| PRINCIPAL FINANCIAL GROUP INC Item 1A Risk Factors A decline or increased volatility in the securities markets could result in investors withdrawing from the markets or decreasing their rates of investment, either of which could reduce our net income, revenues and assets under management |
| Favorable performance by the US and international securities markets increases investments in these markets and benefits our asset management and accumulation businesses and increases our assets under management |
| Because the revenues of our asset management businesses are, to a large extent, based on the value of assets under management, a decline in these securities markets would decrease our revenues |
| Turmoil in these securities markets could lead investors to withdraw from these markets, decrease their rates of investment or refrain from making new investments which may reduce our net income, revenues and assets under management |
| Our investment portfolio is subject to several risks which may diminish the value of our invested assets and affect our sales, profitability and the investment returns credited to our customers |
| An increase in defaults on our fixed maturity securities portfolio may reduce our profitability |
| We are subject to the risk that the issuers of the fixed maturity securities we own will default on principal and interest payments, particularly if a major downturn in economic activity occurs |
| As of December 31, 2005, our USinvestment operations held dlra40dtta1 billion of fixed maturity securities, or 74prca of total US invested assets, of which approximately 17 _________________________________________________________________ 5dtta4prca were below investment grade, including dlra143dtta6 million, or 0dtta4prca of our total fixed maturity securities which we classified as either "e problem, "e "e potential problem, "e or "e restructured "e |
| As of December 31, 2005, our international investment operations held dlra2dtta1 billion of fixed maturity securities, or 69prca of total international invested assets |
| Some of these securities have been rated on the basis of the issuerapstas country credit rating while others have not been rated by external agencies, which makes the assessment of credit quality more difficult |
| An increase in defaults on our fixed maturity securities portfolio could harm our financial strength and reduce our profitability |
| An increased rate of delinquency and defaults on our commercial mortgage loans, especially those with balloon payments, could decrease our profitability |
| Our commercial mortgage loan portfolio faces both delinquency and default risk |
| Commercial mortgage loans of dlra9dtta9 billion represented 17prca of our total invested assets as of December 31, 2005 |
| As of December 31, 2005, loans that were either delinquent or in the process of foreclosure totaled, on a statutory basis, dlra10dtta1 million, or 0dtta1prca of our commercial mortgage loan portfolio, compared to the industry average of 0dtta1prca as reported by the American Council of Life Insurers as of December 31, 2005 |
| An increase in the delinquency rate of our commercial mortgage loan portfolio could harm our financial strength and decrease our profitability |
| As of December 31, 2005, approximately dlra8dtta1 billion, or 81prca, of our commercial mortgage loans before valuation allowance had balloon payment maturities |
| A balloon maturity is a loan with larger dollar amounts of payments becoming due in the later years of the loan |
| The default rate on commercial mortgage loans with balloon payment maturities has historically been higher than for commercial mortgage loans with standard repayment schedules |
| Since most of the principal is being repaid at maturity, the amount of loss on a default is generally greater than on other commercial mortgage loans |
| An increase in defaults on such loans as a result of the foregoing factors could harm our financial strength and reduce our net income |
| We may have difficulty selling our privately placed fixed maturity securities, commercial mortgage loans and real estate investments because they are less liquid than our publicly traded fixed maturity securities |
| As of December 31, 2005, our privately placed fixed maturity securities, commercial mortgage loans and real estate investments represented approximately 40prca of the value of our invested assets |
| If we require significant amounts of cash on short notice, we may have difficulty selling these investments at attractive prices, in a timely manner, or both |
| Derivative instruments may not be honored by counterparties resulting in ineffective hedging of our risks |
| We use derivative instruments to hedge various risks we face in our businesses |
| We enter into a variety of derivative instruments, including interest rate swaps, swaptions, financial futures, currency swaps, currency forwards, credit default swaps, total return swaps, bond forwards, mortgage-backed security forwards and options, with a number of counterparties |
| If, however, our counterparties fail to honor their obligations under the derivative instruments, we will have failed to effectively hedge the related risk |
| That failure may harm our financial strength and reduce our profitability |
| Environmental liability exposure may result from our commercial mortgage loan portfolio and real estate investments |
| Liability under environmental protection laws resulting from our commercial mortgage loan portfolio and real estate investments may harm our financial strength and reduce our profitability |
| Under the laws of several states, contamination of a property may give rise to a lien on the property to secure recovery of the costs of cleanup |
