(EDGAR Online via COMTEX) -- Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
The following analysis discusses our financial condition as of September 30, 2019, compared with December 31, 2018, and our consolidated results of operations for the three and nine months ended September 30, 2019 and 2018, prepared in conformity with U.S. GAAP. The discussion and analysis includes, where appropriate, factors that may affect our future financial performance. The discussion should be read in conjunction with our Form 10-K, for the year ended December 31, 2018, filed with the SEC and the unaudited consolidated financial statements and the related notes to the financial statements and the other financial information included elsewhere in this Form 10-Q.
Our narrative analysis below contains forward-looking statements intended to enhance the reader's ability to assess our future financial performance. Forward-looking statements include, but are not limited to, statements that represent our beliefs concerning future operations, strategies, financial results or other developments, and contain words and phrases such as "anticipate," "believe," "plan," "estimate," "expect," "intend" and similar expressions. Forward-looking statements are made based upon management's current expectations and beliefs concerning future developments and their potential effects on us. Such forward-looking statements are not guarantees of future performance.
Actual results may differ materially from those included in the forward-looking statements as a result of risks and uncertainties including, but not limited to, the following: (1) adverse capital and credit market conditions may significantly affect our ability to meet liquidity needs, as well as our access to capital and cost of capital; (2) conditions in the global capital markets and the economy generally may materially and adversely affect our business and results of operations; (3) volatility or declines in the equity, bond or real estate markets could reduce our AUM and may result in investors withdrawing from the markets or decreasing their rates of investment, all of which could reduce our revenues and net income; (4) changes in interest rates or credit spreads or a sustained low interest rate environment may adversely affect our results of operations, financial condition and liquidity, and our net income can vary from period to period; (5) our investment portfolio is subject to several risks that may diminish the value of our invested assets and the investment returns credited to customers, which could reduce our sales, revenues, AUM and net income; (6) our valuation of investments and the determinations of the amount of allowances and impairments taken on our investments may include methodologies, estimations and assumptions which are subject to differing interpretations and, if changed, could materially adversely affect our results of operations or financial condition; (7) any impairments of or valuation allowances against our deferred tax assets could adversely affect our results of operations and financial condition; (8) we may face losses on our insurance and annuity products if our actual experience differs significantly from our pricing and reserving assumptions; (9) the pattern of amortizing our DAC asset and other actuarial balances on our universal life-type insurance contracts, participating life insurance policies and certain investment contracts may change, impacting both the level of our DAC asset and other actuarial balances and the timing of our net income; (10) changes in laws or regulations may reduce our profitability; (11) we may not be able to protect our intellectual property and may be subject to infringement claims; (12) our ability to pay stockholder dividends and meet our obligations may be constrained by the limitations on dividends Iowa insurance laws impose on Principal Life; (13) changes in accounting standards may adversely affect our reported results of operations and financial condition; (14) litigation and regulatory investigations may affect our financial strength or reduce our profitability; (15) from time to time we may become subject to tax audits, tax litigation or similar proceedings, and as a result we may owe additional taxes, interest and penalties in amounts that may be material; (16) applicable laws and our certificate of incorporation and by-laws may discourage takeovers and business combinations that some stockholders might consider in their best interests; (17) competition, including from companies that may have greater financial resources, broader arrays of products, higher ratings and stronger financial performance may impair our ability to retain existing customers, attract new customers and maintain our profitability; (18) technological and societal changes may disrupt our business model and impair our ability to retain existing customers, attract new customers and maintain our profitability; (19) damage to our reputation may adversely affect our revenues and profitability; (20) a downgrade in our financial strength or credit ratings may increase policy surrenders and withdrawals, reduce new sales and terminate relationships with distributors, impact existing liabilities and increase our cost of capital, any of which could adversely affect our profitability and financial condition; (21) client terminations or withdrawals or changes in investor preferences may lead to a reduction in revenues for our asset management and accumulation businesses; (22) guarantees within certain of our products that protect policyholders may decrease our net income or increase the volatility of our results of operations or financial position under U.S. GAAP if our hedging or risk management strategies prove ineffective or insufficient; (23) if we are unable to attract and retain qualified employees and sales representatives and develop new distribution sources, our results of operations, financial condition and sales of our products may be adversely impacted; (24) an interruption in telecommunication, information technology, or other systems, or a failure to maintain the confidentiality, integrity, or availability of data residing on such systems, could disrupt our business, damage our reputation and adversely impact our profitability; (25) our international businesses face political, legal, operational and other risks that could reduce our profitability in those businesses; (26) we face risks arising from our participation in joint ventures;
