Nature of Operations and Significant Accounting Policies

9 Months Ended

Sep. 30, 2012

Nature of Operations and Significant Accounting Policies

Nature of Operations and Significant Accounting Policies

1. Nature of Operations and Significant Accounting Policies

Basis of Presentation

The accompanying unaudited consolidated financial statements of Principal Financial Group, Inc. (“PFG”), its majority-owned subsidiaries and its consolidated variable interest entities (“VIEs”), have been prepared in conformity with accounting principles generally accepted in the U.S. (“U.S. GAAP”) for interim financial statements and with the instructions to Form 10-Q and Article 10 of Regulation S-X. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and nine months ended September 30, 2012, are not necessarily indicative of the results that may be expected for the year ended December 31, 2012. These interim unaudited consolidated financial statements should be read in conjunction with our annual audited financial statements as of December 31, 2011, included in our Form 10-K for the year ended December 31, 2011, filed with the United States Securities and Exchange Commission (“SEC”). The accompanying consolidated statement of financial position as of December 31, 2011, has been derived from the audited consolidated statement of financial position but does not include all of the information and footnotes required by U.S. GAAP for complete financial statements.

Reclassifications have been made to prior period financial statements to conform to the September 30, 2012, presentation.

Accounting Changes

In October 2010, the Financial Accounting Standards Board (“FASB”) issued authoritative guidance that modifies the definition of the types of costs incurred by insurance entities that can be capitalized in the successful acquisition of new or renewal insurance contracts. Capitalized costs should include incremental direct costs of contract acquisition, as well as certain costs related directly to acquisition activities such as underwriting, policy issuance and processing, medical and inspection and sales force contract selling. This guidance was effective for us on January 1, 2012, and we adopted the guidance retrospectively.

Effective January 1, 2012, we voluntarily changed our method of accounting for the cost of long duration universal life and variable universal life reinsurance contracts. In conjunction with this change, we also changed our accounting policy for estimated gross profits (“EGPs”). These changes are collectively referred to as the “Reinsurance Accounting Change”. Under our previous method, we recognized all reinsurance cash flows as part of the net cost of reinsurance and amortized this balance over the estimated lives of the underlying policies in proportion to the pattern of EGPs on the underlying policies. Under the new method, any difference between actual and expected reinsurance cash flows are recognized in earnings immediately instead of being deferred and amortized over the life of the underlying policies. In conjunction with this change, we also changed our policy for determining EGPs relating to these contracts to include the difference between actual and expected reinsurance cash flows, where previously these effects had not been included. We adopted the new policies because we believe that they better reflect the economics of our reinsurance transactions by accounting for direct claims and related reinsurance recoveries in the same period. In addition, the new policies are consistent with our intent to purchase reinsurance to protect us against large and unexpected claims.

Comparative amounts from prior periods have been adjusted to apply the new deferred policy acquisition cost (“DPAC”) guidance (“DPAC Guidance”) and the Reinsurance Accounting Change retrospectively in these financial statements.

Our retrospective adoption of the DPAC Guidance and the Reinsurance Accounting Change resulted in reductions to the opening balances of retained earnings and accumulated other comprehensive income (“AOCI”) as of January 1, 2011, as shown in the following table.

	Impact on			Attributed to
	opening balance as of January 1, 2011			DPAC Guidance			Reinsurance Accounting Change
	(in millions)
Retained earnings	$	(612.9	)	$	(631.7	)	$	18.8
Accumulated other comprehensive income	34.3			29.5			4.8

The following tables show the prior period financial statement line items that were affected by the DPAC Guidance and the Reinsurance Accounting Change.

Consolidated Statements of Financial Position

	December 31, 2011
								Change attributed to
			As								Reinsurance
	As		originally		Effect of			DPAC			Accounting
	adjusted		reported		change			Guidance			Change
	(in millions)
Assets
Other investments	$	2,985.8	$	2,988.0	$	(2.2	)	$	(2.2	)	$	—
Premiums due and other receivables	1,196.5		1,245.2		(48.7		)	—			(48.7		)
Deferred policy acquisition costs	2,428.0		3,313.5		(885.5		)	(884.4		)	(1.1		)
Liabilities
Future policy benefits and claims	20,210.4		20,207.9		2.5			—			2.5
Other policyholder funds	548.6		543.7		4.9			7.0			(2.1		)
Deferred income taxes	208.7		533.4		(324.7		)	(307.1		)	(17.6		)
Stockholders’ equity
Retained earnings	4,402.3		5,077.5		(675.2		)	(642.0		)	(33.2		)
Accumulated other comprehensive income	258.0		201.9		56.1			55.5			0.6