| In some states, this kind of lien has priority over the lien of an existing mortgage against the property, which would impair our ability to foreclose on that property should the related loan be in default |
| In addition, under the laws of some states and under the federal Comprehensive Environmental Response, Compensation and Liability Act of 1980, we may be liable for costs of addressing releases or threatened releases of hazardous substances that require remedy at a property securing a mortgage loan held by us, if our agents or employees have become sufficiently involved in the hazardous waste aspects of the operations of the related obligor on that loan, regardless of whether or not the environmental damage or threat was caused by the obligor |
| We also may face this liability after foreclosing on a property securing a mortgage loan held by us |
| This may harm our financial strength and decrease our profitability |
| Regional concentration of our commercial mortgage loan portfolio in California may subject us to economic downturns or losses attributable to earthquakes in that state |
| California accounted for 18prca, or dlra1dtta8 billion, of our commercial mortgage loan portfolio as of December 31, 2005 |
| Due to this concentration of commercial mortgage loans in California, we are exposed to potential losses resulting from the risk of an economic downturn in California as well as to catastrophes, such as earthquakes, that may affect the region |
| While we generally do not require earthquake insurance for properties on which we make commercial mortgage loans, we do take into account property specific engineering reports, construction type and geographical concentration by fault 18 _________________________________________________________________ lines in our investment underwriting guidelines |
| If economic conditions in California deteriorate or catastrophes occur, we may experience delinquencies on the portion of our commercial mortgage loan portfolio located in California in the future, which may harm our financial strength and reduce our profitability |
| Competition 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 |
| We believe that our ability to compete is based on a number of factors including scale, service, product features, price, investment performance, commission structure, distribution capabilities, financial strength ratings and name recognition |
| We compete with a large number of financial services companies such as banks, broker-dealers, insurers and asset managers, many of which have advantages over us in one or more of the above competitive factors |
| Each of our segments faces strong competition |
| The primary competitors for our US Asset Management and Accumulation segment are asset managers, banks, broker-dealers and insurers |
| Our ability to increase and retain assets under management is directly related to the performance of our investments as measured against market averages and the performance of our competitors |
| Even when securities prices are generally rising, performance can be affected by investment styles |
| Principal Global Investors may also be at a disadvantage in competing for investment management personnel due to its location in Des Moines |
| Competition for our International Asset Management and Accumulation segment comes primarily from local financial services firms and other international companies operating on a stand-alone basis or in partnership with local firms |
| Our Life and Health Insurance segment competes with insurers and health maintenance organizations |
| National banks, with their large existing customer bases, may increasingly compete with insurers as a result of court rulings allowing national banks to sell annuity products in some circumstances, and as a result of legislation removing restrictions on bank affiliations with insurers |
| Specifically, the Gramm-Leach-Bliley Act of 1999 permits mergers that combine commercial banks, insurers and securities firms under one holding company |
| These developments may increase competition, in particular for our asset management and accumulation businesses, by substantially increasing the number, size and financial strength of potential competitors who may be able to offer, due to economies of scale, more competitive pricing than we can |
| A downgrade in any of our ratings may increase policy surrenders and withdrawals, reduce new sales and terminate relationships with distributors, and impact existing liabilities, any of which could adversely affect our profitability and financial condition |
| Ratings are important factors in establishing the competitive position of insurance companies |
| A rating downgrade, or the potential for such a downgrade, could, among other things: • materially increase the number of policy or contract surrenders for all or a portion of their net cash values and withdrawals by policyholders of cash values from their policies or with respect to general account guaranteed investment contracts and funding agreements purchased by pension plans and other institutions; • result in the termination of our relationships with broker-dealers, banks, agents, wholesalers and other distributors of our products and services; • reduce new sales, particularly with respect to general account guaranteed investment contracts and funding agreements purchased by pension plans and other institutions; and • cause some of our existing liabilities to be subject to acceleration, additional collateral support, changes in terms, or creation of additional financial obligations |
| Any of these consequences could adversely affect our profitability and financial condition |
| Certain aspects of our businesses help us mitigate potential liquidity risk: • Our liability portfolio is diverse |
