Lincoln National Corporation — Q2 2016 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2016. LNC is an insurance and retirement-services holding company, with Annuities, Retirement Plan Services, Life Insurance and Group Protection segments. Financial amounts are in millions of dollars except per-share data. Segment operating income is a non-GAAP measure; consolidated net income is GAAP.
Financial performance
| Metric | Q2 2016 | Q2 2015 | Six months 2016 | Six months 2015 |
|---|---|---|---|---|
| Total revenue | $3,307 | $3,381 | $6,551 | $6,685 |
| Income before tax | $414 | $449 | $650 | $811 |
| Net income | $325 | $344 | $533 | $644 |
| Diluted EPS | $1.35 | $1.35 | $2.17 | $2.50 |
| Net margin, calculated as net income/revenue | 9.8% | 10.2% | 8.1% | 9.6% |
| Net investment income | $1,199 | $1,187 | $2,371 | $2,374 |
| Realized gain (loss) | $(45) | $10 | $(159) | $(38) |
Q2 comprehensive income was $1,589, including $1,264 of other comprehensive income (OCI); six-month comprehensive income was $2,883, including $2,350 of OCI. These OCI amounts substantially reflect changes in unrealized investment values and should not be treated as operating earnings.
Segment operating income
| Segment | Q2 2016 | Q2 2015 | Six months 2016 | Six months 2015 |
|---|---|---|---|---|
| Annuities | $235 | $255 | $453 | $494 |
| Retirement Plan Services | $31 | $30 | $61 | $65 |
| Life Insurance | $120 | $105 | $195 | $215 |
| Group Protection | $15 | $19 | $20 | $13 |
| Other Operations | $(28) | $(38) | $(42) | $(63) |
Group Protection’s six-month improvement was partly driven by favorable mortality and disability claim recoveries. Life Insurance improved in Q2 but declined for the six-month period. Annuities’ operating income fell 8% in both comparisons.
Financial position, cash flow and capital
- Balance sheet: Total assets were $263,028 at June 30, up from $251,908 at year-end 2015. Stockholders’ equity was $15,920, compared with $13,617; accumulated OCI rose to $3,195 from $845.
- Investments: Total investments were $110,587, including $91,461 of fixed-maturity securities and $9,257 of mortgage loans. Cash and invested cash was $4,113, up from $3,146.
- Debt: Short-term debt was $250 and long-term debt $5,460, versus no short-term debt and $5,553 of long-term debt at December 31, 2015. Total reported debt was $5,710.
- Cash flows, six months: Operating cash flow was $533 (prior year $582); investing cash flow was $(240) (prior year $(2,134)); financing cash flow was $674 (prior year $(40)). Cash and invested cash increased by $967.
- Holding-company liquidity: Available liquidity was $523 at June 30. LNC reported compliance with covenants under its new June 30, 2016 credit facility. Insurance-subsidiary dividends and intercompany funding are important sources of holding-company cash.
- Capital returns: LNC repurchased $475 of stock and paid $121 of common dividends during the six months. The quarterly dividend was $0.25 per share. Remaining repurchase authorization was $891 at June 30.
Changes versus prior comparable periods
- Q2 revenue declined 2% and net income declined 6%; six-month revenue declined 2% and net income declined 17%. Six-month diluted EPS fell from $2.50 to $2.17.
- Six-month total deposits decreased 16% to $10,548, and net flows fell 50% to $1,404. Annuity deposits declined 30% year to date; annuity net flows were negative $486, versus positive $593 a year earlier. Retirement Plan Services net flows were $82, versus $422.
- Life Insurance deposits were nearly flat year to date at $2,630; net flows were $1,808, essentially unchanged. Group Protection operating revenue declined 13% year to date, while operating income increased to $20 from $13.
- Management attributed lower consolidated earnings to realized investment losses and higher OTTI, weaker alternative-investment income, lower prepayment and make-whole premiums, lower average equity markets/account values, and spread compression as new-money yields trailed portfolio yields. Legal accrual releases, business-in-force growth and improved Group Protection loss experience partly offset these pressures.
- Fixed-maturity AFS securities had $92,061 fair value versus $85,562 at year-end; gross unrealized losses and OTTI in loss positions fell to $768 from $2,135. Management said it did not expect to need to sell temporarily impaired securities before recovery and believed expected cash flows supported amortized cost.
Outlook, risks and unusual items
- Outlook: The filing provides no specific full-year earnings or revenue guidance. Management said it expected to manage near-term spread effects through portfolio management and, to a lesser extent, crediting-rate actions. Results for the first half are not necessarily indicative of full-year results.
- Interest-rate and market exposure: Sustained low rates may reduce investment spreads and product demand; rising rates may increase policy surrenders and realized investment losses. Equity-market declines can reduce fee income and increase guaranteed-benefit exposure. About 66% of individual annuity account values had GLB features; 11% of contracts with GLBs were in the money, versus 4% a year earlier. Net exposure after reinsurance was $724, versus $287.
- Hedging and earnings volatility: Six-month excluded realized losses after tax were $159, compared with $83. The filing cites asset sales, credit impairments—particularly energy and commodity-related holdings—and variable-annuity hedge results. LNC reported a $1,505 loss on GLB reserve embedded derivatives in the first half, substantially affected by market and non-performance-risk assumptions.
- Credit and portfolio risks: 95.5% of fixed-maturity AFS securities were investment grade. Energy AFS bonds had $7,820 fair value; 14.3% of their amortized cost was below investment grade. LNC recorded $64 of net OTTI in earnings for the six months, primarily tied to corporate bonds. Mortgage loans were $9,257, with $4 delinquent or in foreclosure.
- Legal contingencies: LNC estimated aggregate reasonably possible losses of up to approximately $50, including amounts above accruals; some matters could not be estimated. A newly served putative class action alleged improper cost-of-insurance charges on certain universal-life policies; LNC said it was vigorously defending the case.
- Regulatory and reserve financing: The Department of Labor fiduciary rule was scheduled for phased implementation beginning April 10, 2017, with full implementation by January 1, 2018. LNC also described statutory reserve requirements for term and secondary-guarantee life products, captive reinsurance and reliance on letters of credit and other financing arrangements.
- Other notable items: Management estimated favorable hypothetical assumption unlocking at June 30 of $105 for Annuities, $20 for Retirement Plan Services and $15 for Life Insurance, pre-tax; these were not recorded as actual quarter results. Disclosure controls were reported effective, with no material change in internal control over financial reporting.
Most important facts for investors to verify
- Whether annuity deposit and net-flow weakness continues, and how it affects fee income and future earnings.
- How persistent low rates and spread compression affect investment yields, crediting rates and policyholder behavior.
- Whether the increase in credit impairments—especially in energy and commodity holdings—continues, despite management’s recovery assumptions.
- The sensitivity of GLB reserves and hedge results to equity markets, volatility, interest rates and non-performance-risk assumptions.
- Holding-company liquidity, subsidiary dividend capacity, statutory capital, and continued access to reinsurance financing and letters of credit.
- Developments in the cost-of-insurance litigation and other legal or regulatory matters, including the potential exposure beyond recorded accruals.