LNC

Business Context and Reporting Period

Company: Lincoln National Corporation (LNC)
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: March 31, 2003
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. The reporting period reflects the impact of continued declines in equity markets and the adoption of new accounting standards regarding stock-based compensation.

Key Financial Metrics

Note: Q1 2002 figures have been restated to reflect the retroactive adoption of FAS 123 for stock-based compensation.

Material Changes vs. Prior Period

• Net Income Decline: Net income decreased by $44.0 million (51%) compared to Q1 2002. This was primarily driven by negative equity market performance, which reduced fee income and increased costs related to Guaranteed Minimum Death Benefits (GMDB) and Deferred Acquisition Cost (DAC) unlocking.
• Revenue Decrease: Total revenue fell by $26.7 million, largely due to lower insurance fees and investment advisory fees resulting from declines in variable annuity and unit-linked account values.
• Investment Losses: While net realized losses on investments improved by $11.9 million compared to the prior year, the company recorded significant write-downs totaling $137.3 million, primarily in the airline, electric utility, and asset-backed securities (ABS) sectors.
• Segment Performance:
  • Lincoln Retirement: Net income dropped 85% to $6.9 million due to equity market declines impacting fees and GMDB reserves.
  • Life Insurance: Net income increased 11% to $48.5 million, aided by improved mortality margins and lower realized losses, despite restructuring charges of $3.6 million.
  • Investment Management: Net income declined to $1.0 million due to lower assets under management.
  • Lincoln UK: Net income fell 34% to $6.8 million, impacted by UK equity market declines and a higher effective tax rate.

Guidance, Outlook, and Risks

Equity Market Volatility Guidance

Management provided illustrative scenarios for Q2 2003 regarding the impact of equity market movements on earnings:

• No Change: Estimated negative impact of $8.3 million on earnings.
• 2.5% Increase: Estimated negative impact of $3.7 million.
• 2.5% Decline: Estimated negative impact of $18.2 million.

The company notes that a decline of approximately 8% in equity markets could trigger an impairment loss on the deferred dealer commission asset in the Investment Management segment ranging from $7.3 million to $11.2 million.

Accounting Changes and Contingencies

• FAS 123 Adoption: LNC adopted the fair value method for stock-based compensation effective Jan 1, 2003, restating prior periods. This reduced reported net income for Q1 2002 by $8.9 million.
• Variable Interest Entities (VIE): Under new FASB Interpretation No. 46, LNC is reviewing potential consolidation of Collateralized Debt Obligation (CDO) pools. Consolidation could add approximately $800 million in assets and liabilities, though management states these liabilities are without recourse to LNC.
• Reinsurance Contingencies: Ongoing uncertainty exists regarding reserves for personal accident and disability income business sold to Swiss Re. Future reserve adjustments could impact earnings, though no cash transfer is expected between LNC and Swiss Re.
• UK Selling Practices: A liability of $56.2 million remains for UK selling practice issues. Management believes future developments will not materially affect the consolidated financial position.

Investor Verification Checklist

• Investment Portfolio Quality: Verify the extent of unrealized losses in the airline, electric utility, and ABS sectors, which accounted for the majority of the $137.3 million in write-downs.
• GMDB Reserve Adequacy: Assess the sensitivity of Lincoln Retirement's earnings to further equity market declines, specifically regarding the $91.7 million GMDB reserve and the $5.0 billion Net Amount at Risk.
• Dividend Restrictions: Confirm the status of The Lincoln National Life Insurance Company's (LNL) statutory earned surplus, which was negative as of Dec 31, 2002, potentially restricting dividend payments to the parent company without regulatory approval.
• VIE Consolidation Impact: Monitor the final determination regarding the consolidation of CDO pools under Interpretation No. 46 and its effect on the balance sheet.
• Deferred Dealer Commission Asset: Track the equity market performance relative to the 8% decline threshold that could trigger a $7.3M-$11.2M impairment charge in the Investment Management segment.