PRINCIPAL FINANCIAL GROUP INC, 10-Q filed on 11/3/2010
Quarterly Report
Consolidated Statements of Financial Position (USD $)
In Millions
Sep. 30, 2010
Dec. 31, 2009
Assets
 
 
Fixed maturities, available-for-sale (2010 includes $251.4 million related to consolidated variable interest entities)
$ 49,311 
$ 46,221 
Fixed maturities, trading (2010 includes $162.2 million related to consolidated variable interest entities)
1,500 
1,032 
Equity securities, available-for-sale
174 
214 
Equity securities, trading (2010 includes $69.3 million related to consolidated variable interest entities)
215 
222 
Mortgage loans
11,096 
11,846 
Real estate
1,087 
1,035 
Policy loans
904 
903 
Other investments (2010 includes $129.2 million related to consolidated variable interest entities of which $129.1 million are measured at fair value under the fair value option)
3,009 
2,465 
Total investments
67,295 
63,937 
Cash and cash equivalents (2010 includes $150.0 million related to consolidated variable interest entities)
2,269 
2,240 
Accrued investment income
710 
692 
Premiums due and other receivables
1,295 
1,065 
Deferred policy acquisition costs
3,240 
3,681 
Property and equipment
461 
489 
Goodwill
344 
386 
Other intangibles
842 
852 
Separate account assets
65,659 
62,739 
Other assets
1,342 
1,678 
Total assets
143,457 
137,759 
Liabilities
 
 
Contractholder funds
38,550 
39,802 
Future policy benefits and claims
19,754 
19,248 
Other policyholder funds
583 
559 
Short-term debt
132 
102 
Long-term debt
1,582 
1,585 
Income taxes currently payable
Deferred income taxes
559 
120 
Separate account liabilities
65,659 
62,739 
Other liabilities (2010 includes $467.7 million related to consolidated variable interest entities of which $111.4 million are measured at fair value under the fair value option)
6,600 
5,586 
Total liabilities
133,422 
129,743 
Stockholders' equity
 
 
Common stock, par value $.01 per share - 2,500.0 million shares authorized, 448.4 million and 447.0 million shares issued, and 320.3 million and 319.0 million shares outstanding in 2010 and 2009
Additional paid-in capital
9,548 
9,493 
Retained earnings (deficit)
4,592 
4,161 
Accumulated other comprehensive income (loss)
477 
(1,042)
Treasury stock, at cost (128.1 million and 128.0 million shares in 2010 and 2009, respectively)
(4,725)
(4,723)
Total stockholders' equity attributable to Principal Financial Group, Inc.
9,896 
7,894 
Noncontrolling interest
139 
123 
Total stockholders' equity
10,034 
8,016 
Total liabilities and stockholders' equity
143,457 
137,759 
Series A
 
 
Stockholders' equity
 
 
Preferred stock, value
 
 
Series B
 
 
Stockholders' equity
 
 
Preferred stock, value
$ 0 
$ 0 
Consolidated Statements of Financial Position (Parenthetical) (USD $)
In Millions, except Per Share data
Sep. 30, 2010
Dec. 31, 2009
Fixed maturities, available-for-sale related to consolidated VIEs
251 
 
Fixed maturities, trading related to consolidated VIEs
162 
 
Equity securities, trading related to consolidated VIEs
69 
 
Other investments related to consolidated VIEs
129 
 
Other investments measured at fair value under fair value option
129 
 
Cash and cash equivalents related to consolidated VIEs
150 
 
Other liabilities related to consolidated VIEs
468 
 
Other liabilities measured at fair value under fair value option
111 
 
Common stock, par value (in dollars per share)
$ 0.01 
$ 0.01 
Common stock, authorized (in shares)
2,500 
2,500 
Common stock, issued (in shares)
448 
447 
Common stock, outstanding (in shares)
320 
319 
Treasury stock (in shares)
128 
128 
Series A
 
 
Preferred stock, par value (in dollars per share)
0.01 
0.01 
Preferred stock, liquidation preference (in dollars per share)
100 
100 
Preferred stock, authorized (in shares)
Preferred stock, issued (in shares)
Preferred stock, outstanding (in shares)
Series B
 
 
Preferred stock, par value (in dollars per share)
0.01 
0.01 
Preferred stock, liquidation preference (in dollars per share)
$ 25 
$ 25 
Preferred stock, authorized (in shares)
10 
10 
Preferred stock, issued (in shares)
10 
10 
Preferred stock, outstanding (in shares)
10 
10 
Consolidated Statements of Operations (USD $)
In Millions, except Per Share data
3 Months Ended
Sep. 30,
9 Months Ended
Sep. 30,
2010
2009
2010
2009
Revenues
 
 
 
 
Premiums and other considerations
$ 865 
$ 933 
$ 2,613 
$ 2,821 
Fees and other revenues
564 
551 
1,686 
1,539 
Net investment income (loss)
880 
853 
2,620 
2,542 
Net realized capital gains (losses), excluding impairment losses on available-for-sale securities
29 
51 
51 
63 
Total other-than-temporary impairment losses on available-for-sale securities
(56)
(163)
(248)
(510)
Portion of impairment losses on fixed maturities, available-for-sale recognized in other comprehensive income
45 
64 
162 
Net impairment losses on available-for-sale securities
(50)
(117)
(183)
(348)
Net realized capital gains (losses)
(21)
(67)
(133)
(285)
Total revenues
2,289 
2,270 
6,786 
6,617 
Expenses
 
 
 
 
Benefits, claims and settlement expenses
1,320 
1,317 
3,933 
3,958 
Dividends to policyholders
53 
62 
165 
188 
Operating expenses
752 
643 
2,111 
1,894 
Total expenses
2,125 
2,022 
6,209 
6,040 
Income (loss) before income taxes
164 
248 
578 
576 
Income taxes (benefits)
12 
44 
79 
86 
Net income (loss)
151 
204 
499 
491 
Net income (loss) attributable to noncontrolling interest
11 
18 
Net income (loss) attributable to Principal Financial Group, Inc.
150 
193 
492 
473 
Preferred stock dividends
25 
25 
Net income (loss) available to common stockholders
142 
185 
467 
448 
Earnings per common share
 
 
 
 
Basic earnings per common share (in dollars per share)
0.44 
0.58 
1.46 
1.54 
Diluted earnings per common share (in dollars per share)
$ 0.44 
$ 0.57 
$ 1.45 
$ 1.54 
Consolidated Statements of Stockholders' Equity
In Millions
preferred stock
preferred stock
Common stock
Additional paid-in capital
Retained earnings (deficit)
Accumulated other comprehensive income (loss)
Treasury stock
Noncontrolling interest
Comprehensive income (loss)
Total
Balances at Dec. 31, 2008
 
8,377 
3,723 
(4,912)
(4,719)
97 
 
2,569 
Increase (decrease) in stockholders' equity
 
 
 
 
 
 
 
 
 
 
Common stock issued
 
 
1,122 
 
 
 
 
 
1,123 
Stock-based compensation and additional related tax benefits
 
 
 
28 
 
 
 
 
 
28 
Treasury stock acquired, common
 
 
 
 
 
 
(4)
 
