Principal Financial Group Inc Q1 FY2023 Earnings Call

Thank you, and good morning. Welcome to Principal Financial Group's First Quarter 2023 Conference Call. As always, material related to today's call are available on our website at investors.principal.com. In addition to our earnings call materials, we included additional details of our commercial real estate exposure in our slide presentation. As a reminder, financial results are now reported under the long-duration targeted improvements accounting guidance, or LDTI. Historical results have been recast, and are also available on our website. Following a reading of the safe harbor provision, CEO, Dan Houston; and CFO, Deanna Strable, will deliver some prepared remarks. We will then open up the call for questions. Others available for Q&A include Chris Littlefield, Retirement and Income Solutions; Pat Halter, Asset Management; and Amy Friedrich, Benefits and Protection. Some of the comments made during this conference call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act. The company does not revise or update them to reflect new information, subsequent events or changes in strategy. Risks and uncertainties that could cause actual results to differ materially from those expressed or implied are discussed in the company's most recent annual report on Form 10-K filed by the company with the U.S. Securities and Exchange Commission. Additionally, some of the comments made during this conference call may refer to non-GAAP financial measures. Reconciliations of the non-GAAP financial measures to the most directly comparable U.S. GAAP financial measures may be found in our earnings release, financial supplement and slide presentation.

Thanks, Humphrey, and welcome to everyone on the call. This morning, I will share highlights of our financial results and key performance highlights for the quarter. Deanna will follow with additional details on our first quarter results, our current financial and capital position as well as some details on our investment portfolio. Our integrated business model remains resilient during periods of macroeconomic volatility, as shown on our strong first quarter results. While we are not immune to credit and market pressures, we are well positioned for a variety of economic conditions. Starting on Slide 3, we reported $367 million of non-GAAP operating earnings or $1.48 per diluted share in the first quarter. We returned more than $300 million of capital to shareholders during the quarter through share repurchase and common stock dividends. We are delivering on our capital deployment strategy by investing for growth in our business, and returning excess capital to shareholders. We ended the quarter with $660 billion of total company managed AUM, an increase of 4% from year-end 2022, reflecting favorable equity and fixed income markets, positive net cash flow as well as positive impacts from foreign currency. We generated $600 million of positive total company net cash flow, a strong result during a period of outflows across much of the industry. This highlights one of the benefits of having a diversified and integrated business model across the asset management, retirement and benefits and protection. Turning to investment performance on Slide 4. Market volatility is underscoring the value of our diversified offering. Our fixed income strategies are delivering strong results, managing through a challenging credit environment. While our asset allocation in U.S. equity strategies have been impacted in their short-term performance, our international equity strategies are delivering strong alpha so far this year, boosting one-year performance. Our approach to invest in high-quality, high-growth companies continues to resonate with our clients, winning additional mandates. We have also received gold and silver ratings from Morningstar for several of our key equity funds. Turning to Slide 5, I'd like to spend a moment on our investment portfolio as there has recently been increased market focus on credit and commercial real estate exposures. We're confident in our high-quality, diversified investment portfolio, which is well aligned with our liability profile. We actively manage our investment risk and have been intentional about further improving credit quality of our portfolio since the global financial crisis. The reinsurance transaction we completed in 2022 decreased our general account by 25%. This reduced our credit exposure and lowered our investment asset leverage well below the industry average. We are a global real estate leader with more than seven decades of experience, managing nearly $100 billion of assets, including more than $70 billion for third parties. Today, we have over 300 real estate investment professionals, 55 of which have more than three decades of real estate experience through many different market cycles. Over the last decade, we have reduced office exposure in our commercial mortgage portfolio as we saw signs of stress coming in this segment, a move which has proven to be appropriate as the recent stress on the banking sector has raised financing concerns for office properties in particular. We've also enhanced our underwriting standards since the global financial crisis, producing a high-quality portfolio with substantial cushion to withstand severe downturns. Our investment and risk management teams have been diligent in transforming the portfolio, delivering a track record of strong financial performance and positioning us to weather a variety of economic conditions and market cycles. Turning to our growth drivers and some additional highlights for the quarter. We continue to benefit from strong employment and wage growth in the U.S., particularly in the small to midsize segment with our retirement benefits and protection business. In retirement, we generated strong sales across all segments, growth in net participant activity and positive net cash flow with recurring deposits up 11% on a trailing 12-month basis. While large market sales and lapses can fluctuate quarter-to-quarter, we have good momentum, and our pipeline is strong for the rest of the year. Our SMB segment is holding up very well with strong recurring deposit growth, and low contract lapses contributing to a 33% increase in net cash flow compared to the first quarter of 2022. And in Benefits and Protection, our focus on the durable small to midsized business market continues to drive growth. Over the last 12 months, the small to midsized employer market has experienced record sales, strong retention, and demonstrated continued strong employment growth, all of which are contributing to our above-industry growth in premium and fees for Specialty Benefits. In Asset Management, our broad distribution and geographic footprint continues to produce benefits. PGI-managed net cash flow was a positive $400 million in the first quarter. While flows for many active managers were negative in the quarter, we continue to benefit from our integrated business model and differentiated investment capabilities, including hybrid target date, stable value, and guaranteed income products. We are winning business from both new and existing retirement customers while generating flows from our general account. As we look forward, we continue to see active engagement with global institutional clients involving investment strategies in private debt and credit, specialized investment income capabilities, and opportunistic investing in real estate. We also drove strong quarterly net cash flow of $800 million in Principal International. These flows were well diversified across Southeast Asia, Brazil, Mexico, and Hong Kong, as we continue to execute on our strategy, building upon our market leadership and key joint venture relationships. Specific to Brazil, we remain a market leader in pension AUM, deposits as well as net cash flow. Bottom line, we are very excited about the growth opportunities which lie ahead. I'm confident we have the right product mix, the right market focus, and the right distribution channels to drive value for our customers and our shareholders. Deanna?

