendous amount of deterioration, even from our current (inaudible) and residential mortgages for those to be harmed. So we still feel very good about those.
Then you recall that the rest of our sub-prime is up in that CDO category. That is where all of our impairments occurred is the sub-prime inside of those CDOs.
And we took probably more impairment than I would have anticipated. A couple reasons for that.
There were probably more sub-prime issues that occurred than we anticipated and the values of those declined even more than we anticipated. I’m not sure we believe that we’re going to see full impairment down to those levels, but those are probably two things.
So what’s left over in those CDO categories is about – and you’ll see this in the 8K, but I think we can say this – about $56 million. And while it’s a small number, again, it would take a substantial amount of deterioration yet on the sub-prime market for those to be affected.
So, I think for now we have reflected pretty conservative impairment numbers for our sub-prime portfolio. So before I move on to the next question I want to make sure I answered that one for you.
Tamara Kravec – Banc of America Securities
Yes. Thank you.
Julia M. Lawler-Johnson
On the hedging program, you know, we worked really hard to make sure our asset liability management is tightly managed and we do that through derivatives. So despite the volatility in the market, I think that causes us to continue to be very, very disciplined in our hedging program.
So the interest rate movement that you see is related to our duration management. And the only time you really see that market through net income is when we can’t get hedge accounting treatment, which means that we’re either doing it short term for daily cash position or at a portfolio level.
So I would see no change and, in fact, continued discipline in that hedging program.
Tamara Kravec – Banc of America Securities
Okay. And then one other quick question and actually follow upon Suneet’s question, Barry.
Is the life and health business – and I guess more the health business – is it at all in your mind a matter of scale or is it really just more the fine tuning of the size of the organization that you have?
J. Barry Griswell
Well, you know, certainly scale in that business is important. We don’t think scale in that business is terribly important at a macro level.
In other words, you don’t have to be a certain size in total. But what you do need to have is scale within individual markets.
And that’s really been a key part of our strategy is to reduce the number of markets we operate in and to make sure that we’re in markets where we do have scale or where we think we can achieve scale. There are a lot of things going on in the business that are not necessarily related to that.
They’re related more to some of the shifts to consumer-driven health care, health savings accounts. There’s quite a bit of movement in discounts and the way discount networks are working.
And quite frankly, some behaviour changes on how people try to get around limits within discounts. So I would say it’s more around fine tuning and getting the business on track with the current way of running the business and not so much around scale.
But we do watch scale and obviously scale is important. One other area that’s important is in discount networks and we try to get around that in certain ways, as I mentioned or Larry mentioned.
We’re doing more direct contracting on discounts and we’re also, on the fee-for-service business, as you know, we have the Etna (sic) signator national discounts, so those are just a few things that we’re doing and hope responds to your question.
Tamara Kravec – Banc of America Securities
Okay. And you had said in your opening comments that this business is a benefit in terms of the credit markets.
I guess, what specifically did you mean by that?
J. Barry Griswell
Well, I think what we would argue broadly is that being in the risk business is a good diversification of earnings and it’s a good point that unfortunately the health business has gotten a little sideways at a time when the equity markets are more volatile. But generally speaking you would think being in the risk business is a good thing during times of volatility.
It just happens to be at this very moment that our health business is a bit off. But I would remind people that the run rate on that business is still double-digit ROE and even on a reporting basis it’s about 7%.
So it’s not altogether bad to be in the risk businesses, we just need to focus on getting the health business turned around. As was mentioned, specialty benefits in the life division are performing very, very well.
Tamara Kravec – Banc of America Securities
Okay. Thank you.
Operator
Your next question will be from Jeff Schuman of KBW.
Jeff Schuman – Keefe, Bruyette, and Woods
Good morning. Question on the realized and unrealized capital losses.
We have the GAAP number, I believe $212 million. What did that map to on a statutory basis?
J. Barry Griswell
You know, we don’t have that number exactly yet. I know there’s some question about that.
We don’t think it’s going to be significantly different, but we don’t really have the refined number. When we do we’ll find a way to get that out.
Jeff Schuman – Keefe, Bruyette, and Woods
And I guess what we’re seeing with some companies is that there is a spread between the GAAP write off and the stat write off and, Mike, to the extent there are stat and GAAP differences at this point would we still look to the stats joint capital position as being kind of the governing determinant of your capital adequacy?
Michael H. Gersie
That’s correct. Yes.