 
(4)
Dividends to preferred stockholders
 
 
 
 
(25)
 
 
 
 
(25)
Distributions to noncontrolling interest
 
 
 
 
 
 
 
(17)
 
(17)
Purchase of subsidiary shares from noncontrolling interest
 
 
 
(46)
 
 
 
 
(46)
Effects of reclassifying noncredit component of previously recognized impairment losses on fixed maturities, available-for-sale, net
 
 
 
 
10 
(10)
 
 
 
 
Comprehensive income (loss):
 
 
 
 
 
 
 
 
 
 
Net income (loss)
 
 
 
 
473 
 
 
18 
491 
491 
Net unrealized gains (losses), net
 
 
 
 
 
3,426 
 
 
3,426 
3,426 
Noncredit component of impairment losses on fixed maturities, available-for-sale, net
 
 
 
 
 
(99)
 
 
(99)
(99)
Foreign currency translation adjustment, net of related income taxes
 
 
 
 
 
115 
 
115 
115 
Unrecognized postretirement benefit obligation, net of related income taxes
 
 
 
 
 
45 
 
 
45 
45 
Comprehensive income (loss)
 
 
 
 
 
 
 
 
3,978 
3,978 
Balances at Sep. 30, 2009
 
9,481 
4,180 
(1,434)
(4,723)
98 
 
7,607 
Balances at Dec. 31, 2009
 
9,493 
4,161 
(1,042)
(4,723)
123 
 
8,016 
Increase (decrease) in stockholders' equity
 
 
 
 
 
 
 
 
 
 
Common stock issued
 
 
 
20 
 
 
 
 
 
20 
Stock-based compensation and additional related tax benefits
 
 
 
35 
 
 
 
 
 
35 
Treasury stock acquired, common
 
 
 
 
 
 
(2)
 
 
(2)
Dividends to preferred stockholders
 
 
 
 
(25)
 
 
 
 
(25)
Distributions to noncontrolling interest
 
 
 
 
 
 
 
(6)
 
(6)
Contributions from noncontrolling interest
 
 
 
 
 
 
 
14 
 
14 
Effects of implementation of accounting change related to variable interest entities, net
 
 
 
 
(11)
11 
 
 
 
 
Effects of electing fair value option for fixed maturities upon implementation of accounting change related to embedded credit derivatives, net
 
 
 
 
(25)
25 
 
 
 
 
Comprehensive income (loss):
 
 
 
 
 
 
 
 
 
 
Net income (loss)
 
 
 
 
492 
 
 
499 
499 
Net unrealized gains (losses), net
 
 
 
 
 
1,339 
 
 
1,339 
1,339 
Noncredit component of impairment losses on fixed maturities, available-for-sale, net
 
 
 
 
 
(37)
 
 
(37)
(37)
Foreign currency translation adjustment, net of related income taxes
 
 
 
 
 
 
Unrecognized postretirement benefit obligation, net of related income taxes
 
 
 
 
 
172 
 
 
172 
172 
Comprehensive income (loss)
 
 
 
 
 
 
 
 
1,982 
1,982 
Balances at Sep. 30, 2010
 
9,548 
4,592 
477 
(4,725)
139 
 
10,034 
Consolidated Statements of Cash Flows (USD $)
In Millions
9 Months Ended
Sep. 30,
2010
2009
Operating activities
 
 
Net income (loss)
$ 499 
$ 491 
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
 
 
Amortization of deferred policy acquisition costs
212 
70 
Additions to deferred policy acquisition costs
(368)
(361)
Accrued investment income
(18)
Net cash flows for trading securities
(57)
(101)
Premiums due and other receivables
(31)
(106)
Contractholder and policyholder liabilities and dividends
1,005 
1,190 
Current and deferred income taxes (benefits)
22 
128 
Net realized capital (gains) losses
133 
285 
Depreciation and amortization expense
131 
104 
Mortgage loans held for sale, acquired or originated
(42)
(42)
Mortgage loans held for sale, sold or repaid, net of gain
43 
49 
Real estate acquired through operating activities
 
(25)
Real estate sold through operating activities
34 
Stock-based compensation
34 
27 
Other
333 
74 
Net adjustments
1,430 
1,304 
Net cash provided by (used in) operating activities
1,930 
1,794 
Investing activities
 
 
Available-for-sale securities: Purchases
(5,227)
(6,601)
Available-for-sale securities: Sales
1,374 
3,771 
Available-for-sale securities: Maturities
3,608 
3,146 
Mortgage loans acquired or originated
(662)
(272)
Mortgage loans sold or repaid
1,239 
1,247 
Real estate acquired
(24)
(50)
Real estate sold
 
22 
Net (purchases) sales of property and equipment
(11)
(21)
Purchases of interest in subsidiaries, net of cash acquired
 
(46)
Net change in other investments
(41)
Net cash provided by (used in) investing activities
306 
1,156 
Financing activities
 
 
Issuance of common stock
20 
1,123 
Acquisition of treasury stock
(2)
(4)
Proceeds from financing element derivatives
79 
121 
Payments for financing element derivatives
(36)
(58)
Excess tax benefits from share-based payment arrangements
Dividends to preferred stockholders
(25)
(25)
Issuance of long-term debt
745 
Principal repayments of long-term debt
(9)
(466)
Net proceeds from (repayments of) short-term borrowings
27 
(397)
Investment contract deposits
3,016 
3,438 
Investment contract withdrawals
(5,312)
(6,871)
Net increase (decrease) in banking operation deposits
36 
80 
Other
(3)
(5)
Net cash provided by (used in) financing activities
(2,207)
(2,317)
Net increase (decrease) in cash and cash equivalents
28 
633 
Cash and cash equivalents at beginning of period
2,240 
2,608 
Cash and cash equivalents at end of period
$ 2,269 
$ 3,241 
Nature of Operations and Significant Accounting Policies
Nature of Operations and Significant Accounting Policies

1. Nature of Operations and Significant Accounting Policies

 

Basis of Presentation

 

The accompanying unaudited consolidated financial statements of Principal Financial Group, Inc. (“PFG”), its majority-owned subsidiaries and its consolidated variable interest entities (“VIEs”), have been prepared in conformity with accounting principles generally accepted in the U.S. (“U.S. GAAP”) for interim financial statements and with the instructions to Form 10-Q and Article 10 of Regulation S-X. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and nine months ended September 30, 2010, are not necessarily indicative of the results that may be expected for the year ended December 31, 2010. These interim unaudited consolidated financial statements should be read in conjunction with our annual audited financial statements as of December 31, 2009, included in our Form 10-K for the year ended December 31, 2009, filed with the United States Securities and Exchange Commission (“SEC”). The accompanying consolidated statement of financial position as of December 31, 2009, has been derived from the audited consolidated statement of financial position but does not include all of the information and footnotes required by U.S. GAAP for complete financial statements.

 

Recent Accounting Pronouncements

 

In October 2010, the Financial Accounting Standards Board (“FASB”) issued authoritative guidance that modifies the definition of the types of costs incurred by insurance entities that can be capitalized in the successful acquisition of new or renewal insurance contracts. Capitalized costs should include incremental direct costs of contract acquisition, as well as certain costs related directly to acquisition activities such as underwriting, policy issuance and processing, medical and inspection, and sales force contract selling. This guidance will be effective for us on January 1, 2012, with retrospective application permitted but not required. We are currently evaluating the impact this guidance will have on our consolidated financial statements.