Thanks, Dan. Good morning to everyone on the call. This morning, I will share key contributors to financial performance for the quarter, an update on our current financial and capital position and details of our investment portfolio. Reported net income attributable to Principal was a negative $140 million in the first quarter. Excluding the loss from exited businesses, net income was a positive $347 million with $11 million of credit losses. Credit drift was slightly positive in the quarter. Excluding significant variances, first quarter non-GAAP operating earnings were $395 million or $1.60 per diluted share, a strong result despite macroeconomic pressures on AUM levels during 2022. As Dan noted, first quarter results highlight the value of focus and the strength and resiliency of our diversified business strategy. As detailed on Slide 17, significant variances had a net negative impact on our first quarter non-GAAP operating earnings of approximately $33 million pretax, $29 million after tax and $0.12 per diluted share. The significant variances were primarily due to lower-than-expected variable investment income in RIS and Benefits and Protection. Mortality experience true-ups in RIS were mostly offset by LDTI model refinements in Specialty Benefits. As discussed during our 2023 outlook call, we expected variable investment income from alternative investment returns, real estate sales and prepayment fees to be lower than 2022 levels and lower than our expected long-term run rate due to the macro environment heading into the year. VII was positive in total for the quarter, but we did not have any VII from prepayment fees or real estate sales. Macroeconomic volatility continued in the first quarter and pressured earnings in our fee-based businesses relative to a year ago quarter. While the S&P 500 daily average increased 4% from the fourth quarter of 2022, it was 11% lower than the first quarter of 2022 and 10% lower on a trailing 12-month basis. Foreign exchange rates were a tailwind compared to the fourth quarter but a headwind relative to the year ago quarter and on a trailing 12-month basis. Impacts to reported pretax operating earnings included a positive $7 million compared to fourth quarter of 2022, a slight negative compared to first quarter 2022 and a negative $17 million on a trailing 12-month basis. Turning to the business units. The following comments on our first quarter results exclude significant variances. As a reminder, comparisons to first quarter of 2022 are impacted by the reinsurance transactions that closed in the second quarter of 2022. Revenue growth and margins in Specialty Benefits and Principal International were in line with our expectations in the first quarter. Revenue growth in RIS and PGI were pressured by the impacts of macroeconomic volatility and lower account values and AUM compared to a year ago but both businesses are benefiting from more favorable conditions relative to the assumptions in our 2023 outlook. Despite the pressures on revenue growth, the margin in RIS was strong in the first quarter and benefited from diligent expense management, one-time items in the quarter and timing of expenses. For the full year, we continue to expect to be within the 35% to 39% guided range with the ultimate level impacted by macro conditions for the remainder of the year. PGI's margin and pretax operating earnings were pressured by expected expense seasonality as well as expected lower transaction and borrower fees. Expenses in the first quarter were elevated by approximately $20 million due to seasonality of payroll taxes and deferred compensation. We continue to expect PGI's margin to be within the 34% to 37% guided range for the full year. Principal International had strong earnings in the first quarter driven by growth across the business and higher AUM. Favorable impacts of inflation and higher interest rates in Brazil were offset by lower-than-expected encaje performance and VII in Chile. In life, pretax operating earnings and margin were lower than expected, primarily due to higher claims experience in the quarter. The decline in premium and fees was driven by the 2022 reinsurance transaction and will normalize throughout the year. We continue to expect to deliver on our 2023 guidance for the full year, both at the business unit level as well as for the total company. Turning to capital and liquidity. We remain in a strong financial position despite the