LINCOLN NATIONAL CORP quarterly report, Q2 FY2012

Lincoln National Corporation — Q2 2012 Form 10-Q

Business context and reporting period. Lincoln National is a holding company whose insurance and retirement businesses offer annuities, life insurance, retirement-plan services, and group life, disability, and dental products. This unaudited report covers the three and six months ended June 30, 2012; comparative income and cash-flow figures are for 2011, and balance-sheet figures are compared with December 31, 2011. Dollar amounts below are in millions unless otherwise noted.

Financial results and position

Metric	Q2 2012	Q2 2011	Six months 2012	Six months 2011
Total revenue	$2,899	$2,807	$5,614	$5,526
Income from continuing operations	$324	$304	$570	$617
Net income	$324	$304	$569	$617
Diluted EPS	$1.10	$0.95	$1.94	$1.92
Operating cash flow	Not presented by quarter	$614	$878

Q2 revenue increased about 3% and net income about 7%; first-half revenue rose about 2%, while net income declined about 8%.
Q2 pre-tax income was $442 versus $409; first-half pre-tax income was $750 versus $838. Q2 tax expense was $118 and first-half tax expense was $180.
Realized gains were $43 in Q2 2012 versus a $9 loss in Q2 2011; the first-half realized loss was $43 versus $7 in 2011. Q2 benefited from variable-annuity derivative results, including the GLB nonperformance-risk component; these items are market-sensitive and can be volatile.
Comprehensive income was $1,081 in Q2 and $1,269 for the first half, including other comprehensive income of $757 and $700, respectively.

Balance sheet and liquidity

At June 30, 2012, total assets were $211.1 billion, up from $201.5 billion at year-end 2011; investments were $96.9 billion, cash and invested cash $5.3 billion, and stockholders’ equity $14.2 billion.
Total liabilities were $196.9 billion. Short-term debt was $300 million and long-term debt $5.719 billion, compared with $5.391 billion of long-term debt at year-end.
Operating activities generated $614 million of cash in the first half, down from $878 million. Investing activities used $1.022 billion and financing activities provided $1.155 billion. Cash and invested cash rose $747 million to $5.257 billion.
Management reported $102.1 billion of investments and cash against $83.8 billion of insurance-policy obligations, net of reinsurance recoverables. The holding company had about $1 billion of cash and cash equivalents at June 30.
In March, LNC issued $300 million of 4.20% senior notes due 2022; it expected to use the proceeds to repay $300 million of 5.65% notes due August 2012. The filing states that future debt maturities may be funded from resources selected in light of market conditions.

Material changes and segment performance

For Q2, segment operating income was $158 million in Annuities, $38 million in Retirement Plan Services, $138 million in Life Insurance, $27 million in Group Protection, and a $39 million loss in Other Operations. For the first half, respective results were $294 million, $72 million, $281 million, $43 million, and a $73 million loss.
Q2 consolidated income improved partly on growth in account values, insurance in force, and group premiums, and favorable GLB nonperformance-risk effects. The first-half decline reflected higher 2011 portfolio-repositioning gains, spread compression, and increased strategic and technology spending.
Retirement Plan Services’ first-half operating income fell 20% to $72 million; Group Protection fell 14% to $43 million. Life Insurance and Annuities were broadly stable for the first half, at $281 million and $294 million, respectively.
Total deposits declined 2% to $10.446 billion in the first half. Life Insurance deposits fell 10% to $2.297 billion, while Retirement Plan Services deposits increased 10% to $2.802 billion. Total net flows were $2.874 billion, up 2%.
Group Protection first-half premiums increased 7% to $958 million, but operating income declined. Management expects its non-medical loss ratio to remain within a 71%–74% long-term range in 2012; it estimates each one-percentage-point increase above expectation would reduce annual operating income by about $10–$12 million.

Outlook, risks, and unusual items

No formal full-year earnings or revenue guidance is provided. Management cautions that first-half results are not necessarily indicative of full-year results.
In a hypothetical scenario where the 10-year Treasury rate stays near 1.50% through 2014, management estimated an unfavorable earnings effect of about $10 million for the remainder of 2012, $75 million in 2013, and $140 million in 2014 versus its stated comparison scenario. The estimates assume other factors are unchanged and exclude potential mitigation actions.
Persistently low rates may compress investment spreads, increase withdrawals, and weaken product economics. In the first half, Annuities’ interest-rate spread was 1.87% versus 2.08% a year earlier; Retirement Plan Services’ was 2.13% versus 2.54%.
Variable-annuity guarantees remain market-sensitive: about 49% of variable-annuity account values had a guaranteed withdrawal benefit rider. The share of in-force GWB contracts “in the money” was 65% at June 30, 2012, versus 34% a year earlier; after-reinsurance exposure to guaranteed amounts was $1.8 billion.
Draft NAIC proposals on reserves for universal-life policies with secondary guarantees could require materially higher statutory reserves; the company said the impact was not yet predictable. Its reserve-financing strategies, including captive reinsurance and letters of credit, are subject to regulatory and rating-agency review.
The company adopted revised insurance-acquisition-cost accounting retrospectively from January 1, 2012. The adoption reduced deferrable acquisition costs and affected reported expenses; prior-period figures were restated. It also adopted comprehensive-income and fair-value disclosure updates, which management said did not materially affect financial condition or results.
Investment risks include credit and impairment exposure, interest-rate and equity-market movements, derivative and counterparty risk, and concentration in mortgage-related securities. First-half net OTTI recognized in earnings was $80 million, compared with $72 million in 2011. Management said it did not expect to be forced to sell temporarily impaired securities before recovery, but that conclusion depends on liquidity, credit, and market assumptions.
Legal and regulatory matters include pending or threatened proceedings, including class actions; management said outcomes and potential losses are difficult to estimate and did not expect currently known matters to materially harm financial position.
Management reported effective disclosure controls and no material change in internal control over financial reporting during the quarter.

Important facts for investors to verify

Whether underlying earnings sustain Q2’s improvement after separating volatile realized gains, derivative marks, and guarantee-related effects from segment operating results.
How sustained low interest rates affect spreads, investment yields, policyholder behavior, and the company’s ability to manage crediting rates.
Any final regulatory changes to AG38/XXX reserve requirements, and the capacity, cost, and regulatory acceptability of the company’s reserve-financing arrangements.
Claims experience and exposure under variable-annuity living benefits, including hedge effectiveness and sensitivity to equity markets and credit spreads.
Investment-portfolio credit quality, mortgage delinquencies and impairments, and the assumptions supporting management’s conclusion that unrealized losses are temporary.
Holding-company liquidity and subsidiary dividend capacity, debt maturities, and the effects of share repurchases and dividends on capital flexibility.
The effects of retrospective acquisition-cost accounting on period-to-period comparability and the assumptions behind the annual third-quarter actuarial review.