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(29) our reinsurers could default on their obligations or increase their rates, which could adversely impact our net income and financial condition; (30) we face risks arising from acquisitions of businesses; (31) loss of key vendor relationships or failure of a vendor to protect information of our customers or employees could adversely affect our business or result in losses; (32) our enterprise risk management framework may not be fully effective in identifying or mitigating all of the risks to which we are exposed and (33) our financial results may be adversely impacted by global climate changes. With respect to the acquisition of the Acquired Business (the "Acquisition") in particular, additional risks and uncertainties that could cause actual results to differ materially from results anticipated in forward-looking statements include, but are not limited to: risks related to purchase price adjustments and the failure to realize the expected synergies and benefits of the Acquisition or any delay in the realization thereof.
We provide financial products and services through the following reportable segments:
Retirement and Income Solutions is organized into Retirement and Income Solutions - Fee, which includes full service accumulation, trust services, individual variable annuities and revenues and expenses associated with the ? Acquired Business; and Retirement and Income Solutions - Spread, which includes individual fixed annuities, investment only, pension risk transfer and banking services. We offer a comprehensive portfolio of products and services for retirement savings and retirement income:
To businesses of all sizes, we offer products and services for defined contribution plans, including 401(k) and 403(b) plans, defined benefit pension ? plans, nonqualified executive benefit plans, employee stock ownership plan services and pension closeout services. For more basic retirement services, we offer SIMPLE IRAs and payroll deduction plans;
? To large institutional clients, we also offer investment only products, including investment only guaranteed investment contracts ("GICs"); and
To employees of businesses and other individuals, we offer the ability to ? accumulate savings for retirement and other purposes through mutual funds, individual annuities and bank products, along with retirement income options.
Principal Global Investors, which includes our mutual fund business, manages assets for sophisticated investors around the world, using a multi-boutique strategy that provides diverse investment capabilities including equity, fixed ? income, real estate and other alternative investments. We also have experience in asset allocation, stable value management and other structured investment strategies. We focus on providing services to our other segments in addition to our retail mutual fund and third party institutional clients.
Principal International, which offers pension accumulation products and services, mutual funds, asset management, income annuities and life insurance ? accumulation products through operations in Latin America (Brazil, Chile and Mexico) and Asia (China, Hong Kong Special Administrative Region, India and Southeast Asia).
U.S. Insurance Solutions is organized into Specialty Benefits insurance, which provides group dental and vision insurance, individual and group disability insurance, critical illness, accident, group life insurance and non-medical ? fee-for-service claims administration; and Individual Life insurance, which provides universal life, variable universal life, indexed universal life and traditional life insurance. We focus on solutions for individuals and small-to-medium sized businesses and their employees.
Corporate, which manages the assets representing capital that has not been allocated to any other segment. Financial results of the Corporate segment primarily reflect our financing activities (including financing costs), income on capital not allocated to other segments, inter-segment eliminations, income ? tax risks and certain income, expenses and other adjustments not allocated to the segments based on the nature of such items. Results of PSI, our retail broker-dealer and RIA; RobustWealth, our financial technology company; and our exited group medical and long-term care insurance businesses are reported in this segment.
Effective January 1, 2019, we made changes to the allocation of certain compensation and other expenses and net investment income among the reportable segments. These allocation changes were made as a result of a global financial process improvement project. The expense allocation changes simplify the allocation processes, increase transparency and allow for more effective expense management across the enterprise. The net investment income allocation changes better align our internal capital allocation with enterprise capital targets. Segment results for prior periods were recast so they are reported on a comparable basis, with no impact to total company financial results.