volatile environment. We ended the first quarter with $1.8 billion of excess and available capital, including more than $1.5 billion at the holding company. This includes our $800 million target and $700 million of proceeds from debt issuance in the first quarter that is earmarked for debt maturity and redemption in the second quarter, $300 million in our subsidiaries and $30 million in excess of our targeted 400% risk-based capital ratio. During the quarter, in addition to returning excess capital to shareholders, we accelerated our organic capital deployment as we saw attractive return opportunities in our businesses. This was a pull forward of our business plan for 2023. Looking ahead, our free capital flow generation will increase throughout the year. We returned $306 million to shareholders in the first quarter, including $150 million of share repurchases and $156 million of common stock dividends. Last night, we announced a $0.64 common stock dividend payable in the second quarter, in line with our targeted 40% dividend payout ratio. We remain focused on maintaining our capital and liquidity targets at both the life company and the holding company, and we'll continue pursuing a balanced and disciplined approach to capital deployment. I want to end my comments by providing some additional details of our investment portfolio, including our real estate exposure. As Dan mentioned, we have intentionally improved the overall credit quality across our fixed maturity and real estate portfolios since the global financial crisis. Our investments are high quality, well aligned with our liability profile, and we are well positioned for a variety of economic conditions. Starting on Slide 11. Specific to the real estate portfolio. As of the end of the first quarter, our commercial loan portfolio has a current average loan-to-value of 46% and a debt service coverage of 2.5 times. This has improved from 62% and 1.8 times in 2008. We have minimal exposure to floating rate loans and a very manageable maturity schedule of high-quality loans with only 4% maturing in 2023 and another 7% in 2024. Our commercial office portfolio is geographically diverse and high quality. We saw signs of stress building in this sector and proactively reduced our office exposure from 37% of our mortgage portfolio in 2016 down to 25% today. We have taken a conservative approach to our office portfolio and have manageable near-term maturities. We have already reduced valuations in our office portfolio by 22% from the peak, and they are 20% below the current implied index value. The current loan-to-value on our office portfolio is 52% and debt service coverage is 2.5 times. We have looked at a number of different stress scenarios on office valuation. This includes an additional 20% to 40% decrease from our current conservative valuations and assumes an immediate default of all office loans over 100% LTV. The ultimate impact on our RBC ratio is estimated to be 2 to 3 percentage points under the 20% additional decrease scenario and 10 to 12 percentage points under the 40% additional decrease scenario, both very manageable. That said, we have the experience and a long-established track record of navigating real estate cycles. It will take time for any market cycle to emerge, and the impacts would play out over a number of years. Looking at our CMBS portfolio, relative to 2008, we have decreased the overall size of our portfolio by 22% and improved the quality to 98% with an NAIC 1 rating today. Our equity real estate portfolio is well diversified with a high concentration of property types with strong fundamentals, such as industrials and life sciences. The market value of our portfolio is substantially higher than our carrying value. Overall, we are confident in the quality of our real estate portfolio, and remain diligent in monitoring and proactive in servicing it. We have built a high-quality portfolio that is well diversified and a good fit for our liability profile. 2023 will not be without its challenges, but we are positioned to focus on maximizing our growth drivers of retirement, global asset management, and benefits and protection which will drive long-term growth for the enterprise and long-term shareholder value. We have the financial flexibility, discipline, and a track record of managing through times of macro volatility and uncertainty. This concludes our prepared remarks. Operator, please open the call for questions.