| Importantly, our products have features to discourage surrenders |
| • Our asset portfolio is also diverse and spread over many different types of exposures (asset class, credit, geography, industry, etc) |
| Our efforts to reduce the impact of interest rate changes on our profitability and surplus may not be effective |
| We attempt to significantly reduce the impact of changes in interest rates on the profitability and surplus of our asset accumulation and life and health insurance operations |
| We accomplish this reduction primarily by managing the duration of our assets relative to the duration of our liabilities |
| During a period of rising interest rates, policy surrenders, withdrawals and requests for policy loans may increase as customers seek to achieve higher returns |
| Despite our efforts to reduce the impact of rising interest rates, we may be required to sell assets to raise the cash necessary to respond to such 19 _________________________________________________________________ surrenders, withdrawals and loans, thereby realizing capital losses on the assets sold |
| An increase in policy surrenders and withdrawals may also require us to accelerate amortization of policy acquisition costs relating to these contracts, which would further reduce our net income |
| During periods of declining interest rates, borrowers may prepay or redeem mortgages and bonds that we own, which would force us to reinvest the proceeds at lower interest rates |
| For some of our products, such as guaranteed investment contracts and funding agreements, we are unable to lower the rate we credit to customers in response to the lower return we will earn on our investments |
| In addition, it may be more difficult for us to maintain our desired spread between the investment income we earn and the interest we credit to our customers during periods of declining interest rates thereby reducing our profitability |
| For further discussion on interest rate risk management, see Item 7A, "e Quantitative and Qualitative Information About Market Risk — Interest Rate Risk "e |
| If we are unable to attract and retain sales representatives and develop new distribution sources, sales of our products and services may be reduced |
| We distribute our asset accumulation, asset management and life, health and specialty benefit insurance products and services through a variety of distribution channels, including our own internal sales representatives, independent brokers, banks, broker-dealers and other third-party marketing organizations |
| We must attract and retain sales representatives to sell our products |
| Strong competition exists among financial services companies for efficient sales representatives |
| We compete with other financial services companies for sales representatives primarily on the basis of our financial position, support services and compensation and product features |
| If we are unable to attract and retain sufficient sales representatives to sell our products, our ability to compete and revenues from new sales would suffer |
| Our international businesses face political, legal, operational and other risks that could reduce our profitability in those businesses |
| Our international businesses are subject to comprehensive regulation and supervision from central and/or local governmental authorities in each country in which we operate |
| New interpretations of existing laws and regulations or the adoption of new laws and regulations may harm our international businesses and reduce our profitability in those businesses |
| Our international businesses face political, legal, operational and other risks that we do not face in our operations in the US We face the risk of discriminatory regulation, nationalization or expropriation of assets, price controls and exchange controls or other restrictions that prevent us from transferring funds from these operations out of the countries in which they operate or converting local currencies we hold into US dollars or other currencies |
| Some of our international businesses are, and are likely to continue to be, in emerging or potentially volatile markets |
| In addition, we rely on local staff, including local sales forces, in these countries and we may encounter labor problems especially in countries where workers &apos associations and trade unions are strong |
| If our business model is not successful in a particular country, we may lose all or most of our investment in that country |
| Our reserves established for future policy benefits and claims may prove inadequate, requiring us to increase liabilities |
| Our earnings depend significantly upon the extent to which our actual claims experience is consistent with the assumptions used in setting prices for our products and establishing liabilities for future insurance and annuity policy benefits and claims |
| The liability that we have established for future policy benefits is based on assumptions concerning a number of factors, including the amount of premiums that we will receive in the future, rate of return on assets we purchase with premiums received, expected claims, expenses and persistency, which is the measurement of the percentage of insurance policies remaining in force from year to year, as measured by premiums |
| However, due to the nature of the underlying risks and the high degree of uncertainty associated with the determination of the liabilities for unpaid policy benefits and claims, we cannot determine precisely the amounts which we will ultimately pay to settle these liabilities |
| As a result, we may experience volatility in the level of our reserves from period to period, particularly for our health and disability insurance products |