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Transactions Affecting Comparability of Results of Operations
Wells Fargo Institutional Retirement & Trust Business. On July 1, 2019, we closed on our agreement with Wells Fargo Bank, N.A. to acquire its Institutional Retirement & Trust business, which includes defined contribution, defined benefit, executive deferred compensation, employee stock ownership plans, institutional trust and custody, and institutional asset advisory businesses. The results of this acquisition are reflected in the Retirement and Income Solutions segment. The purchase price consisted of (i) $1.2 billion cash paid at closing and (ii) an additional earn-out payment of up to $150.0 million based upon the retention of fee revenue of the Acquired Business through December 31, 2020. The transaction was funded with available cash and debt financing. For additional information regarding the debt issuance, see Item 1. "Financial Statements, Notes to Unaudited Consolidated Financial Statements, Note 7, Long-Term Debt."
RobustWealth. On July 2, 2018, we finalized the acquisition of RobustWealth, a financial technology company. The acquisition adds RobustWealth's digital capabilities to our industry knowledge, asset management experience and technology to help consumers meet their financial goals on an enhanced digital advice platform. The RobustWealth platform will retain its open architecture philosophy, and RobustWealth will continue to sell its platform to outside firms as part of its growth strategy. RobustWealth is consolidated within the Corporate segment due to its strategic benefits across the organization with the majority of goodwill allocated to the Principal Global Investors segment.
INTERNOS. On April 16, 2018, we finalized the acquisition of INTERNOS, a London-based European real estate investment manager. Upon acquisition, INTERNOS became Principal Real Estate Europe Limited and operates as our dedicated European real estate private equity investment boutique, expanding our global real estate capabilities. At the time of closing, the acquisition increased our AUM by $3.5 billion. Principal Real Estate Europe Limited is reported within the Principal Global Investors segment.
MetLife Afore, S.A. de C.V. On February 20, 2018, we finalized the acquisition of MetLife Afore, S.A. de C.V., which was MetLife, Inc.'s pension fund management business in Mexico. At the time of closing, the acquisition increased our AUM by $3.8 billion, making us the fifth largest AFORE in Mexico in terms of AUM. The results of this acquisition are reflected in the Principal International segment.
Actuarial Assumption Updates. We periodically review and update actuarial assumptions that are inputs to the models for DAC and other actuarial balances and make model refinements as necessary. During the third quarter of 2019, assumption updates and model refinements were made resulting in an unlocking of DAC and other actuarial balances that decreased consolidated net income by $36.5 million for both the three and nine months ended September 30, 2019. During the third quarter of 2018, assumption updates and model refinements were made resulting in an unlocking of DAC and other actuarial balances that increased consolidated net income by $32.1 million for both the three and nine months ended September 30, 2018.
The following table presents the increase (decrease) impact on pre-tax operating earnings for each segment.
For the three and nine months ended September 30, 2019 2018 (in millions) Retirement and Income Solutions $ (34.3) $ 19.2 Principal International 7.8 (53.5) U.S. Insurance Solutions (13.3) (9.3)
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The Individual Life insurance business actuarial assumption updates and model refinements affected several line items within our income statement. The following table presents the increase (decrease) on the Individual Life insurance income statement line items.
For the three and nine months ended September 30, 2019 2018 (in millions) Pre-tax operating earnings $ (33.8) $ (15.5) Fees and other revenues 100.2 (2.3) Benefits, claims and settlement expenses 47.1 20.7 Dividends to policyholders 1.7 1.8 Operating expenses 85.2 (9.3)
Real Estate Realignment. Effective August 1, 2018, we agreed to a realignment of one of our real estate investment teams. With the realignment, we no longer manage $9.2 billion of assets for a large real estate client but accelerated the recognition of a significant performance fee that was earned due to our successful management of the assets, which drove market value appreciation of the real estate investments. During the third quarter of 2018 we recognized, within the Principal Global Investors segment, $253.1 million of fees and other revenue related to the performance fee. This was partially offset by $151.9 million of operating expenses related to revenue sharing arrangements, resulting in a $101.2 million increase to pre-tax operating earnings within the Principal Global Investors segment. Ongoing impacts to segment pre-tax operating earnings are not expected to be material.