And it’s very sad. I think there’s some differences of approach in terms of will it have the same impact on stat capital versus GAAP capital.
Our expectation is it’s probably close to the same, but obviously, I’ll say from a capital adequacy standpoint we’re exploring avenues as to making them different.
Jeff Schuman – Keefe, Bruyette, and Woods
Okay. And then lastly I want to make sure I understood you right.
When you talked about your capital position you talked about modest debt capacity, I believe was your phrase. I thought I understood you to say that the capital was sort of right sized relative to the rating agencies at this point.
Is that sort of the correct understanding?
Michael H. Gersie
That’s correct.
J. Barry Griswell
That’s correct.
Jeff Schuman – Keefe, Bruyette, and Woods
And so if you think in terms of free cash flow generation or excess capital generation in ’08, kind of look at the whole picture including the credit environment, what would be sort of excess capital generation, do you think, in ’08?
J. Barry Griswell
That’s a good question. We’re actually just, obviously we put together capital plans and actually update those capital plans periodically.
We’re just going through the process of updating our plan right now. I would have to say, compared to prior years our capital plan is probably a little more subdued for 2008 than it was, let’s say, in 2007.
Jeff Schuman – Keefe, Bruyette, and Woods
Okay. Thank you very much.
J. Barry Griswell
Thanks. And I might have to remind everybody too, we need to kind of move along.
We have quite a few people in the cue on this call. So maybe if you could limit your questions to just one or two that would be appreciated.
Operator
Your next question will be from Andrew Kligerman of UBS.
J. Barry Griswell
Andrew? I hope I didn’t scare him away.
Operator
Andrew, please check to see if you have your phone on mute. Your next question will be from Tom Gallagher of Credit Suisse.
Tom Gallagher – Credit Suisse
Good morning. The only questions I had were, I just want to understand what’s driving the big change in impairment methodology here.
Are you seeing a much more conservative assessment for bid-versus-ask spread? And then also, how does that change involved to your outlook for investment losses through the balance of ’08?
Thanks.
J. Barry Griswell
Tom, I would say that the values have not changed. We think we’ve had the values right.
A lot of these assets were sitting in other comprehensive income categories and I think just being prudent you at some point say, well, over what type, if they are going to recover over what time would it be? And you have to make a judgement.
And our judgement is let’s be transparent, let’s be conservative, and let’s mark them to, and yeah, it’s a tough thing to do because there’s not a lot of good ask out there. So you end up taking a hit and that’s why we’re pretty confident a lot of these assets will come back over time.
But really the only change is that time to look over what period of time they might recover and just making the decision to go ahead and permanently impair them. We think that’s the right, conservative, prudent thing to do.
Tom Gallagher – Credit Suisse
And then in terms of just expectations for ’08 in terms of investment.
J. Barry Griswell
Maybe Julia can answer that. Obviously we’re in a difficult environment to predict.
Julia, do you want to?
Julia M. Lawler-Johnson
Well, actually I think if you look at what we did at the end of ’07 in these numbers and the approach we took to be more conservative for the end of ’07, I actually feel barring any major recession I feel very good about the outlook for ’08. Because we were so conservative in our position at the end of ’07.
So I’m actually feeling a little bit optimistic about our outlook for ’08.
Tom Gallagher – Credit Suisse
And Julia, that also captures any substantial changes we’ve had in spreads just for the full month of the year.
Julia M. Lawler-Johnson
Yes, although I would tell you that interestingly enough on some of the structured assets that we permanently impaired at the end of the year we’re actually seeing improvement in the market values on those assets already this year. So now, we have seen some spreads widening yet this year and I think we are going to see some volatility.
I’m not going to say we’re not going to see volatility in the markets, but I am optimistic about where our impairments might be in ’08.
Jeff Schuman – Keefe, Bruyette, and Woods
Okay. Thanks.
J. Barry Griswell
Thank you.
Operator
Your next question will be from Ed Spehar of Merrill Lynch.
Ed Spehar – Merrill Lynch
Thank you. Good morning.
Two quick questions. Number one, Mike, I think you said that there was an increase in capital of $130 million at the other operating segments and I was wondering if you could talk about what the driver is.
I mean, if it’s in the fee businesses, sort of help us understand why. And then the second question was that the higher loss in the corporate line when it seems like there should be more capital there, could you go over that one more time why you’re looking for that?
Thanks.
Michael H. Gersie
Sure, Ed. The place where we sopped up the capital it was returned to corporate.