 

In July 2010, the FASB issued authoritative guidance that requires new and expanded disclosures related to the credit quality of financing receivables and the allowance for credit losses. Reporting entities are required to provide qualitative and quantitative disclosures on the allowance for credit losses, credit quality, impaired loans, modifications and nonaccrual and past due financing receivables. The disclosures are required to be presented on a disaggregated basis by portfolio segment and class of financing receivable. Disclosures required by the guidance that relate to the end of a reporting period will be effective for us in our December 31, 2010, consolidated financial statements. Disclosures required by the guidance that relate to an activity that occurs during a reporting period will be effective for us on January 1, 2011. We do not anticipate this guidance will have a material impact on our consolidated financial statements.

 

In April 2010, the FASB issued authoritative guidance addressing how investments held through the separate accounts of an insurance entity affect the entity’s consolidation analysis. This guidance clarifies that an insurance entity should not consider any separate account interests held for the benefit of policyholders in an investment to be the insurer’s interests and should not combine those interests with its general account interest in the same investment when assessing the investment for consolidation. This guidance will be effective for us on January 1, 2011, and will not have a material impact on our consolidated financial statements.

 

In March 2010, the FASB issued authoritative guidance that amends and clarifies the guidance on evaluation of credit derivatives embedded in beneficial interests in securitized financial assets, including asset-backed securities, credit-linked notes, collateralized loan obligations and collateralized debt obligations (“CDOs”). This guidance eliminates the scope exception for bifurcation of embedded credit derivatives in interests in securitized financial assets, unless they are created solely by subordination of one financial instrument to another. We adopted this guidance effective July 1, 2010, and elected the fair value option for our fixed maturities within the scope of this guidance, effectively reclassifying them from available-for-sale to trading. The cumulative change in accounting principle related to unrealized losses on these fixed maturities resulted in a net $25.4 million decrease to retained earnings, with a corresponding increase to accumulated other comprehensive income.

 

In January 2010, the FASB issued authoritative guidance that requires new disclosures related to fair value measurements and clarifies existing disclosure requirements about the level of disaggregation, inputs and valuation techniques. Specifically, reporting entities now must disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and describe the reasons for the transfers. In addition, in the reconciliation for Level 3 fair value measurements, a reporting entity should present separately information about purchases, sales, issuances and settlements. The guidance clarifies that a reporting entity needs to use judgment in determining the appropriate classes of assets and liabilities for disclosure of fair value measurement, considering the level of disaggregated information required by other applicable U.S. GAAP guidance and should also provide disclosures about the valuation techniques and inputs used to measure fair value for each class of assets and liabilities. This guidance was effective for us on January 1, 2010, except for the disclosures about purchases, sales, issuances and settlements in the reconciliation for Level 3 fair value measurements, which will be effective for us on January 1, 2011. This guidance will not have a material impact on our consolidated financial statements.

 

In June 2009, the FASB issued authoritative guidance to improve the relevance, representational faithfulness and comparability of the information that a reporting entity provides in its financial reports about a transfer of financial assets; the effects of a transfer on its financial position, financial performance and cash flows; and a transferor’s continuing involvement in transferred financial assets. The most significant change is the elimination of the concept of a qualifying special-purpose entity (“QSPE”). Therefore, former QSPEs, as defined under previous accounting standards, should be evaluated for consolidation by reporting entities on and after the effective date in accordance with the applicable consolidation guidance. This guidance was effective for us on January 1, 2010, and did not have a material impact on our consolidated financial statements.

 

Also in June 2009, the FASB issued authoritative guidance related to the accounting for VIEs, which amends prior guidance and requires an enterprise to perform an analysis to determine whether the enterprise’s variable interest or interests give it a controlling financial interest in a VIE. This analysis identifies the primary beneficiary of a VIE as the enterprise with (1) the power to direct the activities of a VIE that most significantly impact the entity’s economic performance and (2) the obligation to absorb losses of the entity or the right to receive benefits from the entity that could potentially be significant to the VIE. In addition, this guidance requires ongoing reassessments of whether an enterprise is the primary beneficiary of a VIE. Furthermore, we are required to enhance disclosures that will provide users of financial statements with more transparent information about an enterprise’s involvement in a VIE. The enhanced disclosures are required for any enterprise that holds a variable interest in a VIE. We adopted this guidance prospectively effective January 1, 2010. Due to the implementation of this guidance, certain previously unconsolidated VIEs were consolidated and certain previously consolidated VIEs were deconsolidated. The cumulative change in accounting principle from adopting this guidance resulted in a net $10.7 million decrease to retained earnings and a net $10.7 million increase to accumulated other comprehensive income. In February 2010, the FASB issued an amendment to this guidance. The amendment indefinitely defers the consolidation requirements for reporting enterprises’ interests in entities that have the characteristics of investment companies and regulated money market funds. This amendment was effective January 1, 2010, and did not have a material impact to our consolidated financial statements. The required disclosures are included in our consolidated financial statements. See Note 3, Variable Interest Entities, for further details.

 

Separate Accounts

 

At September 30, 2010 and December 31, 2009, the separate accounts include a separate account valued at $181.5 million and $191.5 million, respectively, which primarily includes shares of our stock that were allocated and issued to eligible participants of qualified employee benefit plans administered by us as part of the policy credits issued under our 2001 demutualization. These shares are included in both basic and diluted earnings per share calculations. In the consolidated statements of financial position, the separate account shares are recorded at fair value and are reported as separate account assets with a corresponding separate account liability to eligible participants of the qualified plan. Changes in fair value of the separate account shares are reflected in both the separate account assets and separate account liabilities and do not impact our results of operations.

 

Goodwill
Goodwill

2. Goodwill

 

The changes in carrying value of goodwill reported in our operating segments for the nine months ended September 30, 2010, were as follows:

 

 

 

U.S. Asset
Accumulation

 

Global Asset
Management

 

International
Asset
Management
and
Accumulation

 

U.S.
Insurance
Solutions

 

Corporate

 

Consolidated

 

 

 

(in millions)

 

Balances at January 1, 2010

 

$

72.6

 

$

169.0

 

$

56.3

 

$

43.4

 

$

45.1

 

$

386.4

 

Impairment

 

 

 

 

 

(43.6

)

(43.6

)

Foreign currency translation

 

 

 

1.0

 

 

 

1.0

 

Balances at September 30, 2010

 

$

72.6

 

$

169.0

 

$

57.3

 

$

43.4

 

$

1.5

 

$

343.8

 

 

On September 30, 2010, we announced our decision to exit the group medical insurance business. This event constituted a substantive change in circumstances that would more likely than not reduce the fair value of our group medical insurance reporting unit below its carrying amount. Accordingly, we performed an interim goodwill impairment test as of September 30, 2010. As a result of the shortened period of projected cash flows, we determined that the goodwill related to this reporting unit within our Corporate operating segment was impaired and it was written down to a value of zero. We recorded a $43.6 million pre-tax impairment loss as an operating expense in the consolidated statements of operations during both the three and nine months ended September 30, 2010. We had no other significant impairments as of September 30, 2010.