CIMB Joint Ventures. On May 25, 2018, we and CIMB Group ("CIMB") completed new ownership agreements in our joint ventures, CIMB-Principal Asset Management Berhad ("CPAM") and CIMB-Principal Islamic Asset Management ("CPIAM"). With the completion we increased our ownership stake to 60% with CIMB retaining 40% ownership and co-management of both CPAM and CPIAM. Our investment in both entities will continue to be reported using the equity method within the Principal International segment.
Other Factor Affecting Comparability of Results of Operations
Fluctuations in Foreign Currency to U.S. Dollar Exchange Rates
Fluctuations in foreign currency to U.S. dollar exchange rates for countries in which we have operations can affect reported financial results. In years when foreign currencies weaken against the U.S. dollar, translating foreign currencies into U.S. dollars results in fewer U.S. dollars to be reported. When foreign currencies strengthen, translating foreign currencies into U.S. dollars results in more U.S. dollars to be reported.
Foreign currency exchange rate fluctuations create variances in our financial statement line items. The most significant impact occurs within our Principal International segment where pre-tax operating earnings were negatively impacted $3.5 million and $20.3 million for the three and nine months ended September 30, 2019, respectively, as a result of fluctuations in foreign currency to U.S. dollar exchange rates. This impact was calculated by comparing (a) the difference between current year results and prior year results to (b) the difference between current year results and prior year results translated using current year exchange rates for both periods. We use this approach to calculate the impact of exchange rates on all revenue and expense line items. For a discussion of our approaches to managing foreign currency exchange rate risk, see Item 3. "Quantitative and Qualitative Disclosures About Market Risk - Foreign Currency Risk."
Recent Accounting Changes
For recent accounting changes, see Item 1. "Financial Statements, Notes to Unaudited Consolidated Financial Statements, Note 1, Nature of Operations and Significant Accounting Policies" under the caption, "Recent Accounting Pronouncements."
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Results of Operations The following table presents summary consolidated financial information for the periods indicated: For the three months ended September 30, For the nine months ended September 30, Increase Increase 2019 2018 (decrease) 2019 2018 (decrease) (in millions) Revenues: Premiums and other considerations $ 2,274.2 $ 2,172.4 $ 101.8 $ 5,932.0 $ 4,433.4 $ 1,498.6 Fees and other revenues 1,230.0 1,261.8 (31.8) 3,210.1 3,285.7 (75.6) Net investment income 996.6 919.4 77.2 2,994.7 2,710.7 284.0 Net realized capital gains(losses), excluding impairment losses on available-for-sale securities (31.3) (1.9) (29.4) 73.3 59.3 14.0 Net other-than-temporary impairment losses on available-for-sale securities (4.7) (1.4) (3.3) (31.3) (8.3) (23.0) Other-than-temporary impairment losses on fixed maturities, available-for-sale reclassified from other comprehensive income (6.4) (2.2) (4.2) (3.9) (14.2) 10.3 Net impairment losses on available-for-sale securities (11.1) (3.6) (7.5) (35.2) (22.5) (12.7) Net realized capital gains (losses) (42.4) (5.5) (36.9) 38.1 36.8 1.3 Total revenues 4,458.4 4,348.1 110.3 12,174.9 10,466.6 1,708.3 Expenses: Benefits, claims and settlement expenses 2,840.1 2,642.1 198.0 7,481.3 5,752.4 1,728.9 Dividends to policyholders 30.3 31.9 (1.6) 90.3 92.6 (2.3) Operating expenses 1,242.3 1,105.0 137.3 3,281.3 3,080.1 201.2 Total expenses 4,112.7 3,779.0 333.7 10,852.9 8,925.1 1,927.8 Income before income taxes 345.7 569.1 (223.4) 1,322.0 1,541.5 (219.5) Income taxes 61.1 109.1 (48.0) 193.2 219.5 (26.3) Net income 284.6 460.0 (175.4) 1,128.8 1,322.0 (193.2) Net income attributable to noncontrolling interest 7.5 3.7 3.8 35.5 12.0 23.5 Net income attributable to Principal Financial Group, Inc. $ 277.1 $ 456.3 $ (179.2) $ 1,093.3 $ 1,310.0 $ (216.7)
Three Months Ended September 30, 2019 Compared to Three Months Ended September 30, 2018
Net Income Attributable to Principal Financial Group, Inc.