The first question comes from Ryan Krueger with KBW.

The first question was about the office stress scenario you described. I am curious if the impact was primarily related to downward ratings migration and some credit losses, or if you considered the potential effect of having to take over certain properties, which would incur a higher capital charge as owned real estate.

Yes, appreciate that question, Ryan. I'll have Deanna handle that.

Yes. It was us taking over those properties in a complete default. Obviously, the extreme one was very unlikely 40% additional decrease from our already reduced 22% values. And then I also think it's important that, that wouldn't all happen at one time and would happen over an extended period of time.

Got it. And then could you talk about, I guess, the amount of committed capital you already have to deploy into real estate within PGI over time as well as your evolving thoughts on when the market may pick up for new deployment opportunities?

Thank you for the question, Ryan. As you know, we have been a strong and active advisor to investors globally in real estate. Currently, we have a robust pipeline of over $7 billion in committed but unfunded capital, derived from our discussions with clients worldwide. We have not yet deployed this capital because we are waiting for valuations to reach a level that allows us to re-enter the market confidently. We plan to do so at the appropriate time. Regarding your second question, the timing of this will depend on when we observe valuations that are attractive for us to engage, likely later this year. We expect to see some adjustments in valuations over the next two quarters that will enable us to move forward with conviction. We are eager to get back into the markets when the timing is right. Additionally, I was in Asia three weeks ago and noted a significant interest from institutional investors looking to take advantage of real estate opportunities. We are engaged in new conversations with these investors globally to raise funds, particularly in private debt, which we view as an entry point, as well as in private equity as we approach 2024.

Hopefully, that helps, Ryan?

Great.

Our next question comes from the line of Jimmy Bhullar with JPMorgan.

So the first one is just on the fee retirement business. And if I look at the flows in 1Q, even if you include the spread retirement, the flows seem pretty light relative to what you've had in previous 1Qs over the last several years, especially given the fact that the labor market is as strong as it is. So if you could just give some color on what drove that?

Chris, please.

Thank you for the question, Jimmy. When we examine the flows from the first quarter, there are a few key points to mention. We have noticed some variability in the large market, and one low-fee plan, totaling about $2.8 billion in assets, lapsed during the quarter. Despite this lapse, we maintain a strong pipeline in the large sector. It’s important to remember that large plans tend to show variability in both inflows and outflows due to their size. When I evaluate our transfer deposit performance, we observed a 22% increase, indicating strong momentum and a robust pipeline in our business. The underlying fundamentals remain solid, particularly in the small and medium-sized business (SMB) sector, as highlighted by Dan in his comments. Recurring deposits have grown by about 4% compared to last year and 11% on a trailing 12-month basis, especially strong in the SMB space where recurring deposits have increased by approximately 8% to 9%. Notably, our net cash flow in the SMB alone reached nearly $2 billion for the quarter, demonstrating strong performance there. However, this does not overshadow the variability in flows associated with the lapse of a large plan and the full fee plan.

Yes, one large plan like that can mask a really strong quarter. Do you have a follow-up, Jimmy?

Yes. Regarding PGI margins, as we consider the margins for the remainder of the year, is the first quarter a good benchmark for expenses and overall margin levels in PGI?

Pat, please.

Thank you for the question, Jimmy. The margin for the first quarter was just over 30%. However, this should not be taken as an accurate representation of margins for the rest of the year. We had a one-time expense adjustment related to retirement deferred compensation and payroll taxes in the first quarter, totaling around $20 million. That's an important point to keep in mind regarding the margin discussion. Additionally, we have observed a reset in some valuations in the first quarter, which will help to expand our assets under management going forward, in line with the growth we expect from our platforms. We remain confident in our guidance of achieving a margin of 34% to 37% by the end of the year, Jimmy.

Our next question comes from the line of John Barnidge with Piper Sandler.

Oftentimes, you talk about employee withholding match and the trends there. How has that trended versus last year? Are you seeing employees or employers pull back at all on how much they're contributing? And how did that factor into the recurring deposit growth within RIS?

