LINCOLN NATIONAL CORP quarterly report, Q3 FY2011

Business context and reporting period

Lincoln National Corporation (Lincoln Financial Group) is a U.S. insurance and retirement-services holding company operating through Retirement Solutions and Insurance Solutions, with four reporting segments. This unaudited Form 10-Q covers the quarter and nine months ended September 30, 2011; comparisons are with the same periods in 2010 unless otherwise noted. Amounts are in millions of dollars except per-share data.

Key financial results and condition

Metric	Q3 2011	Q3 2010	Nine months 2011	Nine months 2010
Total revenue	$2,548	$2,613	$8,065	$7,745
Income from continuing operations	$151	$248	$816	$756
Net income	$143	$246	$808	$785
Diluted EPS	$0.44	$0.75	$2.52	$1.94
Operating cash flow	Not presented for quarter	$934	$1,144

Q3 pre-tax continuing income was $139, down from $303; the company recorded a $12 tax benefit. Nine-month pre-tax continuing income was $1,050, versus $982.
Segment income from operations for Q3 / nine months: Annuities $162 / $459 (2010: $126 / $361); Defined Contribution $40 / $132 ($50 / $122); Life Insurance $132 / $450 ($60 / $348); Group Protection $28 / $78 ($9 / $54); Other Operations loss $45 / $104 ($40 / $113). These are company-defined non-GAAP measures, not consolidated GAAP net income.
At September 30, cash and invested cash was $4,833, versus $2,741 at year-end 2010; total assets were $197,747 and stockholders’ equity $14,919, compared with $193,824 and $12,806. Separate account assets and liabilities were each $78,195.
Short-term and long-term debt totaled $5,898 ($550 short-term; $5,348 long-term), versus $5,750 at December 31, 2010. The company reported $850 of borrowings and $1,466 of letters of credit issued under its listed credit facilities, with $4,106 maximum facility capacity in total.
Investments totaled $92,191, including $75,291 of fixed-maturity AFS securities. 96.1% of fixed-maturity AFS fair value was investment grade, versus 94.8% at year-end 2010. Net investment income was $3,522 for nine months, up 5%.
No consolidated operating-margin figure is clearly provided in the filing text. Annuities’ interest-rate spread was 2.00% for nine months, down from 2.08%; Defined Contribution’s was 2.44%, up from 2.24%.

Material changes versus prior comparable periods

Q3 revenue declined 2% and net income fell 42%, while nine-month revenue rose 4% and net income rose 3%. Q3 realized losses were $163, versus gains of $43 a year earlier; nine-month realized losses were $177, versus gains of $22.
The Q3 earnings comparison was affected by market-driven derivative marks and variable-annuity hedge results, unfavorable benefit-ratio and assumption unlocking, higher death claims, and higher expenses. Nine-month earnings growth reflected higher fees and investment income and lower amortization, partly offset by realized losses, higher expenses, and an $8 discontinued-operations loss.
Quarterly underwriting, acquisition, insurance and other expenses rose to $1,040 from $689. Management attributed the increase in part to significant Life Insurance unlocking reclassifications between benefits and expenses, as well as higher incentive compensation, trail commissions and strategic investment spending.
Cash provided by operations decreased to $934 from $1,144 for the first nine months. Cash rose overall partly because financing cash flows were positive and investment collateral payables increased by $2,196 during the period, including a $1,793 increase related to derivative collateral.
Account values were down $4.6 billion from year-end 2010, primarily due to Q3 equity-market declines, despite positive net flows in the first nine months. Total nine-month net flows were $4,783, down from $5,002; annuity net flows fell 39% to $1,846.

Outlook, commentary, risks and unusual items

Management described volatile equity markets, the European debt crisis, weak growth, high unemployment and persistent low interest rates. It emphasized capital and liquidity monitoring, expense discipline, product and distribution development, and managing low-rate and statutory-reserve pressures. The filing does not provide a specific consolidated earnings or revenue forecast.
Management expected Group Protection loss ratios to remain near the high end of its 71%–74% long-term expectation in Q4 2011, with improvement over time. Non-medical loss ratios were 71.8% for Q3 and 73.1% for nine months; each one-percentage-point increase above expectation was estimated to reduce annual segment operating income by about $10–$12.
Management expected higher Q4 strategic-investment expenses in Annuities, Defined Contribution, Life Insurance and Group Protection; Other Operations expenses were also expected to rise, including marketing. Annuity lapse rates were 8% in 2011 versus 7% in 2010.
New DAC accounting guidance is due to be adopted retrospectively January 1, 2012. The company estimated a $950–$1,150 cumulative reduction to opening retained earnings for the earliest period presented, with an additional AOCI adjustment dependent on market values at adoption. Management estimated nine-month 2011 segment results would have been 5%–7% lower under the new method, before any mitigating actions.
Variable-annuity guarantees remain market-sensitive: 91% of in-force guaranteed withdrawal benefit contracts were “in the money,” versus 45% one year earlier; exposure after reinsurance was $3.8 billion, versus $1.7 billion. Management cautioned that hedges may not fully offset changes in guarantee liabilities.
Life subsidiaries face audits and inquiries concerning unclaimed benefits and abandoned property; potential additional payments, escheatment, penalties and process costs cannot currently be estimated. Management said other pending proceedings were expected to resolve without materially affecting consolidated financial position, but adverse outcomes could affect results in a particular period.
Other notable items include a $5 after-tax loss on early debt extinguishment, an $8 discontinued-operations loss related to a prior-year tax return true-up, and a $9 estimated assessment tied to the Executive Life of New York liquidation plan.
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 the Q3 GAAP earnings decline and $163 realized loss are primarily market-related and how much reflects recurring operating performance; compare GAAP results with the company’s non-GAAP segment measures.
The impact of 2012 DAC adoption on restated earnings, opening retained earnings and AOCI, and whether the estimated 5%–7% segment-results effect changes with management actions.
Capital and liquidity capacity under stress, including subsidiary dividend availability, the use and renewal of letters of credit for XXX/AG38 reserves, and the effect of derivative collateral calls.
Developments in variable-annuity guarantee exposure, hedge effectiveness, equity markets and interest rates; the disclosed sensitivities are modeled estimates and may not capture combined shocks.
Credit quality and impairment trends, particularly mortgage-backed and commercial-mortgage exposures, below-investment-grade holdings, and the company’s ability to hold temporarily impaired securities until recovery.
Group Protection claims and loss-ratio trends, reserve-financing costs for secondary-guarantee life products, and the outcomes and potential costs of unclaimed-property audits and other legal or regulatory matters.