Principal Life Insurance Company 711 High Street Des Moines Ia – Shares of Principal Financial Group ( NASDAQ:PFG ) have underperformed over the past year, losing about 17% of their value as the asset management arm struggled with capital flows and profitability was challenged by higher mortality rates. Overall, however, the company reported a solid third quarter. The stock appears to be at a fair value and I would view the stock as a hold. PFG pays a decent dividend, which it has raised, but the stock is unlikely to recover from losses this year in my view.
In the company’s third quarter, Principal earned $1.72 in adjusted EPS, beating estimates by $0.10. This is an increase of almost 8% compared to last year. This result is broadly consistent with published firm sensitivities to the financial market. As you can see below, every 10% move in changes in the S&P 500 returns 5-8%. The company is generally neutral due to its focus on life and retirement policies (more below) and unlike property and casualty insurers that benefit from higher interest rates. With the S&P up about 14% on average in the second quarter, we expect PFG to earn 7-10% more, all else being equal. It is usually delivered
Principal Life Insurance Company 711 High Street Des Moines Ia
The principal’s most important unit was retirement and income solutions, which saw revenue rise 15% to $710 million, helped by acquisitions and higher interest rates. The company recorded sales of $7.6 billion, an increase of 30%. Higher rates and volatile stocks increase consumer demand for annuities and other retirement products, boosting these sales. Thanks to top-line growth, normalized operating income increased 13% to $260 million.
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Principal also has several smaller insurance operations. Special benefits income rose 8% to $771 million, operating income rose 32% to $132 million thanks to lower claims. Life premiums fell 1% to $242 million and operating income fell 27% to $30 million. The higher mortality rate weighed in favor of this group. Last year, amid disappointing underwriting results, it also struck a reinsurance deal, which reduced its capital base and earnings power, but should reduce earnings volatility. Therefore, earnings should be stable at this lower level.
One encouraging aspect of this quarter was that PFG completed its annual actuarial case and only had to take $6 million in reserves, which is generally a rounding error for a company of PFG’s size. When insurers, especially life and pensions, sell a policy, they cannot be sure how profitable it will be. If you sell life insurance to a 40-year-old, you can assume they live to 80 and build annuities from it, but they may die at age 78 or 82, making the policy more or less profitable. than expected.
Each year, as the insurance company gathers more data about how its policies are actually performing compared to modeled expectations, it adjusts reserves, essentially changing previously reported earnings. It is reassuring that only minor changes are needed here, meaning that the policies are working broadly in line with management expectations.
In addition to insurance, Principal is a major asset manager. Principal Global Investors’ revenue rose 6% to $394 million, helped by real estate performance fees. Operating income rose 7% to $152 million. AUM of $469 billion was up 4% from last year. It also has a strong international presence with international revenue up 10% to $239 million thanks to $1 billion in Brazil. $168 billion in AUM, up 16%. Operating income rose just 3% to $76 million, although it reflected a loss of operating leverage
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PGE’s AUM growth is actually due to strength in the stock market, and that’s a tough unit. As you can see below, the company had net outflows of $2.6 billion during the quarter. Last year, it had revenue of $8.3 billion.
While PGE has delivered solid long-term returns, its most recent performance has been mixed. Only 45% of its assets exceed the average capital in their universe. The stock has also underperformed fixed income over the past five years. Fees for equities are likely to be higher, so even if PGI keeps flows steady but there are outflows from equities and into fixed, it is likely to be profit-negative.
Today, these results are not bad enough to cause massive outflows from PGI coffers. His performance is not bad, just very average. This is probably good enough to keep most of the existing customers, but not enough to get many new customers, which is why the net flows are negative. This is an area where investors should stay focused, as the investment provides returns without particular capital. For capital flows to develop in a sustainable manner, I suspect we will need to see yields rise.
In addition to managing funds for others, PFG as an insurer also has its own large investment portfolio. It has an investment portfolio of $76 billion, of which $64 billion is fixed income. This is a high quality wallet. 90% of maturities assigned are classified NAIC 1 or 2 (investment grade) with 70% rated A- or higher. PFG generally does not take significant credit risk in its portfolio, investing in the highest quality securities, including a $26 billion corporate debt portfolio.
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I would like to point out that there are $3.75 billion in commercial mortgages on balance. Some commercial real estate, particularly office space, faces significant secular pressure. However, the typical mortgage has a loan-to-value of 47%, so half of the property’s value would have to be lost for PFG to break even. This may happen in select properties, of course, but in general, I expect the losses from this exposure to be relatively small.
Given the size of its fixed income portfolio, it may seem odd that at the beginning of this review I indicated that PFG saw little P&L exposure to interest rates. However, looking at its results, its net investment income rose just 0.1% to 4.8% year-on-year. This is because as a life insurer, PFG tends to hold long-term bonds (10+ years). It takes a long time for the portfolio to mature to significantly increase returns. In addition, the life and annuity policies he writes are based on prevailing rates. When interest rates are 3%, he prices annuities accordingly and buys bonds at 3%. With interest rates at 5%, he prices a higher yield and buys bonds at 5%.
The liability owed to policyholders retains the same interest duration as the bonds it purchases, so the balance is inherently protected (assuming it is entitled to its policies), so interest rates do not offer much headwind or the opposite. Now, on the accounting side, it doesn’t mark to market its liabilities like its bonds, which flow through accumulated other comprehensive income, where it has a loss of $7.1 billion. But the current value of its liabilities should also be $7.1 billion less than their book value. That’s why when looking at book value per share, I suggest looking at ex-AOCI. PFG’s book value ex-AOCI is $53.21, up about 5% this year.
Quarter-on-quarter, PFG increased its quarterly dividend by $0.02 to $0.67. So far this year, it has returned about $900 million to shareholders, and for the year the return on capital (dividend and stock returns) is about 8%. PFG has a strong but not spectacular capital position. It has a risk-adjusted capital ratio of 404%, just over 400%, which is a line for a life insurer you want to stay on top of. Companies like Lincoln Financial (LNC) have seen their stock and credit ratings suffer when they face shortages along these lines.
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PFG now has $904 million in holdco liquidity that it can use to return capital. To be clear, the opco insurer has $360 million in excess capital. PFG has room to maneuver, but being close to the 400% level, I think it is prudent for PFG to share only the profits from the opco, not from this buffer of excess capital. Over time, PFG believes the free cash flow conversion of its business is 75-85% with residual earnings in the insurance entity to support growth and new policies.
Having earned $4.73 so far this year, PFG is on pace to earn around $6.50 in calendar 2023. If stock markets remain at this level and underwriting results continue as they are, the PFG should earn around $7-7.20 by 2024. At 80% conversion, there will be around $5.70 returned to shareholders in dividends and buybacks.
This ensures adequate dividend coverage. At $68, the stock yields an 8% return on equity, the same as Prudential ( PRU ). I see this as a reasonable amount for insurers with limited capital surplus, especially as I am concerned about capital flows to PGI. Furthermore, if the stock market falls, PFG’s profitability will fall in sympathy.
Now, if you are bullish on the stock, PFG will see its earnings increase and the stock may become more attractive. Similarly, if you are bearish, you should avoid PFG. All else being equal, I personally think of percentages
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