LINCOLN NATIONAL CORP quarterly report, Q3 FY2016

Business context and reporting period

Lincoln National Corporation (Lincoln Financial Group) filed this unaudited Form 10-Q for the quarter ended September 30, 2016. The company sells annuity, life insurance, retirement-plan and group-protection products through four operating segments: Annuities, Retirement Plan Services, Life Insurance and Group Protection.

Financial performance and position

Unless noted, figures are in millions. Third-quarter and nine-month results are compared with the same periods in 2015.

• Q3 net income increased 106%; nine-month net income rose 15%. The filing attributes improvement to annual assumption unlocking, variable-annuity hedge results, business growth and, in part, favorable tax benefits from releasing reserves for prior tax years. Nine-month results also benefited from legal accrual releases and better Group Protection claims experience.
• GAAP realized results were a $37 gain for Q3 versus $27, but a $121 loss for the nine months versus an $11 loss. The nine-month loss reflected investment disposals, higher credit impairments and other investment-related losses. Net other-than-temporary impairment losses recognized in earnings were $76 for the nine months, versus $38.
• Segment operating income for Q3 was Annuities $240 (down 7%), Retirement Plan Services $32 (down 24%), Life Insurance $167 (versus $36) and Group Protection $28 (up 65%). For the nine months, the respective figures were $693 (down 8%), $94 (down 12%), $361 (up 44%) and $49 (up 69%). These are management-defined non-GAAP segment measures.
• Interest spreads compressed amid low rates: Annuities reported a 1.61% Q3 spread versus 1.81% and a 1.55% nine-month spread versus 1.76%. Management cited new-money yields trailing portfolio yields, partly offset by crediting-rate actions.
• At September 30, total assets were $266.6 billion, liabilities $250.3 billion and stockholders’ equity $16.3 billion, up from $13.6 billion at year-end 2015. AOCI increased to $3.4 billion from $0.8 billion, chiefly reflecting unrealized investment gains. Cash and invested cash was $3.4 billion.
• Consolidated short- and long-term debt totaled $5.7 billion ($250 short-term and $5.457 billion long-term). Holding-company available liquidity was $546 million. Long-term senior debt was rated A-/Baa1 by S&P/Moody’s; the company reported compliance with credit-facility covenants.
• The company repurchased $675 million of common stock and paid $179 million in dividends during the first nine months. Shares outstanding fell to 228.5 million from 243.8 million at year-end 2015. The declared quarterly dividend was $0.25 per share.

Material changes, outlook, risks and unusual items

• Annual assumption unlocking in Q3 contributed a reported $50 million pre-tax gain to continuing operations, compared with an $81 million loss in Q3 2015. Management said a separate reversion-to-the-mean adjustment, if applied at September 30, would have produced an estimated favorable $175 million pre-tax effect; this was hypothetical, not a reported result.
• Deposits fell 21% in Q3 and 18% for the nine months year over year, primarily reflecting Annuities. Total net flows were $331 million for Q3 and $1.736 billion for the nine months, both below prior-year levels; Annuities had negative net flows. Management noted market uncertainty and low interest rates.
• Management expected to meet ongoing holding-company cash needs and said it expected further share repurchases in the remainder of 2016, subject to market conditions and alternative capital uses. On November 1, the board approved a quarterly dividend increase from $0.25 to $0.29 per share. The filing gives no earnings or revenue guidance.
• Key exposures include persistently low or rapidly rising interest rates, equity-market declines and volatility, credit losses, policyholder behavior, hedge effectiveness, reinsurance collectability, reserve and capital requirements, regulatory changes, ratings downgrades and litigation. The DOL fiduciary rule was scheduled for phased implementation beginning April 10, 2017, with full implementation by January 1, 2018.
• Management estimated aggregate reasonably possible litigation losses of up to approximately $50 million; some matters could not be estimated. A putative class action concerning cost-of-insurance increases on certain universal-life policies was being defended. Management did not believe currently known matters were likely to materially adversely affect financial condition.
• Investment portfolio sensitivities merit attention: 95.5% of fixed-maturity AFS securities were investment grade; energy-sector AFS bonds had a $7.7 billion fair value, including below-investment-grade exposure. Unrealized losses on AFS securities had fallen $1.6 billion since year-end, but management cautioned that market, credit and liquidity conditions could change.

Important facts for investors to verify

• How much of the earnings increase is recurring versus driven by annual unlocking, hedge results, tax releases and legal accrual changes.
• Whether annuity deposits and net flows stabilize, and how falling sales affect future fee income and earnings.
• Whether investment spreads continue to narrow and whether management’s crediting-rate and portfolio actions offset that pressure.
• Developments in energy and other credit exposures, realized losses, OTTI and the recoverability assumptions for unrealized-loss securities.
• Insurance-subsidiary statutory capital, dividend capacity, reserve-financing arrangements and holding-company liquidity, including the effect of repurchases and the higher dividend.
• Updates to the $50 million reasonably possible legal-loss estimate, the cost-of-insurance litigation and DOL-rule implementation.