__________________________________________________________________________________________________________
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
_________________
FORM 10-Q
(Mark One)
x Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the quarterly period ended March 31, 2020
OR
¨ Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the transition period from ______ to ______
Commission File Number: 1-6028
LINCOLN NATIONAL CORPORATION
(Exact name of registrant as specified in its charter)
Indiana
35-1140070
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
150 N. Radnor-Chester Road, Suite A305, Radnor, Pennsylvania
19087
(Address of principal executive offices)
(Zip Code)
(484) 583-1400
(Registrant’s telephone number, including area code)
Not Applicable
(Former name, former address and former fiscal year, if changed since last report.)
__________________________________
Securities registered pursuant to Section 12(b) of the Act:
Title of each class
Trading symbol(s)
Name of each exchange on which registered
Common Stock
LNC
New York Stock Exchange
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large Accelerated Filer
Accelerated Filer
Non-accelerated Filer
Smaller Reporting Company
Emerging Growth Company
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨No x
As of May 4, 2020, there were 193,224,445 shares of the registrant’s common stock outstanding.
_________________________________________________________________________________________________________
Lincoln National Corporation
Table of Contents
Item
Page
PART I
1.
Financial Statements
1
2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
49
Forward-Looking Statements – Cautionary Language
50
Introduction
51
Executive Summary
Critical Accounting Policies and Estimates
52
Acquisitions and Dispositions
54
Results of Consolidated Operations
55
Results of Annuities
56
Results of Retirement Plan Services
61
Results of Life Insurance
65
Results of Group Protection
69
Results of Other Operations
72
Realized Gain (Loss) and Benefit Ratio Unlocking
74
Consolidated Investments
76
Review of Consolidated Financial Condition
88
Liquidity and Capital Resources
3.
Quantitative and Qualitative Disclosures About Market Risk
92
4.
Controls and Procedures
93
PART II
Legal Proceedings
94
1A.
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
95
6.
Exhibits
Exhibit Index for the Report on Form 10-Q
96
Signatures
97
PART I – FINANCIAL INFORMATION
Item 1. Financial Statements
CONSOLIDATED BALANCE SHEETS
(in millions, except share data)
As of
March 31,
December 31,
2020
2019
(Unaudited)
ASSETS
Investments:
Fixed maturity available-for-sale securities, at fair value
(amortized cost: 2020 – $96,217; 2019 – $94,295; allowance for credit losses: 2020 – $20; 2019 – $0)
$
102,606
105,200
Trading securities
4,019
4,673
Equity securities
83
103
Mortgage loans on real estate, net of allowance for credit losses
(portion at fair value: 2020 – $765; 2019 – $0)
16,791
16,339
Policy loans
2,571
2,477
Derivative investments
4,417
1,911
Other investments
4,765
2,994
Total investments
135,252
133,697
Cash and invested cash
6,202
2,563
Deferred acquisition costs and value of business acquired
9,212
7,694
Premiums and fees receivable
562
465
Accrued investment income
1,185
1,148
Reinsurance recoverables, net of allowance for credit losses
16,923
17,144
Reinsurance related embedded derivatives
137
-
Funds withheld reinsurance assets
535
536
Goodwill
1,778
Other assets
16,246
16,170
Separate account assets
130,617
153,566
Total assets
318,649
334,761
LIABILITIES AND STOCKHOLDERS’ EQUITY
Liabilities
Future contract benefits
37,100
36,420
Other contract holder funds
99,508
98,018
Short-term debt
300
Long-term debt
6,748
6,067
327
Funds withheld reinsurance liabilities
1,843
1,810
Payables for collateral on investments
8,434
5,082
Other liabilities
17,824
13,482
Separate account liabilities
Total liabilities
302,074
315,072
Contingencies and Commitments (See Note 11)
Stockholders’ Equity
Preferred stock – 10,000,000 shares authorized
Common stock – 800,000,000 shares authorized; 193,208,244 and 196,668,532 shares
issued and outstanding as of March 31, 2020, and December 31, 2019, respectively
5,071
5,162
Retained earnings
8,500
8,854
Accumulated other comprehensive income (loss)
3,004
5,673
Total stockholders’ equity
16,575
19,689
Total liabilities and stockholders’ equity
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(Unaudited, in millions, except per share data)
For the Three
Months Ended
Revenues
Insurance premiums
1,373
1,446
Fee income
1,539
1,475
Net investment income
1,375
1,251
Realized gain (loss):
Total other-than-temporary impairment losses on securities
(23
)
Portion of loss recognized in other comprehensive income
15
Net other-than-temporary impairment losses on securities recognized in earnings
(8
Realized gain (loss), excluding other-than-temporary impairment losses on securities
(24
(354
Total realized gain (loss)
(362
Amortization of deferred gain on business sold through reinsurance
11
8
Other revenues
151
147
Total revenues
4,425
3,965
Expenses
Interest credited
725
678
Benefits
2,501
1,757
Commissions and other expenses
1,085
1,176
Interest and debt expense
68
71
Strategic digitization expense
12
Total expenses
4,391
3,697
Income (loss) before taxes
34
268
Federal income tax expense (benefit)
(18
16
Net income (loss)
252
Other comprehensive income (loss), net of tax
(2,669
2,046
Comprehensive income (loss)
(2,617
2,298
Net Income (Loss) Per Common Share
Basic
0.27
1.23
Diluted
0.15
1.22
Cash Dividends Declared Per Common Share
0.40
0.37
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
Balance as of beginning-of-year
5,392
Stock compensation/issued for benefit plans
9
(5
Retirement of common stock/cancellation of shares
(100
(102
Balance as of end-of-period
5,285
Retained Earnings
8,551
Cumulative effect from adoption of new accounting standards
(203
Retirement of common stock
(125
(48
Common stock dividends declared
(78
(76
8,679
Accumulated Other Comprehensive Income (Loss)
407
2,453
Total stockholders’ equity as of end-of-period
16,417
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited, in millions)
Cash Flows from Operating Activities
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
Realized (gain) loss
24
362
Trading securities purchases, sales and maturities, net
235
(1,209
(11
Change in:
