Lincoln National Corporation — Q3 2017 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2017. Lincoln National operates insurance and retirement businesses through Annuities, Retirement Plan Services, Life Insurance, and Group Protection, with results also reported for Other Operations. Dollar amounts below are in millions unless stated otherwise.
Financial performance and condition
- Q3 revenue and earnings: Revenue was $3.511 billion, down 0.4% from $3.525 billion a year earlier. Net income was $418 million, down 10.5% from $467 million; diluted EPS was $1.87 versus $2.00.
- Nine-month performance: Revenue was $10.588 billion, up 5.1% from $10.076 billion. Net income rose 26.1% to $1.264 billion from $1.002 billion; diluted EPS was $5.58 versus $4.17.
- Revenue mix and expenses: Q3 insurance premiums were $774 million, fee income $1.401 billion, and net investment income $1.239 billion. Q3 benefits increased to $1.261 billion from $922 million; commissions and other expenses fell to $1.020 billion from $1.283 billion. Strategic digitization expense was $10 million in Q3 and $33 million for the nine months.
- Operating segments: Q3 operating income was $277 million for Annuities (+15%), $35 million for Retirement Plan Services (+9%), $121 million for Life Insurance (-28%), and $41 million for Group Protection (+46%); Other Operations reported a $20 million loss. For the nine months, segment operating income increased in Annuities to $809 million (+17%), Retirement Plan Services to $109 million (+16%), Life Insurance to $384 million (+6%), and Group Protection to $83 million (+69%); Other Operations reported a $71 million loss. Segment operating income is a company-defined non-GAAP measure.
- Cash flow: Nine-month operating cash flow was $609 million versus $680 million in 2016. Investing activities used $2.784 billion versus $1.612 billion; financing activities provided $1.418 billion versus $1.230 billion. Cash and invested cash ended at $1.965 billion, down from $2.722 billion at year-end 2016.
- Balance sheet and debt: Total assets were $276.8 billion and stockholders’ equity $16.3 billion, compared with $261.6 billion and $14.5 billion, respectively, at December 31, 2016. Debt comprised $450 million short-term and $4.9 billion long-term, versus $5.345 billion long-term debt at year-end 2016. The filing reports $569 million of holding-company available liquidity.
- Investments and liquidity context: Total investments were $111.7 billion. Fixed-maturity AFS securities were $93.8 billion, with 96.1% investment grade. Management said investments and cash exceeded policy and contract liabilities, net of reinsurance recoverables, by $16.6 billion; it cited $82.2 billion of securities in unrealized gain positions and stated it did not expect to need to sell temporarily impaired securities to meet cash needs.
- Capital returns: The company repurchased $600 million of common stock and paid $195 million of common dividends during the first nine months. On October 31, 2017, the board approved raising the quarterly dividend from $0.29 to $0.33 per share. The company said it expected further repurchases during the rest of 2017, subject to market conditions and alternative uses of capital.
Material changes and management commentary
- Q3 net income declined despite higher operating income in most segments. Management cited annual assumption unlocking, no Q3 amortization of a deferred reinsurance gain, lower prepayment and bond make-whole premiums, spread compression, and strategic digitization costs. Growth in account values, business in force, and group earned premiums partly offset these factors.
- Nine-month net income increased, helped by business growth, investment income from alternative investments, higher prepayment and make-whole premiums, tax benefits, and lower prior-year investment-related realized losses. Offsetting items included unlocking, unfavorable guaranteed-living-benefit non-performance-risk effects, spread compression, and digitization expense.
- Annual assumption review produced a reported $22 million pretax reduction in consolidated income for Q3. Management also stated that, if it had unlocked its reversion-to-the-mean assumption at September 30, 2017, it would have recorded favorable pretax unlocking of approximately $210 million in Annuities, $40 million in Life Insurance, and $25 million in Retirement Plan Services.
- Interest spreads remained under pressure: Annuities’ Q3 spread was 1.53%, down 22 basis points year over year; Life Insurance’s was 1.50%, down 25 basis points. Management attributed pressure primarily to new-money yields trailing portfolio yields, partly mitigated by lower crediting rates.
- Annuities had negative net flows of $3.044 billion for the first nine months, compared with negative $1.354 billion in 2016. Management cited lower variable-annuity sales amid evolving market trends. Retirement Plan Services and Life Insurance reported positive nine-month net flows of $926 million and $3.090 billion, respectively.
Outlook, risks, contingencies, and unusual items
- Outlook: The filing provides no specific earnings or revenue guidance. Management said it expected to manage near-term spread effects through portfolio management and, to a lesser extent, crediting-rate actions; these expectations assume no significant change in account flows or other spread drivers. Management also said it expected to meet holding-company cash needs, while noting that adverse market conditions could constrain subsidiary dividends.
- Market and insurance risks: Key risks include sustained low or rapidly rising interest rates, equity-market declines and volatility, policy surrenders, mortality and morbidity experience, credit losses, hedge performance, reinsurance collectability, and changes in regulation or tax law. The company reported that 6% of in-force variable-annuity contracts with GLB features were “in the money,” with $402 million of exposure after reinsurance, down from 9% and $624 million a year earlier.
- Reserving and financing: The company was completing the final $90 million annual increase in New York reserves related to secondary-guarantee life policies in Q4 2017; $360 million of a planned $450 million increase had been recorded through September. It uses captive reinsurance, letters of credit, and debt financing for reserve support and said unavailable capital-market solutions could affect returns, although it believed it had sufficient capital under current projections.
- Legal contingency: A putative class action filed in September 2017 alleges that cost-of-insurance rate increases on certain universal-life policies breached policy terms. The company is defending the case. Management estimated aggregate reasonably possible losses of up to approximately $50 million across matters; it cautioned that other matters could not yet be estimated and that some future charges could be material in a particular period.
- Regulatory and accounting matters: The DOL fiduciary rule took effect in June 2017, with phased implementation and potential further changes or delays; the company said related changes to products, services, and compensation could affect future sales or margins. Adoption of the new revenue-recognition standard was scheduled for January 1, 2018; management expected minimal effect on its current revenue-recognition pattern and no material consolidated impact.
- Other unusual items: Two credit-linked note VIEs matured, and the company stated it no longer had exposure to those VIEs. The filing also reports a $3 million after-tax loss on early extinguishment of debt for the nine months.
Important facts for investors to verify
- Reconcile the Q3 and nine-month GAAP earnings changes with the company’s segment operating measure, unlocking effects, and derivative-related realized losses.
- Review annuity net outflows, product sales, GLB exposure, and hedge-program sensitivity to credit spreads, equity markets, and volatility.
- Assess the sustainability of investment income and spreads, including the role of variable alternative-investment returns and prepayment premiums.
- Confirm holding-company liquidity, subsidiary dividend capacity, reserve-financing arrangements, and the timing of debt maturities and required reserve increases.
- Monitor the universal-life cost-of-insurance litigation, the stated loss range, DOL rule implementation, and any changes to the company’s risk disclosures or outlook.