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Principal Financial Group 10-K 2007

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K


ý

 

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2006

OR

o

 

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to             

Commission file number 1-16725

PRINCIPAL FINANCIAL GROUP, INC.
(Exact name of Registrant as specified in its charter)

Delaware
(State or other jurisdiction of
incorporation or organization)
  711 High Street,
Des Moines, Iowa 50392
(Address of principal executive offices)
  42-1520346
(I.R.S. Employer
Identification Number)

(515) 247-5111
(Registrant's telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

Title of each class
Common Stock, par value $0.01
Series B Non-Cumulative Perpetual Preferred Stock
  Name of each exchange on which registered
New York Stock Exchange
New York Stock Exchange

Securities registered pursuant to Section 12(g) of the Act:
Series A Non-Cumulative Perpetual Preferred Stock

 

 

        Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ý No o

        Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes o No ý

        Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes ý No o

        Indicate by check mark if disclosure of delinquent filers pursuant Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment of this Form 10-K. o

        Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definitions of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act.

Large accelerated filer ý    Accelerated filer o    Non-accelerated filer o

        Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.) Yes o No ý

        As of February 20, 2007, there were outstanding 267,878,346 shares of Common Stock, $0.01 par value per share of the Registrant.

        The aggregate market value of the shares of the Registrant's common equity held by non-affiliates of the Registrant was $14,973,612,997 based on the closing price of $55.65 per share of Common Stock on the New York Stock Exchange on June 30, 2006.

Documents Incorporated by Reference

        The information required to be furnished pursuant to Part III of this Form 10-K is set forth in, and is hereby incorporated by reference herein from, the Registrant's definitive proxy statement for the annual meeting of stockholders to be held on May 22, 2007, to be filed by the Registrant with the Securities and Exchange Commission pursuant to Regulation 14A not later than 120 days after the year ended December 31, 2006.





PRINCIPAL FINANCIAL GROUP, INC.
TABLE OF CONTENTS

PART I   4

Item 1.

 

Business

 

4

Item 1A.

 

Risk Factors

 

19

Item 1B.

 

Unresolved Staff Comments

 

26

Item 2.

 

Properties

 

26

Item 3.

 

Legal Proceedings

 

26

Item 4.

 

Submission of Matters to a Vote of Security Holders

 

27
    Executive Officers of the Registrant   27

PART II

 

28

Item 5.

 

Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

28

Item 6.

 

Selected Financial Data

 

29

Item 7.

 

Management's Discussion and Analysis of Financial Condition and Results of Operations

 

32

Item 7A.

 

Quantitative and Qualitative Disclosures About Market Risk

 

84

Item 8.

 

Financial Statements and Supplementary Data

 

90
    Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting   91
    Report of Independent Registered Public Accounting Firm   92
    Consolidated Statements of Financial Position   93
    Consolidated Statements of Operations   94
    Consolidated Statements of Stockholders' Equity   95
    Consolidated Statements of Cash Flows   97
    Notes to Consolidated Financial Statements   99

Item 9.

 

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

 

190

Item 9A.

 

Controls and Procedures

 

190

Item 9B.

 

Other Information

 

190

PART III

 

191

Item 10.

 

Directors, Executive Officers and Corporate Goverance

 

191

Item 11.

 

Executive Compensation

 

191

Item 12.

 

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

 

191

Item 13.

 

Certain Relationships and Related Transactions and Director Independence

 

192

Item 14.

 

Principal Accounting Fees and Services

 

192

PART IV

 

193

Item 15.

 

Exhibits and Financial Statement Schedules

 

193

Signatures

 

197
 
Report of Independent Registered Public Accounting Firm on Schedules

 

198
  Schedule I — Summary of Investments — Other Than Investments in Related Parties   199
  Schedule II — Condensed Financial Information of Registrant (Parent Only)   200
  Schedule III — Supplementary Insurance Information   204
  Schedule IV — Reinsurance   206
  Exhibit Index   207

2


NOTE CONCERNING FORWARD-LOOKING STATEMENTS

        This Annual Report on Form 10-K, including the Management's Discussion and Analysis of Financial Condition and Results of Operations, contains statements which constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, including statements relating to trends in operations and financial results and the business and the products of the Registrant and its subsidiaries, as well as other statements including words such as "anticipate," "believe," "plan," "estimate," "expect," "intend" and other similar expressions. Forward-looking statements are made based upon management's current expectations and beliefs concerning future developments and their potential effects on the Company. 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) 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; (2) 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; (3) 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; (4) 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; (5) our efforts to reduce the impact of interest rate changes on our profitability and surplus may not be effective; (6) if we are unable to attract and retain sales representatives and develop new distribution sources, sales of our products and services may be reduced; (7) our international businesses face political, legal, operational and other risks that could reduce our profitability in those businesses; (8) our reserves established for future policy benefits and claims may prove inadequate, requiring us to increase liabilities; (9) 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 Insurance Company ("Principal Life"); (10) the pattern of amortizing our deferred policy acquisition costs ("DPAC") on our Statement of Financial Accounting Standard ("SFAS") No. 97 Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments ("SFAS 97") products may change, impacting both the level of the asset and the timing of our operating earnings; (11) we may need to fund deficiencies in our closed block ("Closed Block") assets; (12) a pandemic, terrorist attack, or other catastrophic event could adversely affect our earnings; (13) our reinsurers could default on their obligations or increase their rates, which could adversely impact our earnings and profitability; (14) we may encounter difficulty integrating WM Advisors, Inc. and may incur substantial costs in connection with the integration; (15) changes in laws, regulations or accounting standards may reduce our profitability; (16) litigation and regulatory investigations may affect our financial strength or reduce our profitability; (17) fluctuations in foreign currency exchange rates could reduce our profitability; and (18) applicable laws and our stockholder rights plan, certificate of incorporation and by-laws may discourage takeovers and business combinations that our stockholders might consider in their best interests.

3



PART I

Item 1.    Business

        The Principal Financial Group is a leading provider of retirement savings, investment and insurance products and services with $256.9 billion in assets under management and approximately eighteen million customers worldwide as of December 31, 2006.

        Our U.S. and international operations concentrate primarily on asset accumulation and management. In addition, we offer a broad range of individual and group life insurance, group health insurance, and individual and group disability insurance.

        We primarily focus on small and medium sized businesses, which we define as companies with less than 1,000 employees, providing a broad array of retirement and employee benefit solutions to meet the needs of the business, the business owner and their employees. With over 32,000 plans, we are the leading provider of corporate defined contribution plans in the U.S., according to Spectrem Group. We are also the leading employee stock ownership plan consultant. In addition, we are a leading provider of nonqualified plans, defined benefit plans and plan termination annuities. We are also one of the largest providers of non-medical insurance product solutions.

        We believe small and medium sized businesses are an underserved market, offering attractive growth opportunities in the U.S. in retirement services and other employee benefits. We also believe there is a significant opportunity to leverage our U.S. retirement expertise into select international markets that have adopted or are moving toward private sector defined contribution pension systems. This opportunity is particularly compelling as aging populations around the world are driving increased demand for retirement accumulation, retirement asset management, and retirement income management solutions.

Our Operating Segments

        We organize our businesses into the following operating segments:

    U.S. Asset Management and Accumulation;

    International Asset Management and Accumulation; and

    Life and Health Insurance.

        We also have a Corporate and Other segment, which consists of the assets and activities that have not been allocated to any other segment.

4



        The following table summarizes our operating revenues for our products and services, which are described in each of the subsequent operating segment discussions:

 
  For the year ended December 31,
 
 
  2006
  2005
  2004
 
 
  (in millions)

 
U.S. Asset Management and Accumulation:                    
  Full-service accumulation   $ 1,383.6   $ 1,267.4   $ 1,177.2  
  Mutual funds     344.9     206.6     182.1  
  Individual annuities     582.8     471.6     393.8  
  Bank and trust services     53.0     38.8     33.7  
  Eliminations     (168.8 )   (62.6 )   (53.3 )
   
 
 
 
    Total Accumulation     2,195.5     1,921.8     1,733.5  
  Investment only     1,080.7     1,002.3     931.6  
  Full-service payout     830.8     863.5     811.8  
   
 
 
 
    Total Guaranteed     1,911.5     1,865.8     1,743.4  
   
 
 
 
    Total U.S. Asset Accumulation     4,107.0     3,787.6     3,476.9  
  Principal Global Investors     488.1     417.3     343.4  
  Eliminations     (83.5 )   (71.1 )   (58.7 )
   
 
 
 
    Total U.S. Asset Management and Accumulation     4,511.6     4,133.8     3,761.6  
International Asset Management and Accumulation     605.4     604.5     518.4  
Life and Health Insurance:                    
  Individual life insurance     1,344.7     1,361.7     1,370.4  
  Health insurance     2,077.7     1,894.3     1,806.9  
  Specialty benefits insurance     1,316.0     1,131.5     1,004.0  
  Eliminations     (2.2 )        
   
 
 
 
    Total Life and Health Insurance     4,736.2     4,387.5     4,181.3  
Corporate and Other     (27.4 )   (59.1 )   (23.0 )
   
 
 
 
Total operating revenues   $ 9,825.8   $ 9,066.7   $ 8,438.3  
   
 
 
 
Total operating revenues   $ 9,825.8   $ 9,066.7   $ 8,438.3  
Net realized/unrealized capital gains (losses), including recognition of front-end fee revenues and certain market value adjustments to fee revenues     44.2     (22.2 )   (114.9 )
Operating revenues from discontinued real estate investments     0.5     (2.8 )   (2.5 )
   
 
 
 
Total U.S. GAAP revenues   $ 9,870.5   $ 9,041.7   $ 8,320.9  
   
 
 
 

U.S. Asset Management and Accumulation Segment

        Our U.S. Asset Management and Accumulation segment consists of:

    asset accumulation operations, which provide retirement savings and related investment products and services to businesses, their employees and other individuals; and

    Principal Global Investors, our U.S.-based asset manager.

        For financial results for the U.S. Asset Management and Accumulation segment, see Item 8. "Financial Statements and Supplementary Data, Notes to Consolidated Financial Statements, Note 19 Segment Information."

U.S. Asset Accumulation

        Our asset accumulation activities in the U.S. date back to the 1940s when we first began providing pension plan products and services. We now offer a comprehensive portfolio of asset accumulation products and services for retirement savings and investment:

    To businesses of all sizes with a concentration on small and medium-sized businesses, which we define as businesses with fewer than 1,000 employees, we offer products and services for defined contribution pension plans, including 401(k) and 403(b) plans, defined benefit pension plans, non-qualified executive benefit plans, and employee stock ownership plan ("ESOP") consulting services. For more basic investment needs, we offer SIMPLE IRA and payroll deduction plans;

5


    To large institutional clients, we also offer investment-only products, including guaranteed investment contracts and funding agreements; and

    To employees of businesses and other individuals, we offer the ability to accumulate funds for retirement and savings through mutual funds, individual annuities and bank products.

        We organize our U.S. asset accumulation operations into six product and service categories: full-service accumulation, mutual funds, individual annuities, bank and trust services, investment only and full-service payout.

Full-Service Accumulation

Products

        We offer a wide variety of investment and administrative products for defined contribution pension plans, including 401(k) and 403(b) plans, defined benefit pension plans, non-qualified executive benefit plans, and ESOPs. A 403(b) plan is a plan described in Section 403(b) of the Internal Revenue Code that provides retirement benefits for employees of tax-exempt organizations and public schools.

        Full-service accumulation products respond to the needs of plan sponsors seeking both administrative and investment services for defined contribution plans or defined benefit plans. The investment component of both the defined contribution and defined benefit plans may be in the form of a general account, separate account or a mutual fund offering.

        As of December 31, 2006, we provided full-service accumulation products to 32,139 defined contribution pension plans, of which 26,189 were 401(k) plans, covering 2.9 million plan participants, and to 2,785 defined benefit pension plans, covering 329,275 plan participants. As of December 31, 2006, approximately 70% of our full-service accumulation account values were managed by Principal Global Investors. Third-party asset managers provide asset management services with respect to the remaining assets.

        We deliver both administrative and investment services to our defined contribution plan and defined benefit plan customers through annuities and mutual funds. Annuities and the underlying investment options are not required to be registered with the United States Securities and Exchange Commission ("SEC"). Our mutual fund offering is called Principal Advantage. It is a qualified plan product based on our series mutual fund, Principal Investors Fund, and is a registered product with the SEC. We offer investments covering the full range of stable value, equity, fixed income and international investment options managed by our affiliated asset manager, Principal Global Investors, as well as third-party asset managers.

        On December 17, 2004, we entered into a strategic agreement to acquire ABN AMRO Trust Services Company ("Principal Services Trust Company"), the Chicago-based pension and retirement business of ABN AMRO. As of December 31, 2004, Principal Services Trust Company provided full-service defined contribution recordkeeping and investment services in the U.S., administering approximately 280 401(k) plans with more than 120,000 participants, representing $4.0 billion in full-service account values. The transaction closed on December 31, 2004 and the business was fully integrated into full-service accumulation in early 2006.

Markets and Distribution

        We offer our full-service accumulation products and services to employer-sponsored pension plans, including qualified and non-qualified defined contribution plans and defined benefit plans. Our primary target market is plans sponsored by small and medium-sized businesses, which we believe remains under-penetrated. Only 15% of businesses with between 5 and 99 employees, and 47% of businesses with between 100 and 500 employees, offered a 401(k) plan in 2006, according to Spectrem Group. The same study indicates that 63% of employers with between 500 and 1,000 employees; 71% of employers with between 1,000 and 5,000 employees; and 90% of employers with 5,000 or more employees offered a 401(k) plan in 2006.

        We distribute our full-service accumulation products and services nationally, primarily through a captive retirement services sales force. As of December 31, 2006, approximately 345 retirement services sales representatives in over 43 offices, operating as a wholesale distribution network, maintained relationships with over 9,347 independent brokers, consultants and agents. Retirement services sales representatives are an integral part of the sales process alongside the referring consultant or independent broker. We compensate retirement services sales representatives through a blend of salary and production-based incentives, while we pay independent brokers, consultants and agents a commission or fee.

        As of December 31, 2006, we had a separate staff of over 255 service and education specialists located in the sales offices who play a key role in the ongoing servicing of pension plans by: providing local services to our customers, such as reviewing plan performance, investment options and plan design; communicating the customers' needs and feedback to us; and helping employees understand the benefits of their pension plans. The following summarizes our distribution channels:

    We distribute our annuity-based products through sales representatives, agents and brokers who are primarily state licensed individuals.

6


    Principal Advantage, our mutual fund-based product, is targeted at defined contribution plans through broker/dealer distribution channels. Principal Advantage gives us access to National Association of Securities Dealers-registered distributors who are not traditional sellers of annuity-based products and broadens opportunities for us in the investment advisor and broker-dealer distribution channels.

    Principal Security Builder Retirement Program Individual 401(k) is the newest retirement plan solution from the Principal Financial Group. It was created for the small business owner giving them a low-cost retirement program that allows them to save on taxes while saving for retirement. The Principal Security Builder Retirement Program Individual 401(k) is available through the group annuity contract.

    Through our Retire Secure strategy we provide financial education and assistance to individual investors who are participants/members of employer-based accumulation solutions to help them achieve financial security.

        We believe that our approach to full-service accumulation plan services distribution gives us a local sales and service presence that differentiates us from many of our competitors. We have also recently established a number of marketing and distribution relationships to increase the sales of our accumulation products with firms such as Bank of America and Smith Barney.

Mutual Funds

        We have been providing mutual funds to customers since 1969. We offer mutual funds to individuals, businesses, and institutional investors for use within variable life and variable annuity contracts, for use in employer-sponsored pension plans, as a rollover investment option, and for general investment purposes.

Products

        We were ranked in the top quartile among U.S. mutual fund managers in terms of total mutual fund assets under management as of December 31, 2006, according to the Investment Company Institute ("ICI"). The value of our mutual fund assets we managed was $56.0 billion as of December 31, 2006, including the assets under management from our acquisition of WM Advisors, Inc. At $56.0 billion in assets under management, we rank 41st according to the ICI. We provide accounting, compliance, corporate governance, product development and transfer agency functions for all mutual funds we organize. As of December 31, 2006, our mutual fund operations served approximately 1,800,000 mutual fund shareholder accounts.

        Principal Variable Contracts Fund.    Principal Variable Contracts Fund is a series mutual fund, which, as of December 31, 2006, provided 31 investment options for use as funding choices in variable annuity and variable life insurance contracts issued by Principal Life. As of December 31, 2006, this fund had $4.8 billion in assets under management (excluding assets under management from the acquisition of WM Advisors, Inc.). We report the results for the funds backing variable annuity contracts in this segment under "Individual Annuities." We report the results for the funds backing variable life insurance contracts in the Life and Health Insurance segment.

        Principal Investors Fund.    Principal Investors Fund is a series mutual fund, which as of December 31, 2006, offered 55 investment options. This fund acts as the funding vehicle for Principal Advantage, the defined contribution product described above under "U.S. Asset Management and Accumulation Segment-Full-Service Accumulation Products." This fund also offers retail classes of shares ("J shares") to individuals for IRA rollovers and general investment purposes and a class of shares ("I shares") offered primarily to specified institutional investors. As of December 31, 2006, this retail class of shares had $8.4 billion in assets under management (excluding assets under management from the acquisition of WM Advisors, Inc.); $1.2 billion of this retail class invests in other share classes of Principal Investors Funds. All other share classes of Principal Investors Funds, including seed money, had $20.3 billion of assets under management. We report the results for this fund, excluding the retail class of shares, under "Full-Service Accumulation." We report the results of the three retail share classes under "Mutual Funds."

        Principal Managed Portfolio.    Principal Managed Portfolio is a wrap product offered by our registered investment advisor, Princor Financial Services Corporation ("Princor"), which only invests in Principal Investors Funds. We started to market this product in mid-2005. Clients are charged a quarterly asset based fee on this account. As of December 31, 2006, Principal Managed Portfolio had accumulated $378.7 million in assets.

        Principal Passage Fee Based Brokerage Account.    Principal Passage is a fee based brokerage account. Clients are charged a quarterly asset based fee on their account in lieu of traditional transaction based commissions. As of December 31, 2006, Principal Passage accounts had accumulated $1.4 billion in assets.

        WM Advisors, Inc. Acquisition.    On July 25, 2006, we announced a definitive agreement to acquire WM Advisors, Inc. ("WM Advisors") and its subsidiaries from Washington Mutual, Inc. WM Advisors was the manager of the WM Funds, a family of 40 retail mutual funds and variable trust funds. As of December 31, 2006, the WM Funds acquired had $22.5 billion in assets under management. The transaction closed on December 31, 2006, for a total cost of $741.1 million in cash, subject to closing adjustments..

7



Markets and Distribution

        Our markets for retail mutual funds are individuals seeking to accumulate savings for retirement and other purposes and small businesses seeking to use mutual funds as the funding vehicle for pension plans, as well as non-qualified individual savings plans utilizing payroll deductions. We also market our retail mutual funds to participants in pension plans who are departing their plans and reinvesting their retirement assets into individual retirement accounts.

        Our retail mutual funds are sold primarily through our affiliated financial representatives, independent brokers registered with our securities broker-dealer, Princor, registered representatives from other broker-dealers, direct deposits from our employees and others and Principal Connection. Princor, as the marketing arm of our mutual fund business, recruits, trains and supervises registered representatives selling our products. With the WM Advisors acquisition, we will obtain established relationships with a number of marketing and outside broker dealer distributors to increase the sales of our mutual fund products.

Individual Annuities

        Individual annuities offer a tax-deferred means of accumulating retirement savings and provide a tax-efficient source of income during the payout period.

Products

        We offer both fixed and variable annuities to individuals and pension plans. Individual annuities may be categorized in two ways: (1) deferred, in which case assets accumulate until the contract is surrendered, the customer dies or the customer begins receiving benefits under an annuity payout option, or (2) immediate, in which case payments begin within one year of issue and continue for a fixed period of time or for life.

        Fixed Deferred Annuities.    Our individual fixed deferred annuities consist of both single premium deferred annuity contracts ("SPDAs") and flexible premium deferred annuity contracts ("FPDAs"). Some FPDA contracts limit the period of time deposits are allowed (i.e., only one year). For most contracts, the principal amount is guaranteed. We credit the customer's account with a fixed interest rate and for a specified time period, typically one year. Thereafter, we reset, typically annually, the interest rate credited to the contract based upon our discretion, taking into account market and other conditions. We also offer a fixed deferred annuity where the interest credited is linked to an external equity index, subject to maximum and minimum values. Our major source of income from fixed deferred annuities is the spread between the investment income earned on the underlying general account assets and the interest rate credited to the contracts. We bear the investment risk because, while we credit customers' accounts with a stated interest rate, we cannot be certain the investment income we earn on our general account assets will exceed that rate. Our affiliated asset manager, Principal Global Investors, manages the assets supporting these contracts.

        Variable Deferred Annuities.    Our individual variable deferred annuity products consist almost entirely of flexible premium deferred variable annuity contracts. These contracts are savings vehicles through which the customer makes a single deposit or a series of deposits of varying amounts and intervals. Customers have the flexibility to allocate their deposits to investment sub-accounts managed by Principal Global Investors, or other third-party asset managers. As of December 31, 2006, 65% of our $4.8 billion in variable annuity account balances was allocated to investment sub-accounts and our general account, which are managed by Principal Global Investors and 35% to investment sub-accounts managed by third-party asset managers. Generally speaking, the customers bear the investment risk and have the right to allocate their assets among various separate investment sub-accounts. The value of the annuity fluctuates in accordance with the experience of the investment sub-accounts chosen by the customer. Customers have the option to allocate all or a portion of their account to our general account, in which case we credit interest at rates we determine, subject to contractual minimums. Customers may also elect death benefit guarantees and/or a living benefit guarantee, commonly known in the industry as a guaranteed minimum withdrawal benefit ("GMWB"). The GMWB feature became available in 2005. Our major source of revenue from variable annuities is mortality and expense fees we charge to the customer, generally determined as a percentage of the market value of the assets held in a separate investment sub-account.

        Fixed Immediate Annuities.    Our individual fixed immediate annuities consist almost exclusively of single premium immediate annuity contracts ("SPIAs"). SPIAs are products where the customer makes a single deposit, and from which periodic benefit payments are made. Payments may be contingent upon the survival of one or two individuals, or payments may be fixed, meaning payments are contractually guaranteed and do not depend on the continuing survival of any individual. Our major source of income from fixed immediate annuities is the spread between the investment income earned on the underlying general account assets, and the interest rate implied in the calculation of annuity benefit payments. We bear the investment risk because we cannot be certain the investment income we earn on our general account assets will exceed the rate implied in the SPIA contracts. Our affiliated asset manager, Principal Global Investors, manages the assets supporting these contracts.

8



Markets and Distribution

        Our target markets for individual annuities include owners, executives and employees of small and medium-sized businesses, and individuals seeking to accumulate and/or eventually receive distributions of assets for retirement. We market both fixed and variable annuities to both qualified and non-qualified pension plans.

        We sell our individual annuity products through our affiliated financial representatives, who accounted for 40%, 43%, and 35% of annuity sales for the years ended December 31, 2006, 2005 and 2004, respectively. The remaining sales were made through brokerage general agencies, banks, mutual fund companies, Principal Connection and unaffiliated broker-dealer firms. Although our percentage of sales from affiliated financial representatives has declined, they continued to be significant in 2006. The decline is a result of focused efforts to increase fixed annuity sales through non-affiliated distribution channels.

Bank and Trust Services

        Bank and trust services include Principal Bank and Principal Trust Company (formerly known as Trustar). Principal Bank, our electronic banking operation, is a federal savings bank that began its activities in February 1998. It offers traditional retail banking products and services via the telephone, Internet, ATM or by mail. Our current products and services include checking and savings accounts, money market accounts, certificates of deposit, consumer loans, first mortgage loans, home equity loans, credit cards, debit cards, small account rollovers from qualified retirement plans and health savings accounts. As of December 31, 2006, Principal Bank had approximately 139,000 customers and approximately $1.5 billion in assets, primarily funded by retail customer deposits in checking accounts, money market accounts and certificates of deposit.

        We market our Principal Bank products and services to our existing customers and external prospects, through Principal Connection and other means such as the Internet, direct mail, and targeted advertising. Through Principal Bank, we also pursue asset retention strategies with our customers who seek to transfer assets from our other asset accumulation products by offering them our banking products and services.

        Principal Trust Company is a Delaware state chartered non-deposit trust company. Principal Trust Company, chartered in 1899 as Delaware Charter Guarantee and Trust Company, is one of the largest non-deposit trust companies in the nation. As of December 31, 2006, we served as trustee to over 280,000 accounts and held assets in excess of $50 billion. Principal Trust Company may not accept deposits and cannot make personal or commercial loans.

        Principal Trust Company specializes in providing affordable and innovative trust solutions directed at self-directed tax-advantaged savings accounts, such as Individual Retirement Accounts ("IRAs"), Health Savings Accounts ("HSAs") and a full array of employee benefit plans and accounts including 401(k) and 403(b) plans, defined benefit pension plans, non-qualified executive benefit plans, and ESOPs. We provide these services to Principal affiliates, brokerage firms, clearing firms, financial advisors and asset managers.

Investment Only

Products

        The three primary products for which we provide investment-only services are: guaranteed investment contracts ("GICs"); funding agreements; and other investment-only products.

        GICs and funding agreements pay a specified rate of return. The rate of return can be a floating rate based on an external market index or a fixed rate. Our investment-only products contain provisions disallowing or limiting early surrenders, including penalties for early surrenders and minimum notice requirements.

        Deposits to investment-only products are predominantly in the form of single payments. As a result, the level of new deposits can fluctuate from one fiscal quarter to another. Assets invested in GICs and funding agreements generate a spread between the investment income earned by us and the amount credited to the customer. Our other investment-only products consist of separate accounts invested in either equities or fixed income instruments. Our affiliated asset manager, Principal Global Investors, manages the assets supporting investment-only account values.

Markets and Distribution

        We market GICs and funding agreements primarily to pension plan sponsors and other institutions. We also offer them as part of our full-service accumulation products. We sell our GICs primarily to plan sponsors for funding of tax-qualified retirement plans. We sell our funding agreements directly to institutions that may or may not be pension funds and unconsolidated special purpose vehicles domiciled either in the U.S. or offshore for funding agreement-backed note programs. The funding agreements sold as part of these funding agreement-backed note programs work by having investors purchase debt obligations from the special purpose vehicle which, in turn, purchases the funding agreement from us with terms similar to those of the debt obligations. The strength of this market is dependent on debt capital market conditions. As a result, our sales through this channel can vary widely from one quarter to another. In addition to

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the special purpose vehicle selling the funding agreement-backed notes to U.S. and foreign institutional investors, the special purpose vehicle may also sell notes to U.S. retail investors through a SEC-registered shelf debt issuance program.

Full-Service Payout

Products

        Full-service payout products respond to the needs of pension plan participants who, upon retirement or termination of their employment, seek a guaranteed income stream. Plan participants who seek these services include those from pension plans we service, as well as pension plans other providers service. We primarily offer single premium group annuities, which are immediate or deferred annuities that provide a current or future specific income amount, fully guaranteed by us. These are available to defined contribution and defined benefit plan participants. We make regular payments to individuals, invest the underlying assets on their behalf and provide tax reporting to them. We also reinsure single premium immediate annuities issued by another insurer.

        Single premium group annuities are traditionally used in conjunction with defined benefit plans, particularly those where the plan is being terminated. In such instances, the plan sponsor transfers all its obligations under the plan to an insurer by paying a single premium. Increasingly, these products are purchased by defined contribution plan participants who reach retirement age. Generally, plan sponsors restrict their purchases to insurance companies with superior or excellent financial quality ratings because the Department of Labor has mandated that annuities be purchased only from the "safest available" insurers.

        Premium received from full-service payout products are generally in the form of single payments. As a result, the level of new premiums can fluctuate depending on the number of retirements and large-scale annuity sales in a particular fiscal quarter. Our affiliated asset manager, Principal Global Investors, manages the assets supporting full-service payout account values.

Markets and Distribution

        Our primary distribution channel for full-service payout products is comprised of several specialized home office sales consultants working through consultants and brokers that specialize in this type of business. Our sales consultants also make sales directly to institutions. Our nationally dispersed retirement services sales representatives act as a secondary distribution channel for these products. Principal Connection also distributes full-service payout products to participants in plans we service who are terminating employment or retiring. Principal Connection is our direct response distribution channel for retail financial services products to individuals. Principal Connection's services are available over the phone, on the Internet or by mail.

U.S. Asset Management

Principal Global Investors

        As of December 31, 2006, Principal Global Investors, together with its affiliates, Principal Real Estate Investors, Spectrum Asset Management, Post Advisory Group, Columbus Circle Investors and Edge Asset Management managed $191.4 billion in assets. Edge Asset Management, which consists of the investment advisor portion of our WM Advisors Inc. acquisition, provides investment advisory services for equities, fixed income and asset allocation and has been in business since 1944 and is located in Seattle, Washington. Principal Global Investors provides asset management services to our other operating segments and to third-party institutional clients.

        On October 24, 2005, Principal Real Estate Investors and U.S. Bank National Association announced that they agreed to create Principal Commercial Funding II, a jointly-owned business that will compete in the commercial mortgage-backed securities ("CMBS") market. Principal Real Estate Investors is the real estate investment arm of Principal Global Investors. U.S. Bank National Association is the principal banking subsidiary of U.S. Bancorp. The new company is the CMBS platform for both Principal Real Estate Investors and U.S. Bank National Association and focuses on securitizing commercial mortgages originated by both Principal Real Estate Investors and U.S. Bank National Association on its behalf. Principal Commercial Funding II began operations immediately, and started contributing collateral to securitizations during the first quarter of 2006.

Products

        Principal Global Investors provides a full range of asset management services covering a broad range of asset classes, investment styles and portfolio structures:

        Equity Investments.    As of December 31, 2006, Principal Global Investors, along with Columbus Circle Investors and Edge Asset Management managed $52.5 billion in global equity assets. Our equity capabilities encompass large-cap, mid-cap and small-cap stocks in developed and emerging markets worldwide. As of December 31, 2006, 48% of equity assets under management were derived from our pension products, 35% from other products of the Principal Financial Group, and the remaining 17% from third-party institutional clients.

