Lincoln National Corporation — Q3 2014 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2014; comparisons are with the corresponding 2013 periods unless otherwise noted. Amounts are in millions of dollars, except per-share data. Lincoln National operates Annuities, Retirement Plan Services, Life Insurance and Group Protection businesses, plus Other Operations.
Financial performance and condition
| Metric | Q3 2014 | Q3 2013 | Nine months 2014 | Nine months 2013 |
|---|---|---|---|---|
| Total revenue | $3,411 | $3,009 | $9,869 | $8,847 |
| Income before taxes | $601 | $442 | $1,564 | $1,165 |
| Net income | $439 | $337 | $1,166 | $893 |
| Diluted EPS | $1.65 | $1.23 | $4.34 | $3.24 |
| Comprehensive income (loss) | $162 | $194 | $2,525 | $(1,165) |
| Net cash from operating activities | — | $1,095 | $504 |
Q3 realized gains were $89, compared with a $28 realized loss in Q3 2013; nine-month realized gains were $106, versus a $105 loss. These results were affected by investment and derivative marks, variable-annuity hedges and reserve assumption changes. Net income is therefore not solely a measure of underlying segment performance.
Segment operating income (after tax): Q3 / nine months, respectively: Annuities $245 / $688; Retirement Plan Services $40 / $118; Life Insurance $150 / $418; Group Protection $8 / $29; Other Operations $(29) / $(80). The company’s operating measure excludes specified realized gains and losses and other items; it is not GAAP net income.
Balance sheet and liquidity: At September 30, total assets were $248,446 and stockholders’ equity $15,452, compared with $236,945 and $13,452 at December 31, 2013. Cash and invested cash was $1,821, down from $2,364. Short-term debt was $250 and long-term debt $5,186, totaling $5,436 versus $5,821 at year-end. Holding-company available liquidity was $572. Operating cash flow improved, while investing activities used $1,722; financing activities provided $84. The company repaid $500 of long-term debt and repurchased $450 of common stock in the first nine months.
Investment and margin indicators: Net investment income was $1,212 in Q3 and $3,627 year to date. Fixed-maturity AFS securities were $85,946 at fair value; 95.3% were investment grade. The company reported $533 of gross unrealized losses on AFS securities and said it did not expect to be required to sell temporarily impaired securities before recovery. Annuities’ interest-rate spread was 1.73% in Q3 and 1.79% year to date, down from 1.78% and 2.02%. Retirement Plan Services’ spread was 1.88% and 1.89%, down from 2.03% and 2.05%. Life Insurance’s interest-sensitive spread was 1.80% in Q3 and 1.77% year to date, versus 1.83% and 1.85%.
Material changes versus prior periods
- Consolidated net income increased 30% in Q3 and 31% for the first nine months. Management cited account-value and in-force growth, realized gains versus prior-year losses, stronger alternative-investment income and more favorable unlocking.
- Annuities operating income rose 24% in Q3 and 25% year to date, supported by higher fee income from larger variable account values. Annuity deposits fell 5% in Q3 and 6% year to date; nine-month net flows fell 45%.
- Retirement Plan Services operating income increased 21% in Q3 and 9% year to date. Nine-month net flows declined to $55 from $901, with management noting mature-block outflows and the importance of new deposits.
- Life Insurance operating income rose 7% in Q3 and 8% year to date. Nine-month sales declined 6%, while deposits increased 4%; benefits and expenses also rose.
- Group Protection operating income fell 65% in Q3 and 52% year to date. Q3 non-medical loss ratio rose to 77.6% from 73.4%, mainly because of lower long-term disability recoveries.
- Accumulated other comprehensive income increased to $2,922 from $1,563 at year-end; nine-month OCI was positive $1,359, despite a Q3 OCI loss of $277.
Outlook, commentary, risks and unusual items
- No consolidated numerical earnings or revenue guidance is provided. Management said Group Protection loss ratios were expected to be at or above the high end of the 71%–74% long-term non-medical target range for the remainder of 2014. A one-percentage-point increase in the loss ratio was estimated to reduce annual operating income by approximately $13–$15.
- Management expects to manage near-term spread pressure through portfolio management and, to a lesser extent, crediting-rate actions. It cautioned that sustained low interest rates can compress spreads; rising rates can increase policy surrenders and affect investment results and hedges.
- The third-quarter annual assumption review produced a net $22 pre-tax benefit to continuing operations, including $12 for Annuities, $1 for Retirement Plan Services, $(16) for Life Insurance and $25 in excluded realized gains. Management also disclosed hypothetical favorable RTM unlocking of approximately $280, $25 and $40 pre-tax for Annuities, Retirement Plan Services and Life Insurance, respectively, if reset at quarter-end; these amounts were not recorded as actual unlocking.
- The company amended its variable-annuity living-benefit reinsurance treaty in July, adding $4 billion of capacity through December 31, 2015. It retains product cash flows other than the living-benefit guarantee.
- Statutory reserve financing depends partly on captive reinsurance and letters of credit. The NAIC was considering regulatory changes, some expected from January 1, 2015; management noted uncertainty about effects on future structures and capital efficiency.
- Legal and regulatory matters include pending or threatened proceedings, some seeking large or indeterminate damages. Management said currently known matters were not likely to materially adversely affect financial condition, while acknowledging that some losses could not be estimated.
- Key risks identified include market and credit volatility, low or rapidly changing interest rates, equity declines, policyholder behavior and claims experience, hedge effectiveness, reinsurance collectability, ratings downgrades, reserve regulation, and access to subsidiary dividends and capital.
Most important facts for investors to verify
- How much of the earnings improvement reflects recurring segment performance versus realized gains, derivative movements and assumption unlocking.
- Whether spread compression continues and whether crediting-rate actions can offset lower reinvestment yields without materially affecting retention.
- Whether Group Protection disability recoveries and loss ratios improve as management expects.
- Whether Annuities and Retirement Plan Services can sustain account values and profitability amid lower deposits or net flows and mature-block outflows.
- How captive-reinsurance and statutory-reserve rule changes affect subsidiary capital, dividend capacity and holding-company liquidity.
- Whether investment impairments, collateral requirements, legal contingencies or ratings changes create material cash or capital demands.