Yes, it's a great question. The one thing that's amazing is just how competitive that SMB marketplace still is in terms of attracting and retaining talent. Those things still remain strong. But Chris, you want to provide some additional detail on the strength of the matching contributions.

Yes, sure. I would say we still see growth, although it's certainly slowing from what we saw in 2022. So John, when I look at the number of participants deferring the numbers receiving a match, the new participants with account value and the overall average of deferred dollars per participant, all of those metrics are up 3% to 4% year-over-year. And again, as I highlighted in the SMB, it's particularly strong at 8% to 9% on recurring deposits. So that's all positive, albeit a bit slower than we've seen in past years.

And my follow-up question, maybe just to clarify, on the $1.8 billion on Slide 3 of the presentation, there is a footnote you talked about in your prepared remarks about the $700 million in proceeds. Are we supposed to normalize for that? Or is the $1.8 billion the number we should be using?

Deanna, please.

Thank you, John, for your question. I hope you're recovering well after your accident. Regarding the $1.8 billion shown on the slide, it is elevated because of the $700 million in debt we issued in the first quarter, but we will be paying off the existing debt in the second quarter. A more accurate figure would be around $1.1 billion. As for your follow-up about the decrease from the end of last year, there are a couple of factors affecting that. Besides the debt issuance, two main influences are the return of capital to our shareholders and any free cash flow and dividends between entities during the quarter. In the first quarter, we returned a significant amount to shareholders, over $300 million, which included $150 million in share buybacks and a slightly larger amount through our common stock dividend. The first quarter typically sees less free cash flow due to two main reasons: the buildup of cash, and the seasonality of dividend timing. Additionally, this quarter had cash payments for bonuses, which also affects the first quarter. If you look back to 2022 and compare the roll forward from the fourth quarter of 2021 to the first quarter of 2022, you'll notice a similar pattern, showing minimal free cash flow in the first quarter but strong overall for the year. The fourth quarter is generally our largest for free cash flow. This quarter saw a higher volume of high-return organic deployment opportunities and accelerated some of our full year sales plan, but we are not changing our full year sales expectations. This is merely shifting some activity into the current quarter, and we anticipate higher free cash flow in the other quarters. A notable example is PRT, where we had nearly $600 million in sales this quarter, making it usually much lighter. Ultimately, the seasonal trends we observed are not unexpected; we've noted this in prior years and will continue to in the future. We remain optimistic about our free cash flow potential for the entire year. Thank you.

Our next question comes from the line of Tracy Dolin-Benguigui with Barclays.

I would like to touch upon specialty group benefits. Can you add color regarding what drove higher loss ratios across several products like dental and vision, group life, the individual disability?

Amy will handle that accordingly. Amy, please.

Yes, I'm feeling generally positive about the loss ratios. They're within the expected ranges. I want to emphasize dental, which does show some seasonality. As we've noted in previous calls, dental loss ratios were impacted by COVID, disrupting the usual seasonal patterns. Now, I see dental seasonality returning to pre-COVID levels. Typically, dental utilization peaks in the first quarter. Therefore, the loss ratio we’re observing for dental is seasonal and aligns with expected patterns, remaining within our anticipated levels. Overall, the loss ratios across our group benefits and individual disability are within normal parameters for the year.

Tracy, you also mentioned Group Life. Actually, group life is down once you adjust the first quarter of '22 for the COVID claims. It is up from fourth quarter, but it was more because we had an abnormally low loss ratio in the fourth quarter of '22. So you had mentioned group life, so I just wanted to touch on that one as well.

Excellent. Just circling back on the comments about adjusting your available and excess cash. So if I take out the $700 million from your $1.5 billion of OCO cash, you're exactly at the $800 million minimum threshold. And then when I'm thinking about it, there isn't a lot of excess capital from your subsidiaries, $300 million or so. You do sound confident about meeting your 75% to 85% free cash flow conversion. Are you expecting greater organic surplus generation through earnings and that's how you'll get there for the remainder of the year?