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        Fixed Income Investments.    Principal Global Investors, along with Spectrum Asset Management, Post Advisory Group and Edge Asset Management managed $100.2 billion in fixed income assets as of December 31, 2006. Collectively, we provide our clients with access to investment-grade corporate debt, mortgage-backed, asset-backed and commercial mortgage-backed securities, high yield and municipal bonds, private and syndicated debt instruments and preferred securities. As of December 31, 2006, 37% of these assets were derived from our pension products, 25% from other products of the Principal Financial Group, and the remaining 38% from third-party institutional clients.

        Real Estate Investments.    Principal Global Investors, through its affiliate Principal Real Estate Investors, managed a portfolio of commercial real estate assets of $37.7 billion as of December 31, 2006. Principal Real Estate Investors provides our clients with a broad range of real estate investment options, including private real estate equity, commercial mortgages, credit tenant debt, construction-permanent financing, bridge/mezzanine loans, commercial mortgage-backed securities and real estate investment trusts. Principal Global Investors had $0.4 billion of assets under management as of December 31, 2006, from bridge/mezzanine loans and commercial mortgages, which appear on its statement of financial position. As of December 31, 2006, 40% of the commercial real estate portfolio was derived from our pension products, 27% from other products of the Principal Financial Group, and the remaining 33% from third-party institutional clients.

Markets and Distribution

        Principal Global Investors employed 110 institutional sales, relationship management and client service professionals as of December 31, 2006, who worked with consultants and directly with large investors to acquire and retain third-party institutional clients. As of December 31, 2006, Principal Global Investors and its affiliates has approximately 400 institutional clients with $59.1 billion of assets under management.

International Asset Management and Accumulation Segment

        Our International Asset Management and Accumulation segment consists of Principal International, which has operations in Chile, Mexico, Hong Kong, Brazil, India, China and Malaysia. We focus on countries with favorable demographics and a trend toward private sector defined contribution pension systems. We entered these countries through acquisitions, start-up operations and joint ventures.

        On May 26, 2005, we announced jointly with our partner, ING, the intent to liquidate the ING/Principal Pensions Company, Ltd. operation in Japan. On December 20, 2005, the liquidation process was completed with a formal liquidation filing to the Japanese corporate registry.

        The decision to liquidate the ING/Principal Pensions Company, Ltd. operation in Japan followed a careful evaluation of the joint venture's activities and its prospects for further growth in the Japanese market. After consideration of all the issues, both ING and The Principal determined that the market for defined contribution pensions was unlikely to meet initial expectations.

        On July 2, 2004, we closed the sale of Principal International Argentina S.A. ("PI Argentina"), our subsidiary in Argentina, and its wholly owned subsidiaries, Principal Life Compania de Seguros, S.A. and Principal Retiro Compania de Seguros de Retiro, S.A. Our total after-tax proceeds from the sale were approximately U.S. $29.2 million.

        The decision to sell PI Argentina was made with a view toward focusing our resources, executing on core strategic priorities and in core markets, and meeting stockholder expectations. Changing market dynamics since the 2001 economic crisis in Argentina led us to conclude that the interests of our stockholders would best be served by our exit of this market.

        PI Argentina qualified for discontinued operations treatment; therefore, the income from discontinued operations has been removed from our results of continuing operations and segment operating earnings for all periods presented. We have separately disclosed the operating, investing and financing portions of the cash flows attributable to our discontinued operations in our consolidated statements of cash flows. The results of operations for PI Argentina are reported as other after-tax adjustments in our International Asset Management and Accumulation segment

        On October 31, 2002, we sold substantially all of BT Financial Group to Westpac Banking Corporation ("Westpac"). Our total after-tax proceeds from the sale were approximately U.S. $900.0 million. This amount includes cash proceeds from Westpac, tax benefits and a gain from unwinding the hedged asset associated with our investment in BT Financial Group.

        The decision to sell BT Financial Group was made with a view toward focusing our resources, executing on core strategic priorities and meeting stockholder expectations. Changing market dynamics since our acquisition of BT Financial Group, including industry consolidation, led us to conclude that the interests of BT Financial Group clients and staff would be best served under Westpac's ownership.

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        BT Financial Group is accounted for as a discontinued operation and therefore, the income from discontinued operations has been removed from our results of continuing operations and segment operating earnings for all periods presented. We have separately disclosed the operating, investing and financing portions of the cash flows attributable to our discontinued operations in our consolidated statements of cash flows. The historical results of operations (excluding corporate overhead) for BT Financial Group are reported as other after-tax adjustments.

        For financial results for the International Asset Management and Accumulation segment see Item 8. "Financial Statements and Supplementary Data, Notes to Consolidated Financial Statements, Note 19 Segment Information."

Principal International

        The activities of Principal International reflect our efforts to accelerate the growth of our assets under management by capitalizing on the international trend toward private sector defined contribution pension systems. Through Principal International, we offer retirement products and services, annuities, long-term mutual funds, life insurance and institutional asset management. We have operations in Chile, Mexico, Hong Kong, Brazil, India, China, and Malaysia.

Products, Markets and Distribution

Asia/Pacific Region

        Hong Kong.    Our subsidiary in Hong Kong is actively competing in the defined contribution pension plan market. The government requires employers and employees each to contribute 5% of an employee's income to a Mandatory Provident Fund. We target small and medium-sized employers and distribute products through strategic alliances with insurance companies, mutual funds or banks, direct marketing and through our own sales representatives. Our strategic partners help distribute our Mandatory Provident Fund products and services, or use our administrative and investment services in their own products. Our Mandatory Provident Fund products and services are marketed by agents under the various distribution arrangements we have with our strategic partners. On January 31, 2004, our wholly owned subsidiary, Principal Asset Management Company (Asia) Limited, purchased a 100% ownership of Dao Heng Fund Management in Hong Kong from Guoco Group Limited. Effective September 17, 2004, we changed the name of this subsidiary to Principal Fund Management (Hong Kong) Limited. This acquisition increases our presence in the Hong Kong defined contribution pension market and increases the potential of our long-term mutual fund operations. In 2006, we initiated our development of an asset management business for the institutional market.

        India.    We own 65% of Principal PNB Asset Management Company in India. This company competes in the mutual fund market, managing and administering funds for both individuals and corporations. We sell our mutual funds through regional offices and regional bank branches located throughout India. In addition to the current mutual fund business, we are positioning ourselves to compete in the emerging pension and long-term savings market in India.

        On August 31, 2003, we announced that our wholly owned subsidiary, Principal Financial Group (Mauritius) Ltd. ("PFGM"), had entered into a joint venture agreement with Punjab National Bank ("PNB") and Vijaya Bank, two large Indian commercial banks with a combined 5,000 branch network, to sell long-term mutual funds and related financial services in India. We closed the transaction on May 5, 2004. As part of this transaction, we rolled our then existing fund management company, Principal Asset Management Company, into the joint venture. We retained 65% of the new company, sold 30% to PNB, who merged their own PNB funds into the new company, and 5% to Vijaya Bank.

        On October 21, 2004, PFGM funded a 65% stake in the start-up company PNB Principal Financial Planners Pvt. Ltd. ("PFP"). This company is a distributor of financial products including mutual fund products for other providers, bonds, retail debt offerings, and portfolio management services. Business operations for the company commenced in July of 2005.

        On February 21, 2005, PFGM acquired a 26% stake and management control of PNB Principal Insurance Advisory Company Pvt. Ltd. ("PPIAC"), an insurance brokerage company in India.

        On October 10, 2006, PFGM funded a 26% stake and obtained management control in the start-up company Principal PNB Life Insurance Company Limited. This company will compete in the life insurance sector in India.

        Malaysia.    After purchasing an additional 10% on August 31, 2005, we now own a 40% interest in a joint venture with our partner CIMB-Berhad, a large Malaysian bank holding company. The company markets mutual funds through wholesale bank channels and its own sales force. In addition, the company manages a significant amount of institutional asset mandates.

        On October 30, 2006, our joint venture company in Malaysia, CIMB-Principal, announced its intention to purchase the mutual fund and asset management companies of the former Southern Bank Bhd ("SBB"), SBB Mutual Berhad and SBB Asset Management Sdn Bhd. On February 5, 2007, we invested an additional RM$192.4 million Malaysian ringgits ("RM$") (approximately U.S. $55.1 million) to retain our 40% ownership interest in the larger CIMB-Principal.

        China.    On August 7, 2005, Principal Financial Group announced that it entered into a joint venture agreement with China Construction Bank ("CCB") to market mutual funds in the People's Republic of China. We closed the

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transaction on September 19, 2005 with a 25% ownership in CCB-Principal Asset Management Company, Ltd. We sell mutual funds primarily through our partner bank, CCB. This bank delivers expansive distribution capabilities for the joint venture in terms of brand awareness and the sheer number of outlets (14,250).

Latin America

        Brazil.    We own 46% of BrasilPrev Seguros e Previdencia S.A. ("BrasilPrev"), a private pension company in Brazil, through a joint venture arrangement with Banco do Brasil, Brazil's largest bank with a 3,960 branch network. We are Banco do Brasil's exclusive partner for distributing pension, retirement and asset accumulation products. BrasilPrev provides defined contribution products and annuities for the retirement needs of employers and individuals. Banco do Brasil's employees sell directly to individual clients through its bank branches. In addition, BrasilPrev reaches corporate clients through two wholesale distribution channels: (1) a network of independent brokers who sell to the public, and (2) in coordination with Banco do Brasil's corporate account executives to reach Banco do Brasil's existing corporate clients. Based upon managed assets, BrasilPrev ranked 3rd in the private pension market with U.S. $5.8 billion as of December 2006.

        Chile.    We own Principal Companía de Seguros de Vida Chile S.A., a Chilean insurance company, that primarily sells retirement annuities to individuals exiting the pre-retirement accumulation system. We distribute our annuity products through a network of brokers and 213 independent agents as of December 31, 2006. We also market life accumulation products (qualified and non-qualified) to individuals through brokers. Based upon assets, we were ranked as the fifth largest life insurance company in Chile as of September 30, 2006, according to the Superintendencia de Valores y Seguros, the Chilean regulatory agency for insurance companies. We also own Principal Administradora General de Fondos S.A. Its primary business focus is to serve the voluntary/complementary long-term savings market offering "APV plans" (qualified individual solutions). As of December 31, 2006, we rank first in AUM for mutual fund companies offering these plans. We distribute to retail clients through our proprietary sales force, alliances with financial institutions and the largest retailer in Chile, Falabella. We also own Principal Créditos Hipotecarios S.A. Through this business, we originate, sell and service mortgage loans in Chile. We established Principal Asset Management Chile in 2006 to offer asset management services to institutional clients.

        Mexico.    We own Principal Afore S.A. de C.V., a private pension company which manages and administers more than three million individual retirement accounts under the mandatory privatized social security system in effect for all non-government employees in Mexico; Principal Fondos de Inversión, S.A. de C.V. ("PFI"), a mutual fund company, Principal Pensiones S.A. de C.V., ("Principal Pensiones"), an annuity company; and Principal México Compañía de Seguros S.A. de C.V., ("Principal Seguros"), a life insurance company. Our focus is on both pre-retirement and post-retirement savings plans. As of December 31, 2006, we distribute Principal Afore S.A. de C.V.'s products and services through a proprietary sales force of approximately 1,000 sales representatives as well as independent brokers, who sell directly to individuals. PFI distributes its products and services through a sales force of approximately 113 employees and through distribution agreements with other financial entities. Principal Pensiones distributes annuities directly to customers that are exiting the pre-retirement accumulation system. Our life insurance company, Principal Seguros, primarily focuses on manufacturing life products to complement our annuities business. In 2006, Mexico initiated asset management for institutional clients, offering both domestic and international products.

Life and Health Insurance Segment

        Our Life and Health Insurance segment offers (1) individual life insurance (2) group health insurance and (3) specialty benefits, including group dental, group vision, group life, group long-term and short-term disability and individual disability insurance throughout the U.S. We focus on providing comprehensive insurance solutions for small-to-medium sized businesses.

        For financial results for the Life and Health Insurance segment see Item 8. "Financial Statements and Supplementary Data, Notes to Consolidated Financial Statements, Note 19 Segment Information."

Individual Life Insurance

        We began as an individual life insurer in 1879. Our U.S. operations administer approximately 616,000 individual life insurance policies with $105.8 billion of individual life insurance in force as of December 31, 2006. As of September 30, 2006, our life insurance business was ranked 27th in the United States for annualized sales according to LIMRA.

Products and Services

        We offer a variety of individual life insurance products, including universal and variable universal life insurance and term life insurance, with a focus on using these products for nonqualified executive benefits for small-to-medium sized businesses.

        Nonqualified Executive Benefits.    Small and medium-sized companies are challenged with how to build quality benefits packages for executives, how to transition the company's ownership to a partner or family member and how to save the

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amount of money they desire for retirement. Executives and other key employees often have personal insurance needs. These needs are the focus of our products within the individual life insurance arena.

        We have a growing focus and expertise in providing executive life insurance benefits to companies designated by the Internal Revenue Service as S-corporations, in addition to traditional C-corporation clients. As a growing segment of the small-to-medium sized business market, S-corporations require unique plan designs that meet very specific legal requirements.

        Universal and Variable Universal Life Insurance.    Universal and variable universal life insurance products offer life insurance protection for which both the premium and the death benefit may be adjusted by the policyholder. Universal life insurance usually includes a cash value account that accumulates at a floating interest rate, with a minimum rate guarantee. Variable life insurance substitutes various investment options for the single floating interest rate of universal life insurance.

        For the year ended December 31, 2006, 84% of individual life insurance annualized first year premium sales have come from universal and variable universal life insurance products. Universal and variable universal life insurance represent 46% of individual life insurance premium and deposits for the year ended December 31, 2006, and 44% of individual life insurance in force as of December 31, 2006. Variable universal life insurance products represented 52% of our universal and variable universal life insurance deposits for the year ended December 31, 2006.

        After removing expenses for a policy, we credit net deposits to an account maintained for the policyholder. For universal life contracts, the entire account balance is invested in our general account. Interest is credited to the policyholder's account based on the earnings on general account investments. For variable universal life contracts, the policyholder may allocate the account balance among our general account and a variety of separate account choices. Interest is credited on amounts allocated to the general account in the same manner as for universal life. Net investment performance on separate account investments is allocated directly to the policyholder accounts; the policyholder bears the investment risk. Some of our universal life and variable universal life insurance contracts contain what are commonly referred to as "secondary" or "no-lapse" guarantee provisions. A no-lapse guarantee keeps the contract in force, even if the contractholder's account balance is insufficient to cover all of the contract charges, provided that the contractholder has continually paid a specified minimum premium.

        In November 2006, Principal Life established a wholly owned reinsurance subsidiary, Principal Reinsurance Company of Vermont ("PVT"), which reinsures a portion of our universal life "secondary" or "no-lapse" guarantee provisions through an intercompany reinsurance agreement with Principal Life. The transaction, which was accompanied with a third party letter of credit issued to PVT and guaranteed by Principal Financial Group, Inc.("PFG"), reduced our statutory capital requirements and allowed us to redeploy capital for other general corporate purposes.

        Traditional Life Insurance.    Traditional life insurance includes participating whole life, adjustable life products and term life insurance products. Participating products and term life insurance products represented 10% and 6%, respectively, of our individual life insurance annualized first year premium sales for the year ended December 31, 2006, and 32% and 24%, respectively, of individual life insurance in force as of December 31, 2006. Adjustable life insurance products provide a guaranteed benefit in return for the payment of a fixed premium and allow the policyholder to change the premium and face amount combination. Term insurance products provide a guaranteed death benefit for a specified period of time in return for the payment of a fixed premium. Policyholder dividends are not paid on term insurance.

Group Health Insurance

        We began offering group health insurance in 1941. We offer a variety of group medical insurance products, including high deductible health plans with health savings accounts. We also provide administrative services on a fee-for-service basis for medical, dental, disability, vision, and wellness benefits.

Products and Services

        Our group health insurance products described below provide appropriate interactions for members along a continuum of care management, from wellness services to acute and chronic care and disease management programs. These programs include care management, a transplant network, chronic disease management, pre-natal assistance and 24-hour access to online health management resources such as symptom checkers, prescription drug information and provider information.

        Group Health Insurance.    As of December 31, 2006, we provided group medical insurance benefits to more than 21,600 employer customers and their 643,000 employees and dependents. Our traditional group medical insurance plans provide reimbursement of medical expenses for insured employees and their dependents. These members are responsible for deductibles, co-payments and co-insurance. Our products are well-positioned to address our members' preferences for a variety of provider choices and preferred provider discounts. Through our wholly owned subsidiary, HealthRisk Resource Group, LLC., we negotiate discounts with providers on claims for which we have no other pre-arranged discount.

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        Our consumer-driven health care plans offer greater flexibility for employers and more opportunity for members to take charge of their health and health care. We offer Health Reimbursement Arrangements ("HRA") and Health Savings Accounts. The Principal HRA is an employer funded benefit plan that allows the employer to design a consumer driven health care program to meet their specific needs. The employer determines if a deductible applies before the HRA, what percentage the HRA reimburses, the maximum benefit, the ability to roll over the funds to future periods, and accessibility of the funds when employment has ended. The Principal Health Savings Account ("Principal HSA") can be funded by employers and employee members. Money can be contributed pre-tax and grows tax free. Funds can be used to pay for qualified medical expenses tax free. The account is portable from job to job or from work to retirement. The Principal HSA is coupled with a high deductible health plan, typically either insured or administered by Principal Life. The Principal HSA features a checking account with a debit card and certificates of deposit through Principal Bank and investment options through Princor Financial Services Corporation. Because of these internal resources and expertise, we are uniquely positioned to offer competitive and high-quality health savings account plans and high deductible health plans.

        Fee-for-Service.    We offer administration of group medical, dental, disability, and vision benefits on a fee-for-service basis to almost 370 self-insured employers and their approximately 1.1 million employees and dependents as of December 31, 2006. The acquisition of J.F. Molloy and Associates in 2004 added 106 self-insured employers.

        We also recognize the importance of promoting healthy behavior. Our 2004 acquisition of J.F. Molloy and Associates included Molloy Wellness Company. The wellness company, now known as Principal Wellness Company, brought expertise in providing wellness screenings, counseling and services to employers and their employees, demonstrating health improvement through reduced health insurance claim costs, reduced absenteeism and increased employee productivity. This preventative focus is currently being integrated into both our fully-insured and fee-for-service offerings. We provide wellness services to almost 300 employers and nearly 105,000 employees.

Specialty Benefits

        Specialty Benefits, including group dental, vision and life insurance, as well as individual and group disability insurance, are an important component of the employee benefit offering at small-to-medium size businesses. We offer both traditional employer sponsored and voluntary products for group dental, vision, life, and disability. We began selling our first specialty benefit products in 1941 with group disability and group life insurance. We began selling individual disability insurance in 1952 and group dental and group vision insurance in the late 1960's.

Products and Services

        Group Dental and Vision Insurance.    Group dental and vision insurance plans provide partial reimbursement for dental and vision expenses. As of December 31, 2006, we had approximately 37,000 group dental and vision insurance policies in force covering more than 913,000 employee lives. According to LIMRA, we were the third largest group dental insurer in terms of number of contracts/employer groups in force in 2005. In addition to indemnity and PPO dental offered on both an employer paid and voluntary basis, we offer a prepaid dental plan in Arizona through our Principal Dental Services, Inc. subsidiary.

        Group Life Insurance.    Group life insurance provides coverage to employees and their dependents for a specified period. As of December 31, 2006, we had over 53,000 group policies providing $113.0 billion of group life insurance in force to approximately 2.2 million employee lives. According to LIMRA in 2005, we were ranked third in the U.S. in terms of the number of life insurance contracts in force. We currently sell traditional group life insurance that does not provide for accumulation of cash values on both an employer paid and voluntary basis. Our group life insurance business remains focused on the traditional, annually renewable term product. Group term life and group universal life accounted for 95% and 5% respectively of our total group life insurance in force as of December 31, 2006. As of January 1, 2004, we no longer market group universal life insurance to new employer groups.

        Group Disability Insurance.    Group disability insurance provides a benefit to insured employees who become disabled. Our group disability products include both short-term and long-term disability, offered on both an employer paid and voluntary basis. Long-term disability represents 62% of total group disability premium, while short-term disability represents 38% of total group disability premium. In addition, we provide disability management services, also called rehabilitation services, to assist individuals in returning to work as quickly as possible following disability. We also work with disability claimants to improve the approval rate of Social Security benefits, thereby reducing payment of benefits by the amount of Social Security payments received. As of December 31, 2006, we served approximately 1.4 million employee lives under nearly 30,000 contracts, with our group short-term disability business being ranked fourth and our group long-term disability business being ranked seventh in the U.S. as of December 31, 2005, in terms of number of contracts/employer groups in force, according to LIMRA.

        Individual Disability Insurance.    Individual disability insurance products provide a benefit to the insured member in the event he/she becomes disabled. In most instances, this benefit is in the form of a monthly income. In addition to income replacement, we offer products to pay business overhead expenses for a disabled business owner, and for the purchase by the other business owners of the disabled business owner's interests in the business. As of December 31,

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2006, we served approximately 105,000 individual disability policyholders, with our individual disability business being ranked seventh in the U.S. as of December 31, 2005, in terms of premium in force, according to LIMRA.

Life and Health Markets and Distribution

        For each of our products, administration and distribution channels are customized to meet customer needs and expectations for that product.

        We sell our individual life and individual disability income products in all 50 states and the District of Columbia, primarily targeting owners and executives of small and medium-sized businesses. Small and medium-sized business sales represented 74% of individual life sales and 64% of individual disability sales for the year ended December 31, 2006, based on first year annualized premium.

        We distribute our individual insurance products through our affiliated financial representatives and independent brokers, as well as other marketing and distribution alliances. Affiliated financial representatives were responsible for 56% of individual life insurance sales based on first year annualized premium and 19% of individual disability sales for the year ended December 31, 2006. We had 1,029 affiliated financial representatives in 29 offices. Although they are independent contractors, we have a close tie with affiliated financial representatives and offer them benefits, training and access to tools and expertise. To meet the needs of the various markeing channels, particularly the independent brokers, we employ wholesale distributors — Advance Planning Regional Vice Presidents for individual life and Disability Income Regional Vice Presidents for individual disability. A key differentiator in the nonqualified executive benefit sale is our Advance Planning Regional Vice Presidents, who are not only wholesalers but also consultants and subject-matter experts providing point-of-sale support in closing cases.

        We market our group medical, life, disability, dental and vision insurance products to small and medium-sized businesses, primarily targeting our sales toward owners and human resources professionals. We sell our group life, disability and dental products in all 50 states and the District of Columbia. We sell vision coverage in 48 states, plus the District of Columbia. We sell our group medical insurance in 35 states and the District of Columbia with a growing focus on 13 states that we consider to have the best competitive environments. They are also considered to be attractive markets because of a lack of deep penetration by HMOs and a favorable regulatory environment. We continually adapt our products and pricing to meet local market conditions. We market our fee-for-service capabilities to employers that self-insure their employees' benefits. We sell our fee-for-service business in all 50 states and the District of Columbia.

        Group insurance and fee-for-service products are distributed through independent benefit brokers, consultants, financial planners and the same channels that sell our U.S. asset accumulation products. To reach these marketers, we employ three types of wholesale distributors: our medical sales representatives, our non-medical sales representatives (for Specialty Benefits products) and two independent wholesale organizations, Rogers Benefit Group and Excelsior Benefits, dedicated to marketing group medical, life, disability, dental and vision insurance products. We have also formed a number of strategic distribution alliances with national brokerages and regional brokerage agencies.

        The non-medical group insurance market continues to see a shift to voluntary/worksite products. In keeping with this market change, which shifts the funding of such products from the employer to the employee, we have enhanced our focus on our voluntary benefits platform. We believe the voluntary/worksite market presents growth opportunities, and we will continue to develop strategies to capitalize on this expanding market.

        As of December 31, 2006, we had 131 medical and non-medical sales representatives and 113 service representatives in 42 offices. Our medical and non-medical sales representatives accounted for 73% of our group insurance sales for the year ended December 31, 2006. The group sales force plays a key role in the ongoing servicing of the case by providing local, responsive services to our customers and their brokers, such as renewing contracts, revising plans and solving any administrative issues; communicating the customers' needs and feedback to us; and helping employees understand the benefits of their plans.

        Rogers Benefit Group is a marketing and service organization that represents major high quality insurance carriers specializing in group medical, life, disability and dental insurance plans. Our relationship with Rogers Benefit Group dates back to its creation in 1970. It accounted for 25% of our group insurance sales for the year ended December 31, 2006.

Corporate and Other Segment

        Our Corporate and Other segment manages the assets representing capital that has not been allocated to any other segment. Financial results of the Corporate and Other segment primarily reflect our financing activities (including interest expense and preferred stock dividends), income on capital not allocated to other segments, inter-segment eliminations, income tax risks and certain income, expenses and other after-tax adjustments not allocated to the segments based on the nature of such items.

        For financial results for Corporate and Other see Item 8. "Financial Statements and Supplementary Data, Notes to Consolidated Financial Statements, Note 19 Segment Information".

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Competition

        Competition in our operating segments is based on a number of factors including: service, product features, price, investment performance, commission structure, distribution capacity, financial strength ratings and name recognition. We compete for customers and distributors with a large number of financial services companies such as banks, mutual funds, broker-dealers, insurers and asset managers. Some of these companies offer a broader array of products, more competitive pricing, greater diversity of distribution sources, better brand recognition or, with respect to insurers, higher financial strength ratings. Some may also have greater financial resources with which to compete or may have better investment performance at various times.

        Competition in the retirement services market is very fragmented. Our main competitors in this market include Fidelity, Nationwide, AXA, Mass Mutual and Manulife. We believe the infrastructure and system support needed to meet the needs of the small and medium-sized business market is a significant barrier to entry for our competitors. Many of our competitors in the mutual fund industry are larger, have been established for a longer period of time, offer less expensive products, have deeper penetration in key distribution channels and have more resources than we do. There were over 8,131 mutual funds in the U.S. as of November 30, 2005 according to the Investment Company Institute 2006 Mutual Fund Fact Book. The institutional asset management market has grown at a rapid pace over the last decade. Our primary competitors in this market are large institutional asset management firms, such as J.P. Morgan Chase, Morgan Stanley Investment Management and T. Rowe Price, some of which offer a broader array of investment products and services and are better known. The asset management business has relatively few barriers to entry and continually attracts new entrants. The variable annuity market is also highly competitive. As we expand into additional distribution channels for this product, we will face strong competition from Nationwide and Hartford. Competition in the international markets in which we operate comes primarily from local financial services firms and other international companies operating on a stand-alone basis or in a partnership with local firms, including ING, AXA, Allianz and AIG. In the highly competitive life and health insurance business, our competitors include other insurers such as UNUM, Guardian, Northwestern Mutual Life, Manulife, Blue Cross and Blue Shield organizations, and health maintenance organizations such as United Health Care and Aetna. We believe we distinguish ourselves from our competitors through our:

    full-service platform;

    strong customer relationships;

    focus on financial performance; and

    performance-oriented culture.

Ratings

        Insurance companies are assigned financial strength ratings by rating agencies based upon factors relevant to policyholders. Financial strength ratings are generally defined as opinions as to an insurer's financial strength and ability to meet ongoing obligations to policyholders. Information about ratings provides both industry participants and insurance consumers meaningful insights on specific insurance companies. Higher ratings generally indicate financial stability and a stronger ability to pay claims.

        Principal Life has been assigned the following long-term insurance financial strength ratings:

Rating Agency

  Financial Strength Rating
  Rating Structure
A.M. Best Company, Inc.   A+ ("Superior") with a stable outlook   Second highest of 16 rating levels
Fitch Ratings   AA ("Very Strong") with a stable outlook   Third highest of 21 rating levels
Moody's Investors Service   Aa2 ("Excellent") with a stable outlook   Third highest of 21 rating levels
Standard & Poor's Rating Services   AA ("Very Strong") with a stable outlook   Third highest of 21 rating levels

        A.M. Best's ratings for insurance companies range from "A++" to "S". A.M. Best indicates that "A++" and "A+" ratings are assigned to those companies that in A.M. Best's opinion have superior ability to meet ongoing obligations to policyholders. Fitch's ratings for insurance companies range from "AAA" to "C". Fitch "AA" ratings indicate very strong capacity to meet policyholder and contractholder obligations on a timely basis. Moody's ratings for insurance companies range from "Aaa" to "C". Moody's indicates that "Aa" ratings are assigned to those companies that have demonstrated excellent financial security. Standard & Poor's ratings for insurance companies range from "AAA" to "R". Standard & Poor's indicates that "AA" ratings are assigned to those companies that have demonstrated very strong financial security characteristics. In evaluating a company's financial and operating performance, these rating agencies review its profitability, leverage and liquidity, as well as its book of business, the adequacy and soundness of its reinsurance, the quality and estimated market value of its assets, the adequacy of its policy reserves, the soundness of its risk management programs, the experience and competency of its management and other factors.

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        We believe that our strong ratings are an important factor in marketing our products to our distributors and customers, since ratings information is broadly disseminated and generally used throughout the industry. Our ratings reflect each rating agency's opinion of our financial strength, operating performance and ability to meet our obligations to policyholders and are not evaluations directed toward the protection of investors. Such ratings are neither a rating of securities nor a recommendation to buy, hold or sell any security, including our common stock.

Risk Management

        Like all financial services companies, we are exposed to a wide variety of financial, operational, and other risks, as described in Item 1A, "Risk Factors". Effective enterprise risk management is, therefore, a key component of our business model. Enterprise risk management enables us to:

    identify and successfully manage those risks that present profitable growth opportunities, and walk away from those that do not;

    avoid surprises and deliver on the promises that we make; and

    balance the sometimes competing demands of our various stakeholders, meet our customer obligations, satisfy regulatory requirements, and optimize shareholder returns relative to the risks we take.