 

Variable Interest Entities
Variable Interest Entities

3.  Variable Interest Entities

 

We have relationships with and may have a variable interest in various types of special purpose entities. Following is a discussion of our interest in entities that meet the definition of a VIE. When we are the primary beneficiary we are required to consolidate the entity in our financial statements. On January 1, 2010, we adopted authoritative guidance that changed the method of determining the primary beneficiary of a VIE. Prior to January 1, 2010, the primary beneficiary was the enterprise who absorbed the majority of the entity’s expected losses, received a majority of the expected residual returns or both. The new guidance identifies the primary beneficiary of a VIE as the enterprise with (1) the power to direct the activities of a VIE that most significantly impact the entity’s economic performance and (2) the obligation to absorb losses of the entity or the right to receive benefits from the entity that could potentially be significant to the VIE. The guidance also requires ongoing assessment of whether we are the primary beneficiary of a VIE. See further discussion of the adoption in Note 1, Nature of Operations and Significant Accounting Policies.

 

Consolidated Variable Interest Entities

 

Grantor Trusts

 

We contributed undated subordinated floating rate notes to three grantor trusts. The trusts separated the cash flows by issuing an interest-only certificate and a residual certificate related to each note contributed. Each interest-only certificate entitles the holder to interest on the stated note for a specified term, while the residual certificate entitles the holder to interest payments subsequent to the term of the interest-only certificate and to all principal payments. We retained the interest-only certificates and the residual certificates were subsequently sold to third parties.

 

We have determined these grantor trusts are VIEs due to insufficient equity to sustain them. As our interest-only certificates are exposed to the majority of the risk of loss due to interest rate risk, we determined we were the primary beneficiary prior to January 1, 2010. Beginning January 1, 2010, we determined we remain the primary beneficiary as a result of our contribution of securities into the trusts.

 

Collateralized Private Investment Vehicles

 

We invest in synthetic CDOs, collateralized bond obligations, collateralized loan obligations, collateralized commodity obligations and other collateralized structures, which are VIEs due to insufficient equity to sustain the entities (collectively known as “collateralized private investment vehicles”). The performance of the notes of these structures is primarily linked to a synthetic portfolio by derivatives; each note has a specific loss attachment and detachment point. The notes and related derivatives are collateralized by a pool of permitted investments. The investments are held by a trustee and can only be liquidated to settle obligations of the trusts. These obligations primarily include derivatives, financial guarantees and the notes due at maturity or termination of the trusts.

 

Prior to January 1, 2010, we determined we were the primary beneficiary of a certain number of these entities due to the nature of our direct investment in the VIEs. As of December 31, 2009, we consolidated five collateralized private investment vehicles with assets of $135.7 million. Upon adoption of the new accounting guidance as of January 1, 2010, we determined we were no longer the primary beneficiary of three of these entities with assets of $65.4 million. For these three entities, we do not control the decisions affecting the economic performance of the entities and we were not involved with the design of the entities. As of September 30, 2010, we continue to hold $55.0 million of investments in these entities classified on the consolidated statements of financial position as fixed maturities, available-for-sale or fixed maturities, trading. We also determined we are the primary beneficiary of two additional collateralized private investment vehicles. For all the collateralized structures consolidated as of September 30, 2010, we are the primary beneficiary because we act as the investment manager of the underlying portfolio and we have an ownership interest.

 

Commercial Mortgage-Backed Securities

 

In September 2000, we sold commercial mortgage loans to a real estate mortgage investment conduit trust. The trust issued various commercial mortgage-backed securities (“CMBS”) certificates using the cash flows of the underlying commercial mortgages it purchased. Prior to January 1, 2010, this entity was scoped out of the consolidation guidance as a QSPE. Based on the new accounting guidance, the previous scope exception for QSPEs no longer exists and this entity is now a VIE due to the entity having insufficient equity to sustain itself. We have determined we are the primary beneficiary as we retained the special servicing role for the assets within the trust as well as the ownership of the bond class which controls the unilateral kick out rights of the special servicer.

 

Hedge Funds

 

We are a general partner with an insignificant equity ownership in various hedge funds. These entities are deemed VIEs due to the equity owners not having decision-making ability. Before January 1, 2010, we consolidated these VIEs due to our related parties’ ownership. Beginning January 1, 2010, we continue to consolidate these entities due to our control through our management relationship, related party ownership and our fee structure in certain of these funds. These entities contain various fixed maturities held as available-for-sale and trading and equity securities held as trading.

 

The carrying amounts of our consolidated VIE assets, which can only be used to settle obligations of consolidated VIEs, and liabilities of consolidated VIEs for which creditors do not have recourse are as follows:

 

 

 

Grantor trusts

 

Collateralized
private investment
vehicles

 

CMBS

 

Hedge funds
(2)

 

Total

 

 

 

(in millions)

 

September 30, 2010

 

 

 

 

 

 

 

 

 

 

 

Fixed maturities, available-for-sale

 

$

236.7

 

$

14.7

 

$

 

$

 

$

251.4

 

Fixed maturities, trading

 

 

162.2

 

 

 

162.2

 

Equity securities, trading

 

 

 

 

69.3

 

69.3

 

Other investments

 

 

 

129.1

 

0.1

 

129.2

 

Cash and cash equivalents

 

 

55.0

 

 

95.0

 

150.0

 

Accrued investment income

 

0.8

 

0.1

 

0.8

 

 

1.7

 

Premiums due and other receivables

 

 

1.5

 

 

28.7

 

30.2

 

Total assets

 

$

237.5

 

$

233.5

 

$

129.9

 

$

193.1

 

$

794.0

 

Deferred income taxes

 

$

2.5

 

$

 

$

 

$

(0.5

)

$

2.0

 

Other liabilities (1)

 

143.3

 

162.3

 

97.6

 

64.5

 

467.7

 

Total liabilities

 

$

145.8

 

$

162.3

 

$

97.6

 

$

64.0

 

$

469.7

 

 


(1) Grantor trusts contain an embedded derivative of a forecasted transaction to deliver the underlying securities; collateralized private investment vehicles include derivative liabilities, financial guarantees and obligation to redeem notes at maturity or termination of the trust; CMBS includes obligation to the bondholders; and hedge funds include liabilities to securities brokers.

 

(2)      The consolidated statements of financial position included a $127.9 million noncontrolling interest for hedge funds.

 

We did not provide financial or other support to investees designated as consolidated VIEs during the three or nine months ended September 30, 2010.

 

Unconsolidated Variable Interest Entities

 

Invested Securities

 

We hold a significant variable interest in a number of VIEs where we are not the primary beneficiary. Our investments in securities issued by these VIEs are reported in fixed maturities, available-for-sale and fixed maturities, trading in the consolidated statements of financial position and are described below.

 

VIEs include CMBS, residential mortgage-backed securities and asset-backed securities. All of these entities were deemed VIEs upon the removal of the QSPE scope exception because the equity within these entities is insufficient to sustain them. We currently are not the primary beneficiary in any of the entities within these categories of investments. This determination was based primarily on the fact we do not own the class of security that controls the unilateral right to replace the special servicer or equivalent function.