| To the extent that actual claims experience is less favorable than our underlying assumptions, we could be required to increase our liabilities, which may harm our financial strength and reduce our profitability |
| 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 |
| We are an insurance holding company whose assets include all of the outstanding shares of the common stock of Principal Life and other direct subsidiaries |
| Our ability to pay dividends to our stockholders and meet our obligations, including paying operating expenses and any debt service, depends upon the receipt of dividends from Principal Life |
| Iowa insurance laws impose limitations on the ability of Principal Life to pay dividends to us |
| Any inability of Principal Life to pay dividends to us in the future may cause us to be unable to pay dividends to our stockholders and meet our other obligations |
| See Item 7, "e Managementapstas Discussion and Analysis of Financial Condition and Results of Operations 20 _________________________________________________________________ — Liquidity and Capital Resources "e for a discussion of regulatory restrictions on Principal Lifeapstas ability to pay us dividends |
| The pattern of amortizing our DPAC on our SFAS 97 products may change, impacting both the level of the asset and the timing of our operating earnings |
| Amortization of the DPAC asset depends on the actual and expected profits generated by the lines of business that generated the expenses |
| Expected profits are dependent on assumptions regarding a number of factors including investment returns, benefit payments, expenses, mortality, and policy lapse |
| Due to the uncertainty associated with establishing these assumptions, we cannot, with precision, determine the exact pattern of profit emergence |
| As a result, amortization of DPAC will vary from period to period |
| To the extent that actual experience emerges less favorably than expected, or our expectation for future profits decreases, the DPAC asset may be reduced, reducing our profitability in the current period |
| We may need to fund deficiencies in our Closed Block |
| In connection with its conversion in 1998 into a stock life insurance company, Principal Life established an accounting mechanism, known as a "e Closed Block, "e for the benefit of participating ordinary life insurance policies that had a dividend scale in force on July 1, 1998 |
| Dividend scales are the actuarial formulas used by life insurance companies to determine amounts payable as dividends on participating policies based on experience factors relating to, among other things, investment results, mortality, lapse rates, expenses, premium taxes and policy loan interest and utilization rates |
| The Closed Block was designed to provide reasonable assurance to policyholders included in the Closed Block that, after the conversion, assets would be available to maintain the aggregate dividend scales in effect for 1997 if the experience underlying such scales were to continue |
| We allocated assets to the Closed Block as of July 1, 1998 in an amount such that we expect their cash flows, together with anticipated revenues from the policies in the Closed Block, to be sufficient to support the Closed Block business, including payment of claims, expenses, charges and taxes and to provide for the continuation of aggregate dividend scales in accordance with the 1997 policy dividend scales if the experience underlying such scales continues, and to allow for appropriate adjustments in such scales if the experience changes |
| We bear the costs of expenses associated with Closed Block policies and, accordingly, these costs were not funded as part of the assets allocated to the Closed Block |
| Any increase in such costs in the future will be borne by us |
| As of December 31, 2005, Closed Block assets and liabilities were dlra4cmam815dtta0 million and dlra5cmam866dtta1 million, respectively |
| We will continue to pay guaranteed benefits under the policies included in the Closed Block, in accordance with their terms |
| The Closed Block assets, cash flows generated by the Closed Block assets and anticipated revenues from polices included in the Closed Block may not be sufficient to provide for the benefits guaranteed under these policies |
| Even if they are sufficient, we may choose for business reasons to support dividend payments on policies in the Closed Block with our general account funds |
| The Closed Block assets, cash flows generated by the Closed Block assets and anticipated revenues from policies in the Closed Block will benefit only the holders of those policies |
| In addition, to the extent that these amounts are greater than the amounts estimated at the time we funded the Closed Block, dividends payable in respect of the policies included in the Closed Block may be greater than they would have been in the absence of a Closed Block |
| Any excess earnings will be available for distribution over time to Closed Block policyholders but will not be available to our stockholders |
| Changes in laws, regulations or accounting standards may reduce our profitability |
| Changes in regulation in the United States may reduce our profitability |
| Our insurance business is subject to comprehensive state regulation and supervision throughout the US The primary purpose of state regulation of the insurance business is to protect policyholders, not stockholders |
| The laws of the various states establish insurance departments with broad powers to regulate such matters as: • licensing companies to transact business, • licensing agents, • admitting statutory assets, • mandating a number of insurance benefits, • regulating premium rates, • approving policy forms, • regulating unfair trade and claims practices, • establishing statutory reserve requirements and solvency standards, 21 _________________________________________________________________ • fixing maximum interest rates on life insurance policy loans and minimum rates for accumulation of surrender values, • restricting various transactions between affiliates, and • regulating the types, amounts and valuation of investments |