        We use a variety of methods to help us identify, monitor, measure, communicate, and manage our risks within established limits and risk tolerances.

        Our Board of Directors and senior management are knowledgeable of and accountable for key risks. Our Board meets at least quarterly and regularly hears reports from the Chief Executive Officer, the Chief Operating Officer, the business unit Presidents, the Chief Financial Officer, and the Chief Investment Officer. The Board has several committees, which include the Audit Committee, the Human Resources Committee, and the Nominating and Governance Committee, that meet at least quarterly and address various aspects of risks. In addition, the Board of Directors and senior management receive quarterly updates from the Chief Risk Officer.

        We also have several senior management groups and committees that meet on a regular and frequent basis to discuss various issues and risks associated with our businesses. These committees encompass numerous functions such as discussing and setting business unit and company strategy, reviewing and approving potential uses of corporate capital, and setting investment policy and reviewing its implementation. Many key members of senior management serve on multiple committees, allowing them to provide oversight and take a holistic view of our key risks.

        Our enterprise risk management program is executed via a federated model. The Chief Risk Officer and the corporate risk units are independent of the business units, and work closely with the business units, providing oversight and integration of all risk management activities. Each business unit is responsible for identifying, monitoring, measuring, and managing its risks, as well as monitoring how its risks impact our overall risk exposure. The business units provide risk reports to the Chief Risk Officer quarterly with current risk management information.

        We have established risk tolerances from an overall corporate perspective as well as for specific types of risks. All potentially significant actions are considered in terms of the possible impact on our risk profile, including the capital required, the impact on near term and long-term earnings, and the ability to meet our targets with respect to return on equity, liquidity, debt/capital, cash coverage, and other ratios and metrics. We monitor a variety of risk metrics on an on-going basis and make any necessary adjustments to help us stay within our established risk tolerances. We have developed a Business Continuity Program that identifies critical business functions and includes plans for their protection and recovery in the event of a disaster or other business interruption. We continually monitor emerging risks, and we regularly build upon our already strong risk management practices to incorporate updated modeling tools, processes, and metrics.

Employees

        As of December 31, 2006, we had 15,289 employees. None of our employees are subject to collective bargaining agreements governing employment with us. We believe that our employee relations are satisfactory.

Internet Website

        Our Internet website can be found at www.principal.com. We make available free of charge on or through our Internet website, access to our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after such material is filed with or furnished to the SEC. Also available free of charge on our Internet website, and in print to any requesting stockholder, is our code of business conduct and ethics, corporate governance guidelines, and charters for the audit, human resources, and nominating and governance committees of our board of directors. Also see Item 10, "Directors, Executive Officers and Corporate Governance."

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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 U.S. 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.

        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, 2006, our U.S. investment operations held $42.4 billion of fixed maturity securities, or 75% of total U.S. invested assets, of which approximately 4.7% were below investment grade, including $16.9 million, or 0.04% of our total fixed maturity securities which we classified as either "problem," "potential problem," or "restructured." See Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations — Investments — U.S. Investment Operations — U.S. Investment Results — Fixed Maturity Securities." As of December 31, 2006, our international investment operations held $2.3 billion of fixed maturity securities, or 69% of total international invested assets. Some of these securities have been rated on the basis of the issuer's country credit rating while others have not been rated by external agencies, which makes the assessment of credit quality more difficult. See Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations — Investments — International Investment Operations." An increase in defaults on our fixed maturity securities portfolio could harm our financial strength and reduce our profitability.

        Our commercial mortgage loan portfolio faces both delinquency and default risk. Commercial mortgage loans of $10.1 billion represented 17% of our total invested assets as of December 31, 2006. As of December 31, 2006, loans that were in the process of foreclosure totaled $10.6 million, or 0.11% of our commercial mortgage loan portfolio. The performance of our commercial mortgage loan portfolio, however, may fluctuate in the future. 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, 2006, approximately $8.3 billion, or 82%, 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.

        As of December 31, 2006, our privately placed fixed maturity securities, commercial mortgage loans and real estate investments represented approximately 41% 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.

        We use derivative instruments to hedge various risks we face in our businesses. See Item 7A, "Quantitative and Qualitative Disclosures About Market Risk." We enter into a variety of derivative instruments, including interest rate swaps, swaptions, futures, currency swaps, currency forwards, credit default swaps, total return swaps, bond forwards, mortgage-backed security forwards, commodity swaps 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.

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        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.

        Credit extensions in the state of California accounted for 17%, or $1.8 billion, of our commercial mortgage loan portfolio as of December 31, 2006. 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 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 U.S. 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. Also, there is a risk that we may not be able to attract and retain the top talent needed to compete in our industry.

        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;

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    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. Many of our products have fairly predictable cash demands, and where cash demands are less predictable, we have the ability to defer or spread out the cash payments. 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 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 DPAC 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, "Quantitative and Qualitative Information About Market Risk — Interest Rate Risk".

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 U.S. 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 U.S. 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' 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.

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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, mortality, morbidity, 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, "Management's Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources" for a discussion of regulatory restrictions on Principal Life's 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 assets.

        In connection with its conversion in 1998 into a stock life insurance company, Principal Life established an accounting mechanism, known as a "Closed Block," 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, 2006, Closed Block assets and liabilities were $4,824.0 million and $5,821.3 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. If they are not sufficient, we must fund the shortfall. 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.

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        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.

A pandemic, terrorist attack, or other catastrophic event could adversely affect our earnings.

        Our mortality and morbidity experience could be adversely impacted by a catastrophic event. In addition, a severe catastrophic event may cause significant volatility in global financial markets, disruptions to commerce, and reduced economic activity. The resulting macroeconomic conditions could adversely affect our cash flows, as well as the value and liquidity of the company's invested assets. We may also experience operational disruptions if our employees are unable or unwilling to come to work due to a pandemic or other catastrophe. We have developed extensive contingency plans to minimize the risk of operational disruptions. In addition, our use of reinsurance reduces our exposure to adverse mortality experience. Despite these measures, we may still be exposed to losses in the event of a pandemic, terrorist attack, or other catastrophe.

Our reinsurers could default on their obligations or increase their rates, which could adversely impact our earnings and profitability.

        We cede material amounts of insurance to other insurance companies through reinsurance. See Item 8. "Financial Statements and Supplementary Data, Notes to Consolidated Financial Statements, Note 1 Nature of Operations and Significant Accounting Policies." However, we remain liable to the policyholder, even if the reinsurer defaults on its obligations with respect to the ceded business. If a reinsurer fails to meet its obligations, we will be forced to cover the claims on the reinsured policies. In addition, a reinsurer insolvency may cause us to lose our reserve credits on the ceded business, in which case the Principal would be required to establish additional reserves.

        The premium rates charged by the Company are based, in part, on the assumption that reinsurance will be available at a certain cost. Some of our reinsurance contracts contain provisions which limit the reinsurer's ability to increase rates on in-force business; however, some do not. If a reinsurer raises the rates that it charges on a block of in-force business, our profitability may be negatively impacted if we are not able to pass the increased costs on to the customer. If reinsurers raise the rates that they charge on new business, we may be forced to raise the premiums that we charge, which could have a negative impact on our competitive position.

        To mitigate the risks associated with the use of reinsurance, we carefully select our reinsurers, and we monitor their ratings and financial condition on a regular basis. We also spread our business among several reinsurers, in order to diversify our risk exposure.

We may encounter difficulty integrating WM Advisors, Inc. and may incur substantial costs in connection with the integration.

        Integrating WM Advisors, Inc. into our business operations will be a complex, time-consuming and expensive process. We may encounter substantial difficulties, costs and delays in integrating WM Advisors, Inc., including difficulties and expenses we did not anticipate, such as

    difficulties in retaining or attracting new portfolio managers, sales representatives and wholesalers;

    difficulties in retaining or attracting management and other key employees;

    difficulties in assimilating employees;

    difficulties in the integration of operations and systems;

    difficulties in keeping existing clients or obtaining new clients; and

    diversion of management's attention to integration matters.

        As a result, we may not be able to realize the expected revenue growth and other benefits we hope to achieve from the acquisition of WM Advisors, Inc. In addition, we may be required to spend additional time or money on integration that we would otherwise spend on the development and expansion of our business.

Changes in laws, regulations or accounting standards may reduce our profitability.

        Our insurance business is subject to comprehensive state regulation and supervision throughout the U.S. 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,

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    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,

    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.

        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 "flat tax" income structure with an exemption from taxation for investment income, could result in fewer sales of our insurance, annuity and investment products.

        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. The law in effect prior to the Act, however, is reinstated for years after 2010. Through the year ended December 31, 2006, we received recurring premium of $29.4 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.

        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.

        Accounting standards are subject to change and can negatively impact our profitability. See Item 8. "Financial Statements and Supplementary Data, Notes to Consolidated Financial Statements, Note 1 Nature of Operations and Significant Accounting Policies." The results for past accounting periods are not necessarily indicative of the results to be expected for any future accounting period.

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        Several years ago the International Accounting Standards Board ("IASB") and the Financial Accounting Standards Board (the "FASB") launched a project to converge International Financial Reporting Standards ("IFRS") and U.S. generally accepted accounting principles ("U.S. 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 U.S. GAAP and IFRS that impact those using, preparing, auditing or regulating cross-border financial reporting. Most recently, a joint project to develop a common conceptual framework that converges and improves upon the framework of the two Boards has been undertaken. As the project to converge IFRS and U.S. GAAP and their respective conceptual frameworks continue, current GAAP fundamentals may be modified to become consistent with IFRS, which may result in changes in the financial statements of U.S. companies.

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 regulatory investigation risk, see Item 3, "Legal Proceedings."

Fluctuations in foreign currency exchange rates could reduce our profitability.

        Principal International generally writes policies denominated in various local currencies and invests the premiums and deposits in local currencies. Although investing in local currencies limits the effect of currency exchange rate fluctuation on local operating results, fluctuations in such rates affect the translation of these results into our consolidated financial statements. For further discussion on foreign currency exchange risk, see Item 7A, "Quantitative and Qualitative Disclosures About Market Risk — Foreign Currency Risk."

Applicable laws and our stockholder rights plan, certificate of incorporation and by-laws may discourage takeovers and business combinations that our stockholders might consider in their best interests.

        State laws and our certificate of incorporation and by-laws may delay, defer, prevent, or render more difficult a takeover attempt that our stockholders might consider in their best interests. For instance, they may prevent our stockholders from receiving the benefit from any premium to the market price of our common stock offered by a bidder in a takeover context. Even in the absence of a takeover attempt, the existence of these provisions may adversely affect the prevailing market price of our common stock if they are viewed as discouraging takeover attempts in the future.

        State laws and our certificate of incorporation and by-laws may also make it difficult for stockholders to replace or remove our management. These provisions may facilitate management entrenchment, which may delay, defer or prevent a change in our control, which may not be in the best interests of our stockholders.

        The following provisions, included in our certificate of incorporation and by-laws, may also have anti-takeover effects and may delay, defer or prevent a takeover attempt that our stockholders might consider in their best interests. In particular, our certificate of incorporation and by-laws:

    permit our board of directors to issue one or more series of preferred stock;

    divide our board of directors into three classes;

    limit the ability of stockholders to remove directors;

    prohibit stockholders from filling vacancies on our board of directors;

    prohibit stockholders from calling special meetings of stockholders;

    impose advance notice requirements for stockholder proposals and nominations of directors to be considered at stockholder meetings; and

    require the approval by the holders of at least 75% of our outstanding common stock for the amendment of our by-laws and provisions of our certificate of incorporation governing:

    the classified board,

    the director's discretion in determining what he or she reasonably believes to be in the best interests of Principal Financial Group, Inc.,

    the liability of directors, and

    the elimination of the prohibition on stockholder actions by written consent.

        In addition, Section 203 of the General Corporation Law of the State of Delaware may limit the ability of an "interested stockholder" to engage in business combinations with us. An interested stockholder is defined to include persons owning 15% or more of our outstanding voting stock.

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        Our stockholder rights plan may have anti-takeover effects. The stockholder rights plan is designed to protect our stockholders in the event of unsolicited offers to acquire us and other coercive takeover tactics, which, in the opinion of our board of directors, could impair the board's ability to represent stockholder interests. Our stockholder rights plan might render an unsolicited takeover more difficult or less likely to occur, even though such a takeover might offer our stockholders the opportunity to sell their stock at a price above the prevailing market price and may be favored by our stockholders.


Item 1B.    Unresolved Staff Comments

        None.


Item 2.    Properties

        We own 25 properties in our home office complex in Des Moines, Iowa and in various other locations. Of these 25 properties, 10 are office buildings, 2 are warehouse facilities, 12 are parking lots and ramps, and 1 is a park/green space. Of the office and warehouse space, we occupy approximately 92% of the 2.78 million square feet of space in these buildings. The balance of the space in these buildings is rented to commercial tenants. Of the parking properties there are approximately 5,323 stalls. We lease office space for various offices located throughout the U.S. and internationally. We believe that our owned and leased properties are suitable and adequate for our current business operations.


Item 3.    Legal Proceedings

        We are regularly involved in litigation, both as a defendant and as a plaintiff, but primarily as a defendant. Litigation naming us as a defendant ordinarily arises out of our business operations as a provider of asset management and accumulation products and services, life, health and disability insurance. Some of the lawsuits are class actions, or purport to be, and some include claims for punitive damages. In addition, regulatory bodies, such as state insurance departments, the SEC, the National Association of Securities Dealers, Inc., the Department of Labor and other regulatory bodies regularly make inquiries and conduct examinations or investigations concerning our compliance with, among other things, insurance laws, securities laws, Employee Retirement Income Security Act ("ERISA") and laws governing the activities of broker-dealers.

        Several lawsuits have been filed against other insurance companies and insurance brokers alleging improper conduct relating to the payment and non-disclosure of contingent compensation and bid-rigging activity. Several of these suits were filed as purported class actions. Several state attorneys general and insurance regulators have initiated industry-wide inquiries or other actions relating to compensation arrangements between insurance brokers and insurance companies and other industry issues. Beginning in March of 2005, we have received subpoenas and interrogatories from the offices of the Attorneys General of New York and Connecticut seeking information related to compensation agreements with brokers and agents and the sale of retirement products and services. We are cooperating with these inquiries. To date, none of these Attorneys General investigations has resulted in any action against us. We are, however, engaged in discussions with the Connecticut and New York Attorney General's Office with respect to broker payments relating to sales of our single premium group annuity products, which primarily fund terminating defined benefit plans. At this point, we cannot predict the outcome of these discussions. We have received other requests from regulators and other governmental authorities relating to other industry issues and may receive additional such requests, including subpoenas and interrogatories, in the future.

        On December 23, 2004, a lawsuit was filed in Iowa state court against us and our wholly owned subsidiaries, Principal Life and Principal Financial Services, Inc., on behalf of a proposed class comprised of the settlement class in the Principal Life sales practices class action settlement, which was approved in April 2001 by the United States District Court for the Southern District of Iowa. This more recent lawsuit claims that the treatment of the settlement costs of that sales practices litigation in relation to the allocation of demutualization consideration to Principal Life policyholders was inappropriate. Demutualization allocation was done pursuant to the terms of a plan of demutualization approved by the policyholders in July 2001 and Insurance Commissioner of the State of Iowa in August 2001. The lawsuit further claims that such allocation was not accurately described to policyholders during the demutualization process and is a breach of the sales practices settlement. On January 27, 2005, we filed a notice to remove the action from state court to the United States District Court for the Southern District of Iowa. On July 22, 2005, the plaintiff's motion to remand the action to state court was denied, and our motion to dismiss the lawsuit was granted. On September 21, 2005, the plaintiff's motion to alter or amend the judgment was denied. On October 4, 2005, the plaintiff filed a notice of appeal to the United States Court of Appeals for the Eighth Circuit. Oral argument was held on April 20, 2006. On October 20, 2006, the Court of Appeals affirmed our motion to dismiss.

        On November 8, 2006, a trustee of Fairmount Park Inc. Retirement Savings Plan filed a putative class action lawsuit in the United States District Court for the Southern District of Illinois against Principal Life. The Complaint alleges, among other things, that Principal Life breached its alleged fiduciary duties while performing services to 401(k) plans by failing to disclose, or adequately disclose, to employers or plan participants the fact that Principal Life receives "revenue sharing fees from mutual funds that are included in its pre-packaged 401(k) plans" and allegedly failed to use the revenue to defray the expenses of the services provided to the plans. Principal Life has filed its Answer and a Motion to Transfer

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and intends to aggressively defend the lawsuit. Plaintiff further alleges that these acts constitute prohibited transactions under ERISA. Plaintiff seeks to certify a class of all retirement plans to which Principal Life was a service provider and for which Principal Life received and retained "revenue sharing" fees from mutual funds. Plaintiff seeks declaratory, injunctive and monetary relief. Principal Life intends to aggressively defend the lawsuit.

        While the outcome of any pending or future litigation cannot be predicted, management does not believe that any pending litigation will have a material adverse effect on our business or financial position. The outcome of litigation is always uncertain, and unforeseen results can occur. It is possible that such outcomes could materially affect net income in a particular quarter or annual period.


Item 4.    Submission of Matters to a Vote of Security Holders

        No matter was submitted to a vote of security holders of Principal Financial Group, Inc. during the fourth quarter of the fiscal year covered by this report.

Executive Officers of the Registrant

        The following information is furnished with respect to each of the executive officers of the Company, each of whom is elected by and serves at the pleasure of the Board of Directors.

        J. Barry Griswell, 57, has been Chairman and Chief Executive Officer of the Company and Principal Life since 2002, a director of the Company since 2001, and a Principal Life director since 1998. Prior thereto, he had been President of the Company from April 2001 until June 2006, Chief Executive Officer of the Company since April 2001, and President and Chief Executive Officer of Principal Life since January 2000. He is a Chartered Life Underwriter, a Chartered Financial Consultant and a LIMRA Leadership Institute Fellow. Mr. Griswell is a director of Herman Miller, Inc., an office furnishings designer and manufacturer. He is Chairman of the Board and Chair of the Board's Executive Committee.

        John E. Aschenbrenner, 57, who heads the Life and Health Insurance division of our operations, has been President, Insurance and Financial Services, of the Company and of Principal Life since December 2003. Prior to that time, he served as Executive Vice President of the Company since April 2001, and Executive Vice President of Principal Life since January 2000. Mr. Aschenbrenner serves as a director of the Principal Mutual Funds.

        Michael H. Gersie, 58, has been Executive Vice President and Chief Financial Officer of the Company since April 2001, and Executive Vice President and Chief Financial Officer of Principal Life since January 2000.

        Daniel J. Houston, 45, was named Executive Vice President, Retirement and Investor Services, in June 2006. He has served as a Senior Vice President of Principal Life since 2000.

        Ellen Z. Lamale, 53, has been Senior Vice President and Chief Actuary of the Company since April 2001, and Senior Vice President and Chief Actuary of Principal Life since June 1999.

        Julia M. Lawler, 47, has been Senior Vice President and Chief Investment Officer of the Company and of Principal Life since July 2002. From 2000 - 2002, she was President of the Real Estate Equity Group of Principal Global Investors, LLC. From 1999 - 2000, she was Vice President — Capital Markets.

        James P. McCaughan, 53, who heads the Global Asset Management division of our operations, has been President, Global Asset Management of the Company and of Principal Life since December 2003. Prior to that time, he served as Executive Vice President and global head of asset management for the Company and Principal Life since April 2002. From 2000 - 2002, he was CEO of the Americas division of Credit Suisse Asset Management in New York, New York.

        Mary A. O'Keefe, 50, who heads Corporate Relations and Strategic Development, has been Senior Vice President and Chief Marketing Officer of the Company and Principal Life since February 2005, Senior Vice President of the Company since April 2001, and Senior Vice President of Principal Life since January 1998.

        Gary P. Scholten, 49, has been Senior Vice President and Chief Information Officer of the Company and Principal Life since November 2002. From 1998 - 2002, he was Vice President of retail information services of Principal Life.

        Karen E. Shaff, 52, has been Executive Vice President and General Counsel of the Company and of Principal Life since February 2004. Prior thereto, she was Senior Vice President and General Counsel of the Company since April 2001, and Senior Vice President and General Counsel of Principal Life since January 2000.

        Norman R. Sorensen, 61, has been President of Principal International, Inc. since 1998, Senior Vice President, International Asset Accumulation, of the Company since April 2001, and Senior Vice President of Principal Life since December 1998.

        Larry D. Zimpleman, 55, has been President and Chief Operating Officer since June 2006, and heads the Retirement and Investor Services division of our operations. He has been President, Retirement and Investor Services of the Company and of Principal Life since December 2003. Prior thereto, he served as head of our International Asset Accumulation business since January 2003, our U. S. Asset Accumulation business since February 2002, and Executive Vice President of the Company and Principal Life since August 2001. Previously, Mr. Zimpleman was Senior Vice

27



President of Principal Life from June 1999 — August 2001. Mr. Zimpleman serves on the Company's Board and as Chairman of the Board and a director of the Principal Mutual Funds.


PART II

Item 5.    Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

        Our common stock began trading on the New York Stock Exchange ("NYSE") under the symbol "PFG" on October 23, 2001. Prior to such date, there was no established public trading market for our common stock. On February 20, 2007, there were 494,151 stockholders of record of our common stock.

        The following table presents the high and low prices for our common stock on the NYSE for the periods indicated and the dividends declared per share during such periods.

 
  High
  Low
  Dividends
2006                  
  First quarter   $ 50.72   $ 45.91    
  Second quarter   $ 55.93   $ 48.51    
  Third quarter   $ 56.47   $ 52.62    
  Fourth quarter   $ 59.40   $ 53.75   $ 0.80

2005

 

 

 

 

 

 

 

 

 
  First quarter   $ 41.96   $ 37.61    
  Second quarter   $ 42.30   $ 36.80    
  Third quarter   $ 48.37   $ 41.80    
  Fourth quarter   $ 52.00   $ 45.78   $ 0.65

        We declared an annual cash dividend of $0.80 per common share on November 7, 2006, and paid such dividend on December 15, 2006, to stockholders of record on the close of business on November 22, 2006. We declared an annual cash dividend of $0.65 per common share on November 2, 2005, and paid such dividend on December 16, 2005, to stockholders of record on the close of business on November 17, 2005. Future dividend decisions will be based on and affected by a number of factors, including our operating results and financial requirements and the impact of regulatory restrictions. See Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources" for a discussion of regulatory restrictions on Principal Life's ability to pay us dividends.

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        The following table presents the amount of our share purchase activity for the periods indicated:


Issuer Purchases of Equity Securities

Period

  Total Number of Shares (or Units) Purchased(1)
  Average Price Paid per Share (or Unit)
  Total Number of Shares (or Units) Purchased as Part of Publicly Announced Plans or Programs
  Maximum Number (or Approximate Dollar Value) of Shares (or Units) that May Yet Be Purchased Under the Plans or Programs (in millions) (2)(3)(4)
January 1, 2006 - January 31, 2006   886,250   $ 47.19   886,200   $ 208.2
February 1, 2006 - February 28, 2006   824,276   $ 48.14   814,895   $ 169.0
March 1, 2006 - March 31, 2006   1,672,028   $ 49.06   1,655,200   $ 87.7
April 1, 2006 - April 30, 2006   1,102,043   $ 49.58   1,102,000   $ 33.1
May 1, 2006 - May 31, 2006   8,296,702   $ 64.26 (3) 8,296,702   $
June 1, 2006 - June 30, 2006     $     $
July 1, 2006 - July 31, 2006     $     $
August 1, 2006 - August 31, 2006     $     $
September 1, 2006 - September 30, 2006   84,406   $ 53.59     $
October 1, 2006 - October 31, 2006   218   $ 52.25     $
November 1, 2006 - November 30, 2006   1,664,568   $ (3) 1,664,568   $ 250.0
December 1, 2006 - December 31, 2006     $     $ 250.0
   
       
     
Total   14,530,491         14,419,565      
   
       
     

(1)
The number of shares includes shares of common stock utilized to execute certain stock incentive awards in 2006: 50 shares in January, 9,381 shares in February, 16,828 shares in March, 43 shares in April, 84,406 shares in September, and 218 shares in October.

(2)
In November 2005, our Board of Directors authorized a repurchase program of up to $250.0 million of our outstanding common stock. On May 18, 2006, the program announced in November 2005 was completed.

(3)
In May 2006, our Board of Directors authorized a repurchase program of up to $500.0 million of our outstanding common stock. We paid $500.0 million and received the initial delivery of 7.7 million common shares, while retaining the right to receive additional common shares depending on the volume weighted average share price of our common stock over the program's duration. The program was completed in November 2006. Under this program, we purchased 9.3 million common shares at an average price of $53.59.

(4)
On November 28, 2006, our Board of Directors authorized a repurchase program of up to $250.0 million of our outstanding common stock. As of December 31, 2006, no purchases have been made under this program.


Item 6.    Selected Financial Data

        The following table sets forth certain selected historical consolidated financial information of Principal Financial Group, Inc. We derived the consolidated financial information (except for amounts referred to as "Other Supplemental Data") for each of the years ended December 31, 2006, 2005 and 2004 and as of December 31, 2006 and 2005 from our audited consolidated financial statements and notes to the financial statements included in this Form 10-K. We derived the consolidated financial information (except for amounts referred to as "Other Supplemental Data") for the years ended December 31, 2003 and 2002 and as of December 31, 2004, 2003 and 2002 from our audited consolidated financial statements not included in this Form 10-K. The following summary of consolidated financial information (except for amounts referred to as "Other Supplemental Data") has been prepared in accordance with U.S. GAAP.

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        In order to fully understand our consolidated financial information, you should also read Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations" and our audited consolidated financial statements and the notes to the financial statements included in this Form 10-K. The results for past accounting periods are not necessarily indicative of the results to be expected for any future accounting period.

 
  As of or for the year ended December 31,
 
 
  2006(1)
  2005(1)
  2004(1)
  2003
  2002
 
 
  ($ in millions, except per share data and as noted)

 
Income Statement Data:                                
Revenues:                                
  Premiums and other considerations   $ 4,305.3   $ 3,975.0   $ 3,710.0   $ 3,630.7   $ 3,877.8  
  Fees and other revenues     1,902.5     1,717.8     1,491.7     1,196.5     954.2  
  Net investment income     3,618.0     3,360.1     3,224.0     3,229.4     3,173.1  
  Net realized/unrealized capital gains (losses)     44.7     (11.2 )   (104.8 )   (63.2 )   (374.1 )
   
 
 
 
 
 
    Total revenues   $ 9,870.5   $ 9,041.7   $ 8,320.9   $ 7,993.4   $ 7,631.0  
   
 
 
 
 
 
Income from continuing operations, net of related income taxes   $ 1,033.7   $ 891.5   $ 700.9   $ 644.7   $ 446.4  
Income (loss) from discontinued operations, net of related income taxes(2)     30.6     27.5     130.4     105.0     (23.2 )
   
 
 
 
 
 
Income before cumulative effect of accounting changes     1,064.3     919.0     831.3     749.7     423.2  
Cumulative effect of accounting changes, net of related income taxes(3)             (5.7 )   (3.4 )   (280.9 )
   
 
 
 
 
 
Net income     1,064.3     919.0     825.6     746.3     142.3  
Preferred stock dividends(4)     33.0     17.7              
   
 
 
 
 
 
Net income available to common stockholders   $ 1,031.3   $ 901.3   $ 825.6   $ 746.3   $ 142.3  
   
 
 
 
 
 

Earnings per Share Data:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 
Income from continuing operations, net of related income taxes, per share                                
  Basic   $ 3.67   $ 3.03   $ 2.24   $ 1.98   $ 1.27  
  Diluted   $ 3.63   $ 3.01   $ 2.23   $ 1.97   $ 1.27  
Net income per share:                                
  Basic   $ 3.78   $ 3.13   $ 2.64   $ 2.29   $ 0.41  
  Diluted   $ 3.74   $ 3.11   $ 2.62   $ 2.28   $ 0.41  
Common shares outstanding at year-end (in millions)     268.4     280.6     300.6     320.7     334.4  
Weighted-average common shares outstanding for the year     272.9     287.9     313.3     326.0     350.2  
Weighted-average common shares and potential common shares outstanding for the year for computation of diluted earnings per share (in millions)     275.5     289.9     314.7     326.8     350.7  
Cash dividends per common share   $ 0.80   $ 0.65   $ 0.55   $ 0.45   $ 0.25  

Balance Sheet Data:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 
Total assets   $ 143,658.1   $ 127,035.4   $ 113,798.1   $ 107,754.4   $ 89,870.6  
Long-term debt   $ 1,553.8   $ 898.8   $ 843.5   $ 1,374.3   $ 1,332.5  
Series A preferred stock   $   $   $   $   $  
Series B preferred stock     0.1     0.1              
Common stock     3.8     3.8     3.8     3.8     3.8  
Additional paid-in capital     8,141.8     8,000.0     7,269.4     7,153.2     7,106.3  
Retained earnings     2,824.1     2,008.6     1,289.5     630.4     29.4  
Accumulated other comprehensive income     846.9     994.8     1,313.3     1,171.3     635.8  
Treasury stock, at cost     (3,955.9 )   (3,200.1 )   (2,331.7 )   (1,559.1 )   (1,118.1 )
   
 
 
 
 
 
Total stockholders' equity   $ 7,860.8   $ 7,807.2   $ 7,544.3   $ 7,399.6   $ 6,657.2  
   
 
 
 
 
 

30


 
  As of or for the year ended December 31,
 
  2006(1)
  2005(1)
  2004(1)
  2003
  2002
 
  ($ in millions, except as noted)

Other Supplemental Data:                              
Assets under management ($in billions)   $ 256.9   $ 195.2   $ 167.0   $ 144.3   $ 110.5
Number of employees (actual)     15,289     14,507     13,976     14,976     15,038

(1)
For a discussion of items materially affecting the comparability of 2006, 2005, and 2004, please see Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations — Transactions Affecting Comparability of Results of Operations."