A little bit of it was in the corporate sector and I actually think maybe the majority of it was in the corporate segment. And I think there was a little bit of additional capital that was allocated over the retirement and investor services business unit.
And so you’d say, well, in terms of, shouldn’t that, because you have more capital now in corporate, shouldn’t you then be generating a little more investment earnings on that capital? Actually, no, compared to the beginning of the year.
So one of the things you’re seeing is you look at very low losses in the corporate segment at the beginning of the year. We had a lot of access capital in corporate and, remember, we bought in $750 million worth of shares in 2007.
Didn’t issue any debt, so we sopped up a lot of that excess capital in 2007. As we got to the end of the year fewer invested assets in corporate and so that related to much lower investment earnings.
On top of that we talked about higher JV gains, income during the first half of the year, more subdued in the second half, so that gets you to why is the big number in the fourth quarter. Well, it’s a number that we kind of expected.
Look at it on a go-forward basis, again maybe just a shade of tick-up in capital because of some of the returns from the life and health business, but for the most part get lower level of capital expecting lower joint venture earnings. Last year was a very big year for joint venture earnings.
Ed Spehar – Merrill Lynch
So that $130 million of higher capital at other operating segments, you’re saying that included an increase in corporate, but that’s versus the end of ’07, right? Or the second half?
What was that versus?
J. Barry Griswell
That was, the capital was returned basically at the end of the year. So that would fall into corporate at the, retransferred in the corporate at the end of the year.
So it’s like, think of it, Ed, as taking money out of one pocket and putting it in another.
Ed Spehar – Merrill Lynch
Got it. Thanks.
Operator
Your next question will be from Colin Devine of Citi.
Colin Devine – Citigroup
I just have a couple quick questions. First on the investment portfolio.
I appreciate the conservatism of the approach. Could you just give us a few comments on how the commercial mortgage business is looking?
Second on the health business, is it fair to say, Barry, that this is really the first chance that you’ve had to re-price this business since you felt it went off the rails in fourth quarter of ’06, just given the annual re-pricing cycle? And then for Larry, in terms of 401K business, and I think sometimes what gets lost is your (inaudible) generating cash flows.
In terms of assets this year, if you didn’t make another sale how much do you think you’d bring in in new money? Is the number $11 billion or $12 billion or is it higher?
Thanks.
J. Barry Griswell
We’ll start with Julia on the investment commercial mortgage outlook.
Julia M. Lawler-Johnson
Good morning, Colin. Thanks for asking about the commercial mortgage portfolio.
That portfolio continues to perform incredibly well. Again, the loan to values on our portfolio are very low.
We’re sitting at about 59% loan to value on that portfolio, very high coverages. We’ve seen very, very little stress in that portfolio.
And I’m not just talking about things that we are immediate issues. We can survey that portfolio pretty closely.
That’s the beauty of having secured assets and if we can look to see what sort of leasing we have on our properties, the values, we’re constantly surveying that portfolio. So I feel very good about our commercial mortgage portfolio.
J. Barry Griswell
On the second point, indeed we do have most of our renewal in probably January and I think June and July, so yeah, we are just now getting into the build of the price increases starting to take, or some of them starting to take effect. It will take a full 18 months for all to take effect, I suppose, so yeah.
But I would also point out that perhaps a bigger issue right now is getting our network discount in place and doing more Principal specific. We are working very, very hard on that, putting some resources on it and we’re hopeful that will bite in and start to pay off more quickly, perhaps, than just pure price increases.
Larry, I think you got a specific question on –
Larry D. Zimpleman
On deposits? Yeah, Colin, good morning.
I think in our financial supplement we do have a breakdown for you in there between transfer deposits, which would be deposits received on new sales versus recurring deposits. Generally speaking, the recurring deposits on existing clients is somewhere between 65% and 70% of the total deposits.
So I think a reasonable expectation would be we’d probably be around $14 billion or so for 2008.
Colin Devine – Citigroup
That’s the number I was looking for. Actually a little bit better.
Thank you very much.
J. Barry Griswell
And actually, we expect to make some sales in 2008. ---Laughter
Colin Devine – Citigroup
I kind of figured that, but thanks.
J. Barry Griswell
Thanks, Colin.
Operator
Your next question will be from Eric Berg of Lehman Brothers.
Eric Berg – Lehman Brothers
Thanks very much. Good morning, Barry, and to the rest of your team.
