Lincoln National Corporation — Q3 2012 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2012; comparisons are with the corresponding 2011 periods unless stated otherwise. LNC is an insurance and retirement-products holding company with Annuities, Retirement Plan Services, Life Insurance and Group Protection segments. Amounts below are in millions of dollars except per-share data and percentages.
Financial performance and position
| Metric | Q3 2012 | Q3 2011 | Nine months 2012 | Nine months 2011 |
|---|---|---|---|---|
| Total revenue | $2,954 | $2,547 | $8,568 | $8,073 |
| Income from continuing operations | $373 | $161 | $944 | $778 |
| Net income | $402 | $153 | $971 | $770 |
| Diluted EPS | $1.41 | $0.47 | $3.35 | $2.40 |
| Net cash from operating activities | Not presented for quarter | Not presented for quarter | $666 | $934 |
Q3 revenue rose about 16% and net income about 163%; nine-month revenue rose about 6% and net income about 26%. Earnings included meaningful effects from investment and derivative marks, annual assumption unlocking, tax adjustments and discontinued operations; reported net income is therefore not solely a measure of underlying segment performance. LNC reports segment operating income as a non-GAAP measure.
- Segment operating income, Q3 / nine months: Annuities $139 / $433 (down 9% / 2%); Retirement Plan Services $29 / $101 (down 26% / 22%); Life Insurance $154 / $434 (flat); Group Protection $16 / $59 (down 41% / 23%); Other Operations loss $3 / $75, improved from losses of $44 / $104.
- Cash flows, nine months: Investing activities used $2,067 versus $1,011 in 2011; financing activities provided $1,264 versus $2,168. Cash and invested cash ended at $4,373, down from $4,510 at year-end 2011.
- Balance sheet at September 30: Total assets were $215,458 and stockholders’ equity $15,237, compared with $201,491 and $13,238 at December 31, 2011. Short-term debt was $200 and long-term debt $5,494, versus $300 and $5,391, respectively. Separate-account assets and matching liabilities were each $93,326.
- Liquidity: The holding company had approximately $700 of cash and cash equivalents and $25 invested in corporate bonds; it also reported a $51 payable under its inter-company cash-management program. Insurance subsidiaries’ dividends and interest supplied $647 to the holding company over nine months.
- Investment quality and impairment: 95.6% of fixed-maturity AFS securities by fair value were investment grade. Gross unrealized AFS losses declined $483 during the first nine months. Net OTTI recognized in earnings was $112 pre-tax, compared with $98 in 2011.
Material changes and operating trends
- Higher account values, insurance in force and group premiums supported revenues. Total account values across Annuities, Retirement Plan Services and Life Insurance increased 14% year over year to $173,850.
- Net flows fell 32% in Q3 and 12% for nine months. Nine-month deposits were down 1%; Retirement Plan Services deposits rose 13%, while Life Insurance deposits fell 12% and Annuities deposits fell 3%.
- Lower interest rates continued to pressure investment yields and spreads. Nine-month spreads narrowed year over year in Retirement Plan Services (2.09% versus 2.44%) and Life Insurance interest-sensitive products (1.93% versus 2.07%); Annuities’ spread was 1.89% versus 2.00%. Q3 Annuities spread improved to 1.93% from 1.87%.
- Group Protection’s Q3 non-medical loss ratio was 75.7%, above management’s long-term expectation of 71%–74%, primarily due to long-term disability claim severity and, to a lesser extent, mortality.
- Common-stock repurchases totaled $400 for nine months, and common dividends paid were $67. The Board increased total repurchase authorization to $1 billion; $900 remained at September 30. The quarterly common dividend was $0.08 per share.
Outlook, management commentary and risks
- Management lowered its new-money investment-yield assumption in Q3 to reflect current rates and the forward curve. It recorded unfavorable after-tax unlocking of $110 for Life Insurance, $4 for Annuities and $6 for Retirement Plan Services from this assumption change. Management’s annual review also included other favorable items; the overall reported effect of prospective unlocking on continuing-operations income was favorable by $104 after tax.
- In a hypothetical scenario where the 10-year Treasury rate remains near 1.50% through 2014, management estimated an unfavorable earnings effect of about $75 in 2013 and $140 in 2014. This is a sensitivity scenario, not earnings guidance, and excludes other market, customer and management responses.
- Management expected Group Protection’s non-medical loss ratio to remain near the high end of its 71%–74% long-term expectation in Q4 2012. Each one-percentage-point increase above that expectation was estimated to reduce annual operating income by about $10–$12.
- Management said the September 2012 revisions to AG38 were not expected to materially affect total in-force reserves, but reserves on new business written after December 31, 2012 would generally be higher. Mitigation strategies include reinsurance, letters of credit and capital-market solutions; regulatory or rating-agency responses remain uncertain.
- Potential risks include sustained low rates and spread compression, equity-market declines and variable-annuity guarantees, investment credit losses, policyholder behavior and claims experience, rating downgrades, reinsurance collectibility, and regulatory or tax changes. A downgrade could also trigger derivative-contract provisions and pressure liquidity.
- The company estimated aggregate reasonably possible litigation and regulatory losses, including amounts above accruals, of up to approximately $200; outcomes and timing are uncertain. Matters include a putative insurance-fee class action, a Lehman-related CDO proceeding, and state audits and inquiries concerning unclaimed benefits.
- Q3 tax benefits and discontinued-operations income included releases or adjustments related to prior-year tax matters. These are unusual items and may not recur.
Important facts for investors to verify
- How much of the earnings increase reflects recurring segment performance versus tax adjustments, derivative and investment marks, and assumption unlocking.
- Whether persistently low new-money yields further reduce spreads, earnings, and reserve or guarantee costs; review the sensitivity assumptions and management’s mitigation actions.
- Group Protection claims trends, especially disability severity, and whether the loss ratio returns toward the stated long-term range.
- Investment portfolio credit quality, OTTI developments, unrealized losses, and the exposure to less-liquid or Level 3 valuations.
- Holding-company liquidity and subsidiary dividend capacity, debt maturities and ratings, and the ultimate cost of legal, regulatory and statutory-reserve matters.