(2)
See Item 8. "Financial Statements and Supplementary Data — Notes to Consolidated Financial Statements, Note 3, Discontinued Operations" for a description of our discontinued operations.

(3)
See Item 8. "Financial Statements and Supplementary Data — Notes to Consolidated Financial Statements, Note 1, Nature of Operations and Significant Accounting Policies" for a description of recent accounting changes.

(4)
On June 16, 2005, we issued 13.0 million shares of non-cumulative perpetual preferred stock under our shelf registration. We declared preferred stock dividends of $33.0 million and $17.7 million in 2006 and 2005, respectively.

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Item 7.    Management's Discussion and Analysis of Financial Condition and Results of Operations

        The following analysis discusses our financial condition as of December 31, 2006, compared with December 31, 2005, and our consolidated results of operations for the years ended December 31, 2006, 2005 and 2004, and, where appropriate, factors that may affect our future financial performance. The discussion should be read in conjunction with our audited consolidated financial statements and the related notes to the financial statements and the other financial information included elsewhere in this Form 10-K.

Forward-Looking Information

        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) 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; (2) 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; (3) 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; (4) 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; (5) our efforts to reduce the impact of interest rate changes on our profitability and surplus may not be effective; (6) if we are unable to attract and retain sales representatives and develop new distribution sources, sales of our products and services may be reduced; (7) our international businesses face political, legal, operational and other risks that could reduce our profitability in those businesses; (8) our reserves established for future policy benefits and claims may prove inadequate, requiring us to increase liabilities; (9) 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; (10) 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; (11) we may need to fund deficiencies in our Closed Block assets; (12) a pandemic, terrorist attack, or other catastrophic event could adversely affect our earnings; (13) our reinsurers could default on their obligations or increase their rates, which could adversely impact our earnings and profitability (14) we may encounter difficulty integrating WM Advisors, Inc. and may incur substantial costs in connection with the integration; (15) changes in laws, regulations or accounting standards may reduce our profitability; (16) litigation and regulatory investigations may affect our financial strength or reduce our profitability; (17) fluctuations in foreign currency exchange rates could reduce our profitability; and (18) applicable laws and our stockholder rights plan, certificate of incorporation and by-laws may discourage takeovers and business combinations that our stockholders might consider in their best interests.

Overview

        We provide financial products and services through the following segments:

    U.S. Asset Management and Accumulation, which consists of our asset accumulation operations, which provide retirement savings and related investment products and services, and our asset management operations conducted through Principal Global Investors. We provide a comprehensive portfolio of asset accumulation products and services to businesses and individuals in the U.S., with a concentration on small and medium-sized businesses, which we define as businesses with fewer than 1,000 employees. We offer to businesses products and services for defined contribution pension plans, including 401(k) and 403(b) plans, defined benefit pension plans, non-qualified executive benefit plans, and employee stock ownership plan consulting services. We also offer annuities, mutual funds and bank products and services to the employees of our business customers and other individuals. Principal Global Investors offers an extensive range of equity, fixed income and real estate investments as well as specialized overlay and advisory services to institutional investors.

    International Asset Management and Accumulation, which consists of Principal International, offers retirement products and services, annuities, long-term mutual funds and life insurance through operations in Chile, Mexico, Hong Kong, Brazil, India, China, and Malaysia.

    Life and Health Insurance, which provides individual life insurance, group health insurance as well as specialty benefits in the U.S. Our individual life insurance products include universal and variable universal life insurance and traditional life insurance. Our health insurance products include group medical insurance and fee-for-service claims administration and wellness services. Our specialty benefit products include group dental and vision insurance, individual and group disability insurance, and group life insurance.

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    Corporate and Other, which manages the assets representing capital that has not been allocated to any other segment. Financial results of the Corporate and Other segment primarily reflect our financing activities (including interest expense), income on capital not allocated to other segments, inter-segment eliminations, income tax risks and certain income, expenses and other after-tax adjustments not allocated to the segments based on the nature of such items.

        Our historical results contained a Mortgage Banking segment, which engaged in originating, purchasing, selling and servicing residential mortgage loans in the U.S. On July 1, 2004, we closed the sale of Principal Residential Mortgage, Inc. to CitiMortgage, Inc., described further in "Transactions Affecting Comparability of Results of Operations."

Economic Factors and Trends

        Modest results in the equity markets along with an increase in net cash flow have led to increases in asset accumulation's account values and our asset management's assets under management.

        In our International Asset Management and Accumulation segment, we continued to grow our existing business through organic growth in our existing subsidiaries and a combination of joint ventures and strategic acquisitions.

        Over the past few years, we have shifted our marketing emphasis to universal and variable universal life insurance products from traditional life insurance products in our Life and Health segment. We are also in the early stages of a trend toward voluntary products sponsored by employers.

Profitability

        Our profitability depends in large part upon our:

    amount of assets under management;

    spreads we earn on our policyholders' general account asset accumulation business that result from the difference between what we earn and what we credit;

    ability to generate fee revenues by providing administrative and investment management services;

    ability to price our life and health insurance products at a level that enables us to earn a margin over the cost of providing benefits and the related expenses;

    ability to manage our investment portfolio to maximize investment returns and minimize risks such as interest rate changes or defaults or impairments of invested assets;

    ability to effectively hedge fluctuations in foreign currency to U.S. dollar exchange rates; and

    ability to manage our operating expenses.

Critical Accounting Policies and Estimates

        The increasing complexity of the business environment and applicable authoritative accounting guidance requires us to closely monitor our accounting policies. Our significant accounting policies are described in Item 8. "Financial Statements and Supplementary Data, Notes to Consolidated Financial Statements, Note 1 Nature of Operations and Significant Accounting Policies". We have identified five critical accounting policies that are complex and require significant judgment and estimates about matters that are inherently uncertain. A summary of our critical accounting policies is intended to enhance the reader's ability to assess our financial condition and results of operations and the potential volatility due to changes in estimates and changes in guidance. The identification, selection and disclosure of critical accounting estimates and policies have been discussed with the Audit Committee of the Board of Directors.

Valuation of Invested Assets

        Fixed Maturities, Available-for-Sale.    Fixed maturity securities include bonds, mortgage-backed securities and redeemable preferred stock. We classify our fixed maturity securities as either available-for-sale or trading and, accordingly, carry them at fair value in the statement of financial position. The fair values of our public fixed maturity securities are based on quoted market prices or estimates from independent pricing services. However, 23% of our invested asset portfolio is invested in fixed maturity securities that are private market assets, where there are no readily available market quotes to determine the fair market value. These assets are valued using a spread pricing matrix. Securities are grouped into pricing categories that vary by asset class, sector, rating, and average life. Each pricing category is assigned a risk spread based on studies of observable public market data or market clearing data from the investment professionals assigned to specific security classes. The expected cash flows of the security are then discounted back at the current Treasury curve plus the appropriate risk spread. Although the matrix valuation approach provides a fair valuation of each pricing category, the valuation of an individual security within each pricing category may actually be impacted by company specific factors. Certain market events that could impact the valuation of securities include issuer credit ratings, business climate, management changes, litigation, and government actions among others. An interest rate increase in the range of 20 to 100 basis points, while holding credit spreads constant, produces total values of $38.1 billion and $36.7 billion, as compared to the recorded amount of $38.5 billion related to our fixed maturity, available-for-sale

33


assets held by the Principal Life general account as of December 31, 2006. This portfolio has a weighted average life of 7 years. An analysis of historical changes in the 7-year Treasury rate supports our belief that an interest rate change of 20 to 100 basis points is reasonably likely.

        Investments classified as available-for-sale are subject to impairment reviews. When evaluating a fixed maturity security for impairment, we consider relevant facts and circumstances in evaluating whether the impairment 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) our ability and intent to hold the security for a period of time that allows for the recovery of value which, in some cases, may extend to maturity. When it is determined that the decline in value is other than temporary the carrying value of the security is reduced to its fair value, with a corresponding charge to net income. The corresponding charge is referred to as an other-than-temporary impairment and is reported as a net realized/unrealized capital loss in our consolidated statement of operations.

        There are a number of significant risks and uncertainties inherent in the process of monitoring impairments and determining if an impairment is other than temporary. These risks and uncertainties include: (1) the risk that our assessment of an issuer's ability to meet all of its contractual obligations will change based on changes in the credit characteristics of that issuer; (2) the risk that the economic outlook will be worse than expected or have more of an impact on the issuer than anticipated; (3) the risk that our investment professionals are making decisions based on fraudulent or misstated information in the financial statements provided by issuers; and (4) the risk that new information obtained by us or changes in other facts and circumstances lead us to change our intent to hold the security until it recovers in value. Any of these situations could result in a charge to net income in a future period. At December 31, 2006, we had $16,464.3 million in available-for-sale fixed maturity securities with gross unrealized losses totaling $308.5 million. Included in the gross unrealized losses are losses attributable to both movements in market interest rates as well as temporary credit issues. Net income would be reduced by approximately $308.5 million, on a pre-tax basis, if all the securities were deemed to be other than temporarily impaired.

        Mortgage Loans.    Mortgage loans consist primarily of commercial mortgage loans on real estate. At December 31, 2006, commercial mortgage loans aggregated to $10,090.3 million. Commercial mortgage loans are generally reported at cost adjusted for amortization of premiums and accrual of discounts, computed using the interest method, and net of valuation allowances. Commercial mortgage loans held for sale are carried at the lower of cost or fair value, less cost to sell, and reported as mortgage loans in the statements of financial position.

        Commercial mortgage loans on real estate are considered impaired when, based on current information and events, it is probable that we will be unable to collect all amounts due according to contractual terms of the loan agreement. When we determine that a loan is impaired, a valuation allowance is established for the difference between the carrying amount of the mortgage loan and the estimated value. Estimated value is based on either the present value of the expected future cash flows discounted at the loan's effective interest rate, the loan's observable market price or fair value of the collateral. The change in valuation allowance is reported as a net realized/unrealized capital loss on our consolidated statements of operations.

        The determination of the calculation and the adequacy of the mortgage loan allowance and mortgage impairments are subjective. Our periodic evaluation and assessment of the adequacy of the allowance for losses and the need for mortgage impairments is based on known and inherent risks in the portfolio, adverse situations that may affect the borrower's ability to repay, the estimated value of the underlying collateral, composition of the loan portfolio, current economic conditions, loss experience and other relevant factors. The calculation for determining loan specific impairment amounts is also subjective, as it requires estimating the amounts and timing of future cash flows expected to be received on impaired loans. Our financial position is sensitive to changes in estimated cash flows from mortgages, the value of the collateral, and changes in the economic environment in general. The allowance for losses can be expected to increase when economic conditions worsen and decrease when economic conditions improve.

Deferred Policy Acquisition Costs

        Commissions and other costs (underwriting, issuance and agency expenses) that vary with and are primarily related to the acquisition of new and renewal insurance policies and investment contract business are capitalized to the extent recoverable. Maintenance costs and acquisition costs that are not deferrable are charged to operations as incurred.

        DPAC of non-participating term life and individual disability insurance policies are amortized over the premium-paying period of the related policies using assumptions consistent with those used in computing policyholder liabilities. Once these assumptions are made for a given policy or group of policies, they will not be changed over the life of the policy.

        DPAC for universal life-type insurance contracts, participating life insurance policies and investment contracts are amortized over the expected lifetime of the policies in relation to the emergence of estimated gross profits.

        At issue and each valuation date, we develop an estimate of the expected future gross profits. These estimated gross profits contain assumptions relating to mortality, morbidity, investment yield and expenses. As actual experience emerges, the gross profits may vary from those expected either in magnitude or timing in which case a true-up to actual

34



occurs as a charge or credit to current operations. In addition, we are required to revise our assumptions regarding future experience as soon as the current assumptions are no longer actuarially credible. Both actions, reflecting actual experience and changing future estimates, can change the amount of the asset and the pattern of future amortization.

        For individual variable annuities and group annuities which have separate account equity investment options, we utilize a mean reversion method (reversion to the mean assumption), a common industry practice, to determine the future domestic equity market growth rate assumption used for the amortization of DPAC. This practice assumes that the expectation for long-term appreciation is not changed by minor short-term market fluctuations.

        DPAC are subject to recoverability testing at the time of policy issue and loss recognition testing on an annual basis, or when an event occurs that may warrant loss recognition. If loss recognition is necessary, DPAC are written off to the extent that it is determined that future policy premiums and investment income or gross profits are not adequate to cover related losses and expenses.

        The total DPAC asset balance as of December 31, 2006, was $2.4 billion. Based on historical experience, we believe a 1% change in the long-term investment performance rate assumption on separate accounts in our DPAC models is reasonably likely. Such a change would cause an estimated $9.2 million change in the DPAC asset as of December 31, 2006. Also, removing the mean reversion methodology from the DPAC asset calculation would increase the December 31, 2006 DPAC balance by $0.8 million.

Insurance Reserves

        Reserves are liabilities representing estimates of the amounts that will come due, at some point in the future, to or on behalf of our policyholders. U.S. GAAP, allowing for some degree of managerial judgment, prescribes the methods of establishing reserves.

        Future policy benefits and claims include reserves for traditional and group life insurance, accident and health insurance, and individual and group annuities that provide periodic income payments, which are computed using assumptions of mortality, morbidity, lapse, investment performance and expense. These assumptions are based on our experience and are periodically reviewed against industry standards to ensure actuarial credibility. For long duration insurance contracts, once these assumptions are made for a given policy or group of policies, they will not be changed over the life of the policy. However, significant changes in experience or assumptions may require us to provide for expected future losses on a product by establishing premium deficiency reserves. Premium deficiency reserves may also be established for short duration contracts to provide for expected future losses. Our reserve levels are reviewed throughout the year using internal analysis including, among other things, experience studies, claim development analysis and annual statutory asset adequacy analysis. To the extent experience indicates potential loss recognition, we recognize losses on certain lines of business. The ultimate accuracy of the assumptions on these long-tailed insurance products cannot be determined until the obligation of the entire block of business on which the assumptions were made is extinguished. Short-term variances of actual results from the assumptions used in the computation of the reserves are reflected in current period net income and can impact quarter-to-quarter net income.

        Future policy benefits and claims also include reserves for incurred but unreported health, disability and life insurance claims. We recognize claims costs in the period the service was provided to our policyowners. However, claims costs incurred in a particular period are not known with certainty until after we receive, process and pay the claims. We determine the amount of this liability using actuarial methods based on historical claim payment patterns as well as emerging medical cost trends, where applicable, to determine our estimate of claim liabilities. We also look back to assess how our prior periods' estimates developed. To the extent appropriate, changes in such development are recorded as a change to current period claim expense. For the years ending 2006, 2005 and 2004, the amount of the claim reserve adjustment made in that period for prior period estimates was within a reasonable range given our normal claim fluctuations.

Benefit Plans

        The reported expense and liability associated with pension and other postretirement benefit plans requires the use of assumptions. Numerous assumptions are made regarding the discount rate, expected long-term rate of return on plan assets, turnover, expected compensation increases, health care claim costs, health care cost trends, retirement rates, and mortality. The discount rate and the expected return on plan assets have the most significant impact on the level of cost.

        The assumed discount rate is determined by projecting future benefit payments and discounting those cash flows using rates based on the Bloomberg AA Finance yield to maturity curves. For 2006 year-end, we set the discount rate at 6.15%. A 0.25% decrease in the discount rate would increase pension benefits Projected Benefit Obligation ("PBO") and the 2007 Net Periodic Pension Cost ("NPPC") by approximately $58.9 million and $8.7 million, respectively. A 0.25% decrease in the discount rate would increase other post-retirement benefits Accumulated Postretirement Benefit Obligation ("APBO") and the 2007 Net Periodic Benefit Cost ("NPBC") by approximately $8.5 million and $0.8 million, respectively. A 0.25% increase in the discount rate would result in decreases in benefit obligations and expenses at a level generally commensurate with that noted above.

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        The assumed long-term rate of return on plan assets is set at the long-term rate expected to be earned based on the long-term investment policy of the plans and the various classes of the invested funds. Historical and future expected returns of multiple asset classes were analyzed to develop a risk-free real rate of return and risk premiums for each asset class. The overall long-term rate for each asset class was developed by combining a long-term inflation component, the risk free real rate of return, and the associated risk premium. A weighted average rate was developed based on long-term returns for each asset class, the plan's target asset allocation policy, and the tax structure of the trusts. For the 2006 NPPC and 2006 NPBC, an 8.25% and 7.3% weighted average long-term rate of return was used, respectively. For the 2007 NPPC and 2007 NPBC, an 8.25% and 7.3% weighted average long-term rate of return assumption will be used, respectively. A 0.25% decrease in the long-term rate of return would increase 2007 NPPC by approximately $3.5 million and the 2007 NPBC by approximately $1.2 million. A 0.25% increase in this rate would result in a decrease to expense at the same levels. The expected return on plan assets is based on the fair market value of plan assets as of September 30, 2006.

        The compensation increase assumption is generally set at a rate consistent with current and expected long-term compensation and salary policy, including inflation.

        Actuarial gains and losses are amortized using a straight-line amortization method over the average remaining service period of employees, which is approximately 9 years for pension costs and approximately 13 years for other postretirement benefit costs.

        Prior service costs are amortized on a weighted average basis over approximately 8 years for both pension and other postretirement benefit costs.

Income Taxes

        We provide for income taxes based on our estimate of the liability for taxes due. Our tax accounting represents management's best estimate of various events and transactions, such as completion of tax audits, which could have an impact on our estimates and effective tax rate in a particular quarter or annual period.

        Inherent in the provision for income taxes are estimates regarding the deductibility of certain items, the timing of income and expense recognition and the realization of certain tax credits. In the event our estimates of the ultimate deductibility of certain items, the timing of the recognition of income and expense or the realization of certain tax credits differ from prior estimates due to the receipt of new information, we may be required to significantly change the provision for income taxes recorded in the consolidated financial statements. Any such change could significantly affect the amounts reported in the consolidated financial statements in the year these estimates change.

        In addition, the amount of income taxes paid is subject to audits in various jurisdictions. Tax benefits are recognized for book purposes when the probable threshold is met with regard to the validity of the tax position. Once this threshold is met, for each tax reporting issue, we provide for our best estimate of the payments to be made to or received from the Internal Revenue Service and other taxing authorities for audits ongoing or not yet commenced. We believe that we have adequate defenses against, or sufficient provisions for, the contested issues, but final resolution of contested issues could take several years while legal remedies are pursued. Consequently, we do not anticipate the ultimate resolution of audits ongoing or not yet commenced to have a material impact on our net income.

Transactions Affecting Comparability of Results of Operations

Acquisitions

        We acquired the following businesses, among others, during the past three years:

        WM Advisors, Inc.    On July 25, 2006, we announced a definitive agreement to acquire WM Advisors, Inc. ("WM Advisors") and its subsidiaries from Washington Mutual, Inc. WM Advisors, with approximately $28.0 billion in assets under management, provides investment advisory services to mutual funds, variable trust funds and asset allocation portfolios to approximately 800,000 shareholder accounts nationwide. We closed the transaction on December 31, 2006, for a total cost of $741.1 million in cash, subject to closing adjustments.. The operations of WM Advisors, Inc. are reported and consolidated in our U.S. Asset Management and Accumulation segment.

        Principal Global Services Private Limited    In December 2005, we formed Principal Global Services Private Limited ("PGS"), which began operations in Pune, India, as of August 2006. PGS employees perform services for our U.S. operations including claims data entry, 401(k) processing, IT coding/application development, and IT quality assurance. PGS start up costs are reported in our Corporate and Other segment through 2006. Beginning in 2007, expenses will be allocated to segments for which services are performed.

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        Principal Commercial Funding II.    On October 24, 2005, Principal Real Estate Investors and U.S. Bank National Association announced that they agreed to create Principal Commercial Funding II, a jointly-owned business that will compete in the CMBS market. Principal Real Estate Investors is the real estate investment arm of Principal Global Investors. U.S. Bank National Association is the principal banking subsidiary of U.S. Bancorp. The new company is the CMBS platform for both Principal Real Estate Investors and U.S. Bank National Association and focuses on securitizing commercial mortgages originated by both Principal Real Estate Investors and U.S. Bank National Association on its behalf. Principal Commercial Funding II began operations immediately, and began contributing collateral to securitizations during the first quarter of 2006. The operations of Principal Commercial Funding II are reported in our U.S. Asset Management and Accumulation segment using the equity method of accounting.

        CCB-Principal Asset Management Company, Ltd.    On August 7, 2005, we announced that we entered into a joint venture agreement with China Construction Bank ("CCB") to market mutual funds in the People's Republic of China. We closed the transaction on September 19, 2005 with a 25% ownership in CCB-Principal Asset Management Company, Ltd. The operations of CCB-Principal Asset Management Company, Ltd. are reported in our International Asset Management and Accumulation segment using the equity method of accounting.

        PNB Principal Insurance Advisory Company Pvt. Ltd.    On February 21, 2005, Principal Financial Group (Mauritius) Ltd. ("PFGM") acquired a 26% stake and management control of PNB Principal Insurance Advisory Company Pvt. Ltd. ("PPIAC"), an insurance brokerage company in India. The operations of PPIAC are reported and consolidated in our International Asset Management and Accumulation segment.

        ABN AMRO Trust Services Company.    On December 17, 2004, we entered into a strategic agreement to acquire ABN AMRO Trust Services Company ("Principal Services Trust Company"), the Chicago-based pension and retirement business of ABN AMRO. As of December 31, 2004, Principal Services Trust Company provided full-service defined contribution recordkeeping and investment services in the U.S., administering approximately 280 401(k) plans with more than 120,000 participants, representing $4.0 billion in full-service account values. The transaction closed on December 31, 2004 and the business was fully integrated into full-service accumulation in early 2006.

        Columbus Circle Investors.    On October 14, 2004, we agreed to purchase a 70% interest in Columbus Circle Investors ("Columbus Circle"). The acquisition of Columbus Circle increased our assets under management by $3.9 billion. Columbus Circle has specialized expertise in the management of growth equities. We closed the transaction on January 3, 2005. The operations of Columbus Circle are reported in our U.S. Asset Management and Accumulation segment.

        Principal Fund Management (Hong Kong) Limited.    On January 31, 2004, our wholly owned subsidiary, Principal Asset Management Company (Asia) Limited, purchased a 100% ownership of Dao Heng Fund Management in Hong Kong from Guoco Group Limited ("Guoco"). Effective September 17, 2004, we changed the name of this subsidiary to Principal Fund Management (Hong Kong) Limited. This acquisition increases our presence in the Hong Kong defined contribution pension market and increases the potential of our long-term mutual fund operations. We report these operations in our International Asset Management and Accumulation segment.

Dispositions

        We entered into disposition agreements or disposed of the following businesses, among others, during the past three years:

        Principal Dental Services, Inc.    Effective July 1, 2006, we sold five dental offices which were substantially all of the assets of Dental Net Group, one component of Principal Dental Services, Inc. The realized gain was reported in our Life and Health segment.

        ING/Principal Pensions Company Ltd.    On May 26, 2005, we announced jointly with our partner, ING, the intent to liquidate the ING/Principal Pensions Company, Ltd. operation in Japan. On December 20, 2005, the liquidation process was completed with a formal liquidation filing to the Japanese corporate registry. The results of ING/Principal Pensions Company Ltd. were reported in our International Asset Management and Accumulation segment.

        Real Estate Investments.    In 2005 and 2006, we sold certain real estate properties previously held for investment purposes. These properties qualify for discontinued operations treatment; therefore, the income from discontinued operations has been removed from our results of continuing operations for all periods presented. The gains on disposal are reported as other after-tax adjustments in our Corporate and Other segment. All assets, including cash, and liabilities of the discontinued operations have been reclassified to separate discontinued asset and liability line items on the consolidated statements of financial position. We have separately disclosed the operating, investing and financing portions of the cash flows attributable to our discontinued operations in our consolidated statements of cash flows.

        The properties were sold to take advantage of positive real estate market conditions in specific geographic locations and to further diversify our real estate portfolio.

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        Selected financial information for the discontinued operations related to our real estate investments is as follows:

 
  December 31,
 
  2006
  2005
 
  (in millions)

Assets            
Real estate   $   $ 99.3
All other assets         3.9
   
 
  Total assets   $   $ 103.2
   
 

Liabilities

 

 

 

 

 

 
All other liabilities   $   $ 4.5
   
 
  Total liabilities   $   $ 4.5
   
 
 
  For the year ended December 31,
 
  2006
  2005
  2004
 
  (in millions)

Total revenues   $ (0.5 ) $ 2.8   $ 2.5
   
 
 
Income from discontinued operations:                  
  Income (loss) before income taxes   $ (0.5 ) $ 2.8   $ 2.5
  Income taxes (benefits)     (0.2 )   1.0     0.9
  Gain on disposal of discontinued operations     47.5     34.3    
  Income taxes on disposal     16.6     12.0    
   
 
 
Net income   $ 30.6   $ 24.1   $ 1.6
   
 
 

        Principal International Argentina S.A.    On July 2, 2004, we closed the sale of PI Argentina, our subsidiary in Argentina, and its wholly owned subsidiaries, Principal Life Compañía de Seguros, S.A. and Principal Retiro Compañía de Seguros de Retiro, S.A. Our total after-tax proceeds from the sale were approximately U.S. $29.2 million.

        The decision to sell PI Argentina was made with a view toward focusing our resources, executing in core strategic priorities and markets and meeting stockholders expectations. Changing market dynamics since the 2001 economic crisis in Argentina led us to conclude that the interests of our stockholders would best be served by our exit of this market.

        PI Argentina qualified for discontinued operations treatment, therefore, the income from discontinued operations has been removed from our results of continuing operations and segment operating earnings for all periods presented in our International Asset Management and Accumulation segment. We have separately disclosed the operating, investing and financing portions of the cash flows attributable to our discontinued operations in our consolidated statements of cash flows.

        Selected financial information for the discontinued operations of PI Argentina is as follows:

 
  For the year ended December 31,
 
 
  2006
  2005
  2004
 
 
  (in millions)

 
Total revenues   $   $   $ 5.8  
   
 
 
 
Income from discontinued operations:                    
  Income before income taxes(1)   $   $   $ 0.3  
  Income taxes(1)             0.1  
  Loss on disposal of discontinued operations             (15.9 )
  Income tax benefits on disposal             (25.7 )
   
 
 
 
Net income   $   $   $ 10.0  
   
 
 
 

(1)
The 2004 summary results of operations information is for the six months ended prior to the July 2, 2004, sale of PI Argentina and, accordingly, there is no statement of operations data to present subsequent to the date of the sale.

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        Principal Residential Mortgage, Inc.    On July 1, 2004, we closed the sale of Principal Residential Mortgage, Inc. to CitiMortgage, Inc. Our total after-tax proceeds from the sale were approximately $620.0 million. Our Mortgage Banking segment, which includes Principal Residential Mortgage, Inc., is accounted for as a discontinued operation, and therefore, the income from discontinued operations (excluding corporate overhead) has been removed from our results of continuing operations and segment operating earnings for all periods presented. We have separately disclosed the operating, investing and financing portions of the cash flows attributable to our discontinued operations in our consolidated statements of cash flows. Corporate overhead allocated to our Mortgage Banking segment does not qualify for discontinued operations treatment and is included in our results of continuing operations and segment operating earnings for all periods prior to July 1, 2004.

        The decision to sell Principal Residential Mortgage, Inc. was made with a view toward intensifying our strategic focus on our core retirement and risk protection business as well as achieving our longer-term financial objectives. In addition, the sale was also viewed as a positive move for our stockholders as it allows us to move forward from an improved capital position, with better financial flexibility and greater stability of earnings.

        Selected financial information for the discontinued operations of our Mortgage Banking segment is as follows:

 
  For the year ended December 31,
 
 
  2006
  2005
  2004
 
 
  (in millions)

 
Total revenues   $   $   $ 446.1  
   
 
 
 
Loss from continuing operations, net of related income taxes (represents corporate overhead)   $   $   $ (10.3 )
Income (loss) from discontinued operations                    
  Income before income taxes             48.3  
  Income taxes             18.3  
  Gain (loss) on disposal of discontinued operations         (1.7 )   134.7  
  Income taxes relating to the disposal of discontinued operations         3.3     42.4  
   
 
 
 
  Income (loss) from discontinued operations, net of related income taxes         (5.0 )   122.3  
   
 
 
 
Net income (loss)   $   $ (5.0 ) $ 112.0  
   
 
 
 

(1)
The 2004 summary results of operations information is for the six months ended prior to the July 1, 2004, sale of Principal Residential Mortgage, Inc. and, accordingly, there is no statement of operations data to present subsequent to the date of the sale.

        Our U.S. Asset Management and Accumulation segment held residential mortgage banking escrow deposits (reported as other liabilities) as of December 31, 2003. The purchaser (or acquirer) closed out the banking escrow deposit accounts as a result of the sale. U.S. Asset Management and Accumulation total revenues from this arrangement reclassified to discontinued operations for the year ended December 31, 2004 was $(5.6) million. Loss from discontinued operations net of related income taxes, for the year ended December 31, 2004, was $3.5 million.

        BT Financial Group.    On October 31, 2002, we sold substantially all of BT Financial Group to Westpac. Our total after-tax proceeds from the sale were approximately U.S. $900.0 million. This amount includes cash proceeds from Westpac, tax benefits and a gain from unwinding the hedged asset associated with our investment in BT Financial Group.

        The decision to sell BT Financial Group was made with a view toward focusing our resources, executing on core strategic priorities and meeting stockholder expectations. Changing market dynamics since our acquisition of BT Financial Group, including industry consolidation, led us to conclude that the interests of BT Financial Group clients and staff would be best served under Westpac's ownership.

        Changes to the loss on discontinued operations due to the close of a tax audit resulted in an increase to net income of $8.4 million in 2005. We have separately disclosed the operating, investing and financing portions of the cash flows attributable to our discontinued operations in our consolidated statements of cash flows.