I have a couple of questions. I want to push a little bit more on the health issue and I have a question regarding investments for Julia.
I’m just trying to understand better than I do the basis for your hope or optimism that you can turn this thing around. The reason I ask the question is that, in the face of price increases and in the face of efforts to focus the business you’ve been steadily losing customers.
So all year you lost customers. And your ability to attract new target customers was also down dramatically.
So my question is, if you have been working on this business for two years, and we know you have been working on it for a while because this concept of target customers goes back at least 2005, if you’ve been working on your strategy for two years and all that we can see in the financials – maybe there’s some other things going on good behind the scenes that we cannot see – but if all we see in the financials is a steadily shrinking business in the face of your efforts, what is the basis for your optimism that this can be fixed?
J. Barry Griswell
That’s your only question, Eric?
Eric Berg – Lehman Brothers
No, I have a question for Julia.
J. Barry Griswell
Well, I appreciate the –
Eric Berg – Lehman Brothers
Pardon me, Barry. I’m not trying to beat up on you.
I’m just trying to reconcile the numbers which are clearly upsetting to your optimism. I genuinely want to know.
J. Barry Griswell
Yeah, I appreciate that. I really do.
I guess I will let John answer if I don’t get it all the way right. But I guess I would go back to two or three years ago when we embarked, maybe a little longer, on this strategy.
We were making good progress. There were quarters and months when our target states were growing and, in fact, we hit a bump in the road.
So our strategy has been derailed slightly because of some things that went on that we’ve explained around fine behaviour changes, claims behaviour changes, some changes in the discount networks. We think we’ve identified those things.
We’ve been through lots of insurance turnarounds and there is a pattern here. You have to raise prices, you have to shrink the business slightly, but you do it with the right kind of thoughtfulness where you don’t run off good customers and you do it in ways that allow you ultimately to return to a growth mode.
And that’s exactly what we’re doing. And yes, there are some things in the background around the discount networks.
There’s a growth in the fee business that’s coming along very, very nicely. There’s growth in the wellness business.
One of the things I’ve said and I think will turn out to be true is I’d like to grow the fee for service business, the national account business, to be a much, much bigger part of our business. We’d even be willing to invest some capital in that business.
And it’s not a business that takes a lot of risk. It’s an administrative business and a business that we know very well.
And we think the outlook for the wellness business is extraordinarily strong. So we’re not sitting here wishfully hoping and praying that this business will turn around.
We have very specific plans in place and we have benchmarks and we have metrics that we’re looking at. And I would ask John if I’ve missed anything because I’ve not apparently gotten the message across a few times.
John E. Aschenbrenner
No, I think you’ve done a good job. I would just re-emphasize some things that Barry said.
One is, the business and the environment is changing and it was a very different picture the end of ’06 and the beginning of ’07 than what we were experiencing before then. So I would say this is a new environment, new challenges that hit us in early ’07.
I would argue a little bit, we haven’t been addressing these same things as maybe as long as you would say we have. The other thing that I think is important is we are losing more of the business we want to lose as opposed to the business that we don’t want to lose.
So that as we raise rates the people that are leaving tend to be the people that have the high loss ratios and the people that we’re losing money on. So we think that in addition to all the things Barry mentioned that we’re doing to improve the business, we think that as we lose the right people that’s going to help us going forward.
Eric Berg – Lehman Brothers
Okay. That was helpful additional information.
My question for Julia or Mike relates to your comments about possible recovery in asset values. My question is, if the majority of what you did from a realized and unrealized gains, pardon me, loss perspective in the quarter, if the majority of it was on a realized basis how can, there can’t be any recovery.
You’ve written off these bonds, right? Or written down the value of these bonds or written them off entirely.
So I don’t quite understand whether there would be any, how there could be any positive financial statement, book value impact to a recovery of assets since you have written these off. How would that happen?
Michael H. Gersie
Good question, Eric. Julia?
Julia M. Lawler-Johnson
Eric, let me describe a little bit about GAAP accounting that’s kind of an interesting phenomena for us. When we permanently impair an asset it doesn’t mean that we’ve sold the asset necessarily.
So for some of these structured assets that we’ve permanently impaired, when they perform we will continue to write those up through earnings because we’re going to get our interest on those deals and if we continue to hold them as we expect to we’ll actually write them up through earnings. It will be as if we bought those bonds at $0.50 on the dollar.
Eric Berg – Lehman Brothers
Okay. I didn’t know that.
