Business Context and Reporting Period
This Form 10-Q covers the quarterly period ended September 30, 2006, for Lincoln National Corporation (LNC). The reporting period is significantly impacted by the completion of the merger with Jefferson-Pilot Corporation on April 3, 2006. Consequently, the nine-month results reflect LNC's standalone operations for the first quarter and the consolidated operations of the combined entity for the second and third quarters. The company operates through five primary business lines: Individual Markets, Employer Markets, Investment Management, Lincoln UK, and Lincoln Financial Media.
Key Financial Metrics
| Metric (in millions) | Three Months Ended Sept 30, 2006 | Nine Months Ended Sept 30, 2006 | Nine Months Ended Sept 30, 2005 |
|---|---|---|---|
| Total Revenue | $2,487 | $6,405 | $4,088 |
| Net Income | $364 | $934 | $606 |
| Diluted EPS | $1.29 | $3.76 | $3.44 |
| Net Investment Income | $1,108 | $2,855 | $2,034 |
| Total Assets (Sept 30, 2006) | $171,726 | ||
| Total Shareholders' Equity (Sept 30, 2006) | $12,043 | ||
| Long-term Debt (Sept 30, 2006) | $3,735 | ||
| Operating Cash Flow (9 months) | $1,944 |
Material Changes vs. Prior Period
- Revenue Growth: Total revenue increased 78% for the quarter and 57% for the nine-month period compared to 2005, primarily driven by the inclusion of Jefferson-Pilot's results.
- Profitability: Net income rose 59% for the quarter and 54% for the nine-month period. The increase was aided by a favorable insurance recovery of $26 million related to U.K. selling practices and a favorable tax adjustment of $39 million related to the dividends-received deduction (DRD).
- Balance Sheet Expansion: Total assets grew from $124.9 billion at year-end 2005 to $171.7 billion at September 30, 2006. This includes $27.9 billion in investment assets acquired from Jefferson-Pilot. Shareholders' equity increased by $5.7 billion, largely due to $5.6 billion in common stock issued for the merger.
- Debt Levels: Long-term debt increased significantly to finance the cash portion of the merger ($1.8 billion) and stock repurchases. The company issued approximately $2.1 billion in new debt securities in the second quarter of 2006.
- Investment Performance: Net investment income increased 65% for the quarter and 40% for the nine-month period. However, the company recorded net realized losses on investments and derivatives of $10 million for the quarter and $16 million for the nine-month period, including $43 million in write-downs for other-than-temporary impairments.
Guidance, Outlook, and Risks
- Merger Integration: Management expects to realize synergies through expense savings and revenue enhancements. Total estimated restructuring costs for the integration are $180 million pre-tax, with completion expected by late 2008.
- Capital Allocation: The company remains committed to returning capital to shareholders. In the nine months ended September 30, 2006, LNC returned $1.176 billion to shareholders via dividends ($320 million) and stock repurchases ($856 million). A new accelerated stock buyback program of $150 million was initiated in November 2006.
- Interest Rate Risk: The company faces margin compression risks if interest rates decline, particularly for fixed annuity and universal life products. Approximately 36% of discretionary rate-setting products have crediting rates within 10 basis points of contract minimums.
- Regulatory and Legal Contingencies:
- U.K. Selling Practices: Liabilities related to U.K. pension and mortgage endowment mis-selling were $6 million at September 30, 2006. The company received a $26 million reimbursement from liability carriers in Q3 2006.
- Reinsurance: The company monitors the financial strength of reinsurers, particularly Swiss Re (largest exposure) and Scottish Re (recent rating downgrades). Management does not believe these downgrades will have a material adverse effect.
- Accounting Changes: The company is evaluating the impact of new accounting standards including FIN 48 (Income Taxes) and SFAS 157 (Fair Value Measurements), with adoption expected in 2007.
Investor Verification Checklist
- Merger Synergies: Verify the progress of the Jefferson-Pilot integration and the realization of the projected $180 million in cost savings.
- Investment Portfolio Quality: Review the $408 million in gross unrealized losses on available-for-sale securities, specifically the $43 million in other-than-temporary impairment write-downs and the exposure to Ford Motor Co. and other automotive-related securities.
- Reinsurance Counterparty Risk: Assess the impact of rating downgrades on Scottish Re and the concentration of risk with Swiss Re ($4.1 billion receivable).
- U.K. Regulatory Exposure: Monitor the status of U.K. regulatory investigations regarding pension and mortgage endowment sales and the potential for additional liabilities beyond the current $6 million accrual.
- Interest Rate Sensitivity: Evaluate the company's hedging strategies and the potential impact of a prolonged low-interest-rate environment on the spreads of fixed annuity and universal life products.