Consolidated Statements of Operations

	For the three months ended September 30, 2011
								Change attributed to
			As								Reinsurance
	As		originally		Effect of			DPAC			Accounting
	adjusted		reported		change			Guidance (1)			Change
	(in millions, except per share data)
Revenue
Fees and other revenues	$	636.4	$	631.5	$	4.9		$	0.5		$	4.4
Net investment income	815.2		815.3		(0.1		)	(0.1		)	—
Expenses
Benefits, claims and settlement expenses	1,114.9		1,131.8		(16.9		)	(0.1		)	(16.8		)
Operating expenses	775.4		766.6		8.8			(5.3		)	14.1
Income before income taxes	151.1		138.2		12.9			5.8			7.1
Income taxes	76.6		71.9		4.7			2.1			2.6
Net income	$	74.5	$	66.3	$	8.2		$	3.7		$	4.5
Net income available to common stockholders	$	71.9	$	63.7	$	8.2		$	3.7		$	4.5
Earnings per common share
Basic earnings per common share	$	0.23	$	0.20	$	0.03		$	0.01		$	0.02
Diluted earnings per common share	$	0.23	$	0.20	$	0.03		$	0.01		$	0.02

Consolidated Statements of Operations

	For the nine months ended September 30, 2011
								Change attributed to
			As								Reinsurance
	As		originally		Effect of			DPAC			Accounting
	adjusted		reported		change			Guidance (1)			Change (2)
	(in millions, except per share data)
Revenue
Fees and other revenues	$	1,892.6	$	1,930.9	$	(38.3	)	$	0.7		$	(39.0	)
Net investment income	2,548.6		2,549.0		(0.4		)	(0.4		)	—
Expenses
Benefits, claims and settlement expenses	3,497.7		3,337.0		160.7			(0.1		)	160.8
Operating expenses	2,232.7		2,360.9		(128.2		)	(7.0		)	(121.2		)
Income before income taxes	722.8		794.0		(71.2		)	7.4			(78.6		)
Income taxes	190.3		214.7		(24.4		)	3.0			(27.4		)
Net income	$	532.5	$	579.3	$	(46.8	)	$	4.4		$	(51.2	)
Net income available to common stockholders	$	471.2	$	518.0	$	(46.8	)	$	4.4		$	(51.2	)
Earnings per common share
Basic earnings per common share	$	1.48	$	1.63	$	(0.15	)	$	0.01		$	(0.16	)
Diluted earnings per common share	$	1.47	$	1.61	$	(0.14	)	$	0.01		$	(0.15	)

(1)In general as a result of the adoption of the DPAC Guidance we capitalize fewer expenses, which lowers earnings. During 2011, we made routine model and assumption refinements that resulted in a write-down of our DPAC asset. The DPAC Guidance was applied to a lower DPAC asset, which reduced the DPAC write-off associated with the model and assumption refinements. This positive impact to earnings more than offset the negative impact of lower capitalization during the period.

(2)In the second quarter of 2011, we made various routine adjustments to our model and assumptions in our individual life insurance business. When we updated our actuarial models for the Reinsurance Accounting Change, several of the components of our integrated insurance accounting model were impacted, resulting in changes to various balance sheet and income statement line items. While the same model and assumptions were used to derive both the “as originally reported” and “as adjusted” balances, the financial statement impacts of the model and assumption changes upon adjustment were different than previously reported because of changes to the pattern of EGPs caused by the application of our Reinsurance Accounting Change.

The following tables show the impact of the Reinsurance Accounting Change on the current period financial statements.

Consolidated Statements of Financial Position

	September 30, 2012
	New		Former		Effect of
	reinsurance		reinsurance		Reinsurance
	accounting		accounting		Accounting
	method		method		Change
	(in millions)
Assets
Premiums due and other receivables	$	1,192.2	$	1,263.3	$	(71.1	)
Deferred policy acquisition costs	2,558.5		2,540.4		18.1
Liabilities
Future policy benefits and claims	21,952.0		21,952.4		(0.4		)
Other policyholder funds	720.8		714.5		6.3
Deferred income taxes	951.5		974.2		(22.7		)
Stockholders’ equity
Retained earnings	4,784.3		4,828.7		(44.4		)
Accumulated other comprehensive income	880.8		882.7		(1.9		)