 

As previously discussed, we invest in several types of collateralized private investment vehicles, which are VIEs. These include cash and synthetic structures that we do not manage. We are currently not the primary beneficiary of these collateralized private investment vehicles primarily because we do not control the economic performance of the entities and were not involved with the design of the entities.

 

We have invested in various VIE trusts as a debt holder. All of these entities are classified as VIEs due to insufficient equity to sustain them. Prior to January 1, 2010, we had performed a quantitative analysis and concluded that although we held a significant variable interest in these entities we were not the primary beneficiary due to lack of majority of the risk of loss or because they were scoped out as a QSPE. Beginning January 1, 2010, we concluded we are not the primary beneficiary primarily because we do not control the economic performance of the entities and were not involved with the design of the entities.

 

The carrying value and maximum loss exposure for our unconsolidated VIEs are as follows:

 

 

 

Asset carrying value

 

Maximum exposure to
loss (1)

 

 

 

(in millions)

 

September 30, 2010

 

 

 

 

 

Fixed maturities, available-for-sale:

 

 

 

 

 

Corporate

 

$

439.4

 

$

367.4

 

Residential mortgage-backed securities

 

3,003.4

 

2,867.5

 

Commercial mortgage-backed securities

 

3,814.6

 

4,570.9

 

Collateralized debt obligations

 

253.3

 

369.4

 

Other debt obligations

 

3,128.2

 

3,180.4

 

Fixed maturities, trading:

 

 

 

 

 

Residential mortgage-backed securities

 

206.7

 

206.7

 

Commercial mortgage-backed securities

 

3.5

 

3.5

 

Collateralized debt obligations

 

84.5

 

84.5

 

Other debt obligations

 

120.7

 

120.7

 

 


(1) Our risk of loss is limited to our initial investment measured at amortized cost for fixed maturities, available-for-sale and to fair value for our fixed maturities, trading.

 

Sponsored Investment Funds

 

We are the investment manager for certain money market mutual funds that are deemed to be VIEs. We are not the primary beneficiary of these VIEs since our involvement is limited primarily to being a service provider, and our variable interest does not absorb the majority of the variability of the entities’ net assets. As of September 30, 2010, these VIEs held $1.7 billion in total assets. We chose to contribute $3.2 million to these VIEs during both the three and nine months ended September 30, 2010, for competitive reasons and have no contractual obligation to further contribute to the funds.

 

Investments
Investments

4. Investments

 

Fixed Maturities and Equity Securities

 

Fixed maturities include bonds, asset-backed securities, redeemable preferred stock and certain nonredeemable preferred stock. Equity securities include mutual funds, common stock and nonredeemable preferred stock. We classify fixed maturities and equity securities as either available-for-sale or trading at the time of the purchase and, accordingly, carry them at fair value. See Note 10, Fair Value Measurements, for methodologies related to the determination of fair value. Unrealized gains and losses related to available-for-sale securities, excluding those in fair value hedging relationships, are reflected in stockholders’ equity, net of adjustments related to deferred policy acquisition costs (“DPAC”), sales inducements, unearned revenue reserves, derivatives in cash flow hedge relationships and applicable income taxes. Unrealized gains and losses related to hedged portions of available-for-sale securities in fair value hedging relationships and mark-to-market adjustments on certain trading securities are reflected in net realized capital gains (losses). We also have trading securities portfolios that support investment strategies that involve the active and frequent purchase and sale of fixed maturities. Mark-to-market adjustments related to these trading securities are reflected in net investment income.

 

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 classified as available-for-sale is adjusted for declines in value that are other than temporary. Impairments in value deemed to be other than temporary are primarily reported in net income as a component of net realized capital gains (losses), with noncredit impairment losses for certain fixed maturities, available-for-sale reported in other comprehensive income (“OCI”). For loan-backed and structured securities, we recognize income using a constant effective yield based on currently anticipated cash flows.

 

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

 

 

 

Amortized cost

 

Gross
unrealized
gains

 

Gross
unrealized
losses

 

Other-than-
temporary
impairments in
OCI

 

Fair value

 

 

 

(in millions)

 

September 30, 2010

 

 

 

 

 

 

 

 

 

 

 

Fixed maturities, available-for-sale:

 

 

 

 

 

 

 

 

 

 

 

U.S. government and agencies

 

$

554.7

 

$

26.0

 

$

 

$

 

$

580.7

 

Non-U.S. governments

 

763.7

 

170.5

 

 

 

934.2

 

States and political subdivisions

 

2,315.2

 

115.9

 

4.5

 

 

2,426.6

 

Corporate

 

33,163.9

 

2,535.9

 

502.7

 

27.6

 

35,169.5

 

Residential mortgage-backed securities

 

2,867.5

 

136.7

 

0.8

 

 

3,003.4

 

Commercial mortgage-backed securities

 

4,570.9

 

117.3

 

670.2

 

203.4

 

3,814.6

 

Collateralized debt obligations

 

369.4

 

0.9

 

86.7

 

30.3

 

253.3

 

Other debt obligations

 

3,180.4

 

85.1

 

55.9

 

81.4

 

3,128.2

 

Total fixed maturities, available-for-sale

 

$

47,785.7

 

$

3,188.3

 

$

1,320.8

 

$

342.7

 

$

49,310.5

 

Total equity securities, available-for-sale

 

$

180.0

 

$

8.4

 

$

14.6

 

 

 

$

173.8

 

December 31, 2009

 

 

 

 

 

 

 

 

 

 

 

Fixed maturities, available-for-sale:

 

 

 

 

 

 

 

 

 

 

 

U.S. government and agencies

 

$

550.1

 

$

9.1

 

$

0.5

 

$

 

$

558.7

 

Non-U.S. governments

 

741.5

 

114.8

 

1.4

 

 

854.9

 

States and political subdivisions

 

2,008.7

 

53.4

 

13.5

 

 

2,048.6

 

Corporate

 

32,767.0

 

1,296.8

 

1,075.0

 

58.0

 

32,930.8

 

Residential mortgage-backed securities

 

3,049.5

 

87.4

 

3.8

 

 

3,133.1

 

Commercial mortgage-backed securities

 

4,898.0

 

20.9

 

1,211.5

 

107.7

 

3,599.7

 

Collateralized debt obligations

 

607.5

 

1.8

 

200.7

 

39.0

 

369.6

 

Other debt obligations

 

2,994.1

 

34.6

 

229.8

 

73.7

 

2,725.2

 

Total fixed maturities, available-for-sale

 

$

47,616.4

 

$

1,618.8

 

$

2,736.2

 

$

278.4

 

$

46,220.6

 

Total equity securities, available-for-sale

 

$

231.1

 

$

17.2

 

$

34.3

 

 

 

$

214.0

 

 

The amortized cost and fair value of fixed maturities available-for-sale as of September 30, 2010, by contractual maturity, were as follows:

 

 

 

Amortized cost

 

Fair value

 

 

 

(in millions)

 

Due in one year or less

 

$

2,436.9

 

$

2,490.9

 

Due after one year through five years

 

13,442.1

 

14,145.5

 

Due after five years through ten years

 

9,278.6

 

9,987.3

 

Due after ten years

 

11,639.9

 

12,487.3

 

Subtotal

 

36,797.5

 

39,111.0

 

Mortgage-backed and other asset-backed securities

 

10,988.2

 

10,199.5

 

Total

 

$

47,785.7

 

$

49,310.5

 

 

Actual maturities may differ because issuers may have the right to call or prepay obligations. Our portfolio is diversified by industry, issuer and asset class. Credit concentrations are managed to established limits.