Other

        Principal Reinsurance Company of Vermont.    In November 2006, Principal Life established a wholly owned reinsurance subsidiary, Principal Reinsurance Company of Vermont, which reinsures a portion of our universal life "secondary" or "no-lapse" guarantee provisions through an intercompany reinsurance agreement with Principal Life. The transaction, which was accompanied with a third party letter of credit issued to PVT and guaranteed by PFG, reduced our statutory capital requirements and allowed us to redeploy capital for other general corporate purposes.

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        Senior Note Issuance.    On October 16 and December 5, 2006, we issued $500.0 million and $100.0 million, respectively, of senior notes from our shelf registration, which was filed with the SEC in December 2003. The notes will bear interest at a rate of 6.05% per year. Interest on the notes is payable semi-annually on April 15 and October 15, beginning on April 15, 2007. The notes will mature on October 15, 2036. A portion of the proceeds was used to fund the acquisition of WM Advisors, Inc., with the remaining proceeds being used for general corporate purposes.

        SBB Mutual Berhad and SBB Asset Management Sdn Bhd.    On October 30, 2006, our joint venture company in Malaysia, CIMB-Principal, announced its intention to purchase the mutual fund and asset management companies of the former Southern Bank Bhd ("SBB"), SBB Mutual Berhad and SBB Asset Management Sdn Bhd. On February 5, 2007, we invested an additional RM$192.4 million Malaysian ringgits ("RM$") (approximately U.S. $55.1 million) to retain our 40% ownership interest in the larger CIMB-Principal.

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 but have not had a material impact on our consolidated income from continuing operations. Our consolidated income from continuing operations was positively impacted $5.4 million, $7.1 million and $1.7 million for the years ended December 31, 2006, 2005, and 2004 respectively as a result of fluctuations in foreign currency to U.S. dollar exchange rates. For a discussion of our approaches to foreign currency exchange rate risk, see Item 7A. "Quantitative and Qualitative Disclosures about Market Risk."

Stock-Based Compensation Plans

        As of December 31, 2006, we have the 2005 Stock Incentive Plan, the Employee Stock Purchase Plan, the 2005 Directors Stock Plan, the Stock Incentive Plan, the Directors Stock Plan and the Long-Term Performance Plan ("Stock-Based Compensation Plans"). As of May 17, 2005, no new grants will be made under the Stock Incentive Plan, the Directors Stock Plan or the Long-Term Performance Plan. Under the terms of the 2005 Stock Incentive Plan, grants may be nonqualified stock options, incentive stock options qualifying under Section 422 of the Internal Revenue Code, restricted stock, restricted stock units, stock appreciation rights, performance shares, performance units, or other stock based awards. The 2005 Directors Stock Plan provides for the grant of nonqualified stock options, restricted stock, restricted stock units, or other stock-based awards to our nonemployee directors. To date, we have not granted any incentive stock options, restricted stock or performance units.

        The compensation cost that was charged against income for the Stock-Based Compensation Plans was $65.5 million, $52.2 million and $47.5 million, and the related income tax benefit recognized in the income statement was $21.3 million, $16.9 million and $15.1 million for the years ended December 31, 2006, 2005 and 2004, respectively. For awards with graded vesting, we use an accelerated expense attribution method. The total compensation cost capitalized as part of the cost of an asset was $3.4 million, $1.6 million and $2.6 million for the years ended December 31, 2006, 2005 and 2004, respectively.

        Beginning in 2006, we granted performance share awards to certain employees under the 2005 Stock Incentive Plan. The performance share awards are treated as an equity award and are paid in shares. Whether the performance shares are earned depends upon the participant's continued employment through the performance period (except in the case of an approved retirement) and our performance against three-year goals set at the beginning of the performance period. A return on equity objective and an earnings per share objective must be achieved for any of the performance shares to be earned. If the performance requirements are not met, the performance shares will be forfeited and no compensation cost is recognized and any previously recognized compensation cost is reversed. There is no maximum contractual term on these awards.

        The total compensation cost related to nonvested awards not yet recognized is $40.5 million. This compensation cost is expected to be recognized over a weighted average period of approximately 1.8 years.

Pension and 401(k) Benefit Expense

        Effective January 1, 2006, we made changes to our retirement program, including the Principal Select Savings Plan ("401(k)") and the Principal Pension Plan ("Pension Plan") and the corresponding nonqualified plans. The qualified and nonqualified Pension Plans' changes include a reduction to the traditional and cash balance formulas, a change in the early retirement factors, and the removal of the cost of living adjustments for traditional benefits earned after January 1, 2006. The qualified and nonqualified 401(k) Plans' company match increased from 50% of a 6% deferral to 75% of an 8% deferral. The Pension Plan changes reduced the Pension Plan expense in 2006, while the 401(k) changes increased the 401(k) expense.

40



        The 2006 annual pension benefit expense for substantially all of our employees and certain agents was $34.6 million pre-tax, which was a $14.0 million decrease from the 2005 pre-tax pension expense of $48.6 million. This decrease is due to the reduction in the Pension Plan formulas and asset performance in excess of our 8.5% long-term assumption. Partially offsetting this was an increase attributable to the use of a lower discount rate and lower long-term asset return assumption. The discount rate used to develop the 2006 expense was lowered to 5.75%, down from the 6.0% discount rate used to develop the 2005 expense. The long-term asset assumption was also lowered to 8.25%, down from the 8.50% assumption used to develop the 2005 expense. The 2006 decrease in pension expense was offset by an approximately $19.7 million increase in the qualified and nonqualified 401(k) Plans' company matching expense resulting from the January 1, 2006 changes.

        The 2007 annual pension benefit expense for substantially all of our employees and certain agents is expected to be $24.0 million pre-tax, which is a $10.6 million decrease from the 2006 pre-tax pension expense of $34.6 million. This decrease is due to the increase in discount rate and asset performance in excess of our 8.25% assumption. The discount rate used to develop the 2007 expense was raised to 6.15%, up from the 5.75% discount rate used to develop the 2006 expense. The long-term asset assumption remained at 8.25%.

Recent Accounting Changes

        For recent accounting changes, see Item 8. "Financial Statements and Supplementary Data, Notes to Consolidated Financial Statements, Note 1 Nature of Operations and Significant Accounting Policies."

Results of Operations

        The following table presents summary consolidated financial information for the years indicated:

 
  For the year ended December 31,
 
 
  2006
  2005
  2004
 
 
  (in millions)

 
Revenues:                    
  Premiums and other considerations   $ 4,305.3   $ 3,975.0   $ 3,710.0  
  Fees and other revenues     1,902.5     1,717.8     1,491.7  
  Net investment income     3,618.0     3,360.1     3,224.0  
  Net realized/unrealized capital gains (losses)     44.7     (11.2 )   (104.8 )
   
 
 
 
    Total revenues     9,870.5     9,041.7     8,320.9  
Expenses:                    
  Benefits, claims and settlement expenses     5,692.4     5,282.9     4,959.5  
  Dividends to policyholders     290.7     293.0     296.7  
  Operating expenses     2,558.7     2,342.1     2,185.6  
   
 
 
 
    Total expenses     8,541.8     7,918.0     7,441.8  
   
 
 
 
Income from continuing operations before income taxes     1,328.7     1,123.7     879.1  
Income taxes     295.0     232.2     178.2  
   
 
 
 
    Income from continuing operations, net of related income taxes     1,033.7     891.5     700.9  
Income from discontinued operations, net of related income taxes     30.6     27.5     130.4  
   
 
 
 
Income before cumulative effect of accounting changes     1,064.3     919.0     831.3  
Cumulative effect of accounting change, net of related income taxes             (5.7 )
   
 
 
 
Net income     1,064.3     919.0     825.6  
Preferred stock dividends     33.0     17.7      
   
 
 
 
  Net income available to common stockholders   $ 1,031.3   $ 901.3   $ 825.6  
   
 
 
 

        Premiums and other considerations increased $330.3 million, or 8%, to $4,305.3 million for the year ended December 31, 2006, from $3,975.0 million for the year ended December 31, 2005. The increase reflected a $331.6 million increase from the Life and Health segment primarily due to strong sales and stable retention in our specialty benefits business and growth in our health insurance business.

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        Fees and other revenues increased $184.7 million, or 11%, to $1,902.5 million for the year ended December 31, 2006, from $1,717.8 million for the year ended December 31, 2005. U.S. Asset Management and Accumulation fees and other revenues increased $192.1 million primarily related to an increase in account values stemming from continued strong net cash flow and strong performance in the equity markets resulting in an increase in asset management fees.

        Net investment income increased $257.9 million, or 8%, to $3,618.0 million for the year ended December 31, 2006, from $3,360.1 million for the year ended December 31, 2005. The increase was related to a $2,331.9 million, or 4%, increase in average invested assets and cash and to an increase in annualized investment yields. The yield on average invested assets and cash was 6.0% for the year ended December 31, 2006, compared to 5.8% for the year ended December 31, 2005.

        Net realized/unrealized capital gains increased $55.9 million to $44.7 million of net realized/unrealized capital gains for the year ended December 31, 2006, from $11.2 million of net realized/unrealized capital losses for the year ended December 31, 2005. The increase in net realized gains was due to the gain on the sale of stock of an equity method investment ($44.3 million), fewer losses on the mark to market adjustment related to derivatives activities ($15.2 million), the non-recurrence of an impairment of an equity partnership interest ($14.4 million), the recovery of previously impaired securities as the result of a litigation claim received in 2006 ($12.9 million), more gains from the mark to market and sales of activities of equity securities ($12.5 million), fewer losses on credit triggered bond sales ($7.3 million), a software impairment in 2005 with no corresponding activity in 2006 ($5.9 million), and more gains as the result of the mark to market of certain seed money investments ($4.4 million). Offsetting these increases were more other than temporary declines in the value of fixed maturity securities resulting from the determination that we no longer had the ability and intent to hold these securities until recovery due to our need to finance the acquisition of WM Advisors ($12.4 million) and a large recovery of previously impaired securities as the result of a litigation settlement that occurred in 2005 ($52.1 million).

        The following table highlights the contributors to net realized/unrealized capital gains and losses for the year ended December 31, 2006.

 
  For the year ended December 31, 2006
 
 
  Impairments and credit losses
  Other gains
(losses)

  Hedging
adjustments

  Net realized/
unrealized
capital gains (losses)

 
 
  (in millions)

 
Fixed maturity securities(1)   $ (32.1 ) $ 10.0   $ (14.6 ) $ (36.7 )
Fixed maturity securities, trading         1.0         1.0  
Equity securities(2)     1.0     22.4         23.4  
Mortgage loans on real estate(3)     2.4             2.4  
Derivatives             (4.7 )   (4.7 )
Other(4)         64.3     (5.0 )   59.3  
   
 
 
 
 
  Total   $ (28.7 ) $ 97.7   $ (24.3 ) $ 44.7  
   
 
 
 
 

(1)
Impairments include $14.6 million of credit impairment write-downs and $16.5 million in realized credit recoveries on the sale of previously impaired assets. As the result of the need to fund the acquisition of WM Advisors, impairments also include $12.4 million of write-downs that resulted from our determination that we no longer had the ability and intent to hold certain fixed maturity securities until they recovered in value. This loss is net of the recovery realized on the subsequent sale of the securities. Credit losses include $0.6 million in realized gains and $22.2 million in realized losses related to credit triggered sales. Other gains (losses) include $5.9 million in net gains as the result of prepayment activity, gross realized gains of $12.1 million and gross realized losses of $8.0 million. Included in the gross realized losses of $8.0 million is $6.3 million that resulted from the sale of certain hybrid securities that had a regulatory classification change that resulted in increased capital requirements.

(2)
Impairments include $1.0 million in realized recoveries on sale of previously impaired assets. Other gains (losses) include $21.8 million in mark to market of net realized/unrealized gains on trading equity securities, gross realized gains of $1.4 million and gross realized losses of $0.8 million.

(3)
Impairments include $2.5 million in realized losses due to the sale of commercial mortgage loans, $3.6 million in realized recoveries on the sale of previously impaired commercial mortgage loans, a $2.1 million decrease in the commercial mortgage valuation allowance, and a $0.7 million increase in the residential mortgage valuation allowance held by our international operations.

42


(4)
Other gains (losses) include a $44.3 million realized gain on the sale of stock of an equity method investment and $16.2 million in mark to market of net realized/unrealized gains on certain seed money investments.

        Benefits, claims and settlement expenses increased $409.5 million, or 8%, to $5,692.4 million for the year ended December 31, 2006, from $5,282.9 million for the year ended December 31, 2005. The increase was primarily due to a $290.1 million increase from the Life and Health Insurance segment, primarily due to growth in the our specialty benefits and health insurance businesses. The increase also reflected a $130.9 million increase from the U.S. Asset Management and Accumulation segment, primarily due to an increase in cost of interest credited, higher benefit payments, and an increase in reserves stemming from an increase in sales related to our payout annuities with life contingencies.

        Dividends to policyholders decreased $2.3 million, or 1%, to $290.7 million for the year ended December 31, 2006, from $293.0 million for the year ended December 31, 2005. The decrease was due to a $4.1 million decrease from the U.S. Asset Management and Accumulation segment related to our participating pension full-service accumulation products. The lower dividends were primarily due to lower dividend payouts stemming from a lower interest rate environment and a dividend reserve methodology change implemented in the second quarter of 2006. Partially offsetting the decrease was a $1.8 million increase in dividends to policyholders from the Life and Health Insurance segment related to the dividend scale changes effective in February 2006.

        Operating expenses increased $216.6 million, or 9%, to $2,558.7 million for the year ended December 31, 2006, from $2,342.1 million for the year ended December 31, 2005. The increase reflected a $124.7 million increase from the U.S. Asset Management and Accumulation segment, primarily due to increases in staff related costs, management fees paid and DPAC amortization. The increase was also primarily due to a $39.7 million increase from the Life and Health Insurance segment primarily resulting from growth in our specialty benefits and insured medical businesses partially offset by lower DPAC amortization from the individual universal and variable universal life business. In addition, the increase reflected a $36.3 million increase from the Corporate and Other segment, primarily due to a contribution to the Principal Financial Group Foundation, Inc., an increase in interest expense related to issuance of corporate debt, and increased interest expense on federal income tax activities.

        Income taxes increased $62.8 million, or 27%, to $295.0 million for the year ended December 31, 2006, from $232.2 million for the year ended December 31, 2005. The effective income tax rate was 22% for the year ended December 31, 2006, and 21% for the year ended December 31, 2005. The effective income tax rate for the year ended December 31, 2006 was lower than the corporate income tax rate of 35% primarily due to income tax deductions allowed for corporate dividends received, interest exclusion from taxable income, and tax refinements in Mexico and Chile. The effective income tax rate for the year ended December 31, 2005 was lower than the corporate income tax rate of 35% primarily due to income tax deductions allowed for corporate dividends received, tax credits on our investment in a synthetic fuel production facility, and interest exclusion from taxable income.

        As a result of the foregoing factors and the inclusion of income from discontinued operations, net of related income taxes, net income increased $145.3 million, or 16% to $1,064.3 million for the year ended December 31, 2006, from $919.0 million for the year ended December 31, 2005. In 2006, the income from discontinued operations was related to our sale of certain real estate properties previously held for investment purposes. In 2005, the income from discontinued operations was related to gains on the sales and operating revenues of real estate properties that qualify for discontinued operations treatment and changes to the estimated loss on the disposal of BT Financial Group partially offset by the negative impact of a change in the estimated gain from the discontinued operations for Principal Residential Mortgage, Inc.

        Preferred stock dividends increased $15.3 million, or 86%, to $33.0 million for the year ended December 31, 2006, from $17.7 million for the year ended December 31, 2005. The preferred stock dividends increase was a result of issuing preferred stock in June 2005.

        Net income available to common stockholders increased $130.0 million, or 14%, to $1,031.3 million for the year ended December 31, 2006, from $901.3 million for the year ended December 31, 2005.

        Premiums and other considerations increased $265.0 million, or 7%, to $3,975.0 million for the year ended December 31, 2005, from $3,710.0 million for the year ended December 31, 2004. The increase was primarily due to a $170.5 million increase from the Life and Health Insurance segment, primarily related to strong sales and stable persistency in our specialty benefits business and higher premium per member in our health insurance business partially offset by a decline in premiums resulting from the continuation of a shift in marketing emphasis from individual traditional life insurance products to individual universal and variable universal life insurance products. The increase also reflected an $85.1 million increase from the U.S. Asset Management and Accumulation segment, primarily a result of an increase in premiums from single premium group annuities with life contingencies, which are typically used to fund defined benefit pension plan terminations. The premium income we receive from these contracts fluctuates due to the variability in the number and size of pension plan terminations in the market, the interest rate environment and our ability to attract new sales.

43


        Fees and other revenues increased $226.1 million, or 15%, to $1,717.8 million for the year ended December 31, 2005, from $1,491.7 million for the year ended December 31, 2004. The increase was primarily due to a $194.1 million increase from the U.S. Asset Management and Accumulation segment primarily related to an increase in account values and assets under management, modest performance in the equity markets and our acquisitions of Principal Services Trust Company and Columbus Circle.

        Net investment income increased $136.1 million, or 4%, to $3,360.1 million for the year ended December 31, 2005, from $3,224.0 million for the year ended December 31, 2004. The increase was primarily related to a $2,343.2 million, or 4%, increase in average invested assets and cash. The yield on average invested assets and cash was 5.8% for the years ended December 31, 2005 and 2004.

        Net realized/unrealized capital losses decreased $93.6 million, or 89%, to $11.2 million for the year ended December 31, 2005, from $104.8 million for the year ended December 31, 2004. The decrease is due to fewer other than temporary impairments of fixed maturity securities ($90.2 million) including a $52.1 million recovery of previously impaired securities received as the result of a litigation settlement, fewer losses related to the mark to market of derivative activities ($56.8 million), and gains versus losses on mortgage loans and real estate ($24.5 million) offset in part by fewer mark to market gains on certain seed money investments ($30.4 million), fewer gains on the sales of other fixed maturity securities ($13.9 million), more credit losses related to the sales of fixed maturity securities ($23.3 million), and the impairment of an equity partnership interest ($14.4 million).

        The following table highlights the contributors to net realized/unrealized capital gains and losses for the year ended December 31, 2005.

 
  For the year ended December 31, 2005
 
 
  Impairments and credit losses
  Other gains (losses)
  Hedging adjustments
  Net realized/unrealized capital gains (losses)
 
 
  (in millions)

 
Fixed maturity securities(1)   $ 16.6   $ 10.6   $ (45.8 ) $ (18.6 )
Fixed maturity securities, trading         (2.4 )       (2.4 )
Equity securities(2)     (3.0 )   9.9         6.9  
Mortgage loans on real estate(3)     1.3             1.3  
Derivatives             17.2     17.2  
Other(4)     (14.4 )   9.8     (11.0 )   (15.6 )
   
 
 
 
 
  Total   $ 0.5   $ 27.9   $ (39.6 ) $ (11.2 )
   
 
 
 
 

(1)
Impairments include $28.6 million of credit impairment write-downs and $74.0 million in realized credit recoveries on the sale of previously impaired assets. Credit losses include $2.0 million in realized gains and $30.8 million in realized losses related to credit triggered sales. Other gains (losses) include $16.2 million in net gains as the result of prepayment activity, gross realized gains of $21.5 million and gross realized losses of $27.1 million. Included in the $27.1 million of losses is an $11.0 million loss related to a large investment that was called from us in September.

(2)
Impairments include $3.0 million of credit impairment write-downs. Other gains (losses) include $9.3 million in mark to market of net realized/unrealized gains on trading equity securities, gross realized gains of $3.1 million and gross realized losses of $2.5 million.

(3)
Impairments include $6.3 million in realized losses due to the sale of commercial mortgage loans and a $7.6 million decrease in the commercial mortgage valuation allowance.

(4)
Impairments include $14.4 million in realized losses related to an equity partnership interest. Other gains (losses) include $11.8 million in mark to market of net realized/unrealized gains on certain seed money investments.

        Benefits, claims and settlement expenses increased $323.4 million, or 7%, to $5,282.9 million for the year ended December 31, 2005, from $4,959.5 million for the year ended December 31, 2004. The increase was primarily due to a $165.6 million increase from the U.S. Asset Management and Accumulation segment, primarily reflecting the increase in reserves resulting from an increase in sales of single premium group annuities with life contingencies and an increase in interest credited on our investment only block of business stemming from an increase in account values. The increase also reflected a $105.5 million increase from the Life and Health Insurance segment, primarily due to increased claim costs per medical member, an increase in medical members, and growth in the specialty benefits business.

44



        Dividends to policyholders decreased $3.7 million, or 1%, to $293.0 million for the year ended December 31, 2005, from $296.7 million for the year ended December 31, 2004. The decrease was primarily due to a $3.3 million decrease from the Life and Health Insurance segment, resulting from a declining interest rate environment.

        Operating expenses increased $156.5 million, or 7%, to $2,342.1 million for the year ended December 31, 2005, from $2,185.6 million for the year ended December 31, 2004. The increase reflected a $160.4 million increase from the U.S. Asset Management and Accumulation segment, primarily due to growth in our asset management business, an increase in compensation costs and due to our acquisitions of Principal Services Trust Company and Columbus Circle.

        Income taxes increased $54.0 million, or 30%, to $232.2 million for the year ended December 31, 2005, from $178.2 million for the year ended December 31, 2004. The effective income tax rate was 21% for the year ended December 31, 2005, and 20% for the year ended December 31, 2004. The effective income tax rates for the year ended December 31, 2005 and 2004, were lower than the corporate income tax rate of 35% primarily due to income tax deductions allowed for corporate dividends received, tax credits on our investment in a synthetic fuel production facility, and interest exclusion from taxable income.

        As a result of the foregoing factors and the inclusion of income from discontinued operations and the cumulative effect of accounting change, net of related income taxes, net income increased $93.4 million, or 11%, to $919.0 million for the year ended December 31, 2005, from $825.6 million for the year ended December 31, 2004. The income from discontinued operations for the year ended December 31, 2005, was related to gains on the sales and operating revenues of real estate properties that qualify for discontinued operations treatment and changes to the estimated loss on the disposal of BT Financial Group partially offset by the negative impact of a change in the estimated gain from the discontinued operations for Principal Residential Mortgage, Inc. The income from discontinued operations for the year ended December 31, 2004, was related to our sale of Principal Residential Mortgage, Inc., the sale of our Argentine companies, and operating revenues of real estate properties that qualify for discontinued operations treatment. The cumulative effect of accounting change was related to our implementation of Statement of Position 03-1 Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long Duration Contracts and for Separate Accounts in 2004.

        Preferred stock dividends were $17.7 million for the year ended December 31, 2005, with no corresponding activity for the year ended December 31, 2004.

        Net income available to common stockholders increased $75.7 million, or 9%, to $901.3 million for the year ended December 31, 2005, from $825.6 million for the year ended December 31, 2004.

Results of Operations by Segment

        We use segment operating earnings, which exclude the effect of net realized/unrealized capital gains and losses, as adjusted, and other after-tax adjustments, for goal setting, determining employee compensation, and evaluating performance on a basis comparable to that used by securities analysts. Segment operating earnings are determined by adjusting U.S. GAAP net income available to common stockholders for net realized/unrealized capital gains and losses, as adjusted, and other after-tax adjustments we believe are not indicative of overall operating trends. Note that after-tax adjustments have occurred in the past and could recur in future reporting periods. While these items may be significant components in understanding and assessing our consolidated financial performance, we believe the presentation of segment operating earnings enhances the understanding of our results of operations by highlighting earnings attributable to the normal, ongoing operations of our businesses.

45



        The following table presents segment information as of or for the years ended December 31, 2006, 2005 and 2004:

 
  As of or for the year ended December 31,
 
 
  2006
  2005
  2004
 
 
  (in millions)

 
Operating revenues by segment                    
U.S. Asset Management and Accumulation   $ 4,511.6   $ 4,133.8   $ 3,761.6  
International Asset Management and Accumulation     605.4     604.5     518.4  
Life and Health Insurance     4,736.2     4,387.5     4,181.3  
Corporate and Other(1)     (27.4 )   (59.1 )   (23.0 )
   
 
 
 
  Total segment operating revenues     9,825.8     9,066.7     8,438.3  
Add:                    
Net realized/unrealized capital gains (losses), including recognition of front-end fee revenues and certain market value adjustments to fee revenues(2)     44.2     (22.2 )   (114.9 )
Subtract:                    
Operating revenues from discontinued real estate investments     (0.5 )   2.8     2.5  
   
 
 
 
Total revenue per consolidated statements of operations   $ 9,870.5   $ 9,041.7   $ 8,320.9  
   
 
 
 

Operating earnings (loss) by segment, net of related income taxes:

 

 

 

 

 

 

 

 

 

 
U.S. Asset Management and Accumulation   $ 645.1   $ 538.4   $ 499.0  
International Asset Management and Accumulation     71.8     71.0     40.3  
Life and Health Insurance     282.5     274.4     256.2  
Mortgage Banking(3)             (10.3 )
Corporate and Other     (27.3 )   (21.4 )   (20.4 )
   
 
 
 
  Total segment operating earnings, net of related income taxes     972.1     862.4     764.8  
Net realized/unrealized capital gains (losses), as adjusted(2)     18.0     (20.6 )   (62.3 )
Other after-tax adjustments(4)     41.2     59.5     123.1  
   
 
 
 
  Net income available to common stockholders per consolidated statements of operations   $ 1,031.3   $ 901.3   $ 825.6  
   
 
 
 

Assets by segment:

 

 

 

 

 

 

 

 

 

 
U.S. Asset Management and Accumulation(5)   $ 117,950.0   $ 103,506.1   $ 94,394.6  
International Asset Management and Accumulation     8,101.0     6,856.2     3,642.0  
Life and Health Insurance     14,364.5     14,080.2     13,185.4  
Corporate and Other(6)     3,242.6     2,592.9     2,576.1  
   
 
 
 
  Total consolidated assets   $ 143,658.1   $ 127,035.4   $ 113,798.1  
   
 
 
 

(1)
Includes inter-segment eliminations primarily related to internal investment management fee revenues and commission fee revenues paid to U.S. Asset Management and Accumulation agents for selling Life and Health Insurance segment insurance products.

(2)
In addition to sales activity and other than temporary impairments, net realized/unrealized capital gains (losses) include unrealized gains (losses) on mark to market changes in certain seed money investments and investments classified as trading securities, as well as unrealized gains (losses) on certain derivatives. Net realized/unrealized capital gains (losses), as adjusted, are net of income taxes, net realized capital gains and losses distributed, minority interest capital gains and losses, related changes in the amortization pattern of

46


    deferred policy acquisition and sales inducement costs, recognition of front-end fee revenues for sales charges on pension products and services and certain market value adjustments to fee revenues.

 
  For the year ended December 31,
 
 
  2006
  2005
  2004
 
 
  (in millions)

 
Net realized/unrealized capital gains (losses)   $ 44.7   $ (11.2 ) $ (104.8 )
Certain market value adjustments to fee revenues     (1.3 )   (12.1 )   (8.0 )
Recognition of front-end fee revenues     0.8     1.1     (2.1 )
   
 
 
 
  Net realized/unrealized capital gains (losses), including recognition of front-end fee revenues and certain market value adjustments to fee revenues     44.2     (22.2 )   (114.9 )
Amortization of deferred policy acquisition and sales inducement costs related to net realized capital gains (losses)     5.4     (0.7 )   6.2  
Capital gains distributed     (11.8 )   (5.8 )   (4.4 )
Minority interest capital gains     (7.7 )   (2.5 )   (0.3 )
   
 
 
 
  Net realized/unrealized capital gains (losses), including recognition of front-end fee revenues and certain market value adjustments to fee revenues, net of related amortization of deferred policy acquisition costs and sales inducement costs, capital gains distributed, and minority interest capital gains     30.1     (31.2 )   (113.4 )
Income tax effect     (12.1 )   10.6     51.1  
   
 
 
 
  Net realized/unrealized capital gains (losses), as adjusted   $ 18.0   $ (20.6 ) $ (62.3 )
   
 
 
 
(3)
Corporate overhead allocated to our Mortgage Banking segment does not qualify for discontinued operations treatment and was included in our results of continuing operations and segment operating earnings prior to July 1, 2004.

(4)
For the year ended December 31, 2006, other after-tax adjustments of $41.2 million included (1) the positive effects of: income from discontinued operations related to (a) a gain on the sale of a real estate property that qualifies for discontinued operations treatment ($30.9 million) and (b) a favorable court ruling on a contested IRS issue for 1991 and later years ($18.8 million) and (2) the negative effect of a contribution to the Principal Financial Group Foundation, Inc. ($8.5 million). For the year ended December 31, 2005, other after-tax adjustments of $59.5 million included (1) the positive effects of: (a) a release of income tax reserves related to IRS tax matters ($33.8 million); (b) gains on sales of real estate properties that qualify for discontinued operations treatment ($22.3 million) and (c) a change in the estimated loss on disposal of BT Financial Group ($8.4 million) and (2) the negative effect from a change in the estimated gain on disposal of Principal Residential Mortgage, Inc. ($5.0 million). For the year ended December 31, 2004, other after-tax adjustments of $123.1 million included (1) the positive effects of: (a) the discontinued operations and estimated gain on disposal of Principal Residential Mortgage, Inc. ($118.8 million) and (b) the discontinued operations and estimated gain on disposal of our Argentine companies ($10.0 million) and (2) the negative effect from a cumulative change in accounting principle related to the implementation of SOP 03-1 ($5.7 million).

(5)
U.S. Asset Management and Accumulation separate account assets include shares of the Principal Financial Group stock allocated to a separate account, a result of our demutualization. The value of the separate account was $768.4 million, $726.6 million, and $782.8 million at December 31, 2006, 2005, and 2004, respectively. Changes in the fair value of the separate account are reflected in both separate account assets and separate account liabilities.

(6)
Includes inter-segment elimination amounts related to an internal line of credit and internally generated mortgage loans. The Corporate and Other segment managed a revolving line of credit used by other segments. The U.S. Asset Management and Accumulation segment and Life and Health Insurance segment reported mortgage loan assets issued for real estate joint ventures. These mortgage loans were reported as liabilities in the Corporate and Other segment.