Consolidated Statements of Operations

	For the three months ended September 30, 2012
	New			Former			Effect of
	reinsurance			reinsurance			Reinsurance
	accounting			accounting			Accounting
	method			method			Change
	(in millions, except per share data)
Revenue
Fees and other revenues	$	675.0		$	674.4		$	0.6
Expenses
Benefits, claims and settlement expenses	1,647.0			1,641.5			5.5
Operating expenses	826.6			827.6			(1.0		)
Income before income taxes	181.4			198.2			(16.8		)
Income tax benefits	(9.9		)	(3.6		)	(6.3		)
Net income	$	191.3		$	201.8		$	(10.5	)
Net income available to common stockholders	$	179.7		$	190.2		$	(10.5	)
Earnings per common share
Basic earnings per common share	$	0.61		$	0.65		$	(0.04	)
Diluted earnings per common share	$	0.60		$	0.64		$	(0.04	)

Consolidated Statements of Operations

	For the nine months ended September 30, 2012
	New		Former		Effect of
	reinsurance		reinsurance		Reinsurance
	accounting		accounting		Accounting
	method		method		Change
	(in millions, except per share data)
Revenue
Fees and other revenues	$	1,909.1	$	1,917.5	$	(8.4	)
Expenses
Benefits, claims and settlement expenses	3,969.5		3,950.0		19.5
Operating expenses	2,106.7		2,129.7		(23.0		)
Income before income taxes	693.5		711.3		(17.8		)
Income taxes	99.2		105.8		(6.6		)
Net income	$	594.3	$	605.5	$	(11.2	)
Net income available to common stockholders	$	554.3	$	565.5	$	(11.2	)
Earnings per common share
Basic earnings per common share	$	1.86	$	1.89	$	(0.03	)
Diluted earnings per common share	$	1.84	$	1.88	$	(0.04	)

Certain of the current and prior period line items in the consolidated statements of cash flows and consolidated statements of stockholders’ equity were affected by the DPAC Guidance and the Reinsurance Accounting Change. All of the line item changes in the consolidated statements of cash flows were included in the operating activities section and the changes in the consolidated statements of stockholders’ equity have largely been addressed through the preceding disclosures.

Our accounting policy for DPAC follows, which has been updated from our Form 10-K for the year ended December 31, 2011, to reflect this change.

Deferred Policy Acquisition Costs

Incremental direct costs of contract acquisition as well as certain costs directly related to acquisition activities (underwriting, policy issuance and processing, medical and inspection and sales force contract selling) for the successful 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 for universal life-type insurance contracts, participating life insurance policies and certain investment contracts are being amortized over the lives of the policies and contracts in relation to the emergence of EGPs or, in certain circumstances, estimated gross revenues. This amortization is adjusted in the current period when EGPs or estimated gross revenues are revised. For individual variable life insurance, individual variable annuities and group annuities that have separate account U.S. 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 assumption used for the amortization of DPAC. The DPAC of nonparticipating term life insurance and individual disability policies are being amortized over the premium-paying period of the related policies using assumptions consistent with those used in computing policyholder liabilities.

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 would be 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.

Recent Accounting Pronouncements

In July 2012, the FASB issued authoritative guidance that amends how indefinite-lived intangible assets are tested for impairment. The amendments provide an option to perform a qualitative assessment to determine whether it is necessary to perform the annual fair value calculation impairment test. This new guidance is effective for our 2013 indefinite-lived intangible asset impairment testing and is not expected to have a material impact on our consolidated financial statements.

In December 2011, the FASB issued authoritative guidance related to balance sheet offsetting. The new guidance requires disclosures about assets and liabilities that are offset or have the potential to be offset. These disclosures are intended to address differences in the asset and liability offsetting requirements under U.S. GAAP and International Financial Reporting Standards. This new guidance will be effective for us for interim and annual reporting periods beginning January 1, 2013, with retrospective application required and is not expected to have a material impact on our consolidated financial statements.

Also in December 2011, the FASB issued authoritative guidance that requires a reporting entity to follow the real estate sales guidance when the reporting entity ceases to have a controlling financial interest in a subsidiary that is in-substance real estate as a result of a default on the subsidiary’s nonrecourse debt. This guidance will be effective for us on January 1, 2013, and is not expected to have a material impact on our consolidated financial statements.

In September 2011, the FASB issued authoritative guidance that amends how goodwill is tested for impairment. The amendments provide an option to perform a qualitative assessment to determine whether it is necessary to perform the annual two-step quantitative goodwill impairment test. This guidance will be effective for our 2012 goodwill impairment test and is not expected to have a material impact on our consolidated financial statements.