 

Net Realized Capital Gains and Losses

 

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

 

 

 

For the three months ended
September 30,

 

For the nine months ended
September 30,

 

 

 

2010

 

2009

 

2010

 

2009

 

 

 

(in millions)

 

Fixed maturities, available-for-sale:

 

 

 

 

 

 

 

 

 

Gross gains

 

$

10.5

 

$

43.8

 

$

51.3

 

$

107.4

 

Gross losses

 

(62.3

)

(154.9

)

(285.3

)

(505.3

)

Portion of other-than-temporary impairment losses recognized in OCI

 

6.3

 

45.3

 

64.3

 

162.4

 

Hedging, net

 

80.8

 

68.3

 

257.4

 

(165.3

)

Fixed maturities, trading

 

11.8

 

15.7

 

26.3

 

57.5

 

Equity securities, available-for-sale:

 

 

 

 

 

 

 

 

 

Gross gains

 

0.9

 

12.6

 

8.7

 

25.1

 

Gross losses

 

(0.7

)

(21.7

)

(2.8

)

(35.8

)

Equity securities, trading

 

(1.7

)

19.2

 

6.1

 

29.9

 

Mortgage loans

 

(19.7

)

(39.2

)

(128.1

)

(115.8

)

Derivatives

 

(25.4

)

(64.5

)

(232.3

)

197.6

 

Other

 

(21.2

)

8.8

 

101.8

 

(42.8

)

Net realized capital losses

 

$

(20.7

)

$

(66.6

)

$

(132.6

)

$

(285.1

)

 

Proceeds from sales of investments (excluding call and maturity proceeds) in fixed maturities, available-for-sale were $0.2 billion and $2.1 billion for the three months ended September 30, 2010 and 2009, and $1.3 billion and $3.7 billion for the nine months ended September 30, 2010 and 2009, respectively.

 

Other-Than-Temporary Impairments

 

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

 

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

 

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

 

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

 

Total other-than-temporary impairment losses, net of recoveries from the sale of previously impaired securities, were as follows:

 

 

 

For the three months ended
September 30,

 

For the nine months ended
September 30,

 

 

 

2010

 

2009

 

2010

 

2009

 

 

 

(in millions)

 

Fixed maturities, available-for-sale

 

$

(56.2

)

$

(153.0

)

$

(251.7

)

$

(498.8

)

Equity securities, available-for-sale

 

0.3

 

(9.5

)

4.1

 

(11.2

)

Total other-than-temporary impairment losses, net of recoveries from the sale of previously impaired securities

 

$

(55.9

)

$

(162.5

)

$

(247.6

)

$

(510.0

)

 

The change in accumulated credit losses associated with other-than-temporary impairments on fixed maturities for which an amount related to credit losses was recognized in net realized capital gains (losses) and an amount related to noncredit losses was recognized in OCI (“bifurcated credit losses”) is summarized as follows:

 

 

 

For the three months ended
September 30,

 

For the nine months ended
September 30,

 

 

 

2010

 

2009

 

2010

 

2009

 

 

 

(in millions)

 

Total other-than-temporary impairments on fixed maturities for which an amount related to noncredit losses was recognized in OCI

 

$

2.1

 

$

(113.2

)

$

(156.5

)

$

(312.5

)

Noncredit loss recognized in OCI

 

6.3

 

45.3

 

64.3

 

162.4

 

Credit loss impairment recognized in net realized capital losses (1)

 

$

8.4

 

$

(67.9

)

$

(92.2

)

$

(150.1

)

 


(1)         Includes additions to bifurcated credit losses recognized in net realized capital gains (losses) during the period for fixed maturities for which an other-than-temporary impairment was not previously recognized and additional credit losses for previously recognized other-than-temporary impairments of $36.0 million and $69.2 million for the three months ended September 30, 2010 and 2009, respectively, and $176.3 million and $151.7 million for the nine months ended September 30, 2010 and 2009, respectively. These losses are offset by reductions for previously recognized bifurcated credit losses on fixed maturities now sold or intended to be sold and fixed maturities reclassified from available-for-sale to trading, which did not impact net income for the period, of $44.4 million and $1.3 million for the three months ended September 30, 2010 and 2009, respectively, and $84.1 million and $1.6 million for the nine months ended September 30, 2010 and 2009, respectively. See the credit loss rollforward table below for further details on bifurcated credit losses.

 

Non-bifurcated other-than-temporary impairment losses, net of recoveries from the sale of previously impaired available-for-sale securities, for fixed maturities recognized in net realized capital gains (losses) during the period were $13.9 million and $38.5 million for the three months ended September 30, 2010 and 2009, respectively, and $11.1 million and $184.7 million for the nine months ended September 30, 2010 and 2009, respectively.

 

The following table provides a rollforward of accumulated credit losses for fixed maturities with bifurcated credit losses. The purpose of the table is to provide detail of (1) additions to the bifurcated credit loss amounts recognized in net realized capital gains (losses) during the period and (2) decrements for previously recognized bifurcated credit losses where the loss is no longer bifurcated and/or there has been a positive change in expected cash flows or accretion of the bifurcated credit loss amount.

 

 

 

For the three months ended
September 30,

 

For the nine months ended
September 30,

 

 

 

2010

 

2009

 

2010

 

2009

 

 

 

(in millions)

 

Beginning balance

 

$

(303.0

)

$

(100.6

)

$

(204.7

)

$

(18.5

)

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

 

(3.7

)

(55.2

)

(97.9

)

(127.5

)

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

 

(32.3

)

(14.0

)

(78.4

)

(24.2

)

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

 

 

1.3

 

39.7

 

1.6

 

Reduction for credit losses previously recognized on fixed maturities reclassified to trading (1)

 

44.4

 

 

44.4

 

 

Reduction for positive changes in cash flows expected to be collected and amortization (2)

 

0.6

 

0.7

 

2.9

 

0.8

 

Ending balance

 

$

(294.0

)

$

(167.8

)

$

(294.0

)

$

(167.8

)

 


(1)  Fixed maturities previously classified as available-for-sale have been reclassified to trading as a result of electing the fair value option upon adoption of accounting guidance related to the evaluation of credit derivatives embedded in beneficial interests in securitized financial assets.

(2)  Amounts are recognized in net investment income.