U.S. Asset Management and Accumulation Segment

        Our sales of pension, institutional and other asset accumulation products and services in the U.S. have been affected by overall trends in the U.S. retirement services industry, as our customers rely less on defined benefit retirement plans,

47


social security and other government programs. Continuing trends in the work environment include a more mobile workforce and the desire of employers to shift the market risk of retirement investments to employees by offering defined contribution plans rather than defined benefit plans. The graying of the population and recent market volatility are also driving growing interest in products generating stable income during retirement. These trends are increasing the demand for defined contribution pension arrangements such as 401(k) plans, mutual funds, annuities and bank IRAs. The "baby-boom" generation of U.S. workers has reached an age at which saving for retirement is critical and it continues to seek increased retirement savings using additional tax-advantaged investment products for retirement. Considering these trends, asset accumulation account values increased as of December 31, 2006, primarily due to significant additional gross new deposits, solid performance of the equity markets and retention of assets from existing clients. The interest rate environment remained relatively low despite an increase in interest rates that was more pronounced at the shorter durations. The S&P 500 posted a 15.8% total return contributing to a strong increase in total account values and assets under management by the end of 2006.

        The following table provides a summary of U.S. Asset Accumulation account values as of December 31, 2006, 2005 and 2004:

As of

  U.S. Asset Accumulation
Total account values

 
  (in billions)

December 31, 2006   $ 163.3
December 31, 2005     120.3
December 31, 2004     108.6

Asset Management Trends

        Asset management services have been among the most profitable and rapidly growing sectors of the financial services industry, at both the retail and institutional level. We seek to take advantage of current trends, which indicate that both retail and institutional investors embrace specialization, providing increased fees to successful active managers with expertise in specialty and niche areas. We have experienced very good success in winning institutional asset management mandates and expect to see continued growth in this area. Our U.S. third-party assets under management increased $18.0 billion during 2006.

        The following table provides a summary of Principal Global Investors' affiliated and third-party assets under management as of December 31, 2006, 2005 and 2004:

 
  Principal Global Investors
As of

  Affiliated assets
under management

  Third-party assets
under management

  Total assets under management
 
  (in billions)

December 31, 2006   $ 132.3   $ 59.1   $ 191.4
December 31, 2005     103.4     41.1     144.5
December 31, 2004     97.0     29.4     126.4

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        The following table presents certain summary financial data relating to the U.S. Asset Management and Accumulation segment for the years indicated:

 
  For the year ended December 31,
 
 
  2006
  2005
  2004
 
 
  (in millions)
 
Operating Earnings Data:                    
Operating revenues(1):                    
  Premiums and other considerations   $ 462.3   $ 455.2   $ 370.1  
  Fees and other revenues     1,412.5     1,230.9     1,035.9  
  Net investment income     2,636.8     2,447.7     2,355.6  
   
 
 
 
    Total operating revenues     4,511.6     4,133.8     3,761.6  
Expenses:                    
  Benefits, claims and settlement expenses, including dividends to policyholders     2,392.1     2,265.3     2,099.8  
  Operating expenses     1,288.4     1,167.9     1,014.2  
   
 
 
 
    Total expenses     3,680.5     3,433.2     3,114.0  
   
 
 
 
Operating earnings before income taxes     831.1     700.6     647.6  
Income taxes     186.0     162.2     148.6  
   
 
 
 
Operating earnings     645.1     538.4     499.0  
Net realized/unrealized capital losses, as adjusted     (23.1 )   (12.8 )   (97.1 )
Other after-tax adjustments             (5.0 )
   
 
 
 
U.S. GAAP Reported:                    
Net income available to common stockholders   $ 622.0   $ 525.6   $ 396.9  
   
 
 
 

(1)
Excludes net realized/unrealized capital losses and their impact on recognition of front-end fee revenues and certain market value adjustments to fee revenues.

        Premiums and other considerations increased $7.1 million, or 2%, to $462.3 million for the year ended December 31, 2006, from $455.2 million for the year ended December 31, 2005. The increase resulted from a $44.9 million increase in individual payout annuity business primarily due to increased sales from certain distribution channels. Partially offsetting the overall increase was a $37.8 million decrease in full-service payout sales primarily related to single premium group annuities with life contingencies, which are typically used to fund defined benefit plan terminations. The premium income received from these contracts fluctuates due to the variability in the number and size of pension plan terminations, the interest rate environment and the ability to attract new sales.

        Fees and other revenues increased $181.6 million, or 15%, to $1,412.5 million for the year ended December 31, 2006, from $1,230.9 million for the year ended December 31, 2005. Full-service accumulation fees and other revenue increased $98.9 million primarily due to an increase in account values stemming from continued strong net cash flow and strong performance in the equity markets. Principal Global Investors fees and other revenues increased $49.0 million primarily due to continued growth in management fees related to our real estate, fixed income and equity businesses. In addition, our mutual fund fees and other revenue contributed $29.0 million to the segment increase primarily due to higher management fees stemming from an increase in average assets under management and increased sales.

        Net investment income increased $189.1 million, or 8%, to $2,636.8 million for the year ended December 31, 2006, from $2,447.7 million for the year ended December 31, 2005. The increase reflects an increase in the average annualized yield on invested assets and cash, which was 5.9% for the year ended December 31, 2006, compared to 5.7% for the year ended December 31, 2005. In addition, the increase in net investment income resulted from a $1,860.3 million, or 4%, increase in average invested assets and cash for the segment.

        Benefits, claims and settlement expenses, including dividends to policyholders, increased $126.8 million, or 6%, to $2,392.1 million for the year ended December 31, 2006, from $2,265.3 million for the year ended December 31, 2005. The increase primarily resulted from an $82.6 million increase in our individual annuity business due to several factors, including an increase in cost of interest credited, higher benefit payments, and an increase in reserves stemming from an increase in sales related to our payout annuities with life contingencies. In addition, our investment only benefits, claims and settlement expenses increased $68.9 million primarily due to an increase in cost of interest credited on this block of business as a result of an increase in account values and an increase in the rate of interest credited, as a result of market

49



conditions. Partially offsetting the overall increase was a $35.2 million decrease in our full-service payout business as a result of decreased sales of single premium group annuities with life contingencies.

        Operating expenses increased $120.5 million, or 10%, to $1,288.4 million for the year ended December 31, 2006, from $1,167.9 million for the year ended December 31, 2005. The increase primarily resulted from a $66.1 million increase in our full-service accumulation operating expenses due to increases in staff related costs, management fees paid and DPAC amortization. In addition, Principal Global Investors operating expenses increased $27.8 million due to an increase in expenses associated with growth in average assets under management and, to a lesser extent, the fact that expenses associated with the origination of securitized mortgages are now expensed rather than deferred and recognized as a reduction in securitization revenue, as was the case prior to the U.S. Bank joint venture. Furthermore, individual annuity operating expenses increased $15.4 million primarily due to strong growth in our block of business.

        Income taxes increased $23.8 million, or 15%, to $186.0 million for the year ended December 31, 2006, from $162.2 million for the year ended December 31, 2005. The effective income tax rate for this segment was 22% for the year ended December 31, 2006, and 23% for the year ended December 31, 2005. The effective income tax rates for the years ended December 31, 2006 and 2005, were lower than the corporate income tax rate of 35%, as a result of income tax deductions allowed for corporate dividends received and interest exclusion from taxable income.

        As a result of the foregoing factors, operating earnings increased $106.7 million, or 20%, to $645.1 million for the year ended December 31, 2006, from $538.4 million for the year ended December 31, 2005.

        Net realized/unrealized capital losses, as adjusted, increased $10.3 million, or 80%, to $23.1 million for the year ended December 31, 2006, from $12.8 million for the year ended December 31, 2005. The increase in net realized losses was due to a $24.3 million recovery of previously impaired securities in 2005 as the result of litigation. In addition, the increase was due to fewer gains on commercial mortgages offset by fewer mark to market losses related to derivatives activities, the recovery of previously impaired securities as the result of a litigation claim received in 2006, more gains from the mark to market and sales activities of equity securities, and fewer other than temporary declines in the value of certain fixed maturity securities.

        As a result of the foregoing factors net income available to common stockholders increased $96.4 million, or 18%, to $622.0 million for the year ended December 31, 2006, from $525.6 million for the year ended December 31, 2005.

        Premiums and other considerations increased $85.1 million, or 23%, to $455.2 million for the year ended December 31, 2005, from $370.1 million for the year ended December 31, 2004. The increase primarily resulted from a $61.2 million increase in full-service payout sales of single premium group annuities with life contingencies, which are typically used to fund defined benefit plan terminations. The premium income received from these contracts fluctuates due to the variability in the number and size of pension plan terminations, the interest rate environment and the ability to attract new sales. In addition, individual fixed annuity premiums and other considerations increased $23.9 million due to increased sales from certain distribution channels and due to higher sales of larger sized contracts in 2005.

        Fees and other revenues increased $195.0 million, or 19%, to $1,230.9 million for the year ended December 31, 2005, from $1,035.9 million for the year ended December 31, 2004. Full-service accumulation fees and other revenues increased $118.3 million primarily due to continued strong net cash flow, modest performance in the equity markets and our acquisition of Principal Services Trust Company. Also contributing to the overall increase was a $69.4 million increase in Principal Global Investors fees and other revenues, which was primarily due to our acquisition of Columbus Circle, higher real estate transaction fees, an increase in assets under management and an increase in loans securitized in 2005.

        Net investment income increased $92.1 million, or 4%, to $2,447.7 million for the year ended December 31, 2005, from $2,355.6 million for the year ended December 31, 2004. The increase reflects a $1,749.6 million, or 4%, increase in average invested assets and cash for the segment. The average annualized yield on invested assets and cash was 5.7% for the years ended December 31, 2005 and 2004.

        Benefits, claims and settlement expenses, including dividends to policyholders, increased $165.5 million, or 8%, to $2,265.3 million for the year ended December 31, 2005, from $2,099.8 million for the year ended December 31, 2004. The increase primarily resulted from a $73.4 million increase in our full-service payout business as a result of increased sales of single premium group annuities with life contingencies. Also contributing to the increase was a $68.5 million increase in investment-only business due primarily to an increase in interest credited on this block of business stemming from higher account values. In addition, individual annuity benefits, claims and settlement expenses increased $56.3 million primarily due to an increase in cost of interest credited and amortization related to sale inducements associated with our deferred annuity business, higher benefit payments and an increase in reserves stemming from an increase in sales related to our life payout annuity business. Partially offsetting the overall increase was a $32.3 million decrease in full-service accumulation benefits, claims and settlement expenses primarily due to lower interest credited on our non-participating deposit type business and, to a lesser extent decreases in cost of interest credited on our participating block.

        Operating expenses increased $153.7 million, or 15%, to $1,167.9 million for the year ended December 31, 2005, from $1,014.2 million for the year ended December 31, 2004. The increase primarily resulted from a $92.4 million

50



increase in full-service accumulation operating expenses due to our acquisition of Principal Services Trust Company, an increase in compensation costs and an increase in amortization of DPAC in 2005. In addition, Principal Global Investors operating expenses increased $46.1 million primarily due to our acquisition of Columbus Circle, growth in existing operations and an increase in allocated expenses.

        Income taxes increased $13.6 million, or 9%, to $162.2 million for the year ended December 31, 2005, from $148.6 million for the year ended December 31, 2004. The effective income tax rate for this segment was 23% for the years ended December 31, 2005 and 2004. The effective income tax rates for the years ended December 31, 2005 and 2004, were lower than the corporate income tax rate of 35%, as a result of income tax deductions allowed for corporate dividends received and interest exclusion from taxable income.

        As a result of the foregoing factors, operating earnings increased $39.4 million, or 8%, to $538.4 million for the year ended December 31, 2005, from $499.0 million for the year ended December 31, 2004.

        Net realized/unrealized capital losses, as adjusted, decreased $84.3 million, or 87%, to $12.8 million for the year ended December 31, 2005, from $97.1 million for the year ended December 31, 2004. The decrease is due to fewer other than temporary impairments of fixed maturity securities including a $24.3 million recovery of previously impaired securities received as the result of a litigation settlement, fewer losses related to the mark to market of derivative activities, and gains versus losses on mortgage loans offset in part by losses versus gains on the sale of fixed maturity securities.

        As a result of the foregoing factors and the inclusion of other after-tax adjustments net income available to common stockholders increased $128.7 million, or 32%, to $525.6 million for the year ended December 31, 2005, from $396.9 million for the year ended December 31, 2004. For the year ended December 31, 2004, net income available to common stockholders included the negative effect of other after-tax adjustments totaling $5.0 million related to: (1) a loss from discontinued operations associated with the sale of Principal Residential Mortgage, Inc. ($3.5 million) and (2) a cumulative effect of accounting change due to our implementation of SOP 03-1 ($1.5 million).

International Asset Management and Accumulation Segment

        Our international asset management and accumulation businesses focus on countries with a trend toward private sector defined contribution pension systems, including privatization of public retirement pension systems. With variations depending upon the specific country, we have targeted these markets for sales of retirement and related products and services, including defined contribution pension plans, annuities and long-term mutual funds to businesses and individuals. In some of our international markets, we complement our sales of these products with sales of life insurance products.

        We have pursued our international strategy through a combination of start-ups, acquisitions and joint ventures, which require infusions of capital consistent with our strategy of long-term growth and profitability.

        The following table provides a summary of our international asset management and accumulation business's assets under management as of December 31, 2006, 2005 and 2004:

As of

  Principal International
Total assets under management

 
  (in billions)

December 31, 2006   $ 19.1
December 31, 2005     15.4
December 31, 2004     10.2

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        The following table presents certain summary financial data of the International Asset Management and Accumulation segment for the years indicated:

 
  For the year ended December 31,
 
  2006
  2005
  2004
 
  (in millions)
Operating Earnings Data:                  
Operating revenues(1):                  
  Premiums and other considerations   $ 239.1   $ 247.6   $ 241.0
  Fees and other revenues     114.0     109.2     85.9
  Net investment income     252.3     247.7     191.5
   
 
 
    Total operating revenues     605.4     604.5     518.4
Expenses:                  
  Benefits, claims and settlement expenses     399.1     409.3     357.3
  Operating expenses     144.5     128.7     112.2
   
 
 
    Total expenses     543.6     538.0     469.5
   
 
 
Operating earnings before income taxes     61.8     66.5     48.9
Income taxes (benefits)     (10.0 )   (4.5 )   8.6
   
 
 
Operating earnings     71.8     71.0     40.3
Net realized/unrealized capital gains, as adjusted     10.3     8.1     17.3
Other after-tax adjustments             6.7
   
 
 
U.S. GAAP Reported:                  
Net income available to common stockholders   $ 82.1   $ 79.1   $ 64.3
   
 
 

(1)
Excludes net realized/unrealized capital gains.

        Premiums and other considerations decreased $8.5 million, or 3%, to $239.1 million for the year ended December 31, 2006, from $247.6 million for the year ended December 31, 2005. The decrease primarily resulted from a $19.5 million decrease in Mexico and Chile due to decreased sales of single premium annuities with life contingencies. Partially offsetting this decrease was an $11.0 million increase in Chile due to the strengthening of the peso versus the U.S. dollar.

        Fees and other revenues increased $4.8 million, or 4%, to $114.0 million for the year ended December 31, 2006, from $109.2 million for the year ended December 31, 2005. Fees and other revenues in India and Hong Kong increased $4.8 million and $4.1 million, respectively,due to an increase in fees from growth in assets under management. In addition, fees and other revenues in Chile increased $2.2 million primarily due to growth in assets under management and increased fees from universal life insurance. Partially offsetting the increase was a $5.5 million decrease in Mexico primarily due to a refinement of accrued fee income in 2005.

        Net investment income increased $4.6 million, or 2%, to $252.3 million for the year ended December 31, 2006, from $247.7 million for the year ended December 31, 2005. The increase was primarily due to an increase of $367.8 million, or 14%, in average invested assets and cash, excluding our equity method investments, the strengthening of the Chilean peso and Brazilian real versus the U.S. dollar, and higher earnings from our equity method investments. Partially offsetting the increase was a decrease in the annualized yield on average invested assets and cash, excluding our equity method investments, which was 7.1% for the year ended December 31, 2006, compared to 8.5% for the year ended December 31, 2005.

        Benefits, claims and settlement expenses decreased $10.2 million, or 2%, to $399.1 million for the year ended December 31, 2006, from $409.3 million for the year ended December 31, 2005. The decrease primarily resulted from a $23.2 million decrease in Chile as a result of lower interest credited to customers. In addition, the decrease in reserves of $4.4 million in Mexico was a result of decreased sales of single premium annuities with life contingencies. Partially offsetting this decrease is an increase of $17.5 million due to the strengthening of the Chilean peso versus U.S. dollar.

        Operating expenses increased $15.8 million, or 12%, to $144.5 million for the year ended December 31, 2006, from $128.7 million for the year ended December 31, 2005. The increase was primarily due to a $5.4 million increase in India due to higher compensation costs in the asset management company coupled with costs from PPIAC. Hong Kong operating expenses increased $2.9 million primarily due to increased incentive compensation costs, commission expenses,

52



and occupancy costs. Mexico operating expenses increased $1.7 million due to increased amortization related to a refinement of present value of future profits ("PVFP"), higher professional fees expenses and sales compensation in 2006. In addition, Chile operating expenses increased $1.5 million primarily due to increased compensation costs.

        Income tax benefits increased $5.5 million to $10.0 million for the year ended December 31, 2006, from $4.5 million for the year ended December 31, 2005. The increase in income tax benefits was primarily due to tax refinements in Mexico and Chile. The increase was partially offset due to a tax benefit associated with the liquidation of the Japan joint venture in 2005 and the benefit from the American Jobs Creation Act in 2005 at International headquarters.

        As a result of the foregoing factors, operating earnings increased $0.8 million, or 1%, to $71.8 million for the year ended December 31, 2006, from $71.0 million for the year ended December 31, 2005.

        Net realized/unrealized capital gains, as adjusted, increased $2.2 million, or 27%, to $10.3 million for the year ended December 31, 2006, from $8.1 million for the year ended December 31, 2005. The increase was primarily related to a $1.3 million increase in Mexico due to realized gains on fixed maturity securities. In addition, net realized/unrealized capital gains, as adjusted, increased $0.8 million in Chile. Unrealized gains on trading fixed maturities were partially offset by mark-to-market losses in 2006 on derivatives that are held to more effectively match the invested asset portfolio to our policyholder liability risks.

        As a result of the foregoing factors net income available to common stockholders increased $3.0 million, or 4%, to $82.1 million for the year ended December 31, 2006, from $79.1 million for the year ended December 31, 2005.

        Premiums and other considerations increased $6.6 million, or 3%, to $247.6 million for the year ended December 31, 2005, from $241.0 million for the year ended December 31, 2004. The increase primarily resulted from an $18.4 million increase in Chile and Mexico due to the strengthening of the peso versus the U.S. dollar. Partially offsetting this increase was a $10.6 million decrease in Chile due to decreased sales of single premium annuities with life contingencies.

        Fees and other revenues increased $23.3 million, or 27%, to $109.2 million for the year ended December 31, 2005, from $85.9 million for the year ended December 31, 2004. The increase was primarily due to a $15.3 million increase in Mexico resulting from a refinement of accrued fee income, improved net transfers of pension customers from competitors, and the strengthening of the peso versus the U.S. dollar. Futhermore, fees and other revenue in India increased $3.4 million due to an increase in fees from PPIAC that began operations in February 2005 and an increase in fees from growth in assets under management. In addition, fees and other revenue in Chile increased $3.3 million primarily due to an increase in mortgage loan servicing revenue, increased fees caused by growth in assets under management and the strengthening of the peso.

        Net investment income increased $56.2 million, or 29%, to $247.7 million for the year ended December 31, 2005, from $191.5 million for the year ended December 31, 2004. The increase was primarily due to an increase of $473.5 million, or 22%, in average invested assets and cash, excluding our equity investments in subsidiaries. In addition, the increase was related to an increase in the annualized yield on average invested assets and cash, excluding our equity investments in subsidiaries, which was 8.5% for the year ended December 31, 2005, compared to 8.1% for the year ended December 31, 2004.

        Benefits, claims and settlement expenses increased $52.0 million, or 15%, to $409.3 million for the year ended December 31, 2005, from $357.3 million for the year ended December 31, 2004. The increase primarily resulted from a $54.5 million increase in Chile, the result of the strengthening of the peso versus the U.S. dollar, and higher interest credited to customers partially offset by a lower change in reserves due to a decrease in sales of single premium annuities with life contingencies in 2005.

        Operating expenses increased $16.5 million, or 15%, to $128.7 million for the year ended December 31, 2005, from $112.2 million for the year ended December 31, 2004. The increase was primarily due to a $4.3 million increase in Chile and Mexico resulting from strengthening of the peso versus the U.S. dollar. In addition, Mexico operating expenses increased $3.0 million due to increased marketing efforts and asset retention training for agents and employees. Furthermore, Chile operating expenses increased $2.2 million due to the impact of an impairment of PVFP stemming from declining interest rates. Also, India operating expenses increased $2.3 million due to higher compensation costs in the asset management company coupled with costs from PPIAC, which started operations in February 2005. Finally, Hong Kong operating expenses increased $2.1 million primarily due to increased costs related to consolidation of our mutual fund products, marketing costs, and compensation costs as well as DPAC unlocking.

        Income tax benefits increased $13.1 million to an income tax benefit of $4.5 million for the year ended December 31, 2005, from income tax expense of $8.6 million for the year ended December 31, 2004. A decrease of $8.9 million in Japan was primarily due to a tax benefit associated with the liquidation of the business in 2005. A decrease of $7.3 million at corporate headquarters was due to the benefit from the American Jobs Creation Act in 2005 and foreign dividend activity that generated tax expense in 2004.

53



        As a result of the foregoing factors, operating earnings increased $30.7 million, or 76%, to $71.0 million for the year ended December 31, 2005, from $40.3 million for the year ended December 31, 2004.

        Net realized/unrealized capital gains, as adjusted, decreased $9.2 million, or 53%, to $8.1 million for the year ended December 31, 2005, from $17.3 million for the year ended December 31, 2004. The decrease was primarily related to a $4.7 million decrease in Chile due to lower realized gains on derivatives that are held to more effectively match the invested asset portfolio to our policyholder liability risks. In addition, India net realized/unrealized capital gains, as adjusted, decreased $2.4 million due to a realized gain in 2004 on recovery of a previously impaired debt security.

        As a result of the foregoing factors and the inclusion of other after-tax adjustments, net income available to common stockholders increased $14.8 million, or 23%, to $79.1 million for the year ended December 31, 2005, from $64.3 million for the year ended December 31, 2004. For the year ended December 31, 2004, net income included the positive effect of other after-tax adjustments totaling $6.7 million, related to: (1) the positive effect of income from discontinued operations related to the sale of our Argentine companies ($10.0 million) and (2) the negative effect of cumulative effect of an accounting change related to the implementation of SOP 03-1 ($3.3 million).

Life and Health Insurance Segment

        Our life insurance premiums have been influenced by both economic and industry trends. In addition, we have continued to shift our marketing emphasis to universal and variable universal life insurance products from traditional life insurance products. Due to this shift in marketing emphasis, premiums related to our traditional life insurance products have declined, while fee revenues from our universal and variable universal life insurance products have grown.

        The following table provides a summary of our individual universal and variable universal life insurance fee revenues and our individual traditional life insurance premiums for the years ended December 31, 2006, 2005 and 2004:

 
  Individual life insurance
 
  Individual universal and variable universal life insurance
   
 
  Individual traditional life insurance
For the year ended

  Fee revenues
  Premiums
 
  (in millions)

December 31, 2006   $ 225.3   $ 624.4
December 31, 2005     212.6     645.2
December 31, 2004     182.8     675.8

        The following table provides a summary of our individual life insurance policyholder liabilities as of December 31, 2006, 2005 and 2004:

 
  Individual life insurance
 
  Individual universal and variable universal life insurance
  Individual traditional life insurance
As of

  Policyholder liabilities(1)
  Policyholder liabilities
 
  (in millions)

December 31, 2006   $ 3,948.6   $ 5,921.5
December 31, 2005     3,493.8     5,955.4
December 31, 2004     2,880.0     6,042.2

(1)
Includes separate account liabilities for policies with variable investment options.

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Health Insurance Trends

        In 2006, we experienced good growth in group medical premium and fees and members due to improved pricing and market focus. While we continue to sell group medical business in 35 states plus the District of Columbia, we have sharpened our focus on 13 states. Premium revenue has grown due to both price and membership increases. The fee-for-service portion of our business had a drop in medical members and fees because of our competitive position in the market. Our fee-for-service offering is available in all 50 states plus the District of Columbia.

        Our health insurance premium and fees for the years ended December 31, 2006, 2005 and 2004 were as follows:

 
  Premium and fees
For the year ended

  Group medical
insurance

  Fee-for-service
 
  (in millions)

December 31, 2006   $ 1,861.4   $ 172.5
December 31, 2005     1,676.5     176.6
December 31, 2004     1,586.9     178.8

        Our covered members as of December 31, 2006, 2005 and 2004 were as follows:

 
  Covered medical members
As of

  Group medical
insurance

  Fee-for-service
 
  (in thousands)

December 31, 2006   642.5   758.0
December 31, 2005   620.1   861.5
December 31, 2004   574.8   986.6

        Premium and fee growth for our specialty benefits insurance business is being driven by growing sales and stable retention. This has been a result of growing and more focused distribution supporting these product lines, increasing focus on marketing products to individuals at employer worksites ("voluntary/worksite"), and the introduction of new products.

        The following table provides a summary of our specialty benefits insurance premium and fees for the years ended December 31, 2006, 2005 and 2004:

 
  Premium and fees
For the year ended

  Group dental and
vision insurance

  Group life
insurance

  Group
disability
insurance

  Individual
disability
insurance

 
  (in millions)

December 31, 2006   $ 496.3   $ 310.4   $ 254.9   $ 141.6
December 31, 2005     434.5     259.9     200.3     130.8
December 31, 2004     383.2     239.1     170.1     113.3

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        The following table presents certain summary financial data relating to the Life and Health Insurance segment for the years indicated:

 
  For the year ended December 31,
 
 
  2006
  2005
  2004
 
 
  (in millions)
 
Operating Earnings Data:                    
Operating revenues(1):                    
  Premiums and other considerations   $ 3,598.7   $ 3,267.1   $ 3,096.6  
  Fees and other revenues     444.2     444.3     421.9  
  Net investment income     693.3     676.1     662.8  
   
 
 
 
    Total operating revenues     4,736.2     4,387.5     4,181.3  
Expenses:                    
  Benefits, claims and settlement expenses     2,910.3     2,620.2     2,514.7  
  Dividends to policyholders     290.3     288.5     291.8  
  Operating expenses     1,110.8     1,066.3     988.7  
   
 
 
 
    Total expenses     4,311.4     3,975.0     3,795.2  
   
 
 
 
Operating earnings before income taxes     424.8     412.5     386.1  
Income taxes     142.3     138.1     129.9  
   
 
 
 
Operating earnings     282.5     274.4     256.2  

Net realized/unrealized capital losses, as adjusted

 

 

(3.4

)

 

(2.3

)

 

(8.9

)
Other after-tax adjustments             (0.9 )
   
 
 
 
U.S. GAAP Reported:                    
Net income available to common stockholders   $ 279.1   $ 272.1   $ 246.4  
   
 
 
 

(1)
Excludes net realized/unrealized capital losses.

        Premiums and other considerations increased $331.6 million, or 10%, to $3,598.7 million for the year ended December 31, 2006, from $3,267.1 million for the year ended December 31, 2005. Health insurance premiums increased $185.8 million, primarily from increased covered medical members and higher premium per member. Specialty benefits insurance premiums increased $180.4 million primarily due to strong sales and stable retention.

        Fees and other revenues decreased $0.1 million to $444.2 million for the year ended December 31, 2006, from $444.3 million for the year ended December 31, 2005. Health insurance fees and other revenues decreased $8.0 million primarily due to a decrease in fee-for-service medical members. In addition, specialty benefits fees and other revenues decreased $2.7 million due to lower dental fees resulting from the sale of the dental offices in June 2006. Partially offsetting the decreases was a $10.6 million increase from our individual life insurance business primarily due to growth in our fee-based universal and variable universal life insurance business.

        Net investment income increased $17.2 million, or 3%, to $693.3 million for the year ended December 31, 2006, from $676.1 million for the year ended December 31, 2005. The increase primarily relates to an increase in the average annualized yield on invested assets and cash and to a $118.3 million, or 1%, increase in average invested assets and cash for the segment. The yield on average invested assets and cash was 6.3% for the year ended December 31, 2006, compared to 6.2% for the year ended December 31, 2005.

        Benefits, claims and settlement expenses increased $290.1 million, or 11%, to $2,910.3 million for the year ended December 31, 2006, from $2,620.2 million for the year ended December 31, 2005. Health insurance benefits, claims and settlement expenses increased $155.1 million primarily due to higher claim costs per member and growth, somewhat offset by reserve refinements. Despite generally lower loss ratios, specialty benefits insurance benefits, claims and settlement expenses increased $115.7 million, primarily due to growth in the business.

        Dividends to policyholders increased $1.8 million, or 1%, to $290.3 million for the year ended December 31, 2006, from $288.5 million for the year ended December 31, 2005. The increase is primarily related to the dividend scale changes effective in February 2006.

        Operating expenses increased $44.5 million, or 4%, to $1,110.8 million for the year ended December 31, 2006, from $1,066.3 million for the year ended December 31, 2005. Specialty benefits insurance operating expenses increased $46.1 million due to growth in the business. Health insurance operating expenses increased $25.5 million, primarily the

56



result of growth in the insured medical business. Partially offsetting these increases was a $27.1 million decrease in the individual life insurance operating expenses primarily due to lower DPAC amortization related to lower single premium sales and changes in claims experience in 2006.

