Lincoln National Corporation — Q2 2018 Form 10-Q
Reporting period: Three and six months ended June 30, 2018. Amounts are in U.S. dollars; financial statement amounts are in millions unless stated otherwise. Lincoln operates Annuities, Retirement Plan Services, Life Insurance and Group Protection businesses.
Financial results and key metrics
| Metric | Q2 2018 | Q2 2017 | Six months 2018 | Six months 2017 |
|---|---|---|---|---|
| Total revenue | $4,020 | $3,577 | $7,629 | $7,077 |
| Income before taxes | $451 | $533 | $886 | $1,008 |
| Net income | $385 | $411 | $752 | $846 |
| Diluted EPS | $1.70 | $1.81 | $3.34 | $3.70 |
| Operating cash flow | — | $632 | $202 |
Reported revenue increased 12% in Q2 and 8% for the half year, while net income declined 6% and 11%, respectively. Approximate GAAP net margin was 9.6% in Q2 versus 11.5% a year earlier, and 9.9% for the half versus 12.0%. Results include Liberty Life only from its May 1 acquisition date, limiting direct year-over-year comparability.
- For the six months, investing cash flow was a use of $2,373; financing cash flow provided $1,888. Cash, invested cash and restricted cash ended at $1,775.
- At June 30, total assets were $298,832 and stockholders’ equity was $15,177, compared with $281,763 and $17,322 at year-end 2017. The equity decline primarily reflects a $2,671 after-tax other comprehensive loss.
- Long-term debt rose to $5,826 from $4,894; short-term debt was zero, down from $450. Holding-company available liquidity was $484. Long-term senior debt ratings were A-/Baa1 (S&P/Moody’s).
- Common dividends declared were $0.33 per share in Q2 and $0.66 for the half, versus $0.29 and $0.58 in 2017. The company repurchased $100 of stock in the first half.
- Fixed maturity AFS securities totaled $93,060 at fair value; 96.2% were investment grade. Gross unrealized losses increased substantially, which management attributed principally to rising rates and wider credit spreads, and management did not consider the positions other-than-temporarily impaired.
Material changes and segment performance
- Liberty Life was acquired May 1. Lincoln paid $1.5 billion cash for the Group Benefits business; Liberty Life’s $1.8 billion excess capital was distributed to Liberty Mutual. The acquired business contributed $373 of revenue and $12 of net income after closing. Preliminary goodwill was $382, allocated to Group Protection; purchase accounting values remain subject to finalization.
- Lincoln ceded Liberty Life’s individual life and individual/group annuity business to Protective for a $423 million ceding commission. Reinsurance recoverables increased to $18.0 billion from $4.9 billion. Related policy liabilities remain on Lincoln’s balance sheet; Protective established trusts that fully collateralize the recoverable. Protective is now Lincoln’s largest reinsurance exposure.
- Group Protection operating income rose to $45 in Q2 and $74 for the half, from $35 and $42; comparisons include two months of acquired activity. Its Q2 total loss ratio was 73.1%, versus 66.1%.
- Operating income increased across Annuities ($275 Q2; $542 half), Retirement Plan Services ($43; $86), and Life Insurance ($150; $294), compared with $251/$532, $37/$74, and $133/$263, respectively. Other Operations’ loss widened to $59 Q2 and $101 for the half, from $37 and $51.
- Management cited higher account values and fee income, lower taxes and the Liberty acquisition as offsets to weaker variable-annuity hedge results, spread compression, lower alternative-investment returns and reduced prepayment/make-whole premiums. Q2 GAAP results also included $44 million of pretax acquisition costs; six-month acquisition costs were $50 million pretax.
Outlook, risks and unusual items
- The filing gives no specific full-year earnings or revenue guidance. Management said results for the six months are not necessarily indicative of full-year results. It expects to manage near-term spread effects through portfolio management and, to a lesser extent, crediting-rate actions, subject to business flows and market conditions.
- Lincoln’s annual assumption review is conducted in the third quarter. Management said that, had it unlocked its reversion-to-the-mean assumption at June 30, the estimated pretax effect would have been favorable by approximately $200 million for Annuities, $45 million for Life Insurance and $25 million for Retirement Plan Services. These are hypothetical estimates, not reported earnings or formal guidance.
- Variable-annuity net derivative results were a $60 million loss for the first half, compared with a $9 million gain in 2017, primarily reflecting less favorable hedge-program performance amid more volatile markets. Management also identified low or rising interest rates, equity-market declines, credit conditions, lapses, mortality/morbidity, reinsurance collectability, ratings downgrades, regulation, cybersecurity and acquisition integration as risks.
- Management estimated aggregate reasonably possible litigation and regulatory losses of up to approximately $50 million. A putative class action alleging excessive cost-of-insurance charges was filed July 17, 2018; Lincoln said it is vigorously defending the matter. The company is also disputing requested reinsurance rate increases and believes those disputes are unlikely to have a material adverse financial effect.
- Lincoln stated that its disclosure controls were effective, but Liberty Life was not yet included in the internal-control effectiveness assessment following the acquisition.
Most important facts for investors to verify
- How much of reported revenue and Group Protection growth is attributable to Liberty Life, and how its integration and preliminary purchase accounting develop.
- Whether operating trends support reported GAAP earnings: variable-annuity hedging, interest spreads, alternative-investment income and benefit/loss ratios warrant particular attention.
- The quality and ongoing collateralization of the $18.0 billion Protective reinsurance recoverable, and any changes in Lincoln’s concentration exposure to Protective.
- Whether unrealized investment losses remain temporary and whether rising rates or credit spreads affect liquidity, capital, or earnings.
- Holding-company liquidity, subsidiary dividend capacity, debt levels and capital needs, alongside the litigation estimate and the July cost-of-insurance complaint.