 

Gross Unrealized Losses for Fixed Maturities and Equity Securities

 

For fixed maturities and equity securities available-for-sale with unrealized losses, including other-than-temporary impairment losses reported in OCI, as of September 30, 2010, the gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities were in a continuous unrealized loss position are summarized as follows:

 

 

 

September 30, 2010

 

 

 

Less than
twelve months

 

Greater than or
equal to twelve months

 

Total

 

 

 

Carrying
value

 

Gross
unrealized
losses

 

Carrying
value

 

Gross
unrealized
losses

 

Carrying
value

 

Gross
unrealized
losses

 

 

 

(in millions)

 

Fixed maturities, available-for-sale:

 

 

 

 

 

 

 

 

 

 

 

 

 

Non-U.S. governments

 

$

0.8

 

$

 

$

 

$

 

$

0.8

 

$

 

States and political subdivisions

 

37.2

 

1.5

 

76.3

 

3.0

 

113.5

 

4.5

 

Corporate

 

845.4

 

28.4

 

4,328.5

 

501.9

 

5,173.9

 

530.3

 

Residential mortgage-backed securities

 

107.8

 

0.8

 

0.5

 

 

108.3

 

0.8

 

Commercial mortgage-backed securities

 

267.5

 

3.7

 

1,306.2

 

869.9

 

1,573.7

 

873.6

 

Collateralized debt obligations

 

11.6

 

0.3

 

224.5

 

116.7

 

236.1

 

117.0

 

Other debt obligations

 

225.4

 

2.5

 

636.5

 

134.8

 

861.9

 

137.3

 

Total fixed maturities, available-for-sale

 

$

1,495.7

 

$

37.2

 

$

6,572.5

 

$

1,626.3

 

$

8,068.2

 

$

1,663.5

 

Total equity securities, available-for-sale

 

$

40.7

 

$

7.1

 

$

82.1

 

$

7.5

 

$

122.8

 

$

14.6

 

 

Of the total amounts, Principal Life Insurance Company’s (“Principal Life”) consolidated portfolio represented $7,706.4 million in available-for-sale fixed maturities with gross unrealized losses of $1,615.3 million. Principal Life’s consolidated portfolio consists of fixed maturities where 71% were investment grade (rated AAA through BBB-) with an average price of 83 (carrying value/amortized cost) at September 30, 2010. Gross unrealized losses in our fixed maturities portfolio decreased during the nine months ended September 30, 2010, primarily due to a decline in interest rates. The decrease is primarily attributed to the corporate and commercial mortgage-backed securities sectors.

 

For those securities that had been in a loss position for less than twelve months, Principal Life’s consolidated portfolio held 195 securities with a carrying value of $1,370.5 million and unrealized losses of $31.2 million reflecting an average price of 98 at September 30, 2010. Of this portfolio, 85% was investment grade (rated AAA through BBB-) at September 30, 2010, with associated unrealized losses of $20.0 million. The losses on these securities can primarily be attributed to changes in market interest rates and changes in credit spreads since the securities were acquired.

 

For those securities that had been in a continuous loss position greater than or equal to twelve months, Principal Life’s consolidated portfolio held 849 securities with a carrying value of $6,335.9 million and unrealized losses of $1,584.1 million. The average rating of this portfolio was BBB with an average price of 80 at September 30, 2010. Of the $1,584.1 million in unrealized losses, the commercial mortgage-backed securities sector accounts for $869.8 million in unrealized losses with an average price of 60 and an average credit rating of BBB+. The remaining unrealized losses consist primarily of $459.7 million within the corporate sector at September 30, 2010. The average price of the corporate sector was 90 and the average credit rating was BBB. The losses on these securities can primarily be attributed to changes in market interest rates and changes in credit spreads since the securities were acquired.

 

For fixed maturities and equity securities available-for-sale with unrealized losses, including other-than-temporary impairment losses reported in OCI, as of December 31, 2009, the gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities were in a continuous unrealized loss position are summarized as follows:

 

 

 

December 31, 2009

 

 

 

Less than
twelve months

 

Greater than or
equal to twelve months

 

Total

 

 

 

Carrying
value

 

Gross
unrealized
losses

 

Carrying
value

 

Gross
unrealized
losses

 

Carrying
value

 

Gross
unrealized
losses

 

 

 

(in millions)

 

Fixed maturities, available-for-sale:

 

 

 

 

 

 

 

 

 

 

 

 

 

U.S. government and agencies

 

$

32.7

 

$

0.4

 

$

1.0

 

$

0.1

 

$

33.7

 

$

0.5

 

Non-U.S. governments

 

24.6

 

0.5

 

36.6

 

0.9

 

61.2

 

1.4

 

States and political subdivisions

 

242.8

 

1.9

 

247.9

 

11.6

 

490.7

 

13.5

 

Corporate

 

2,595.9

 

69.2

 

7,958.2

 

1,063.8

 

10,554.1

 

1,133.0

 

Residential mortgage-backed securities

 

491.9

 

3.7

 

0.6

 

0.1

 

492.5

 

3.8

 

Commercial mortgage-backed securities

 

468.1

 

16.7

 

2,217.3

 

1,302.5

 

2,685.4

 

1,319.2

 

Collateralized debt obligations

 

 

 

366.1

 

239.7

 

366.1

 

239.7

 

Other debt obligations

 

335.4

 

23.4

 

902.3

 

280.1

 

1,237.7

 

303.5

 

Total fixed maturities, available-for-sale

 

$

4,191.4

 

$

115.8

 

$

11,730.0

 

$

2,898.8

 

$

15,921.4

 

$

3,014.6

 

Total equity securities, available-for-sale

 

$

4.4

 

$

0.1

 

$

116.1

 

$

34.2

 

$

120.5

 

$

34.3

 

 

Of the total amounts, Principal Life’s consolidated portfolio represented $14,979.2 million in available-for-sale fixed maturities with unrealized losses of $2,928.9 million. Principal Life’s consolidated portfolio consists of fixed maturities where 83% were investment grade (rated AAA through BBB-) with an average price of 84 (carrying value/amortized cost) at December 31, 2009. Due to the credit disruption that began in the last half of 2007 and continued into first quarter of 2009, which reduced liquidity and led to wider credit spreads, we saw an increase in unrealized losses in our securities portfolio. The unrealized losses were more pronounced in the corporate sector and in structured products, such as commercial mortgage-backed securities, collateralized debt obligations and asset-backed securities (included in other debt obligations). During the second quarter of 2009 and continuing through the end of the year, a narrowing of credit spreads and improvement in liquidity resulted in a decrease in the unrealized losses in our securities portfolio relative to year-end 2008.

 

For those securities that had been in a loss position for less than twelve months, Principal Life’s consolidated portfolio held 406 securities with a carrying value of $3,739.3 million and unrealized losses of $100.5 million reflecting an average price of 97 at December 31, 2009. Of this portfolio, 97% was investment grade (rated AAA through BBB-) at December 31, 2009, with associated unrealized losses of $82.7 million. The losses on these securities can primarily be attributed to changes in market interest rates and changes in credit spreads since the securities were acquired.

 

For those securities that had been in a continuous loss position greater than or equal to twelve months, Principal Life’s consolidated portfolio held 1,481 securities with a carrying value of $11,239.9 million and unrealized losses of $2,828.4 million. The average rating of this portfolio was BBB+ with an average price of 80 at December 31, 2009. Of the $2,828.4 million in unrealized losses, the commercial mortgage-backed securities sector accounts for $1,302.5 million in unrealized losses with an average price of 63 and an average credit rating of AA-. The remaining unrealized losses consist primarily of $993.5 million within the corporate sector at December 31, 2009. The average price of the corporate sector was 88 and the average credit rating was BBB. The losses on these securities can primarily be attributed to changes in market interest rates and changes in credit spreads since the securities were acquired.