Yes. So as you're aware, our free cash flow is all driven by statutory results as well as, again, in non-life entities, it would be the movement of that excess cash and capital up to the holding company. We are confident on that. As mentioned, the seasonality and some of just the pressuring of dividends and the fact that we dividend a high amount in the fourth quarter. So you start the year at a smaller level in those subsidiaries. We feel very confident relative to that. I don't see any meaningful disruption to our capital plans in the current environment. And the other thing I'd bring you back to is, post the transactions last year, our risk profile of our business mix is lower. Our credit risk is lower. We've talked a lot and given you a lot of material of why we feel really good about the high-quality of our investment performance, our portfolio that will perform well. And so again, when you bring that all together, we will see higher dividends in the second quarter, third quarter, and fourth quarter. And we also do see that seasonality in statutory results as we go throughout the year.

Hopefully that helps, Tracy.

Our next question comes from the line of Wes Carmichael with Wells Fargo.

I kind of wanted to stick with free cash flow for a second, too, but on Slide 2 of the deck, it mentions that you expect free cash flow conversion to increase throughout the year. But my understanding is that ratio is on the net income, excluding the exited business. So if I looked at the first quarter, the $300 million returned to shareholders, I calculated a ratio of 86%. So it seems like you're kind of there already in the first quarter. So I'm just trying to reconcile that with your thoughts on that should accelerate.

I'll have Deanna handle that. But Wes, welcome and appreciate you picking up coverage on PFG.

Wes, I want to make you aware that the deployment can originate from two sources: excess funds carried over into the quarter and the free cash flow generated during the quarter. We had nearly $300 million in excess at the beginning of the year within our holding company and entities. Therefore, this needs to be considered in that result as well.

Got it. And can you maybe just talk about your outlook for 2023 for pension risk transfer sales. You had $600 million in the first quarter in RIS. But it seems like it might be a pretty good environment with higher interest rates and as well as a tailwind from the equity markets bouncing back.

True to that. Chris, do you want to go ahead and respond?

Yes, welcome, Wes. Thank you for your question. As Deanna mentioned, we had a strong start to the year, which is somewhat unusual for the first quarter. We anticipate growing our pension risk transfer business by approximately 10% to 15% compared to last year, aiming for about $2.3 billion. The industry expects overall opportunities in the range of $30 billion to $40 billion, and according to Mercer, plans are well funded at 102%. Therefore, we see many opportunities for pension risk transfer. However, the key for us is to deploy capital in a disciplined manner. We are selective about which opportunities we pursue, focusing on those that provide a good return on our investment.

It's also probably worth calling out Wes is that about 25% of those PRT sales actually came from existing full-service customers. And again, that comprehensive approach to retirement solutions is what we're about. And you can see where those intersections come together and help drive results for the organization.

And to that point, Dan, about $150 million of the $600 million in this quarter were existing DB customers of ours. So you do see the power of that in our business.

Our next question comes from the line of Michael Ward with Citi.

I really appreciate the disclosures on CRE; they are very helpful. You mentioned that the LTVs are revalued quarterly. I am curious about the debt service coverage component and how up-to-date these metrics are. I'm trying to understand how this might evolve over time, not just for Principal but for CRE debt in general. How current are the debt service coverage metrics that we see?

Appreciate that, Michael. And Pat also might be able just to maybe share a little bit with the group about the resources we have surrounding this in terms of valuations and feet on the streets to assess this asset class.

Thank you, Michael, for your question. One of the advantages we have as a company, as Dan pointed out in his remarks, is the scale of our organization. Regarding the office sector, which is important for everyone here, we are actively reevaluating each of those loans every quarter. Our experienced team covers 40 major markets in the U.S., and our underwriters have extensive knowledge of those markets. We conduct quarterly reevaluations, reconstructing cash flows related to rental streams and lease structures in real time while collecting market data on potential cap rate movements and current market rents compared to contract rents. We keep our cash flow analyses up to date for each asset from a property income and expense perspective. This thorough examination gives us strong confidence in our debt service coverage ratios. Additionally, we have an experienced equity real estate group that manages properties across the country, obtaining real-time broker insights on cap rate trends and investor sentiment. We have established a comprehensive process that we implement every quarter for our office portfolio, and we are applying a similar approach to our residential and industrial portfolios over a series of quarters.

Did that help, Michael?

