LNC

Business Context and Reporting Period

Company: Lincoln National Corporation (LNC)
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: September 30, 2002
Business Overview: LNC operates through four primary segments: Lincoln Retirement, Life Insurance, Investment Management, and Lincoln UK. The company markets its products under the "Lincoln Financial Group" identity. A significant portion of the company's recent financial activity relates to the run-off of its former reinsurance business, which was sold to Swiss Re in December 2001 via indemnity reinsurance agreements.

Key Financial Metrics

Note: All figures in millions unless otherwise noted. 2001 figures include goodwill amortization, which was eliminated in 2002 due to the adoption of FAS 142.

Material Changes vs. Prior Period

• Net Income Decline: Net income for the nine months ended September 30, 2002, decreased by $392.6 million (93%) compared to the prior year. The third quarter 2002 reported a net loss of $125.5 million, a reversal from the $119.1 million profit in the same period in 2001.
• Revenue Reduction: Total revenue dropped significantly, primarily due to the absence of the former Reinsurance segment's operating revenue (which was sold to Swiss Re in late 2001). The 2001 period included $1.43 billion in revenue from the former Reinsurance segment.
• Realized Investment Losses: The company reported a pre-tax realized loss on investments and derivatives of $221.2 million for the nine months of 2002, compared to $75.8 million in 2001. This was driven by write-downs and sales of WorldCom bonds, other telecommunications debt, and collateralized debt obligations (CDOs).
• Reinsurance Reserve Adjustments: In October 2002 (post-period end but disclosed in the filing), LNC announced a $270 million pre-tax increase in reserves for Unicover and other personal accident reinsurance business sold to Swiss Re. Additionally, a settlement with Swiss Re regarding disputed closing balance sheets resulted in a $195 million payment by LNC. These events significantly impacted third-quarter earnings, reducing net income by approximately $176.4 million after-tax.
• Goodwill Accounting Change: LNC adopted FAS 142 on January 1, 2002, ceasing the amortization of goodwill. This change increased net income by $31.3 million for the nine months of 2002 compared to what it would have been under prior accounting rules.

Guidance, Outlook, and Risks

Management Commentary and Outlook

• Equity Market Sensitivity: Management provided updated guidance on the impact of equity market volatility. A 5% decline in equity markets from September 30, 2002 levels is estimated to reduce fourth-quarter operating income by approximately $34.7 million, excluding potential impairments of deferred dealer commission assets.
• Segment Performance:
  • Lincoln Retirement: Income from operations decreased due to equity market declines, negative DAC unlocking, and increased costs for Guaranteed Minimum Death Benefits (GMDB). However, the segment achieved positive net cash flows for the first time in five consecutive quarters.
  • Life Insurance: Sales of Universal Life and Whole Life products increased, offsetting a decline in Variable Universal Life sales. Income from operations decreased slightly due to poorer mortality experience and lower investment margins.
  • Investment Management: Assets under management declined due to market depreciation, though positive net cash flows helped offset the decline. A deferred dealer commission asset of $58 million is at risk of impairment if markets decline further.
  • Lincoln UK: Earnings were negatively impacted by equity market declines and DAC/PVIF unlocking. The segment agreed to outsource customer service to Capita Group to reduce operational costs.
• Capital Management: LNC has utilized proceeds from the Swiss Re sale to repurchase stock ($474.5 million in the first nine months) and reduce debt. The company has $675.1 million remaining under its stock repurchase authorization.

Risks and Contingencies

• Reinsurance Run-off: Although LNC has no further underwriting risk for the business sold to Swiss Re, it retains legal liability to ceding companies. Future reserve deficiencies in the sold business could result in non-cash charges to net income, partially offset by increases in deferred gain amortization.
• Investment Portfolio: The portfolio contains $2.1 billion (6.5%) in below-investment-grade securities. Continued deterioration in credit quality or market conditions could lead to further realized losses.
• UK Regulatory Issues: LNC faces ongoing scrutiny from UK regulators regarding selling practices of mortgage endowments and pension products. An aggregate liability of $97.5 million was recorded as of September 30, 2002, though management believes this will not materially affect the consolidated financial position.
• Interest Rate Risk: Falling interest rates continue to compress spreads on fixed annuity and interest-sensitive life insurance products. LNC has lowered crediting rates to maintain target spreads.

Key Facts for Investor Verification

• Swiss Re Settlement Impact: Verify the final accounting treatment of the $295 million payable to Swiss Re and the $270 million reserve increase announced in October 2002, as these significantly impacted Q3 earnings and future deferred gain amortization.
• Deferred Dealer Commission Asset: Monitor the $58 million deferred dealer commission asset in the Investment Management segment. Management estimates a potential impairment of $9.7 million to $14.4 million if equity markets decline by 5% from September 30, 2002 levels.
• Reinsurance Reserve Adequacy: Assess the sufficiency of reserves for the personal accident and disability income business sold to Swiss Re, as future increases in these reserves would trigger immediate earnings charges under FAS 113.
• Stock Repurchase Program: Track the utilization of the remaining $675.1 million repurchase authorization and any new derivative strategies (e.g., accelerated stock repurchases) authorized by the Board.
• UK Regulatory Liability: Monitor developments in the UK regarding mortgage endowment mis-selling and pension product advice, as the current $97.5 million liability is based on estimates subject to considerable uncertainty.