Lincoln National Corporation — Q2 2014 Form 10-Q
Reporting period: Three and six months ended June 30, 2014; balance-sheet comparisons are with December 31, 2013. LNC is an insurance and retirement-services holding company, operating Annuities, Retirement Plan Services, Life Insurance and Group Protection, plus Other Operations. Dollar amounts below are in millions unless stated otherwise.
Financial results and position
| Metric | Q2 2014 | Q2 2013 | First half 2014 | First half 2013 |
|---|---|---|---|---|
| Total revenue | $3,282 | $2,999 | $6,457 | $5,838 |
| Income before taxes | $537 | $418 | $963 | $723 |
| Net income | $398 | $317 | $727 | $556 |
| Diluted EPS | $1.48 | $1.15 | $2.69 | $2.01 |
| Net investment income | $1,207 | $1,213 | $2,415 | $2,363 |
| Interest and debt expense | $67 | $65 | $134 | $129 |
Q2 revenue rose 9% and net income 26% year over year; first-half revenue rose 11% and net income 31%. The six-month effective tax rate was 25%, versus 23% in 2013. Comprehensive income was $1,144 in Q2, compared with a loss of $1,371 in Q2 2013, reflecting a large swing in other comprehensive income.
| Segment operating income (after tax) | Q2 2014 | Q2 2013 | First half 2014 | First half 2013 |
|---|---|---|---|---|
| Annuities | $227 | $195 | $443 | $353 |
| Retirement Plan Services | $39 | $39 | $78 | $75 |
| Life Insurance | $148 | $135 | $268 | $247 |
| Group Protection | $2 | $22 | $21 | $37 |
| Other Operations | $(22) | $(40) | $(51) | $(77) |
Segment operating income is a company-defined measure that excludes specified realized gains and losses and other items; it is not GAAP net income. Consolidated realized gain was $35 in Q2 2014 versus a $17 loss in Q2 2013, and $16 for the first half versus a $76 loss in 2013.
- Balance sheet: Total assets were $249,125 and stockholders’ equity $15,451 at June 30, up from $236,945 and $13,452 at year-end. Total investments were $100,958; separate-account assets and liabilities were each $124,159.
- Debt: Short-term debt was $250 and long-term debt $5,170, down from $501 and $5,320 at year-end. LNC repaid $500 of senior notes in the first quarter. Long-term senior debt ratings were A-/Baa1 (S&P/Moody’s).
- Cash flow: First-half operating cash flow was $371, versus $55 in 2013; investing cash flow was $(1,105), versus $(2,803); financing cash flow was $(121), versus $1,092. Cash and invested cash fell by $855 to $1,509. Financing included $300 of share repurchases and $84 of common dividends.
- Liquidity: Holding-company available liquidity was $573 at June 30. Insurance subsidiaries paid $360 in dividends to the holding company during the first half, including $340 from LNL.
Material changes and management commentary
- Growth in account values and insurance in force, plus the shift from realized losses to gains, supported higher consolidated earnings. Management cited spread compression from new-money yields below portfolio yields, partly offset by lower crediting rates.
- Annuities first-half operating income rose 25%, supported by higher fee income from higher variable account values. Annuity deposits fell 6% and net flows fell 41% year over year; management said it was emphasizing variable-annuity products without guaranteed living-benefit riders. Such products were 23% of Q2 variable-annuity deposits, versus 9% a year earlier.
- Life Insurance first-half operating income rose 9%, primarily on higher fee income and investment income, partly offset by higher death claims and expenses. Total life sales fell 6% in the first half, with product-level results mixed.
- Group Protection first-half operating income fell 43%. Q2 non-medical loss ratio was 80.3%, above the company’s 71%–74% long-term expectation, mainly due to elevated long-term disability incidence and mortality. Management expected loss ratios to remain above target for the rest of 2014 and estimated that each one-percentage-point increase in the loss ratio would reduce annual operating income by approximately $13–$15.
- Management planned its annual assumptions review in Q3. It stated that, had the reversion-to-the-mean assumption been unlocked at June 30, the estimated favorable pre-tax unlocking would have been approximately $350 for Annuities, $30 for Retirement Plan Services and $45 for Life Insurance. These are hypothetical estimates, not reported earnings or formal guidance.
- In July 2014, LNL amended its reinsurance treaty for new variable-annuity guaranteed-living-benefit sales, adding $4 billion of capacity through December 31, 2015; LNL retains product cash flows other than the living-benefit guarantee.
- The company authorized up to $1 billion of aggregate securities repurchases; $953 remained available at June 30. Management expected additional repurchases in the remainder of 2014, subject to market conditions and alternative uses of capital.
Risks, contingencies and unusual items
- Low interest rates may compress spreads and reduce investment income; rapidly rising rates may increase surrenders, realized losses and hedge risk. Equity-market declines can reduce fee revenue and increase guaranteed-benefit liabilities. Management reported that 72% of individual annuity variable-account values had guaranteed living-benefit features; 3% of in-force contracts with those features were “in the money” at June 30, 2014, versus 6% a year earlier.
- Captive reinsurance supports statutory reserves for term and secondary-guarantee life products. Regulatory changes could restrict or reduce the capital efficiency of these structures, potentially affecting returns, sales and subsidiary dividends. Management said subsidiaries had statutory surplus and risk-based capital above current regulatory requirements and believed they could support projected reserve increases if financing structures became unavailable.
- Gross unrealized losses on available-for-sale securities, including the portion of impairment recognized in OCI, decreased by $959 during the first half. LNC reported $450 of gross unrealized losses and stated that it did not consider the positions other-than-temporarily impaired overall, citing its intent and ability to hold and expected cash-flow recovery. The filing reports $18 of first-half impairments, split between $9 credit-related and $9 noncredit-related.
- Legal and regulatory matters include the Bezich cost-of-insurance class action. In June 2014, the court denied class certification on all claims except one contract-breach issue; any damages on that issue would require individual trials. LNC sought permission for an interlocutory appeal. Management said potential charges in some matters could be material in the period recorded, but did not believe currently known matters were likely to materially adversely affect financial condition.
- Derivative agreements and counterparty collateral create liquidity exposure; a ratings downgrade could trigger termination provisions. LNC disclosed $81 of derivative counterparty exposure at June 30. The filing also identifies risks from regulation, reinsurance collectability, credit markets, competition, operational and cybersecurity disruptions, and changes in mortality, morbidity, persistency and investment assumptions.
No numerical full-year earnings or revenue guidance is provided. Management cautioned that first-half results are not necessarily indicative of full-year results.
Important facts for investors to verify
- Whether elevated Group Protection disability and mortality claims persist, and how the loss ratio compares with the 71%–74% target range.
- How the Q3 annual assumptions review affects DAC, reserves and segment earnings; distinguish actual results from the hypothetical June 30 unlocking estimates.
- Whether annuity deposit and net-flow declines continue, and whether the product shift toward variable annuities without GLB riders changes risk and profitability.
- Whether spread compression, market movements and derivative hedging materially affect earnings, liquidity or guaranteed-benefit liabilities.
- Developments in captive-reinsurance regulation, statutory capital and subsidiary dividend capacity, along with progress and exposure in the Bezich litigation.
- Holding-company liquidity, debt maturities, share repurchases and dividends; confirm that capital returns remain consistent with insurer capital and rating requirements.