Yes. That's very helpful, guys. So maybe on commercial mortgage loans versus CMBS. Just wondering if you could comment. I think you guys are mainly or almost all conduit. And I believe about 30% of that is office. So hoping you could comment on that and whether or not that's included in the RBC stress test.

Pat, please.

We have conducted an analysis of our CMBS portfolio, and it's noteworthy that our office exposure in the private space is similar to what we have in our CMBS holdings, with about 25% to 30% in office. We are currently assessing those assets in terms of maturity, and for our CMBS portfolio, the office loans maturing in 2023 and 2024 are quite limited. Additionally, we are performing a detailed analysis of the subordination levels, examining how they protect us. The cash flow analysis reinforces this, and we are applying our findings to the actual structure of the CMBS in regard to subordination levels. So far, the results are encouraging. When we stress test these portfolios, the subordination levels provide substantial reassurance, as they would remain at 21% or higher in a stress test scenario, which corresponds to an A-quality rating based on ratings agency standards.

Mike, that was not included in the stress test that we included. But if you actually look at Page 14 and given that 98.5% of those CMBSs are NAIC 1, I think any impact in a stress scenario, and again, in addition to the commentary that, Pat, would be very, very minor relative to that risk.

Our next question comes from the line of Suneet Kamath with Jefferies.

I appreciate all the color on how you go about valuing the office CRE, it does sound like you have a lot of resources. But just curious, is there part of the process where you go through getting a sort of a third party to kind of validate the analysis, just to kind of give you one more check.

Pat?

Yes. Typically, you would obtain an appraisal. The challenge today, as you can imagine, is that these appraisals may not be as current or as effective in capturing real-time information about the reconstruction of cash flows, the buildings, and the relevant changes in tenancy and market rents compared to contract rent buildings. Therefore, in our analysis, we do not seek a third-party valuation opinion. We believe our expertise and in-depth analysis are likely superior to that.

We meet once a week with the real estate team to evaluate investment options in our investment committee. The professionals involved engage in discussions about this and have strong relationships with brokers in each of these subcategories. Therefore, I believe there is a very thorough assessment and valuation process in place for how we manage these investments. It is a rigorous procedure supported by a highly skilled team.

Just to add to that, we have over 550 institutional investors in over 34 countries, and they also feel very comfortable with the process we deploy here.

Got it. That makes sense. I have a quick question for Deanna. Regarding the outlook for buybacks, you completed $150 million in the first quarter. Should we expect that to continue at that pace moving forward? Any insights on what to expect?

Yes, I believe there will be fluctuations from quarter to quarter. However, if you look at the annualized figure, it's in the right range. If you compare our free cash flow projections to what you might expect, you'll likely arrive at a similar conclusion. It's important to acknowledge the current environment, as there will be some variations to consider quarter to quarter. Overall, I think this is a solid indication of what we might see for the remainder of the year.

Our next question comes from the line of Erik Bass with Autonomous Research.

In the RIS business, net investment income increased pretty materially from the fourth quarter, even adjusting for variable investment income. So I was just hoping you could talk about what's driving this, and the outlook going forward? And then how we should think about how much of that benefit drops to the bottom line?

Chris, please.

Yes, thank you for the question, Erik. We are definitely seeing three main factors influencing our investment income. Firstly, the rise in short-term interest rates has positively impacted us. Secondly, there is a timing difference between when rates go up and when those rates are applied for our customers, which creates a delay. Lastly, we are experiencing overall growth in our business segment. These are the key factors affecting net investment income. While reviewing the supplement, focusing only on net investment income may not provide the full picture, as it’s important to consider the interest credited in the BCSD line as well. There is a benefit we are observing, though it might not appear as significant when looking solely at the net investment income. We anticipate additional benefits if interest rates keep rising, although we may be reaching the peak of the larger increases observed throughout 2022. We expect to see some advantages but also note that normalization in net interest margin will occur over time. Competitive pressures and other factors will contribute to this normalization in the long term, but we do anticipate some benefits.

Do you have follow-up, Erik?

Yes, a follow-up for Pat. Just curious what you're seeing in terms of client demand for fixed income. Has interest started to pick up now that rates have stabilized a bit? And if so, are you seeing new money going into traditional active products? Or is more being allocated to passive?