        Income taxes increased $4.2 million, or 3%, to $142.3 million for the year ended December 31, 2006, from $138.1 million for the year ended December 31, 2005. The effective income tax rate for the segment was 33% for the years ended December 31, 2006 and 2005. The effective income tax rates for the years ended December 31, 2006 and 2005, were lower than the corporate income tax rate of 35% primarily due to interest exclusion from taxable income.

        As a result of the foregoing factors, operating earnings increased $8.1 million, or 3%, to $282.5 million for the year ended December 31, 2006, from $274.4 million for the year ended December 31, 2005.

        Net realized/unrealized capital losses, as adjusted, increased $1.1 million, or 48%, to $3.4 million for the year ended December 31, 2006, from $2.3 million for the year ended December 31, 2005. The increase primarily resulted from increased impairments in 2006 as the result of a change in our ability and intent to hold certain fixed maturity securities until recovery due to the need to fund our acquisition of WM Advisors, a $7.5 million recovery of previously impaired securities received in 2005 related to a litigation settlement, and more losses related to derivative activities. These increases were partially offset by gains in 2006 versus losses in 2005 on the sale and call activity of fixed maturity securities, a software impairment in 2005 with no corresponding activity in 2006, the recovery of previously impaired securities as the result of a litigation claim received in 2006, and increased DPAC amortization associated with losses on invested assets.

        As a result of the foregoing factors, net income available to common stockholders increased $7.0 million, or 3%, to $279.1 million for the year ended December 31, 2006, from $272.1 million for the year ended December 31, 2005.

        Premiums and other considerations increased $170.5 million, or 6%, to $3,267.1 million for the year ended December 31, 2005, from $3,096.6 million for the year ended December 31, 2004. Specialty benefits insurance premiums increased $119.5 million primarily due to strong sales and steady retention. Health insurance premiums increased $94.9 million, primarily resulting from higher premium per member and an increase in average insured medical members. Partially offsetting these increases was a decrease of $43.9 million in individual life insurance premiums, primarily a result of the continuation of a shift in marketing emphasis to universal and variable universal life insurance products from traditional life insurance products and an increase in ceded reinsurance premium. Unlike traditional premium-based products, individual universal and variable universal life insurance premiums are not reported as U.S. GAAP revenue.

        Fees and other revenues increased $22.4 million, or 5%, to $444.3 million for the year ended December 31, 2005, from $421.9 million for the year ended December 31, 2004. Fee revenues from our individual life insurance business increased $30.0 million, primarily due to growth in our fee-based universal and variable universal life insurance business. Fee revenues from our health insurance business decreased $7.9 million, primarily due to a decrease in average fee-for-service medical members.

        Net investment income increased $13.3 million, or 2%, to $676.1 million for the year ended December 31, 2005, from $662.8 million for the year ended December 31, 2004. The increase primarily relates to a $518.4, or 5%, increase in average invested assets and cash for the segment. The increase was partially offset by a decrease in the average annualized yield on invested assets and cash, which was 6.2% for the year ended December 31, 2005, compared to 6.4% for the year ended December 31, 2004. This reflects lower yields on fixed maturity securities and commercial mortgages due in part to a lower interest rate environment.

        Benefits, claims and settlement expenses increased $105.5 million, or 4%, to $2,620.2 million for the year ended December 31, 2005, from $2,514.7 million for the year ended December 31, 2004. Health insurance benefits, claims and settlement expenses increased $66.0 million primarily due to increases in claim costs per member and average members, even though loss ratios decreased. Likewise, despite lower loss ratios, specialty benefits insurance benefits, claims and settlement expenses increased $58.9 million, primarily due to growth in the business.

        Dividends to policyholders decreased $3.3 million, or 1%, to $288.5 million for the year ended December 31, 2005, from $291.8 million for the year ended December 31, 2004. The decrease is primarily related to a decrease in the individual life insurance dividend interest crediting rates resulting from a declining interest rate environment.

        Operating expenses increased $77.6 million, or 8%, to $1,066.3 million for the year ended December 31, 2005, from $988.7 million for the year ended December 31, 2004. Specialty benefits insurance operating expenses increased $45.7 million due to growth in the business. Health insurance operating expenses increased $29.5 million, primarily due to growth in the insured medical and wellness businesses and additional salary and benefit-related expenses.

        Income taxes increased $8.2 million, or 6%, to $138.1 million for the year ended December 31, 2005, from $129.9 million for the year ended December 31, 2004. The effective income tax rate for the segment was 33% for the year ended December 31, 2005 and 34% for the year ended December 31, 2004. The effective income tax rates for the years

57



ended December 31, 2005 and 2004, were lower than the corporate income tax rate of 35% primarily due to the interest exclusion from taxable income.

        As a result of the foregoing factors, operating earnings increased $18.2 million, or 7%, to $274.4 million for the year ended December 31, 2005, from $256.2 million for the year ended December 31, 2004.

        Net realized/unrealized capital losses, as adjusted, decreased $6.6 million, or 74%, to $2.3 million for the year ended December 31, 2005, from $8.9 million for the year ended December 31, 2004. The decrease is due to fewer other than temporary impairments of fixed maturity securities including a $7.5 million recovery of previously impaired securities received as the result of a litigation settlement offset in part by more losses related to the mark to market of derivative activities, a software impairment, and losses versus gains on the sale of fixed maturity securities.

        As a result of the foregoing factors and the inclusion of a 2004 other after-tax adjustment, net income available to common stockholders increased $25.7 million, or 10%, to $272.1 million for the year ended December 31, 2005, from $246.4 million for the year ended December 31, 2004. The other after-tax adjustment for the year ended December 31, 2004, had a negative impact on net income of $0.9 million due to the cumulative effect of accounting change, a result of our implementation of SOP 03-1.

Corporate and Other Segment

        The following table presents certain summary financial data relating to the Corporate and Other segment for the years indicated:

 
  For the year ended December 31,
 
 
  2006
  2005
  2004
 
 
  (in millions)
 
Operating Earnings Data:                    
Operating Revenues(1):                    
  Total operating revenues   $ (27.4 ) $ (59.1 ) $ (23.0 )
Expenses:                    
  Total expenses     (11.4 )   (6.9 )   47.9  
   
 
 
 
Operating loss before income taxes and preferred stock dividends     (16.0 )   (52.2 )   (70.9 )
Income tax benefits     (21.7 )   (48.5 )   (50.5 )
Preferred stock dividends     33.0     17.7      
   
 
 
 
Operating loss     (27.3 )   (21.4 )   (20.4 )
Net realized/unrealized capital gains (losses), as adjusted     34.2     (13.6 )   26.4  
Other after-tax adjustments     41.2     64.5      
   
 
 
 
U.S. GAAP Reported:                    
Net income available to common stockholders   $ 48.1   $ 29.5   $ 6.0  
   
 
 
 

(1)
Excludes net realized/unrealized capital gains (losses).

        Total operating revenues increased $31.7 million, or 54%, to a negative $27.4 million for the year ended December 31, 2006, from a negative $59.1 million for the year ended December 31, 2005. Net investment income increased $35.3 million reflecting an increase in average annualized investment yields as well as a decrease in investment expenses related to a significant variable interest in a coal-based synthetic fuel production facility. The decrease in investment expense from this investment largely corresponds to an increase in income taxes due to fewer estimated synthetic fuel tax credits generated from fuel production. Partially offsetting the increase in total revenues was a decrease of $3.5 million in fee revenue for transitional services provided to CitiMortgage, Inc., in the prior year, related to the sale of Principal Residential Mortgage, Inc., which is mostly offset by a corresponding change in total expense.

        Total expenses decreased $4.5 million, or 65%, to a negative $11.4 million for the year ended December 31, 2006, from a negative $6.9 million for the year ended December 31, 2005. The decrease in total expenses was primarily due to a $9.8 million decrease in interest related to federal income tax activities as well as a $3.4 million decrease in transitional services provided to CitiMortgage, Inc., in the prior year, related to the sale of Principal Residential Mortgage, which is mostly offset in total revenue. The decrease in total expenses was largely offset by $12.2 million increase in interest related to the issuance of corporate debt.

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        Income tax benefits decreased $26.8 million, or 55%, to $21.7 million for the year ended December 31, 2006, from $48.5 million for the year ended December 31, 2005. The decrease was primarily due to a decrease in the estimated synthetic fuel tax credits in 2006, as well as a decrease in operating loss before income taxes and preferred stock dividends.

        Preferred stock dividends increased $15.3 million, or 86%, to $33.0 million for the year ended December 31, 2006, from $17.7 million for the year ended December 31, 2005. The preferred stock dividends were a result of issuing preferred stock in June 2005.

        As a result of the foregoing factors, operating loss increased $5.9 million, or 28%, to $27.3 million for the year ended December 31, 2006, from $21.4 million for the year ended December 31, 2005.

        Net realized/unrealized capital gains, as adjusted, increased $47.8 million to $34.2 million for the year ended December 31, 2006, from $13.6 million net realized/unrealized losses for the year ended December 31, 2005. The increase was primarily due to the gain on sale of stock of an equity method investment, fewer losses on sales of invested assets, and the prior year impairment of an equity partnership interest.

        As a result of the foregoing factors and the inclusion of other after-tax adjustments, net income available to common stockholders increased $18.6 million, or 63%, to $48.1 million for the year ended December 31, 2006, from $29.5 million for the year ended December 31, 2005. For the year ended December 31, 2006, net income included other after-tax adjustments totaling $41.2 million related to positive effects of: (1) gains on sales of real estate properties that qualify for discontinued operations treatment ($30.9 million) (2) a favorable court ruling on contested IRS issues for 1991 and later years ($18.8 million) and the negative effect of a contribution to the Principal Financial Group Foundation, Inc. ($8.5 million).

        Total operating revenues decreased $36.1 million to a negative $59.1 million for the year ended December 31, 2005, from a negative $23.0 million for the year ended December 31, 2004. Net investment income decreased $21.5 million primarily due to the increase in investment expenses related to the acquisition of a significant variable interest in a coal-based synthetic fuel production facility in June 2004. The increase in investment expense from this investment is more than offset by a decrease in income taxes due to synthetic fuel tax credits generated from fuel production. In addition, the decrease in total revenues was partially due to a decrease of $7.7 million in fee revenue for transitional services provided to CitiMortgage, Inc., in the prior year, related to the sale of Principal Residential Mortgage, Inc., which is mostly offset by a corresponding change in total expense. Furthermore, the decrease in total revenues was due to a $5.5 million increase in inter-segment eliminations included in this segment, which was offset by a corresponding change in total expenses.

        Total expenses decreased $54.8 million to a negative $6.9 million for the year ended December 31, 2005, from a positive $47.9 million for the year ended December 31, 2004. The decrease in total expenses was partially due to a $23.0 million decrease in interest related to federal income tax audit activities as well as a $13.5 million decrease in interest related to the reduction of corporate debt. Furthermore, the decrease in total expenses was due to a $7.3 million decrease in transitional services provided to CitiMortgage, Inc., in the prior year, related to the sale of Principal Residential Mortgage, which is mostly offset in total revenue. Further contributing to the overall decrease was a $7.2 million decrease related to a prior year prepayment penalty recognized on the redemption of our surplus notes due 2024. In addition, inter-segment eliminations included in this segment increased $5.5 million, resulting in a decrease in total expenses.

        Income tax benefits decreased $2.0 million, or 4%, to $48.5 million for the year ended December 31, 2005, from $50.5 million for the year ended December 31, 2004. The decrease was primarily due to a decrease in operating loss before income taxes and preferred stock dividends, a change in income tax reserves established for IRS tax matters, as well as a tax benefit associated with the sale of a foreign investment in 2004. Largely offsetting these decreases in income tax benefits are a full year of synthetic fuel tax credits.

        Preferred stock dividends were $17.7 million for the year ended December 31, 2005, with no corresponding activity for the year ended December 31, 2004. The preferred stock dividends were a result of issuing preferred stock in June 2005.

        As a result of the foregoing factors, operating loss increased $1.0 million, or 5%, to $21.4 million for the year ended December 31, 2005, from $20.4 million for the year ended December 31, 2004.

        Net realized/unrealized capital losses, as adjusted, increased $40.0 million to $13.6 million for the year ended December 31, 2005, from $26.4 million net realized/unrealized gains for the year ended December 31, 2004. The increase in net realized/unrealized capital losses was primarily due to less mark to market gains on certain seed money investments, increased losses on sales of invested assets, and the impairment of an equity partnership interest.

        As a result of the foregoing factors and the inclusion of other after-tax adjustments, net income available to common stockholders increased $23.5 million to $29.5 million for the year ended December 31, 2005, from $6.0 million for the

59



year ended December 31, 2004. For the year ended December 31, 2005, net income included the positive effect of other after-tax adjustments totaling $64.5 million related to: (1) a decrease in income tax reserves and associated interest related to IRS tax matters ($42.2 million) and (2) gains on sales of real estate properties that qualify for discontinued operations treatment ($22.3 million).

Liquidity and Capital Resources

        Our legal entity organizational structure has an impact on our ability to meet cash flow needs as an organization. Following is a simplified organizational structure.

GRAPHIC

        Liquidity describes the ability of a company to generate sufficient cash flows to meet the cash requirements of business operations. Our parent holding company, Principal Financial Group, Inc., is a Delaware business corporation, whose assets primarily consist of the outstanding capital stock of its subsidiaries. As a holding company, Principal Financial Group Inc.'s ability to meet cash requirements, including the payments of dividends on common stock and the repurchase of stock, substantially depends upon dividends from subsidiaries, primarily Principal Life.

        The payment of stockholder dividends by Principal Life to its parent company is limited by Iowa laws. Under Iowa laws, Principal Life may pay dividends only from the earned surplus arising from its business and must receive the prior approval of the Insurance Commissioner of the State of Iowa ("the Commissioner") to pay a stockholder dividend if such a stockholder dividend would exceed certain statutory limitations. The current statutory limitation is the greater of:

    10% of Principal Life's statutory policyholder surplus as of the previous year-end; or

    the statutory net gain from operations from the previous calendar year.

        Iowa law gives the Commissioner discretion to disapprove requests for dividends in excess of these limits. Based on this limitation and 2006 statutory results, Principal Life could pay approximately $660.4 million in stockholder dividends in 2007 without exceeding the statutory limitation. Principal Life was able to pay approximately $630.7 million in statutory dividends in 2006 based on its 2005 statutory financial results without being subject to the restrictions on payment of extraordinary stockholder dividends.

        On February 28, 2006, Principal Life declared a common stock dividend to its parent company of up to $625.0 million. The ordinary stockholder dividends paid by Principal Life to its parent company in 2006 were $426.2 million. Principal Life requested and received permission from the Commissioner to pay an extraordinary dividend in the amount of $750.0 million. The extraordinary stockholder dividends paid by Principal Life to its parent in 2006 were $750.0 million.

        On November 2, 2005, Principal Life declared a dividend of up to $300.0 million. Total stockholder dividends paid by Principal Life to its parent company in 2005 were $200.0 million.

        On May 19, 2004, Principal Life declared a dividend of up to $1.2 billion. Total ordinary stockholder dividends paid by Principal Life to its parent company in 2004 were $494.0 million. In March 2004, Principal Life redeemed $200.0 million of its surplus notes at a cost of $207.2 million. Principal Life and the Commissioner have agreed that this $207.2 million will be applied against Principal Life's 2004 ordinary dividend capacity. Principal Life requested and received permission from the Commissioner to pay an extraordinary dividend in the amount of $700.0 million, of which $630.0 million was paid in 2004.

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        Registration Statement.    Although we generate adequate cash flow to meet the needs of our normal operations, periodically the need may arise to issue debt to fund internal expansion, acquisitions, investment opportunities and retirement of existing debt and equity. In December 2003, we filed a shelf registration statement with the Securities and Exchange Commission, which became effective on June 30, 2004. The shelf registration totals $3.0 billion, with the ability to issue debt securities, preferred stock, common stock, warrants, stock purchase contracts and stock purchase units of PFG and trust preferred securities of three subsidiary trusts. If we issue additional securities, we intend to use the proceeds from the sale of the securities for general corporate purposes, including working capital, capital expenditures, investments in subsidiaries, share repurchase, acquisitions and refinancing of debt, including commercial paper and other short-term indebtedness. Principal Financial Services, Inc. unconditionally guarantees our obligations with respect to one or more series of debt securities described in the shelf registration statement.

        Senior Note Issuance.    On October 16 and December 5, 2006, we issued $500.0 million and $100.0 million, respectively, of senior notes from our shelf registration, for net proceeds of $597.5 million. The notes will bear interest at a rate of 6.05% per year. Interest on the notes is payable semi-annually on April 15 and October 15, beginning on April 15, 2007. The notes will mature on October 15, 2036. A portion of the proceeds was used to fund the acquisition of WM Advisors, Inc., with the remaining proceeds being used for general corporate purposes. Following our senior note issuance, we now have the ability to issue up to $1.85 billion of debt securities, preferred stock, common stock, warrants, stock purchase contracts and stock purchase units of PFG and trust preferred securities of three subsidiary trusts, under the shelf registration.

        Preferred Stock Issuances.    On June 16, 2005, we issued 13.0 million shares of non-cumulative perpetual preferred stock under our shelf registration for net proceeds of $542.0 million. Substantially all of the preferred securities proceeds were used to repurchase shares of outstanding common stock.

        Preferred Stock Dividend Restrictions and Payments.    The certificates of designations for the preferred stock restrict the declaration of preferred dividends if we fail to meet specified capital adequacy, net income or stockholders' equity levels. As of December 31, 2006, we have no preferred dividend restrictions.

        On March 30, 2006, June 30, 2006, October 2, 2006, and January 2, 2007, we paid a dividend of $8.3 million, $8.2 million, $8.3 million and $8.2 million, respectively, equal to $1.39 per share on Series A non-cumulative perpetual preferred stock and equal to $0.41 per share on Series B non-cumulative perpetual preferred stock. Dividends were paid to stockholders of record as of March 15, 2006, June 15, 2006, September 14, 2006, and December 14, 2006, respectively.

        On September 30, 2005, and December 30, 2005, we paid a dividend of $9.4 million, and $8.3 million, respectively, equal to $1.59 per share and $1.39 per share, respectively, on Series A non-cumulative perpetual preferred stock and equal to $0.47 per share and $0.41 per share, respectively, on Series B non-cumulative perpetual preferred stock, to stockholders of record as of September 1, 2005, and December 15, 2005, respectively.

        Another source of liquidity is issuance of our common stock. Proceeds from the issuance of our common stock were $66.2 million and $59.9 million in 2006 and 2005, respectively.

        In 2006, we paid $214.7 million in dividends to common stockholders. We paid a dividend of $0.80 per share on December 15, 2006, to stockholders of record as of November 22, 2006. In 2005, we paid $182.2 million, or $0.65 per share, in dividends to common stockholders. In 2004, we paid $166.5 million, or $0.55 per share, in dividends to common stockholders.

        Our Board of Directors has authorized various repurchase programs under which we are allowed to purchase shares of our outstanding common stock. Shares repurchased under these programs are accounted for as treasury stock, carried at cost and reflected as a reduction to stockholders' equity. The repurchases are made in the open market or through privately negotiated transactions, from time to time, depending on market conditions.

        On November 28, 2006, our Board of Directors authorized a repurchase program of up to $250.0 million of our outstanding common stock. As of December 31, 2006, no purchases have been made under this program.

        On May 19, 2006, following our Board of Directors' share repurchase authorization, we entered into an accelerated common stock repurchase agreement with a third party investment bank for an aggregate purchase price of $500.0 million. On this date, we paid $500.0 million and received the initial delivery of 7.7 million common shares, while retaining the right to receive additional common shares depending on the volume weighted average share price of our common stock over the program's duration. The program was completed in November 2006. Under this program, we purchased 9.3 million common shares at an average price of $53.59.

        In November 2005, our Board of Directors authorized a repurchase program of up to $250.0 million of our outstanding common stock. This program was completed in May 2006. Under this program, we acquired 5.1 million shares in the open market at an aggregate cost of $250.0 million in 2006.

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        In June 2005, following our Board of Directors authorization of the repurchase of up to 15.0 million shares of our outstanding common stock, we entered into an accelerated stock repurchase agreement with a third party investment banker for approximately 13.7 million shares of our common stock with an initial payment of $542.3 million. This transaction was subject to a market pricing adjustment provision based on the volume weighted average market price over the execution period, which could be settled in shares or cash. On October 3, 2005, we elected to settle in cash. On November 10, 2005, the transaction was completed for an additional payment of $84.0 million. We do not intend to make further purchases under this program.

        In March 2005, our Board of Directors authorized a repurchase program of up to $250.0 million of our outstanding common stock. This program began after the completion of the May 2004 repurchase program, which authorized the repurchase of up to $700.0 million of our outstanding common stock. Under the May 2004 and March 2005 repurchase programs, we acquired 8.4 million shares in the open market at an aggregate cost of $325.0 million in 2005. Of that amount, $75.0 million was acquired under the May 2004 repurchase program and $250.0 million was acquired under the March 2005 repurchase program. The share repurchase program announced in March 2005 was completed in May 2005.

        Our Board of Directors authorized a repurchase program of up to $700.0 million of our outstanding common stock in May 2004. We acquired 21.7 million common shares in the open market at an aggregate cost of $772.0 million during the year ended December 31, 2004. Of that amount, $625.0 million was acquired under the May 2004 repurchase program and $147.0 million was acquired under the May 2003 repurchase program which was completed in 2004.

        Sources of liquidity also include facilities for short-term and long-term borrowing as needed, arranged through our intermediate holding company, Principal Financial Services Inc. ("PFSI"), and its subsidiaries. See "Contractual Obligations and Commercial Commitments" below.

        Historically, the primary cash flow sources for Principal Life have been premiums from life and health insurance products, pension and annuity deposits, asset management fee revenues, administrative services fee revenues, income from investments, proceeds from the sales or maturity of investments, long-term debt and short-term borrowings. Cash outflows consist primarily of payment of benefits to policyholders and beneficiaries, income and other taxes, current operating expenses, payment of dividends to policyholders, payments in connection with investments acquired, payments made to acquire subsidiaries, payment of dividends to parent, and payments relating to policy and contract surrenders, withdrawals, policy loans, interest expense and repayment of short-term borrowings and long-term debt.

        Principal Life maintains investment strategies generally intended to provide adequate funds to pay benefits without forced sales of investments. Products having liabilities with longer lives, such as life insurance and full-service payout pension products, are matched with assets having similar estimated lives such as mortgage loans, long-term bonds and private placement bonds. Shorter-term liabilities are matched with investments such as short and medium-term fixed maturities. In addition, highly liquid, high quality short-term investments are held to fund anticipated operating expenses, surrenders, withdrawals and development and maintenance expenses associated with new products and technologies. Our privately placed fixed maturity securities, commercial mortgage loans and real estate investments are generally less liquid than our publicly traded fixed maturity securities. These asset classes represented approximately 41% and 40% of the value of our consolidated invested assets as of December 31, 2006 and 2005 respectively. See Item 7A. "Quantitative and Qualitative Disclosures about Market Risk — Interest Rate Risk" for a discussion of duration matching.

        Life insurance companies generally produce a positive cash flow from operations, as measured by the amount by which cash inflows are adequate to meet benefit obligations to policyholders and normal operating expenses as they are incurred. The remaining cash flow is generally used to increase the asset base to provide funds to meet the need for future policy benefit payments and for writing and acquiring new business. It is important to match the investment portfolio maturities to the cash flow demands of the type of annuity, investment or insurance product being provided. Principal Life continuously monitors benefits, surrenders and maturities to provide projections of future cash requirements. As part of this monitoring process, Principal Life performs cash flow testing of many of its assets and liabilities under various scenarios to evaluate the adequacy of reserves. In developing its investment strategy, Principal Life establishes a level of cash and securities which, combined with expected net cash inflows from operations, maturities of fixed maturity investments and principal payments on mortgage-backed securities and commercial mortgage loans, are believed adequate to meet anticipated short-term and long-term benefit and expense payment obligations. There can be no assurance that future experience regarding benefits and surrenders will be similar to historic experience since withdrawal and surrender levels are influenced by such factors as the interest rate environment and the claims paying ability and financial strength ratings of Principal Life.

        Principal Life takes into account asset-liability management considerations in the product development and design process. Contract terms of 98% of Principal Life's universal and variable universal life insurance products as of December 31, 2006 and 2005, include surrender and withdrawal provisions which mitigate the risk of losses due to early withdrawals. These provisions generally do one or more of the following: limit the amount of penalty-free withdrawals; limit the circumstances under which withdrawals are permitted; or assess a surrender charge or market value adjustment relating to the underlying assets. The market value adjustment feature in Principal Life's fixed annuity products adjusts

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the surrender value of a contract in the event of surrender prior to the end of the contract period to protect Principal Life against losses due to higher interest rates at the time of surrender.

        Our GICs and funding agreements contain provisions limiting early surrenders, including penalties for early surrenders and minimum notice requirements.

        The following table presents U.S. GAAP reserves for guaranteed investment contracts and funding agreements by withdrawal provisions as of December 31, 2006 and 2005:

 
  December 31,
 
  2006
  2005
 
  (in millions)
Book Value Out(1)            
Surrenderable:            
  Book value out without surrender charge   $ 3.1   $ 3.7
  Book value out with surrender charge     2,322.4     2,189.0
   
 
    Total surrenderable     2,325.5     2,192.7
   
 
      Total book value out     2,325.5     2,192.7

Market Value Out(2)

 

 

 

 

 

 
Less than 30 days' notice        
30 to 89 days' notice         23.8
90 to 180 days' notice     950.1     335.7
More than 180 days' notice     3,261.1     3,591.8
No active surrender provision     314.8     252.3
   
 
Total market value out     4,526.0     4,203.6
Not puttable or surrenderable     19,698.2     18,037.3
   
 
    Total GICs and funding agreements   $ 26,549.7   $ 24,433.6
   
 

(1)
Book Value Out: The amount equal to the sum of deposits less withdrawals with interest accrued at the contractual interest rate.

(2)
Market Value Out: The amount equal to the book value out plus a market value adjustment to adjust for changes in interest rates.

        Our Brazilian, Hong Kong, Indian, and Mexican operations produced positive cash flow from operations for the year ended December 31, 2006. For the years ended December 31, 2005 and 2004, our Chilean, Indian and Mexican operations produced positive cash flow from operations. These cash flows have been historically maintained at the local country level for strategic expansion purposes and local capital requirements. Our international operations have required infusions of capital primarily to fund acquisitions and to a lesser extent, to meet the cash outflow and capital requirements of certain operations. Our capital funding of these operations is consistent with our long-term strategy to establish viable companies that can sustain future growth from internally generated sources. Based on reviews of our current capital needs and strategic opportunities within our foreign operations, we repatriated a portion of the capital from certain countries in 2006, 2005, and 2004.

        Activity, as reported in our consolidated statements of cash flows, provides relevant information regarding our sources and uses of cash. The following discussion of our operating, investing and financing portions of the cash flows excludes cash flows attributable to our discontinued operations, which were as follows:

 
  For the year ended December 31,
 
Cash flows attributable to discontinued operations:

 
  2006
  2005
  2004
 
 
  (in millions)
 
Net cash provided by (used in) operating activities   $ (1.1 ) $ 125.1   $ 627.7  
Net cash used in investing activities     (0.9 )   (125.0 )   (473.7 )
Net cash provided by financing activities             600.0  

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        Net cash provided by operating activities was $2,278.5 million, $2,126.2 million and $2,031.5 million for the years ended December 31, 2006, 2005, and 2004, respectively. The increase in cash provided by operating activities in 2006 compared to 2005 was primarily related to the payment in 2005 of an IRS deficiency related to the examination for 1999 - 2001. Also contributing to the increase in cash provided by operating activities was an increase in proceeds in the net mortgage loans held for sale activity, due to the transition of our CMBS platform from Principal Commercial Funding I to a newly created entity, Principal Commercial Funding II, which is accounted for under the equity method of accounting. The increase in cash provided by operating activities in 2005 compared to 2004 is due to an increase in premiums and fees and other revenues received. This increase is partially offset by increased taxes paid in 2005, largely due to the 2005 payment of an Internal Revenue Service deficiency related to the examination for 1999-2001.

        Net cash used in investing activities was $3,912.9 million, $1,483.7 million and $3,184.6 million for the years ended December 31, 2006, 2005, and 2004, respectively. The increase in cash used in investing activities in 2006 compared to 2005 was primarily due to a decrease in sales and fewer maturities of available-for-sales securities, partially offset by a decrease in purchases of available-for-sale securities. Also contributing to the increase was an increase in mortgage loans acquired and a decrease in mortgage loans sold. The acquisition of WM Advisors in the fourth quarter of 2006 also contributed to the increase in cash used in investing activities. The decrease in cash used in 2005 for investing activities compared to 2004 is primarily due to a decrease in the net acquisitions of available-for-sale securities and mortgage loans. Offsetting this was the sale of subsidiaries, including the sale of Principal Residential Mortgage, Inc. to CitiMortgage, Inc., in 2004, with no corresponding activity in 2005.

        Net cash provided by financing activities was $1,585.9 million, $546.2 million and $414.1 million for the years ended December 31, 2006, 2005, and 2004, respectively. The increase in cash provided by financing activities in 2006 compared to 2005 was primarily due to the issuance of $600.0 million of senior notes from our shelf registration in the fourth quarter of 2006 in addition to an increase in net deposits of investment contracts and a decrease in treasury stock acquisitions in 2006 compared to 2005. Offsetting these increases in cash provided were repayments of short-term borrowings, as well as the preferred stock issuance in 2005, with no corresponding activity in 2006. The increase in cash provided by financing activities in 2005 compared to 2004 was primarily due to a preferred stock issuance in 2005, increases in short term borrowing as well as a reduction in long term debt repayments in 2005. These increases were partially offset by a decrease in net deposits of investment contracts, an increase in treasury stock acquisitions and the accelerated stock repurchase settlement.

        Given the historical cash flow of our subsidiaries and the financial results of these subsidiaries, we believe the cash flow from our consolidated operating activities over the next year will provide sufficient liquidity for our operations, as well as satisfy interest payments and any payments related to debt servicing.