 

Because it was not our intent to sell the fixed maturities, available-for-sale with unrealized losses and it was not more likely than not that we would be required to sell these securities before recovery of the amortized cost, which may be maturity, we did not consider these investments to be other-than-temporarily impaired at September 30, 2010 and December 31, 2009.

 

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

 

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

 

 

 

September 30, 2010

 

December 31, 2009

 

 

 

(in millions)

 

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

 

$

1,794.6

 

$

(1,117.4

)

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

 

(342.7

)

(260.9

)

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

 

(6.2

)

(17.1

)

Adjustments for assumed changes in amortization patterns

 

(433.9

)

211.9

 

Adjustments for assumed changes in policyholder liabilities

 

(248.5

)

(75.7

)

Net unrealized gains on derivative instruments

 

94.7

 

16.8

 

Net unrealized gains on equity method subsidiaries and noncontrolling interest adjustments

 

119.3

 

214.1

 

Provision for deferred income tax benefits (taxes)

 

(316.1

)

397.7

 

Effects of implementation of accounting change related to variable interest entities, net

 

10.7

 

 

Effects of electing fair value option for fixed maturities upon implementation of accounting change related to embedded credit derivatives, net

 

25.4

 

 

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

 

 

(9.9

)

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

 

$

697.3

 

$

(640.5

)

 


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

 

Securities Posted as Collateral

 

We posted $1,140.8 million in fixed maturities as of September 30, 2010, to satisfy collateral requirements primarily associated with a reinsurance arrangement and our derivative credit support annex (collateral) agreements. In addition, we posted $1,747.2 million in commercial mortgage loans as of September 30, 2010, to satisfy collateral requirements associated with our obligation under funding agreements with the Federal Home Loan Bank of Des Moines.

 

Derivative Financial Instruments
Derivative Financial Instruments

5. Derivative Financial Instruments

 

Derivatives are generally used to hedge or reduce exposure to market risks associated with assets held or expected to be purchased or sold and liabilities incurred or expected to be incurred. Derivatives are used to change the characteristics of our asset/liability mix consistent with our risk management activities. Derivatives are also used in asset replication strategies.

 

Types of Derivative Instruments

 

Interest Rate Contracts

 

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

 

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

 

Interest rate caps and interest rate floors, which can be combined to form interest rate collars, are contracts that entitle the purchaser to pay or receive the amounts, if any, by which a specified market rate exceeds a cap strike interest rate, or falls below a floor strike interest rate, respectively, at specified dates. We have entered into interest rate collars whereby we receive amounts if a specified market rate falls below a floor strike interest rate, and we pay if a specified market rate exceeds a cap strike interest rate. We use interest rate collars to manage interest rate risk related to guaranteed minimum interest rate liabilities in our individual annuities contracts.

 

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

 

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

 

Foreign Exchange Contracts

 

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

 

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

 

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

 

Equity Contracts

 

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

 

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

 

Credit Contracts

 

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

 

Other Contracts

 

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

 

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

 

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

 

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

 

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

 

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

 

Exposure

 

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

 

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

 

We posted $327.0 million and $273.7 million in cash and securities under collateral arrangements as of September 30, 2010, and December 31, 2009, respectively, to satisfy collateral requirements associated with our derivative credit support agreements.

 

Certain of our derivative instruments contain provisions that require us to maintain an investment grade rating from each of the major credit rating agencies on our debt. If the rating on our debt were to fall below investment grade, it would be in violation of these provisions and the counterparties to the derivative instruments could request immediate payment or demand immediate and ongoing full overnight collateralization on derivative instruments in net liability positions. The aggregate fair value, inclusive of accrued interest, of all derivative instruments with credit-risk-related contingent features that were in a liability position without regard to netting under derivative credit support annex agreements as of September 30, 2010, and December 31, 2009, was $1,533.6 million and $1,139.7 million, respectively. With respect to these derivatives, we posted collateral of $327.0 million and $273.7 million as of September 30, 2010 and December 31, 2009, respectively, in the normal course of business, which reflects netting under derivative credit support annex agreements. If the credit-risk-related contingent features underlying these agreements were triggered on September 30, 2010, we would be required to post an additional $35.0 million of collateral to our counterparties.

 

As of September 30, 2010, and December 31, 2009, we had received $305.8 million and $353.4 million, respectively, of cash collateral associated with our derivative credit support annex agreements. The cash collateral is included in other assets on the consolidated statements of financial position, with a corresponding liability reflecting our obligation to return the collateral recorded in other liabilities.

 

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

 

 

 

September 30, 2010

 

December 31, 2009

 

 

 

(in millions)

 

Notional amounts of derivative instruments

 

 

 

 

 

Interest rate contracts:

 

 

 

 

 

Interest rate swaps

 

$

19,549.1

 

$

19,588.6

 

Interest rate collars

 

500.0

 

 

Swaptions

 

68.5

 

 

Futures

 

0.1

 

43.3

 

Foreign exchange contracts:

 

 

 

 

 

Foreign currency swaps

 

4,708.0

 

5,284.4

 

Currency forwards

 

79.8

 

91.5

 

Equity contracts:

 

 

 

 

 

Options

 

1,039.2

 

818.2

 

Futures

 

0.2

 

84.6

 

Credit contracts:

 

 

 

 

 

Credit default swaps

 

1,567.4

 

1,586.4

 

Other contracts:

 

 

 

 

 

Embedded derivative financial instruments

 

3,837.0

 

3,344.5

 

Commodity swaps

 

 

40.0

 

Total notional amounts at end of period

 

$

31,349.3

 

$

30,881.5

 

 

 

 

 

 

 

Credit exposure of derivative instruments

 

 

 

 

 

Interest rate contracts:

 

 

 

 

 

Interest rate swaps

 

$

877.0

 

$

579.1

 

Interest rate collars

 

14.1

 

 

Foreign exchange contracts:

 

 

 

 

 

Foreign currency swaps

 

499.1

 

594.4

 

Currency forwards

 

4.1

 

3.8

 

Equity contracts:

 

 

 

 

 

Options

 

238.5

 

149.8

 

Credit contracts:

 

 

 

 

 

Credit default swaps

 

8.4

 

15.5

 

Total gross credit exposure

 

1,641.2

 

1,342.6

 

Less: collateral received

 

344.7

 

395.6

 

Net credit exposure

 

$

1,296.5

 

$

947.0

 

 

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

 

 

 

Derivative assets (1)

 

Derivative liabilities (2)

 

 

 

September 30, 2010

 

December 31, 2009

 

September 30, 2010

 

December 31, 2009

 

 

 

(in millions)

 

Derivatives designated as hedging instruments

 

 

 

 

 

 

 

 

 

Interest rate contracts

 

$

117.4

 

$

81.5

 

$

547.9

 

$

309.1

 

Foreign exchange contracts

 

375.3

 

444.4

 

131.5

 

240.6

 

Total derivatives designated as hedging instruments

 

$

492.7

 

$

525.9

 

$

679.4

 

$

549.7