I had thought that permanent means permanent and that’s it. But you say you can write them even though you’ve permanently impaired them under US GAAP.
Julia M. Lawler-Johnson
Correct. If they continue to perform they can be written up.
If they don’t perform, I mean, obviously then you’ve written them off and they’ve been written off. But if they perform as we expect them to, ultimately over time we can write those up through earnings.
Michael H. Gersie
The key point there is through earnings. That means that the extra earnings that we had not, it’s over and above what we had written it down to come back through earnings.
You can also get there by changing, I think, classification of the asset and that may or may not be an option under 2008 GAAP accounting. But on the accounting as it stands now they could come back through operating earnings.
Eric Berg – Lehman Brothers
Thank you.
Operator
Your next question will be form Dan Johnson of Citadel Investments.
Dan Johnson – Citadel Investments
I want to ask questions about this unrealized losses. Just to be clear, what we’re calling unrealized is just the, other than temporary impairments, we’re just talking about unrealized as it went through the income statement.
Can you help me get my hands around the unrealized losses that actually went through the balance sheet only? I’m just having a hard time sort of reconciling AOCI and other things like that that aren’t sort of as nicely laid out as you did for us here on page 48 in the supplement.
Julia M. Lawler-Johnson
Well, let me make sure I understand your question, Dan. What we’ve separated out on the realized and unrealized, I think we tried to show you both in Mike’s discussion and in the release is that which is truly realized or permanently impaired.
So the two things that cause something to be realized is you sold it, you unwound it if it was a derivative, or you permanently impaired it. Those are realized.
Unrealized going through that section would be marks on derivatives. So we didn’t realize them, we’re just marking them to mark it.
So remember, derivatives, no matter what kind of derivatives, not getting hedge accounting treatment is going through this same section on page 48 and that’s what’s called unrealized. So now that’s the two realized and unrealized going through our net income.
What’s going through our balance sheet in OCI is everything else. The mark on all of our bonds would be going through OCI that’s not being permanently impaired.
Michael H. Gersie
Which would include interest rates.
Dan Johnson – Citadel Investments
Exactly. So what we’ve got going on is the positive effective interest rates.
I’m just trying to figure out, especially since we took losses, there’s stuff that would have been NAOCI last quarter that wouldn’t this quarter. So if you just tried to sort of narrow down the bond, or what is it called?
The invested asset impact to AOCI in the fourth quarter, that’s actually where I was going. Thanks.
Michael H. Gersie
Thank you.
Julia M. Lawler-Johnson
I don’t have the unrealized number in front of me for OCI. I apologize.
It will be out in our 8K this month and I didn’t bring that number with me. But is that what you’re asking for is what’s going to run through OCI?
Dan Johnson – Citadel Investments
Yeah, for the most part. Just in some ways it just helps me understand how you’re marking assets in the quarter, even though you’ve determined that they’re not worthy of other than temporary impairment.
Julia M. Lawler-Johnson
Well, all of our assets, all of our bonds, are being marked at their market value. So either we’re getting trading values or we’re getting bid values.
So all of our bonds are getting marked to market. And the only thing that’s running to realized would be the impaired assets.
So as of December 2007 we showed a growth unrealized loss of about $1.2 billion on that portfolio. So what we’re saying is, and you can see it broken down by sector, you can see that we’ve reduced the value on some of those bonds by that amount.
So we are truly marking to market our bond portfolio. Is that –
Dan Johnson – Citadel Investments
(Inaudible) is a cumulative number, correct? Not an impact in the fourth quarter?
Julia M. Lawler-Johnson
Correct. That’s the total cumulative number.
Dan Johnson – Citadel Investments
Okay. Tell you what, I’ll circle back in, Tom.
I wanted to get in one other one on the CMBS portfolio. Can you give us some colour again?
This is not the mortgages that you have underwritten, but can you tell us a little bit more about that portfolio in terms of vintage and rating, please?
Julia M. Lawler-Johnson
I don’t have all the vintages. I can tell you that these are, in fact, we put this out in our 8K as well, but the quality of that portfolio – and you’re talking about just what we’re holding in our investment portfolio CMBS?
Dan Johnson – Citadel Investments
Yes, please.
Julia M. Lawler-Johnson
The quality of that portfolio is very high. And again, as I said, we’ll put it out in the 8K, but over 50% of that portfolio – in fact, about 55% of that portfolio – is rated AA or better.
And all but 2% of that portfolio is investment grade.
