Lincoln National Corporation — Q3 2010 Form 10-Q
Business context and reporting period. Lincoln National (Lincoln Financial Group) is an insurance and retirement-products holding company with Retirement Solutions and Insurance Solutions businesses, reported through Annuities, Defined Contribution, Life Insurance and Group Protection segments. This unaudited filing covers the quarter and nine months ended September 30, 2010; balance-sheet comparisons are with December 31, 2009. Delaware Investment Management and Lincoln UK are presented as discontinued operations following their sales.
Key financial results
Amounts are in millions of dollars except per-share data and percentages.
| Metric | Q3 2010 | Q3 2009 | Nine months 2010 | Nine months 2009 |
|---|---|---|---|---|
| Total revenue | $2,613 | $2,082 | $7,745 | $6,096 |
| Income from continuing operations | $248 | $81 | $756 | $(513) |
| Net income (loss) | $246 | $153 | $785 | $(587) |
| Net income available to common | $246 | $137 | $617 | $(603) |
| Diluted EPS | $0.75 | $0.44 | $1.94 | $(2.21) |
Revenue rose 26% in Q3 and 27% year to date. The recovery in earnings reflects, among other factors, lower investment impairment losses and more favorable derivative results; the nine-month comparison also benefits from the $600 million goodwill impairment recorded in 2009. Nine-month income available to common was reduced by the $168 million Series B preferred-stock dividend and discount accretion, including the redemption-related charge. These results should not be read as purely recurring operating performance.
Segments and operating trends
- Retirement Solutions: Q3 operating income was $176 million, up 28%; nine-month income was $483 million, up 45%. Annuities contributed $126 million in Q3 and $361 million year to date; Defined Contribution contributed $50 million and $122 million, respectively. Nine-month total deposits were $12.0 billion, up 3%, while net flows fell to $3.0 billion from $4.1 billion. Defined Contribution’s Q3 net flows were negative $278 million, including the lapse of large cases with about $500 million of account values. Annuity fixed-product spreads were 2.04% for Q3 and 2.08% year to date, versus 1.91% and 1.67% in 2009.
- Life Insurance: Operating income fell 56% in Q3 to $60 million and 16% for nine months to $348 million. Q3 benefits rose 75%, reflecting higher death claims and secondary-guarantee reserves. Management lowered its new-money investment-yield assumption; the change generated a $114 million after-tax unfavorable prospective unlocking in the segment. The Q3 interest spread on interest-sensitive products was 1.92%, up from 1.50% a year earlier.
- Group Protection: Operating income declined 74% in Q3 to $9 million and 43% for nine months to $54 million. The Q3 non-medical loss ratio was 79.2%, above the company’s long-term expectation of 71%–74%, driven mainly by disability claims incidence and adverse group-life experience.
Financial position, cash flow and capital
- Total assets were $190.5 billion, including $86.1 billion of investments and $78.6 billion of separate-account assets. Total liabilities were $176.9 billion and stockholders’ equity was $13.6 billion, compared with $11.7 billion at year-end 2009; accumulated other comprehensive income improved to $1.7 billion from a $262 million loss.
- Cash and invested cash were $3.5 billion, down from $4.0 billion at year-end. For the nine months, operating cash flow was $1.14 billion, investing cash flow was negative $3.91 billion and financing cash flow was positive $2.13 billion. The holding company separately reported $885 million in cash and cash equivalents at September 30.
- Short-term debt was $101 million and long-term debt $5.94 billion, versus $350 million and $5.05 billion, respectively, at year-end. The company issued $750 million of senior notes in June: $250 million at 4.30%, due 2015, and $500 million at 7.00%, due 2040. It reported compliance with credit-facility covenants and $3.18 billion of stated facility capacity, with $350 million borrowed under the FHLBI facility and $2.02 billion of letters of credit issued.
- The company repurchased $950 million of Series B preferred stock from the U.S. Treasury in June, ending the associated preferred dividends. It also issued 14.14 million common shares for $368 million. The Treasury’s September warrant sale generated no proceeds for Lincoln; Lincoln paid $48 million to buy and cancel about 2.90 million warrants.
Outlook, risks and unusual items
- Management gave no single consolidated earnings forecast. It expected Group Protection loss ratios to remain elevated at least through the rest of 2010, with improvement over time, and planned renewal price increases and expanded claims-management actions.
- Management identified prolonged low interest rates, volatile equity and credit markets, possible additional investment impairments, changing reserve and capital rules, and the effectiveness of variable-annuity hedges as important risks. It estimated that its lower new-money-yield assumption would recover gradually over eight years to an ultimate rate 54 basis points below the prior assumption.
- Management described hypothetical interest-rate stress effects, not forecasts: estimated unfavorable earnings effects included $25 million in 2011 and $45 million in 2012 for Life Insurance, and $2–$5 million in 2011 and $10–$15 million in 2012 for Retirement Solutions. Equity scenarios also indicate potential changes in asset-based earnings and later unlocking effects; actual outcomes may differ substantially.
- Net OTTI recognized in earnings was $110 million pre-tax for the first nine months, versus $319 million in 2009. Gross unrealized losses on AFS securities declined about $1.5 billion from year-end, which management attributed in part to lower market yields and improved credit fundamentals. Management nevertheless expected some continuing OTTI.
- Adoption of revised VIE consolidation guidance brought two credit-linked-note structures onto the balance sheet and reduced opening retained earnings by $169 million after tax. The structures had two defaults each in their underlying pools, but no default on the notes themselves; management said remaining subordination should absorb future losses, subject to market conditions.
- Contingencies include regulatory inquiries and litigation. A long-running Delaware-related lawsuit seeks substantial damages; Lincoln is defending the case and retained responsibility for it after the Delaware sale. Management said proceedings were not expected to materially affect consolidated financial position, while acknowledging a particular adverse outcome could materially affect a reporting period. The company was also appealing an IRS proposed assessment and did not expect resulting adjustments to be material.
Important facts for investors to verify
- How much of the earnings improvement came from recurring segment operations versus investment marks, derivative results, tax adjustments and the prior-year goodwill impairment.
- Whether disability claims and Group Protection loss ratios improve as management expects, and whether pricing and claims actions offset elevated losses.
- The sensitivity of Life Insurance earnings, reserves and capital to sustained low rates and further changes in investment-yield assumptions.
- Credit quality and valuation of the investment portfolio, including mortgage-related securities, below-investment-grade holdings, unrealized losses and the consolidated credit-linked-note exposure.
- Availability and cost of financing for secondary-guarantee reserves, future holding-company liquidity, insurer dividend capacity, and compliance with credit and capital-security triggers.
- Potential effects of the Delaware litigation, IRS appeal, and ongoing actuarial-model conversions, for which management said it could not yet estimate a range of results effects.