| State insurance regulators and the National Association of Insurance Commissioners, or NAIC, continually reexamine existing laws and regulations, and may impose changes in the future |
| Federal legislation and administrative policies in areas such as employee benefit plan regulation, financial services regulation and federal taxation can reduce our profitability |
| For example, Congress has, from time to time, considered legislation relating to changes in the Employee Retirement Income Security Act of 1974 to permit application of state law remedies, such as consequential and punitive damages, in lawsuits for wrongful denial of benefits, which, if adopted, could increase our liability for damages in future litigation |
| Additionally, new interpretations of existing laws and the passage of new legislation may harm our ability to sell new policies and increase our claims exposure on policies we issued previously |
| In addition, reductions in contribution levels to defined contribution plans may decrease our profitability |
| Changes in federal taxation could reduce sales of our insurance, annuity and investment products |
| Current federal income tax laws generally permit the tax-deferred accumulation of earnings on the premiums paid by the holders of annuities and life insurance products |
| Taxes, if any, are payable on income attributable to a distribution under the contract for the year in which the distribution is made |
| Congress has, from time to time, considered legislation that would reduce or eliminate the benefit of such deferral of taxation on the accretion of value within life insurance and non-qualified annuity contracts |
| Enactment of this legislation, including a simplified "e flat tax "e income structure with an exemption from taxation for investment income, could result in fewer sales of our insurance, annuity and investment products |
| Repeal or modification of the federal estate tax could reduce our revenues |
| The Economic Growth and Tax Relief Reconciliation Act of 2001 amended the federal estate tax laws by increasing the amount of the unified credit beginning in 2002, thereby increasing the amount of property not subject to the estate tax |
| The Act also gradually reduces the federal estate tax rate over a period of years beginning in 2002, and repeals the tax entirely in 2010 |
| Through the twelve months ended December 31, 2005, we received recurring premium of dlra31dtta5 million for survivorship life insurance policies we have sold |
| A significant number of these policies were purchased for the purpose of providing cash to pay federal estate taxes |
| The reduction of the federal estate tax and temporary repeal could result in policyholders reducing coverage under, or surrendering, these policies |
| Changes in federal, state and foreign securities laws may reduce our profitability |
| Our asset management and accumulation and life insurance businesses are subject to various levels of regulation under federal, state and foreign securities laws |
| These laws and regulations are primarily intended to protect investors in the securities markets or investment advisory or brokerage clients and generally grant supervisory agencies broad administrative powers, including the power to limit or restrict the conduct of business for failure to comply with such laws and regulations |
| Changes to these laws or regulations that restrict the conduct of our business could reduce our profitability |
| Changes in accounting standards may reduce our profitability |
| Accounting standards are subject to change and can negatively impact our profitability |
| The results for past accounting periods are not necessarily indicative of the results to be expected for any future accounting period |
| In October 2005, the Financial Accounting Standards Board ( "e FASB "e ) issued a working draft of SFAS Nodtta 15X, "e Fair Value Measurements "e , which will be effective for financial statements issued for fiscal years beginning after November 15, 2006 |
| The purpose of this guidance is to establish a framework for measuring fair value that would apply broadly to financial and nonfinancial assets and liabilities |
| A move to fair value accounting may lead to more volatility in the income statement |
| Several years ago the International Accounting Standards Board ( "e IASB "e ) and the FASB launched a project to converge International Financial Reporting Standards ( "e IFRS "e ) and US GAAP Progress has been made in recent years by both Boards in reducing key differences between the two sets of standards |
| There are many differences between US GAAP and IFRS that impact those using, preparing, auditing or regulating cross-border financial reporting |
| As the project to converge IFRS and US GAAP continues, current GAAP fundamentals may be modified to become consistent with IFRS, which may result in changes in the financial statements of US companies |
| 22 _________________________________________________________________ Litigation and regulatory investigations may affect our financial strength or reduce our profitability |
| We are a plaintiff or defendant in actions arising out of our insurance businesses and investment operations |
| We are, from time to time, also involved in various governmental, regulatory and administrative proceedings and inquiries |
| These factors may affect our financial strength or reduce our profitability |
| For further discussion on litigation and |