        The Internal Revenue Service (the "Service") has completed examinations of the U.S. consolidated federal income tax returns for 2003 and prior years. The Service's completion of the examinations for the years 1999 - 2001 resulted in notices of deficiency dated December 29, 2004, and March 1, 2005. We paid the deficiencies (approximately $444.0 million for 1999 and 2000, and $1.3 million for 2001, including interest) in the first quarter of 2005 and have filed, or will file, claims for refund relating to the disputed adjustments. The examination for the years 2002 and 2003 resulted in a refund of approximately $176.7 million (including interest) of which $161.5 million related to deficiencies previously paid as a result of the 1999-2001 examination. We believe that we have adequate defenses against, or sufficient provisions for, the contested issues, but final resolution of the contested issues could take several years while legal remedies are pursued. Consequently, we do not expect the ultimate resolution of issues in tax years 1999 - 2003 to have a material impact on our net income. Similarly, we believe there are adequate defenses against, or sufficient provisions for, any challenges that might arise in tax years subsequent to 2003.

        On October 22, 2004, the American Jobs Creation Act of 2004 (the "Act") was signed into law. The Act included a repatriation provision granting U.S. corporations a special deduction of 85% of certain qualifying dividends from their foreign subsidiaries. A company could elect to apply this provision to qualifying earnings that were repatriated in its 2005 tax year. Pursuant to the Act, we implemented two domestic reinvestment plans in 2005. In accordance with the provisions of the Internal Revenue Code, we elected an 85% dividend received deduction on eligible cash dividends totaling $28.8 million.

        The ratio of earnings to fixed charges is a measure of our ability to cover fixed costs with current period earnings. A high ratio indicates that earnings are sufficiently covering committed expenses. The following table sets forth, for the years indicated, our ratios of:

    earnings to fixed charges before interest credited on investment products; and

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    earnings to fixed charges.

 
  For the year ended December 31,
 
  2006
  2005
  2004
  2003
  2002
Ratio of earnings to fixed charges before interest credited on investment products   10.2   11.1   9.5   7.5   4.5
Ratio of earnings to fixed charges   2.2   2.1   2.0   1.9   1.4

        We calculate the ratio of "earnings to fixed charges before interest credited on investment products" by dividing the sum of income from continuing operations before income taxes (BT), interest expense (I), interest factor of rental expense (IF) less undistributed income from equity investees (E) by the sum of interest expense (I), interest factor of rental expense (IF), preferred stock dividends by the registrant (PD) and dividends on majority-owned subsidiary redeemable preferred securities (non-intercompany) (D). The formula for this ratio is: (BT+I+IF-E)/(I+IF+PD+D).

        We calculate the ratio of "earnings to fixed charges" by dividing the sum of income from continuing operations before income taxes (BT), interest expense (I), interest factor of rental expense (IF) less undistributed income from equity investees (E) and the addition of interest credited on investment products (IC) by interest expense (I), interest factor of rental expense (IF), preferred stock dividends by the registrant (PD), dividends on majority-owned subsidiary redeemable preferred securities (non-intercompany) (D) and interest credited on investment products (IC). The formula for this ratio is: (BT+I+IF-E+IC)/(I+IF+PD+D+IC). "Interest credited on investment products" includes interest paid on guaranteed investment contracts, funding agreements and other investment-only pension products. Similar to debt, these products have a total fixed return and a fixed maturity date.

        The following table presents payments due by period for long-term contractual obligations as of December 31, 2006:

 
   
  Payments due in year ending
Contractual Obligations(1)

  Total Payments
  2007
  2008- 2009
  2010- 2011
  2012 and thereafter
 
  (in millions)
Contractholder funds(2)   $ 57,615.5   $ 8,653.1   $ 12,054.9   $ 8,661.3   $ 28,246.2
Future policy benefits and claims(3)     38,503.6     1,945.2     3,231.3     3,126.5     30,200.6
Long-term debt(4)     1,553.8     143.5     94.8     578.7     736.8
Certificates of deposit(5)     870.9     430.6     376.2     60.0     4.1
Other long-term liabilities(6)     674.2     457.1             217.1
Capital leases     17.9     0.9     2.1     2.3     12.6
Long-term debt interest     1,624.9     104.2     184.8     164.9     1,171.0
Operating leases(7)     215.5     56.4     85.1     43.8     30.2
Purchase obligations(8)     739.3     707.2     23.1     9.0    
   
 
 
 
 
Total contractual obligations   $ 101,815.6   $ 12,498.2   $ 16,052.3   $ 12,646.5   $ 60,618.6
   
 
 
 
 

(1)
Excludes short-term liabilities, other policyholder funds, taxes and short-term debt as these are not long-term and/or not contractual in nature. Also excludes obligations under our pension and other postretirement benefit plans as benefit payments will be made under a funded plan and will not require company contributions or payments within a five-year period. In addition, separate account liabilities are excluded. Separate account liabilities represent the fair market value of funds that are separately administered by the Company. Generally, the separate account contract owner, rather than the Company, bears the investment risk of these funds. The separate account liabilities are legally segregated and are not subject to claims that arise out of any other business of the Company. Net deposits, net investment income and realized and unrealized capital gains and losses on the separate accounts are not reflected in the consolidated statement of operations. The separate account obligations will be fully funded by cash flows from the separate account assets.

(2)
Includes GICs, funding agreements (described below), individual fixed annuities, universal life insurance, and other investment-type contracts.

            Our guaranteed investment contracts and funding agreements contain provisions limiting early surrenders, which typically include penalties for early surrenders, minimum notice requirements or, in the case of funding agreements with survivor options, minimum pre-death holding periods and specific maximum amounts.

            Funding agreements include those issued directly to nonqualified institutional investors, as well as to three separate programs where the funding agreements have been issued directly or indirectly to unconsolidated special

65



    purpose entities. Claims for principal and interest under funding agreements are afforded equal priority to claims of life insurance and annuity policyholders under insolvency provisions of Iowa Insurance Laws.

            We are authorized to issue up to $4.0 billion of funding agreements under a program established in 1998 to support the prospective issuance of medium term notes by an unaffiliated entity in non-U.S. markets. As of December 31, 2006 and 2005, $3,770.4 million and $3,203.6 million, respectively, of liabilities are being held with respect to the issuance outstanding under this program. We do not anticipate any new issuance activity under this program as we are authorized to issue up to Euro 4.0 billion (approximately USD$5.3 billion) of funding agreements under a program established in 2006 to support the prospective issuance of medium term notes by an unaffiliated entity in non-U.S. markets. The unaffiliated entity is an unconsolidated special purpose vehicle. As of December 31, 2006, $474.1 million of liabilities are outstanding with respect to the issuance outstanding under this new program.

            In addition, we are authorized to issue up to $7.0 billion of funding agreements under a program established in 2001 to support the prospective issuance of medium term notes by an unaffiliated entity in both domestic and international markets. As of December 31, 2006 and 2005, $3,747.9 million and $4,744.5 million, respectively, of liabilities were being held with respect to the issuance outstanding under this program. We do not anticipate any new issuance activity under this program, given our December 2005 termination of the dealership agreement for this program and the availability of the SEC-registered program described in the following paragraph.

            We are authorized to issue up to $4.0 billion of funding agreements under a program established in March 2004 to support the prospective issuance of medium term notes by unaffiliated entities in both domestic and international markets. In recognition of the use of nearly all $4.0 billion of initial issuance authorization, the program was amended in February 2006 to authorize issuance of up to an additional $5.0 billion. Under this program, both the notes and the supporting funding agreements are registered with the SEC. As of December 31, 2006 and 2005, $5,831.4 million and $3,667.9 million, respectively, of liabilities are being held with respect to the issuance outstanding under this program. In contrast with direct funding agreements, GIC issuances and the other two funding agreement-backed medium term note programs described above, Principal Life's payment obligations on each funding agreement issued under this SEC-registered program are guaranteed by Principal Financial Group, Inc.

            Amounts included in the contractholder funds line item reflect estimated cash payments to be made to policyholders. The sum of the cash outflows shown for all years in the table exceeds the corresponding liability amount included in our consolidated financial statements as of December 31, 2006. The liability amount in our consolidated financial statements reflects estimated cash payments to policyholders, assumptions with regard to the timing of cash payments and discounting for interest.

(3)
Amounts included in the future policy benefits and claims line item reflect estimated cash payments to be made to policyholders. The sum of the cash outflows shown for all years in the table exceeds the corresponding liability amount included in our consolidated financial statements as of December 31,2006. The liability amount in our consolidated financial statements reflects estimated cash payments to policyholders, reductions for expected future premiums, assumptions with regard to the timing of cash payments and discounting for interest.

(4)
The following are included in long-term debt:

            On October 16 and December 5, 2006, we issued $500.0 million and $100.0 million, respectively, of senior notes from our shelf registration, which was filed with the SEC in December 2003. The notes will bear interest at a rate of 6.05% per year. Interest on the notes is payable semi-annually on April 15 and October 15, beginning on April 15, 2007. The notes will mature on October 15, 2036. A portion of the proceeds was used to fund the acquisition of WM Advisors, Inc., with the remaining proceeds being used for general corporate purposes.

            On November 3, 2005, Principal International de Chile S.A., a wholly owned indirect subsidiary, entered into long-term borrowing agreements with two Chilean banks in the amount of US $93.9 million. This debt is denominated in Unidades de Formento ("UF"), a Chilean inflation-indexed, peso-denominated monetary unit. Of this amount, US $49.0 million of UF +4.59% notes and US $44.9 million of UF +4.93% notes mature on November 3, 2011. Interest on the notes is payable semi-annually on May 3 and November 3 each year. The debt outstanding and interest expense will vary due to fluctuations in the Chilean peso to US dollar exchange rates and Chilean inflation.

            On August 25, 1999, Principal Financial Group (Australia) Holdings Pty. Limited, a wholly owned indirect subsidiary, issued $665.0 million of unsecured redeemable long-term debt. Of this amount, $200.0 million of 7.95% notes matured on August 15, 2004, with the remaining $465.0 million in 8.2% notes due August 15, 2009. On December 28, 2001, all of the long-term debt obligations of Principal Financial Group (Australia) Holdings Pty. Limited were assumed by its parent, Principal Financial Services, Inc.

            On March 10, 1994, Principal Life issued $100.0 million of surplus notes due March 1, 2044, at an 8% annual interest rate. None of our affiliates hold any portion of the notes. Each payment of interest and principal on the notes, however, may be made only with the prior approval of the Commissioner and only to the extent that Principal Life has sufficient surplus earnings to make such payments.

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            Subject to Commissioner approval, the notes due March 1, 2044, may be redeemed at Principal Life's election on or after March 1, 2014, in whole or in part at a redemption price of approximately 102.3% of par. The approximate 2.3% premium is scheduled to gradually diminish over the following ten years. These notes may be redeemed on or after March 1, 2024, at a redemption price of 100% of the principal amount plus interest accrued to the date of redemption.

            Long-term debt also includes $298.0 million of mortgages and other notes payable related to real estate developments. We, including certain subsidiaries, had $135.0 million in credit facilities as of December 31, 2006, with various financial institutions, in addition to obtaining loans with various lenders to finance these developments. Outstanding principal balances as of December 31, 2006, range from $0.3 million to $96.2 million per development with interest rates generally ranging from 5.5% to 8.6%. Outstanding principal balances as of December 31, 2005, range from $0.3 million to $97.5 million per development with interest rates generally ranging from 5.5% to 8.6%. Outstanding debt is secured by the underlying real estate properties, which were reported as real estate on our consolidated statements of financial position with a carrying value of $246.2 million and $284.1 million as of December 31, 2006 and 2005, respectively.

            In addition to the mortgages and notes payable noted above, we assumed a long-term debt obligation with the purchase of WM Advisors, Inc. As part of the purchase, we will be bound by a class B share financing agreement previously entered into by WM Advisors, Inc. and a third party, which was assigned a value of $86.9 million at purchase. Load mutual fund shares sold without a front end load are referred to as "B shares". In exchange for paying the selling commission, the company receives fees in the future to recover the up-front commission cost incurred. Prior to our purchase, WM Advisors, Inc. had entered into a purchase and sale agreement whereby the third party would purchase the rights to future cash flow streams in exchange for funding the sales commissions. The fair value of these relinquished fees is reported as a long-term debt liability. There will be no additional sales under this agreement following the effective date of the purchase. Therefore, this liability will be extinguished within eight years, which equates to the contractual term in which the fund can recover fees to cover the upfront commission costs.

(5)
Amounts included in the certificates of deposit line item reflect estimated cash payments to be made, including expected interest payments. Certificates of deposits are reported as other liabilities on our consolidated statement of financial position.

(6)
Other long-term liabilities include other liabilities reflected in the consolidated statement of financial position that are contractual, non-cancelable and long-term in nature. This line item excludes accruals and short-term items in the amount of $3,209.4 million.

(7)
As a lessee, we lease office space, data processing equipment and office furniture and equipment under various operating leases.

(8)
Purchase obligations include material contracts where we have a non-cancelable commitment to purchase goods and services in addition to commitments to originate loans and purchase investments.

        In connection with our banking business, we make additional commitments to extend credit, which are agreements to lend to a customer as long as there is no violation of any conditions established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. A majority of these commitments are lines of credit and are expected to expire without being drawn upon. Therefore, the total commitment amounts do not necessarily represent future cash funding requirements. We evaluate each customer's creditworthiness on a case-by-case basis. The total commitments to fund loans were $135.7 million as of December 31, 2006.

        The components of short-term debt as of December 31, 2006 and 2005 are as follows:

 
  December 31,
 
  2006
  2005
 
  (in millions)
Commercial paper   $   $ 349.9
Other recourse short-term debt     23.1     55.1
Non-recourse short-term debt     61.0     71.4
   
 
  Total short-term debt   $ 84.1   $ 476.4
   
 

        As of December 31, 2006, we had credit facilities with various financial institutions in an aggregate amount of $887.7 million. As of December 31, 2006 and 2005, we had $84.1 million and $476.4 million of outstanding borrowings related to our credit facilities, with $74.5 million and $110.6 million of assets pledged as support, respectively. Assets

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pledged consisted primarily of commercial mortgages and securities. Our credit facilities also include a $600.0 million back-stop facility to provide 100% support for our commercial paper program, of which there were no outstanding balances as of December 31, 2006.

        The weighted-average interest rates on short-term borrowings as of December 31, 2006 and 2005, were 5.6% and 4.5% respectively.

        Variable Interest Entities.    We have relationships with various types of special purpose entities and other entities where we have a variable interest as described in Item 8, "Financial Statements and Supplementary Data, Notes to Consolidated Financial Statements, Note 5 Variable Interest Entities." We do not have a direct or contingent obligation related to our unconsolidated variable interest entities other than described below.

        Synthetic Fuel Production Facility.    In June 2004, we acquired a significant variable interest in a coal-based synthetic fuel production facility where we are not the primary beneficiary. Our minority ownership interest was acquired in exchange for consideration of $37.0 million, which is primarily comprised of a non-recourse note payable for $36.0 million, as well as a commitment to fund our pro-rata share of the operations. We have also agreed to make additional payments to the seller based on our pro-rata allocation of the tax credits generated by the facility. The synthetic fuel produced at the facility through 2007 qualifies for tax credits pursuant to Section 29 of the Internal Revenue Code (currently credits are not available for fuel produced after 2007). Our obligation to support the entity's future operations is, therefore, limited to the tax benefit we expect to receive.

        Retained Interests in Securitized Assets.    We, along with other contributors, sell commercial mortgage loans in securitization transactions to trusts. As these trusts are classified as a qualifying special purpose entity, they are not subject to the VIE consolidation rules. We may retain interests in the securitization transaction. At December 31, 2006 and 2005, the fair values of retained interests related to the securitizations of commercial mortgage loans were $345.3 million and $321.0 million, respectively. The investors and the securitization entities have no recourse to our assets for failure of debtors to pay when due. The value of our retained interests is subject primarily to credit risk.

        Guarantees and Indemnifications.    In the normal course of business, we have provided guarantees to third parties primarily related to a former subsidiary, joint ventures and industrial revenue bonds. These agreements generally expire through 2019. The maximum exposure under these agreements as of December 31, 2006, was approximately $180.0 million; however, we believe the likelihood is remote that material payments will be required and therefore have not accrued for a liability on our consolidated statements of financial position. Should we be required to perform under these guarantees, we generally could recover a portion of the loss from third parties through recourse provisions included in agreements with such parties, the sale of assets held as collateral that can be liquidated in the event that performance is required under the guarantees or other recourse generally available to us. Therefore, such guarantees would not result in a material adverse effect on our business or financial position. It is possible that such outcomes could materially affect net income in a particular quarter or annual period. The fair value of such guarantees is not material.

        We are also subject to various other indemnification obligations issued in conjunction with certain transactions, primarily the sale of Principal Residential Mortgage, Inc. and other divestitures, acquisitions and financing transactions whose terms range in duration and often are not explicitly defined. Certain portions of these indemnifications may be capped, while other portions are not subject to such limitations; therefore, the overall maximum amount of the obligation under the indemnifications cannot be reasonably estimated. While we are unable to estimate with certainty the ultimate legal and financial liability with respect to these indemnifications, we believe the likelihood is remote that material payments would be required under such indemnifications and therefore such indemnifications would not result in a material adverse effect on our business or financial position. It is possible that such outcomes could materially affect net income in a particular quarter or annual period. The fair value of such indemnifications was determined to be insignificant.

Investments

        We had total consolidated assets as of December 31, 2006, of $143.7 billion, of which $60.3 billion were invested assets. The rest of our total consolidated assets are comprised primarily of separate account assets for which we do not bear investment risk. Because we generally do not bear any investment risk on assets held in separate accounts, the discussion and financial information below does not include such assets. Of our invested assets, $57.0 billion were held by our U.S. operations and the remaining $3.3 billion were held by our International Asset Management and Accumulation segment.

U.S. Investment Operations

        Our U.S. invested assets are managed by Principal Global Investors, a subsidiary of Principal Life. Our primary investment objective is to maximize after-tax returns consistent with acceptable risk parameters. We seek to protect policyholders' benefits by optimizing the risk/return relationship on an ongoing basis, through asset/liability matching,

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reducing the credit risk, avoiding high levels of investments that may be redeemed by the issuer, maintaining sufficiently liquid investments and avoiding undue asset concentrations through diversification. We are exposed to three primary sources of investment risk:

    credit risk, relating to the uncertainty associated with the continued ability of a given obligor to make timely payments of principal and interest;

    interest rate risk, relating to the market price and/or cash flow variability associated with changes in market yield curves; and

    equity risk, relating to adverse fluctuations in a particular common stock.

        Our ability to manage credit risk is essential to our business and our profitability. We devote considerable resources to the credit analysis of each new investment. We manage credit risk through industry, issuer and asset class diversification. Our Investment Committee, appointed by our Board of Directors, is responsible for establishing all investment policies and approving or authorizing all investments, except the Executive Committee of the Board must approve any investment transaction exceeding $500.0 million. As of December 31, 2006, there are ten members on the Investment Committee, two of whom are members of our Board of Directors. The remaining members are senior management members representing various areas of our company.

        We also seek to reduce call or prepayment risk arising from changes in interest rates in individual investments. We limit our exposure to investments that are prepayable without penalty prior to maturity at the option of the issuer, and we require additional yield on these investments to compensate for the risk that the issuer will exercise such option. We assess option risk in all investments we make and, when we take that risk, we price for it accordingly.

        Our Fixed Income Securities Committee, consisting of fixed income securities senior management members, approves the credit rating for the fixed maturity securities we purchase. Teams of security analysts organized by industry focus either on the public or private markets and analyze and monitor these investments. In addition, we have teams who specialize in residential mortgage-backed securities, commercial mortgage-backed securities, asset-backed securities, and public below investment grade securities. We establish a credit reviewed list of approved public issuers to provide an efficient way for our portfolio managers to purchase liquid bonds for which credit review has already been completed. Issuers remain on the list for one year unless removed by our analysts. Our analysts monitor issuers on the list on a continuous basis with a formal review documented annually or more frequently if material events affect the issuer. The analysis includes both fundamental and technical factors. The fundamental analysis encompasses both quantitative and qualitative analysis of the issuer.

        The qualitative analysis includes an assessment of both accounting and management aggressiveness. In addition, technical indicators such as stock price volatility and credit default swap levels are monitored.

        Our Fixed Income Securities Committee also reviews private transactions on a continuous basis to assess the quality ratings of our privately placed investments. We regularly review our investments to determine whether we should re-rate them, employing the following criteria:

    material declines in the issuer's revenues or margins;

    significant management or organizational changes;

    significant uncertainty regarding the issuer's industry;

    debt service coverage or cash flow ratios that fall below industry-specific thresholds;

    violation of financial covenants; and

    other business factors that relate to the issuer.

        A dedicated risk management team is responsible for centralized monitoring of the commercial mortgage portfolio. We apply a variety of strategies to minimize credit risk in our commercial mortgage loan portfolio. When considering the origination of new commercial mortgage loans, we review the cash flow fundamentals of the property, make a physical assessment of the underlying security, conduct a comprehensive market analysis and compare against industry lending practices. We use a proprietary risk rating model to evaluate all new and a majority of existing loans within the portfolio. The proprietary risk model is designed to stress projected cash flows under simulated economic and market downturns. Our lending guidelines are designed to encourage 75% or less loan-to-value ratios and a debt service coverage ratio of at least 1.2 times. We analyze investments outside of these guidelines based on cash flow quality, tenancy and other factors. The weighted average loan-to-value ratio at origination for brick and mortar commercial mortgages in our portfolio was 67% and the debt service coverage ratio at loan inception was 1.7 times as of December 31, 2006.

        We have limited exposure to equity risk in our common stock portfolio. Equity securities accounted for only 1% of our U.S. invested assets as of December 31, 2006.

        Our investment decisions and objectives are a function of the underlying risks and product profiles of each primary business operation. In addition, we diversify our product portfolio offerings to include products that contain features that

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will protect us against fluctuations in interest rates. Those features include adjustable crediting rates, policy surrender charges and market value adjustments on liquidations. For further information on our management of interest rate risk, see Item 7A, "Quantitative and Qualitative Disclosures about Market Risk".

Overall Composition of U.S. Invested Assets

        U.S. invested assets as of December 31, 2006, were predominantly of high quality and broadly diversified across asset class, individual credit, industry and geographic location. Asset allocation is determined based on cash flow and the risk/return requirements of our products. As shown in the following table, the major categories of U.S. invested assets are fixed maturity securities and commercial mortgages. The remainder is invested in real estate, residential mortgage loans, equity securities and other assets. In addition, policy loans are included in our invested assets. The following discussion analyzes the composition of U.S. invested assets, but excludes invested assets of the participating separate accounts.


U.S. Invested Assets

 
  December 31, 2006
  December 31, 2005
 
 
  Carrying Amount
  % of Total
  Carrying Amount
  % of Total
 
 
  ($ in millions)
 
Fixed maturity securities:                      
  Public   $ 28,772.4   51 % $ 27,826.3   51 %
  Private     13,651.4   24     12,289.4   23  
Equity securities     795.7   1     764.0   2  
Mortgage loans:                      
  Commercial     10,090.3   18     9,890.7   18  
  Residential     1,051.6   2     1,088.5   2  
Real estate held for sale     118.2       133.8    
Real estate held for investment     736.6   1     754.6   1  
Policy loans     850.7   1     827.7   2  
Other investments     972.6   2     755.3   1  
   
 
 
 
 
  Total invested assets     57,039.5   100 %   54,330.3   100 %
         
       
 
Cash and cash equivalents     1,535.8         1,583.1      
   
     
     
  Total invested assets and cash   $ 58,575.3       $ 55,913.4      
   
     
     

U.S. Investment Results

        The following tables present the yield and investment income, excluding net realized/unrealized gains and losses for our U.S. invested assets. The annualized yield on U.S. invested assets and on cash and cash equivalents was 5.9% for the year ended December 31, 2006, compared to 5.7% for the year ended December 31, 2005. We calculate annualized yields using a simple average of asset classes at the beginning and end of the reporting period.

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U.S. Invested Assets
Investment Income Yields by Asset Type

 
  For the year ended December 31,
 
  2006
  2005
 
  Yield
  Amount
  Yield
  Amount
 
  ($ in millions)
Fixed maturity securities   6.0 % $ 2,478.3   5.8 % $ 2,302.5
Equity securities   7.1     55.1   6.5     48.5
Mortgage loans — commercial   6.5     653.3   6.7     671.7
Mortgage loans — residential   5.1     54.9   4.7     51.9
Real estate   7.4     64.7   7.0     64.0
Policy loans   6.1     50.9   6.1     50.3
Cash and cash equivalents   4.1     64.3   3.3     32.1
Other investments   8.9     76.4   2.4     25.0
       
     
  Total before investment expenses   6.1     3,497.9   5.9     3,246.0
Investment expenses   0.2     132.2   0.2     133.6
       
     
  Net investment income   5.9 % $ 3,365.7   5.7 % $ 3,112.4
       
     

Fixed Maturity Securities

        Fixed maturity securities consist of short-term investments, publicly traded debt securities, privately placed debt securities and redeemable preferred stock, and represented 75% and 74% of total U.S. invested assets as of December 31, 2006 and December 31, 2005, respectively. The fixed maturity securities portfolio was comprised, based on carrying amount, of 68% in publicly traded fixed maturity securities and 32% in privately placed fixed maturity securities as of December 31, 2006 and 69% in publicly traded fixed maturity securities and 31% in privately placed fixed maturity securities as of December 31, 2005. Included in the privately placed category as of December 31, 2006, and December 31, 2005, were $7.6 billion and $6.7 billion, respectively, of securities eligible for resale to qualified institutional buyers under Rule 144A under the Securities Act of 1933. Fixed maturity securities were diversified by category of issuer as of December 31, 2006, and December 31, 2005, as shown in the following table:


U.S. Invested Assets
Fixed Maturity Securities by Type of Issuer

 
  December 31, 2006
  December 31, 2005
 
 
  Carrying Amount
  % of Total
  Carrying Amount
  % of Total
 
 
  ($ in millions)
 
U.S. Government and agencies   $ 551.6   1 % $ 555.5   1 %
States and political subdivisions     1,663.5   4     1,283.4   3  
Non-U.S. governments     420.7   1     463.0   1  
Corporate — public     19,791.1   47     19,590.8   49  
Corporate — private     10,596.5   25     9,901.5   25  
Residential pass-through securities     1,557.6   4     1,526.0   4  
Commercial mortgage-backed securities     4,499.6   11     4,118.6   10  
Residential collateralized mortgage obligations     940.4   2     752.5   2  
Asset-backed securities     2,402.8   5     1,924.4   5  
   
 
 
 
 
  Total fixed maturities   $ 42,423.8   100 % $ 40,115.7   100 %
   
 
 
 
 

        We held $9,400.4 million of mortgage-backed and asset-backed securities as of December 31, 2006, and $8,321.5 million as of December 31, 2005.

        We believe that it is desirable to hold residential mortgage-backed pass-through securities due to their credit quality and liquidity as well as portfolio diversification characteristics. Our portfolio is comprised of GNMA, FNMA and FHLMC pass-through securities. In addition, our residential collateralized mortgage obligation portfolio offers structural features that allow cash flows to be matched to our liabilities.

        Commercial mortgage-backed securities provide high levels of credit protection, diversification, reduced event risk and enhanced liquidity. Commercial mortgage-backed securities are predominantly comprised of rated large pool securitizations that are individually and collectively diverse by property type, borrower and geographic dispersion.

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        We purchase asset-backed securities ("ABS") to diversify the overall credit risks of the fixed maturity securities portfolio and to provide attractive returns. The principal risks in holding asset-backed securities are structural and credit risks. Structural risks include the security's priority in the issuer's capital structure, the adequacy of and ability to realize proceeds from the collateral and the potential for prepayments. Credit risks involve issuer/servicer risk where collateral values can become impaired in the event of servicer credit deterioration.

        Our ABS portfolio is diversified both by type of asset and by issuer. We actively monitor holdings of asset-backed securities to ensure that the risk profile of each security improves or remains consistent. Prepayments in the ABS portfolio are, in general, insensitive to changes in interest rates or are insulated to such changes by call protection features. In the event that we are subject to prepayment risk, we monitor the factors that impact the level of prepayment and prepayment speed for those asset-backed securities. In addition, we diversify the risks of asset-backed securities by holding a diverse class of securities, which limits our exposure to any one security.

        The international exposure in our U.S. fixed maturity securities totaled $8,691.4 million, or 20% of total fixed maturity securities, as of December 31, 2006, comprised of corporate and foreign government fixed maturity securities. Of the $8,691.4 million as of December 31, 2006, investments totaled $2,383.1 million in the United Kingdom, $2,232.2 million in the continental European Union, $1,007.4 million in Asia, $827.8 million in Australia, $615.3 million in South America, $401.0 million in Mexico and $59.0 million in Japan. The remaining $1,165.6 million is invested in 17 other countries. All international fixed maturity securities held by our U.S. operations are either denominated in U.S. dollars or have been swapped into U.S. dollar equivalents. Our international investments are analyzed internally by country and industry credit investment professionals. We control concentrations using issuer and country level exposure benchmarks, which are based on the credit quality of the issuer and the country. Our investment policy limits total international fixed maturity securities investments to 18% of total statutory general account assets with a 4% limit in emerging markets. Exposure to Canada is not included in our international exposure. As of December 31, 2006, our investments in Canada totaled $1,451.6 million.

        The following tables present the amortized cost of our top ten exposures including approved counterparty exposure limits as of December 31, 2006, and December 31, 2005.

 
  December 31, 2006
 
  Amortized Cost
 
  (in millions)
HSBC Holdings PLC(1)   $ 387.1
American International Group Inc.(2)     329.5
Bank of America Corp.(2)     328.3
MBIA Inc.(3)     311.5
AT&T Inc.     272.9
JP Morgan Chase & Co.(2)     271.7
Royal Bank of Scotland Group PLC(2)     255.6
Deutsche Bank AG(2)