Business context and reporting period
Lincoln National Corporation is an insurance and retirement-services holding company. Its principal segments are Annuities, Retirement Plan Services, Life Insurance, and Group Protection. This unaudited Form 10-Q covers the quarter and nine months ended September 30, 2013; comparisons are with the corresponding 2012 periods unless noted. Dollar amounts are in millions except per-share data.
Financial performance and condition
| Metric | Q3 2013 | Q3 2012 | Nine months 2013 | Nine months 2012 |
|---|---|---|---|---|
| Total revenue | $3,009 | $2,954 | $8,847 | $8,562 |
| Income before tax | $442 | $418 | $1,165 | $1,168 |
| Continuing-operations income | $337 | $400 | $893 | $965 |
| Net income | $337 | $428 | $893 | $992 |
| Diluted EPS | $1.23 | $1.51 | $3.24 | $3.42 |
| Net cash from operating activities | Not provided for quarter | Not provided for quarter | $504 | $666 |
Q3 2012 net income included $28 million from discontinued operations; nine-month 2012 net income included $27 million from discontinued operations, largely from a tax-reserve release. Q3 2013 tax expense was $105 million versus $18 million, with effective tax rates of 24% and 4%, respectively. For nine months, effective tax rates were 23% and 17%.
Revenue growth reflected higher fees and premiums, while investment income was broadly stable. Total realized losses were $28 million in Q3 2013 versus gains of $70 million in Q3 2012, and $105 million for the first nine months versus gains of $28 million a year earlier. Other comprehensive loss was $143 million in Q3 and $2,058 million for nine months, compared with gains of $771 million and $1,471 million in 2012; the year-to-date decline was principally associated with unrealized investment losses and related items.
Segment income from operations, a company-defined non-GAAP measure, was: Annuities $198 million in Q3 and $551 million year to date; Retirement Plan Services $33 million and $108 million; Life Insurance $140 million and $387 million; Group Protection $23 million and $60 million; and Other Operations a loss of $27 million and a loss of $104 million. Annuities and Group Protection improved in Q3; Life Insurance declined, while Other Operations was weaker than the prior-year quarter.
At September 30, 2013, total assets were $229.9 billion, liabilities $216.5 billion, and stockholders’ equity $13.4 billion, compared with $218.9 billion, $203.9 billion, and $15.0 billion at year-end 2012. AOCI fell to $1.75 billion from $3.81 billion. Cash and invested cash declined to $2.65 billion from $4.23 billion. Short- and long-term debt totaled $5.87 billion, versus $5.64 billion at year-end. Nine-month cash flows were $504 million from operations, a $3.81 billion investing outflow, and $1.73 billion from financing; cash and invested cash decreased by $1.58 billion.
Holding-company available liquidity was $1.0 billion at quarter-end. The company reported compliance with its credit-facility covenants and said insurance subsidiaries’ statutory surplus and risk-based capital exceeded current regulatory requirements. Common dividends were $97 million and share repurchases $350 million during the first nine months.
Material changes versus the prior comparable period
- Q3 revenue rose 2%, but net income declined 21%; nine-month revenue increased 3% while net income fell 10%.
- Management attributed lower consolidated earnings mainly to more favorable 2012 unlocking and tax benefits, spread compression as new-money yields remained below portfolio yields, and higher death claims. Growth in account values, insurance in force, and group premiums partly offset these pressures.
- Annuities operating income increased 42% in Q3 and 27% year to date, supported by higher fee income and lower benefits from unlocking. Life Insurance operating income declined 8% in Q3 and 9% year to date, with higher benefits, including death claims and unlocking effects.
- Total deposits rose 22% in Q3 and 25% year to date; total net flows increased 76% in both comparisons. These measures include Annuities, Retirement Plan Services, and Life Insurance.
- AFS securities’ gross unrealized losses, including the OCI portion of impairment, increased by $799 million during the first nine months. Management considered the losses temporary and stated it did not expect forced sales before recovery.
Outlook, commentary, risks, and unusual items
- No full-year earnings guidance is provided. Management cautioned that nine-month results are not necessarily indicative of full-year results.
- Under a hypothetical scenario in which the 10-year U.S. Treasury rate remains at 2.50% through year-end 2014, the company estimated an approximately $30 million unfavorable 2014 earnings effect relative to 2013. This is a scenario estimate, not guidance, and excludes many possible market, customer, and management responses.
- Management cited ongoing spread pressure from low new-money rates and described crediting-rate actions and portfolio management to help manage spreads. Retirement Plan Services expected strategic infrastructure and distribution investments to raise expenses during the remainder of 2013. The company also expected additional share repurchases in 2013, subject to market conditions and alternative capital uses.
- In Annuities, product changes included additional risk-managed funds and tighter terms on certain living-benefit riders. A reinsurance treaty covers 50% coinsurance on qualifying new rider sales through December 31, 2014, subject to an $8 billion sales limit.
- Statutory reserve rules for term and secondary-guarantee life products remain a capital consideration. New York’s insurance regulator declined to recognize the NAIC’s AG38 revisions for year-end 2013 reserve reporting; the exact effect on the New York subsidiary was not yet known, though management did not expect a material adverse effect on the company’s financial condition.
- Market risks include prolonged low or rapidly rising interest rates, equity-market declines affecting variable-annuity guarantees and fees, investment-credit losses, hedge and counterparty performance, policyholder behavior, ratings downgrades, and limits on dividends from regulated subsidiaries. Approximately 72% of individual annuity account values had guaranteed living benefits; management reported 5% of in-force contracts with such features were “in the money” at September 30, 2013.
- Legal matters include a putative class action concerning cost-of-insurance charges and a Lehman-related CDO proceeding. Outcomes and potential losses can be difficult to estimate; management said currently known matters were not expected to have a material adverse effect on financial position, while acknowledging that material charges remain possible.
Key facts investors should verify
- Reconcile GAAP earnings with segment operating income, especially the effects of annual unlocking, realized gains and losses, and the prior-year tax and discontinued-operation items.
- Monitor investment portfolio marks, credit quality, impairment judgments, and whether unrealized losses or realized investment losses worsen.
- Assess fixed-account spreads, interest-rate sensitivity, and the cost and effectiveness of hedging variable-annuity guarantees.
- Check holding-company liquidity and subsidiary dividend capacity, debt maturities, capital needs, and compliance with credit-facility covenants.
- Follow the year-end New York AG38 reserve treatment, reinsurance and reserve-financing capacity, and developments in the disclosed litigation.