Business context and reporting period
Lincoln National Corporation (LNC) is an Indiana-based insurance and retirement-services holding company. This Form 10-K covers the fiscal year ended December 31, 2016; the filing also gives unaudited fourth-quarter results. Its four segments are Annuities, Retirement Plan Services, Life Insurance and Group Protection. Unless noted, financial amounts below are in U.S. dollars.
Financial and operating performance
| Metric | 2016 | 2015 | Change |
|---|---|---|---|
| Total revenue | $13.330 billion | $13.572 billion | Down 2% |
| Net income | $1.192 billion | $1.154 billion | Up 3% |
| Diluted EPS | $5.03 | $4.51 | Up 12% |
| Operating cash flow | $1.272 billion | $2.243 billion | Down 43% |
| Net investment income | $4.874 billion | $4.827 billion | Up 1% |
| Assets at year-end | $261.627 billion | $251.908 billion | Up 4% |
| Stockholders’ equity at year-end | $14.478 billion | $13.617 billion | Up 6% |
| Long-term debt principal | $5.123 billion | $5.323 billion | Down 4% |
Fourth-quarter 2016 revenue was $3.255 billion, total expenses were $3.058 billion and net income was $189 million, compared with $3.171 billion, $2.820 billion and $283 million, respectively, in fourth-quarter 2015.
Segment income from operations was $935 million for Annuities (down 6%), $127 million for Retirement Plan Services (down 9%), $515 million for Life Insurance (up 39%), $65 million for Group Protection (up 51%) and a $102 million loss for Other Operations (versus a $154 million loss). These are management’s segment measures, not consolidated GAAP net income.
Total deposits fell 16% to $21.639 billion. Annuity deposits dropped 35% to $8.214 billion, with net outflows of $2.286 billion; Retirement Plan Services deposits were $7.657 billion and net inflows were $565 million; Life Insurance deposits were $5.768 billion and net inflows were $4.119 billion. Total account values increased 4% to $229.128 billion.
Interest spreads narrowed: Annuities’ spread was 1.49% versus 1.76%; Retirement Plan Services’ was 1.66% versus 1.76%; and Life Insurance’s spread on interest-sensitive products was 1.56% versus 1.65%. Consolidated net investment income yield on invested assets was 4.90%, down from 5.04%. Group Protection’s total non-medical loss ratio improved to 68.3% from 75.4%; excluding favorable reserve refinements, it was 70.8%.
Cash and invested cash was $2.722 billion at year-end. LNC reported $561 million of holding-company available liquidity and a $2.5 billion unsecured credit facility expiring in 2021. Insurance subsidiaries’ statutory capital and surplus was $8.218 billion; the principal subsidiaries’ RBC ratios exceeded the company action level. Insurance-subsidiary dividends available to LNC without prior regulatory approval were estimated at approximately $765 million for 2017.
Material changes versus prior periods
- Net income rose modestly, while diluted EPS grew faster, reflecting a lower weighted-average share count after repurchases. LNC repurchased $879 million of common stock in 2016 and returned $1.115 billion to shareholders through dividends and repurchases.
- Revenue declined, with lower Group Protection premiums following repricing and substantially lower Annuity deposits and flows. Total net flows fell 60% to $2.398 billion.
- Realized losses increased to $339 million pre-tax from $151 million in 2015. The 2016 loss included investment sales and impairments, as well as variable-annuity derivative results. The filing reports $102 million of net OTTI recognized in earnings and $157 million of total impairments, including noncredit impairments recognized in OCI.
- Operating cash flow fell to $1.272 billion from $2.243 billion, with changes in contract-holder funds and other working-capital items contributing to year-to-year volatility.
- Equity-market gains contributed to higher account values and improved AOCI; comprehensive income was $1.913 billion versus a $1.097 billion comprehensive loss in 2015.
Outlook, commentary, risks and unusual items
The filing provides no specific consolidated earnings or revenue guidance. Management identified regulatory uncertainty, variable-annuity sales trends and capital-market volatility as key 2017 issues. It plans to invest in technology, digitization, product development and distribution, manage expenses, monitor capital and liquidity, and continue evaluating reserve-financing strategies.
LNC expected approximately $40 million of annual pre-tax net costs during the first two years of its digitization initiative and anticipated meaningful cost savings over four to five years. Group Protection management expected to approach normal target margins by the end of 2018. Management also said it expected the trend of lower variable-annuity deposits and negative Annuities net flows to continue into 2017.
Material risks include prolonged low interest rates and spread compression; equity-market declines, volatility and higher costs or ineffectiveness of hedging variable-annuity guarantees; changes in policyholder withdrawals and behavior; investment credit losses and illiquid assets; and reinsurance collectability, particularly the $2.1 billion recoverable from Swiss Re. The DOL fiduciary rule could affect product distribution, compensation, sales and margins; the filing noted that implementation might be delayed following a presidential directive. New principles-based life-reserving requirements began taking effect in 2017, while further changes to variable-annuity reserving and capital rules remained under review.
Several putative class actions filed in 2016 and early 2017 alleged that cost-of-insurance increases on universal-life policies breached policy terms; LNC said it was vigorously defending the cases. The company estimated aggregate reasonably possible losses of up to approximately $50 million for certain matters, while stating that it could not estimate losses for some other proceedings. A 2016 debt refinancing and tender offer generated a $63 million pre-tax loss on early extinguishment of debt ($41 million after tax). The independent auditor issued an unqualified opinion, and management and the auditor concluded internal control over financial reporting was effective as of year-end.
Important facts for investors to verify
- Whether Annuities’ steep deposit decline and negative net flows persist, and how these affect account values, fee income and earnings.
- How variable-annuity guarantee exposures, hedge performance and required statutory capital respond to adverse equity, interest-rate and volatility movements.
- The status, potential exposure and any reserve changes related to cost-of-insurance litigation and the policy rate increases at issue.
- Whether spread compression continues, and how it affects earnings, subsidiary dividend capacity and holding-company liquidity.
- The quality and collectability of reinsurance recoverables, especially Swiss Re exposure, and the availability and cost of reserve-financing arrangements.
- Whether further investment impairments, legal costs or regulatory changes materially affect earnings, capital or liquidity.