In June 2011, the FASB issued authoritative guidance that changes the presentation of comprehensive income in the financial statements. The new guidance eliminates the presentation options contained in current guidance and instead requires entities to report components of comprehensive income in either a continuous statement of comprehensive income or two separate but consecutive statements that show the components of net income and other comprehensive income (“OCI”), including adjustments for items that are reclassified from OCI to net income. The guidance does not change the items that must be reported in OCI or when an item of OCI must be reclassified to net income. In December 2011, the FASB issued a final standard to defer the new requirement to present classification adjustments out of OCI to net income on the face of the financial statements. All other requirements contained in the original statement on comprehensive income are still effective. This guidance was effective for us on January 1, 2012, and did not have a material impact on our consolidated financial statements. The required disclosures are included in our consolidated financial statements. See Note 9, Stockholders’ Equity, for further details.

In May 2011, the FASB issued authoritative guidance that clarifies and changes fair value measurement and disclosure requirements. This guidance expands existing disclosure requirements for fair value measurements and makes other amendments but does not require additional fair value measurements. This guidance was effective for us on January 1, 2012, and did not have a material impact on our consolidated financial statements. See Note 10, Fair Value Measurements, for further details.

In April 2011, the FASB issued authoritative guidance that modifies the criteria for determining when repurchase agreements would be accounted for as secured borrowings as opposed to sales. The guidance was effective for us on January 1, 2012, for new transfers and modifications to existing transactions and did not have a material impact on our consolidated financial statements.

Also in April 2011, the FASB issued authoritative guidance which clarifies when creditors should classify a loan modification as a troubled debt restructuring (“TDR”). A TDR occurs when a creditor grants a concession to a debtor experiencing financial difficulties. Loans denoted as a TDR are considered impaired and are specifically reserved for when calculating the allowance for credit losses. This guidance also ends the indefinite deferral issued in January 2011 surrounding new disclosures on loans classified as a TDR required as part of the credit quality disclosures guidance issued in July 2010. This guidance was effective for us on July 1, 2011, and was applied retrospectively to restructurings occurring on or after January 1, 2011. This guidance did not have a material impact on our consolidated financial statements. See Note 3, Investments, for further detail.

In July 2010, the FASB issued authoritative guidance that requires new and expanded disclosures related to the credit quality of financing receivables and the allowance for credit losses. Reporting entities are required to provide qualitative and quantitative disclosures on the allowance for credit losses, credit quality, impaired loans, modifications and nonaccrual and past due financing receivables. The disclosures are required to be presented on a disaggregated basis by portfolio segment and class of financing receivable. Disclosures required by the guidance that relate to the end of a reporting period were effective for us in our December 31, 2010, consolidated financial statements. Disclosures required by the guidance that relate to an activity that occurs during a reporting period were effective for us on January 1, 2011, and did not have a material impact on our consolidated financial statements. See Note 3, Investments, for further details.

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

In January 2010, the FASB issued authoritative guidance that requires new disclosures related to fair value measurements and clarifies existing disclosure requirements about the level of disaggregation, inputs and valuation techniques. Specifically, reporting entities now must disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and describe the reasons for the transfers. In addition, in the reconciliation for Level 3 fair value measurements, a reporting entity should present separately information about purchases, sales, issuances and settlements. The guidance clarifies that a reporting entity needs to use judgment in determining the appropriate classes of assets and liabilities for disclosure of fair value measurement, considering the level of disaggregated information required by other applicable U.S. GAAP guidance and should also provide disclosures about the valuation techniques and inputs used to measure fair value for each class of assets and liabilities. This guidance was effective for us on January 1, 2010, except for the disclosures about purchases, sales, issuances and settlements in the reconciliation for Level 3 fair value measurements, which were effective for us on January 1, 2011. This guidance did not have a material impact on our consolidated financial statements. See Note 10, Fair Value Measurements, for further details.

Separate Accounts

At September 30, 2012 and December 31, 2011, the separate accounts include a separate account valued at $145.9 million and $146.5 million, respectively, which primarily includes shares of our stock that were allocated and issued to eligible participants of qualified employee benefit plans administered by us as part of the policy credits issued under our 2001 demutualization. These shares are included in both basic and diluted earnings per share calculations. In the consolidated statements of financial position, the separate account shares are recorded at fair value and are reported as separate account assets with a corresponding separate account liability to eligible participants of the qualified plan. Changes in fair value of the separate account shares are reflected in both the separate account assets and separate account liabilities and do not impact our results of operations.