Net income attributable to Principal Financial Group, Inc. decreased primarily due to a $73.9 million favorable impact in 2018 related to the realignment of a real estate investment team and $68.6 million related to actuarial assumption updates and model refinements that had an unfavorable impact in 2019 as compared to a favorable impact in 2018.
Premiums increased $60.2 million for the Principal International segment primarily due to higher single premium annuity sales in Chile. Premiums increased $38.1 million for the U.S. Insurance Solutions segment primarily due to growth in the business.
Fees and other revenues decreased $263.9 million for the Principal Global Investors segment primarily due to the accelerated recognition of performance fees in 2018 from the realignment of a real estate investment team. Fees and other revenues increased $123.1 million for the U.S. Insurance Solutions segment primarily due to a favorable impact from actuarial assumption updates and model refinements in 2019 as compared to an unfavorable impact in 2018. Fees and other revenues increased $103.9 million for the Retirement and Income Solutions segment primarily due to the Acquired Business.
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Net investment income increased primarily due to a $40.1 million increase in earnings in our equity method investment in Brazil and $37.4 million attributable to higher average invested assets in our U.S. operations. For additional information, see "Investments - Investment Results - Net Investment Income."
Net realized capital gains (losses) can be volatile due to other-than-temporary impairments of invested assets, mark-to-market adjustments of certain invested assets and our decision to sell invested assets. Net realized capital losses increased due primarily to a $74.0 million impairment of an equity method investment in 2019 and a $50.0 million change in derivatives not designated as hedging instruments that had losses in 2019 versus gains in 2018. These increases were partially offset by an $87.4 million loss from the sale of closed blocks of annuity business within our Principal International operating segment in 2018 and a $19.8 million increase in gains from equity securities. For additional information, see "Investments - Investment Results - Net Realized Capital Gains (Losses)."
Benefits, claims and settlement expenses increased for the U.S. Insurance Solutions segment primarily due to$47.5 million primarily resulting from growth in the businesses and $38.8 million related to a more unfavorable impact from actuarial assumption updates and model refinements in 2019 as compared to 2018. Benefits, claims and settlement expenses increased $58.7 million for the Retirement and Income Solutions segment primarily due to a more unfavorable impact from actuarial assumption updates and model refinements in 2019 as compared to 2018. Benefits, claims and settlement expenses increased for the Principal International segment due to $58.9 million higher single premium annuity sales in Chile partially offset by an $11.1 million decrease as a result of lower inflation-based interest crediting rates to customers.
Operating expenses increased $142.6 million for the Retirement and Income Solutions segment primarily due to the Acquired Business. Operating expenses increased for the U.S. Insurance Solutions segment primarily due to $69.5 million related to an unfavorable impact from actuarial assumption updates and model refinements in 2019 as compared to a favorable impact in 2018 and $38.6 million primarily resulting from growth in the business. Operating expenses increased for the Corporate segment largely due to a $22.4 million increase related to interest on federal income taxes due to settlement agreements reached in the prior year and a $14.0 million increase in strategic initiatives. Operating expenses decreased $169.2 million for the Principal Global Investors segment primarily due to the 2018 expenses associated with the realignment of a real estate investment team.
The effective income tax rate decreased to 18% for the three months ended September 30, 2019, from 19% for the three months ended September 30, 2018. See Item 1. "Financial Statements, Notes to Unaudited Consolidated Financial Statements, Note 8, Income Taxes" for a reconciliation between the U.S. . . .
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