Dan Johnson – Citadel Investments
Do you have a sense as to how much is sitting at A or BBB?
Julia M. Lawler-Johnson
BBB we have, and again, we conservatively, I’m giving you our internal ratings here, which is more conservative than the external ratings, so keep that in mind. BBB is about 25%.
That’s all BBB.
Dan Johnson – Citadel Investments
And just by nature of vintage roughly, this is from more recent years? From four or five years ago?
Julia M. Lawler-Johnson
Oh, we would have, I mean, we’ve been buying CMBS for many, many years. Again, this is a skill set that we have had in house for a very long time.
So we would have vintages across the board. But I don’t have exactly how much would be 2001, 2002, 2003, 2004, 2005.
Dan Johnson – Citadel Investments
That’s fine. Thank you very much.
J. Barry Griswell
Thank you. I think we have time for one more, if we have somebody on the line.
Operator
Your last question will be from Tom Kilmokie (sp) of Goldman Sachs.
Tom Kilmokie – Goldman Sachs
Yeah, good morning. Thank you.
Two quick ones. I’ll try to be quick.
One, in the group business, Barry, you mentioned rising prices and declining enrolment. To me that smells a little bit of potential for adverse selection in that your good people leave you and you’re stuck with your good folks who can’t get insurance elsewhere.
What are you doing to prevent that from happening? And then just real curious, and I’m sorry if I missed this, you had provided guidance back in the fourth quarter for ’08 which incorporated a decline in the equity markets that you had seen in the third and fourth quarter.
I just wanted to clarify why you haven’t really changed your guidance or given what’s occurred just in the month of January do you think that the market’s basically going to revert back to where you saw it originally back in the fourth quarter?
J. Barry Griswell
Sure, Tom. Let me answer the last one and then I’ll ask John to maybe give a little more colour on how we’re avoiding adverse selection in the medical business.
You know, some time ago we went to a methodology where we give annual guidance and that guidance is good at the time that we give it. And I think Tom even read into his statement that we don’t update it and we don’t make any assertions that it’s accurate or not accurate.
And we really haven’t deviated from that. So we are not in the business of trying to go back and reconcile to guidance at this point.
I would strongly suggest that we’ve tried to give everybody as much information as we can. We’ve got a full year behind us of earnings and everybody knows what those earnings were and we’ve tried to give you as much colour as we can around the balance of 2008 and the key areas that we think are different.
And we think from there that you ought to be able to plug into your models good estimates as to what earnings will be. But we really don’t want to go back to giving guidance.
John, do you want to?
John E. Aschenbrenner
Sure. Tom, one of the things that helped is the cases that have the poor experience you’re going out with a larger rate increase for.
So those are the ones with the larger rate increase that are more apt to shop it and more apt to move. We’re monitoring that very closely and in great detail, but at least one high level measure is that 40% of our total business has loss ratios in excess of the target and 55% of our lapses have lost ratio in excess of the target.
So we’re actually lapsing more of the poor business than the percentages of what we have on the book. So we’re comfortable that we’re not getting that anti-selection spiral that you’re talking about.
Tom Kilmokie – Goldman Sachs
Okay. Great.
Thank you.
J. Barry Griswell
Thanks, Tom. Let me make a few brief closing comments.
This has obviously been a more difficult call and quarter than we’re used to experiencing. That’s obviously reflective of the environment we’re operating in.
Nonetheless, I think 2007 was really a very strong year for us and tried to make that point in my opening comments. We are very focused on continuing to show improvement in all of our operations, including especially the health business.
But we think we’re in the right businesses. We think we have the right trends going for us in terms of the accumulation businesses, the asset management businesses, the international businesses.
Our growth engines are doing extraordinarily well. We remain very confident about the long-term future of the operations.
I would say that this is the same management team that took you through the IPO and has managed successfully over the last six years and we have done so in some very challenging environments. And I would just reiterate our commitment to getting through this challenging environment and doing so in a way that continues to create long-term shareholder values.
Thank you all for being on the call. We appreciate it greatly.
We hope you have a great year. Thanks.
Operator
Thank you for participating in today’s conference call. This call will be available for replay beginning at approximately 1:00 p.m.
Eastern Time until end of day February 12th, 2008. Two-eight-four-eight-three-nine-nine-two is the access code for the replay.
The number to dial for the replay is 800-642-1687 for US and Canadian callers or 706-645-9291 for international callers. Thank you.
You may now disconnect.