Lincoln National Corporation — Q1 2015 Form 10-Q
Business context and reporting period
Quarter ended March 31, 2015; comparisons are with the three months ended March 31, 2014, unless otherwise noted. Lincoln National is an insurance and retirement-services holding company operating through Annuities, Retirement Plan Services, Life Insurance and Group Protection, plus Other Operations. Financial amounts below are in millions of dollars except per-share data and percentages.
Key financial results and position
| Metric | Q1 2015 / March 31, 2015 | Comparable period / December 31, 2014 |
|---|---|---|
| Total revenue | $3,304 | $3,176, up 4% |
| Income before tax | $362 | $427 |
| Net income | $300 | $329, down 9% |
| Diluted EPS | $1.15 | $1.21 |
| Other comprehensive income, net of tax | $557 | $890 |
| Operating cash flow | $296 | $263 |
| Investing cash flow | $(1,035) | $(377) |
| Financing cash flow | $307 | $(401) |
| Cash and invested cash | $3,487 | $3,919 at year-end |
| Total assets | $258,485 | $253,377 at year-end |
| Total liabilities / stockholders’ equity | $242,262 / $16,223 | $237,637 / $15,740 at year-end |
| Short-term / long-term debt | $250 / $5,627 | $250 / $5,270 at year-end |
Net income margin was approximately 9.1% of revenue versus 10.4% a year earlier; pretax margin was approximately 11.0% versus 13.4%. These are simple calculations from reported GAAP amounts. The effective tax rate was 17%, compared with 23% in Q1 2014.
Net investment income was $1,187, down 2%; interest credited was $625, down 1%. Consolidated realized loss was $48 versus $18 a year earlier. Total deposits were $6,005, down 6%, while net flows were $1,199, up 3%; reported segment account values totaled $221,610, up 6% year over year.
Material changes and segment performance
- Annuities: Operating income rose 11% to $239, supported by higher fee income and variable account values. Deposits declined 12% and net flows fell 72% to $196. The interest spread narrowed to 1.80% from 1.82%.
- Retirement Plan Services: Operating income declined 10% to $35, primarily due to spread compression and weaker alternative-investment income. Net flows improved to positive $115 from negative $361.
- Life Insurance: Operating income declined 8% to $111. Benefits rose 20% to $650, including higher net death benefits; fee income increased 13%. Sales rose 6% to $153 and net flows rose 7% to $888.
- Group Protection: Operating loss was $6 versus income of $20. The non-medical loss ratio rose to 78.1% from 74.8%; disability loss ratio increased to 79.7% from 73.6%.
- Other Operations: Operating loss narrowed to $27 from $30, mainly due to lower other expenses, partly offset by lower investment income.
Management attributed the decline in consolidated net income principally to higher Life Insurance death claims, unfavorable Group Protection loss experience, weaker variable-annuity hedge results, lower alternative-investment income and spread compression as new-money rates remained below portfolio yields. Growth in account values and insurance in force, and higher prepayment and bond make-whole premiums, partly offset these pressures.
Liquidity, capital, outlook and risks
- Operating activities generated $296 of cash, but investing outflows drove a $432 decrease in cash and invested cash during the quarter. The company reported $786 of holding-company available liquidity at March 31.
- The company issued $300 of 3.35% senior notes due 2025 in March; it expected to use proceeds toward a $250 note maturity due June 15, 2015, and general corporate purposes. Long-term debt increased by $357 from year-end. Long-term senior debt ratings were A-/Baa1 (S&P/Moody’s).
- Cash returned to common shareholders was $401: $350 of share repurchases and $51 of dividends. The quarterly dividend was $0.20 per share. Management expected further repurchases in 2015, subject to market conditions and competing capital needs; $265 remained under the repurchase authorization at quarter-end.
- Management expected Group Protection loss ratios to remain above the high end of its 71%–74% long-term expectation during 2015, and higher DAC amortization to continue versus 2014. Retirement Plan Services expected continued strategic investment in infrastructure and distribution, with higher expenses.
- Management estimated that a 50-basis-point reduction in its long-term new-money yield assumption could reduce operating income by approximately $125, primarily through DAC and VOBA unlocking; actual impact would depend on conditions when assumptions are updated. A separate illustrative estimate indicated favorable pretax reversion-to-the-mean unlocking of about $295 for Annuities, $25 for Retirement Plan Services and $35 for Life Insurance if applied at March 31; this was not reported as actual earnings.
- New York reserve requirements related to XXX/AG38 had resulted in a cumulative $180 reserve increase by March 31, 2015. The company said remaining annual increases were not expected to exceed $90 and did not expect the total increase to materially harm its financial condition. Captive reinsurance and financing arrangements, including letters of credit, remain important to statutory capital management; new NAIC AG48 requirements apply to certain arrangements.
- Key exposures include persistently low or rapidly rising interest rates, equity-market declines and hedge performance, credit losses and investment impairments, policy surrenders, reinsurance collectability, ratings downgrades, regulatory or tax changes, and litigation. The company reported $126 maximum potential payout on sold credit-default swaps and $35 of derivative counterparty exposure after collateral considerations.
- Pending and threatened legal and regulatory matters include cases seeking potentially large or indeterminate damages. Management said some losses could not be estimated, but based on information then known did not expect such matters to have a material adverse effect on financial condition. On April 14, 2015, the Department of Labor re-proposed a fiduciary-advice rule that could constrain some advisory services if finalized as proposed.
Management stated disclosure controls were effective and that no material change in internal control over financial reporting occurred during the quarter. The filing cautions that first-quarter results are not necessarily indicative of full-year results.
Most important facts for investors to verify
- Whether Group Protection claims and loss ratios improve from the elevated Q1 level, and how much higher DAC amortization weighs on earnings.
- Whether Life Insurance mortality normalizes and reserve-financing requirements remain manageable, including developments with New York regulators and AG48 implementation.
- Whether spread compression persists and whether investment yields, crediting-rate actions and portfolio reinvestment offset the pressure.
- Variable-annuity hedge effectiveness, guaranteed-benefit exposures and the sensitivity of reported earnings to market movements and valuation assumptions.
- Holding-company liquidity and subsidiary dividend capacity after the debt maturity, capital contributions, share repurchases and collateral movements.
- Investment credit quality and impairment trends, particularly corporate bonds, below-investment-grade holdings and mortgage-related securities; management’s conclusion that unrealized losses are temporary depends on recovery assumptions and its ability to hold securities.
- Potential financial and business effects of litigation, regulatory changes and the proposed DOL fiduciary rule; no quantified loss estimate is provided for certain contingencies.