Thank you, Erik, for your question. It's been an interesting period for our fixed income portfolio. In the first quarter, we experienced some notable trends, particularly in preferred stocks. Due to banking pressures, we saw a slight outflow from preferreds. However, as we communicated with our investors and as the banking crisis seems to be behind us, there is renewed interest in preferreds. I want to emphasize that our specialty income capabilities remain significant in the market, even as investors turn towards money markets and CDs. While there is a brief pause in activity, there are ongoing discussions about high yield investments and preferreds, as well as sectors where we excel, like emerging market debt and REITs. We anticipate that as interest rates stabilize and the Fed holds off on rate hikes, there will be a resurgence in active investing in fixed income, which we are looking forward to.

Our next question comes from the line of Tom Gallagher with Evercore.

My first question is for Deanna. I wanted to inquire about the specifics of cash flow generation this quarter. I understand your comments about seasonality, and I can appreciate that. However, when considering normal capital generation for the quarter compared to what you achieved, it appears there is a shortfall of about $350 million to $400 million. I assume PRT accounted for around $50 million. The seasonal cash payments you mentioned might add another $50 million to $100 million, which would result in an approximate shortfall of $200 million. Does that math seem accurate? If so, what else could address this gap?

Yes. Thanks, Tom, for the question. I think the seasonality is greater than what you're giving credit to. If you went back to the roll forward from fourth quarter to first quarter last year, there we deployed approximately $900 million in the quarter, and our capital was reduced by just shy of $900 million. And so again, very modest free cash flow. So you're understating the amount of seasonality. I think maybe the organic opportunities is probably in the ballpark. But really that seasonality is much greater than what you were anticipating in your roll forward. There were some modest one-timers in the quarter. I'd say either they were anticipated in our capital plan, but we knew they would be pressuring first quarter or they will reverse in future quarters, but it's really that seasonality that you're understating, and I take you back to a year ago to kind of do a comparison.

Our next question comes from the line of Tracy Dolin-Benguigui with Barclays.

I would like to touch upon specialty group benefits. Can you add color regarding what drove higher loss ratios across several products like dental and vision, group life, the individual disability?

Amy will handle that accordingly. Amy, please.

Yes, I believe we are generally pleased with the loss ratios you are observing, as they align with our expectations. I would notably point out dental, which does exhibit some seasonality. As we've discussed in many previous calls, dental loss ratios became misaligned in terms of seasonality due to COVID disruptions. The closures and other factors impacted our ability to recognize seasonal trends in the industry for a couple of years. However, I am seeing that dental seasonality is returning to pre-COVID levels. Typically, dental utilization peaks in the first quarter of the year. Therefore, the current loss ratio for dental appears to be seasonal, returning to expected patterns, and remains within our anticipated range. For the full year, the loss ratios across our group benefits and individual disability insurance are also at normal levels.

Tracy, you also mentioned group life. Actually, group life is down once you adjust the first quarter of '22 for the COVID claims. It is up from the fourth quarter, but it was more because we had an abnormally low loss ratio in the fourth quarter of '22. So you had mentioned group life, so I just wanted to touch on that one as well.

We have reached the end of the Q&A. Mr. Houston, your closing comments, please.

Yes. I appreciate that, Christine. A couple of quick comments. The first of which we appreciate your insights and your questions. Secondly, a large portion of the management team that's here today was here during that '08, '09 period. We've been through this cycle before, and we'll find an appropriate path through this cycle. Maybe third, just recognizing that we're trying to be very proactive with investors on the disclosures, in particular, around commercial real estate and office because we think it's the right thing to do to provide that level of transparency. Also, I think it's helpful to understand the clarity and the emergence of our free cash flow, again, reaffirming where we had set out from the beginning of the year. Again, the first quarter has had this historically. And then also to recognize the fundamentals of the markets in which we serve. And by the way, the international markets as well, which we didn't get into a lot of conversation today, have really held up well. So seeing very positive cash flows in both Asia and Latin America. So in spite of some very challenging and what I'd call volatile macroeconomic environment, the markets from which we serve have held up very well, and it's certainly our intention to deliver on the promises we made during our outlook call. So thank you, and look forward to seeing you on the road. Have a great day.

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