Deferred acquisition costs, value of business acquired, deferred sales inducements
and deferred front-end loads deferrals and interest, net of amortization
(169
(70
(97
(37
(65
Future contract benefits and other contract holder funds
1,389
(348
Reinsurance related assets and liabilities
(653
(299
Accrued expenses
(317
(56
Federal income tax accruals
Other
57
131
Net cash provided by (used in) operating activities
455
(1,331
Cash Flows from Investing Activities
Purchases of available-for-sale securities and equity securities
(3,590
(4,404
Sales of available-for-sale securities and equity securities
395
2,381
Maturities of available-for-sale securities
1,317
1,456
Purchases of alternative investments
(79
(174
Sales and repayments of alternative investments
32
Issuance of mortgage loans on real estate
(839
(1,103
Repayment and maturities of mortgage loans on real estate
227
242
Issuance (repayment) of policy loans, net
(94
Net change in collateral on investments, derivatives and related settlements
3,411
488
(61
(62
Net cash provided by (used in) investing activities
742
(1,133
Cash Flows from Financing Activities
Payment of long-term debt, including current maturities
(300
Issuance of long-term debt, net of issuance costs
499
Deposits of fixed account values, including the fixed portion of variable
3,917
4,042
Withdrawals of fixed account values, including the fixed portion of variable
(1,684
(1,570
Transfers to and from separate accounts, net
323
(507
Common stock issued for benefit plans
(9
(26
Repurchase of common stock
(225
(150
Dividends paid to common stockholders
(77
Net cash provided by (used in) financing activities
2,442
1,712
Net increase (decrease) in cash, invested cash and restricted cash
3,639
(752
Cash, invested cash and restricted cash as of beginning-of-year
2,345
Cash, invested cash and restricted cash as of end-of-period
1,593
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Nature of Operations and Basis of Presentation
Nature of Operations
Lincoln National Corporation and its subsidiaries (“LNC” or the “Company,” which also may be referred to as “we,” “our” or “us”) operate multiple insurance businesses through four business segments. See Note 15 for additional details. The collective group of businesses uses “Lincoln Financial Group” as its marketing identity. Through our business segments, we sell a wide range of wealth protection, accumulation, retirement income and group protection products and solutions. These products primarily include fixed and indexed annuities, variable annuities, universal life insurance (“UL”), variable universal life insurance (“VUL”), linked-benefit UL, indexed universal life insurance (“IUL”), term life insurance, employer-sponsored retirement plans and services, and group life, disability and dental.
Basis of Presentation
The accompanying unaudited consolidated financial statements are prepared in accordance with United States of America generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions for the Securities and Exchange Commission (“SEC”) Quarterly Report on Form 10-Q, including Article 10 of Regulation S-X. Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements. The information contained in the Notes to Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019 (“2019 Form 10-K”), should be read in connection with the reading of these interim unaudited consolidated financial statements.
Certain GAAP policies, which significantly affect the determination of financial condition, results of operations and cash flows, are summarized in our 2019 Form 10-K.
In the opinion of management, these statements include all normal recurring adjustments necessary for a fair presentation of the Company’s results. Operating results for the three months ended March 31, 2020, are not necessarily indicative of the results that may be expected for the full year ending December 31, 2020, especially when considering the risks and uncertainties associated with the coronavirus, or COVID-19, pandemic and the future impacts of the pandemic on our business, results of operations and financial condition. All material inter-company accounts and transactions have been eliminated in consolidation.
2. New Accounting Standards
Adoption of New Accounting Standards
The following table provides a description of our adoption of new Accounting Standards Updates (“ASUs”) issued by the Financial Accounting Standards Board (“FASB”) and the impact of the adoption on our financial statements. ASUs not listed below were assessed and determined to be either not applicable or insignificant in presentation or amount.
Standard
Description
Date of Adoption
Effect on Financial Statements or Other Significant Matters
ASU 2016-13, Measurement of Credit Losses on Financial Instruments and related amendments
These amendments adopt a new model in Accounting Standards CodificationTM (“ASC”) Topic 326 to measure and recognize credit losses for most financial assets. The ASU requires a financial asset measured at amortized cost to be presented at the net amount expected to be collected over the life of the asset using an allowance for credit losses. Changes in the allowance are charged to earnings. The measurement of expected credit losses is based on relevant information about past events, including historical experience, as well as current economic conditions and reasonable and supportable forecasts that affect the collectability of the financial asset. The method used to measure estimated credit losses for fixed maturity available-for-sale (“AFS”) securities will be unchanged from current GAAP; however, the amendments require credit losses to be recognized through an allowance rather than as a reduction to the amortized cost of those securities. The amendments permit entities to recognize improvements in credit loss estimates on fixed maturity AFS securities by reducing the allowance account immediately through earnings. The amendments are adopted through a cumulative effect adjustment to the beginning balance of retained earnings as of the first reporting period in which the amendments are effective. Early adoption is permitted for annual periods beginning after December 15, 2018, and interim periods therein.
January 1, 2020
The adoption of this standard and related amendments resulted in the recognition of a cumulative effect decrease of $218 million, net of deferred acquisition costs (“DAC”), value of business acquired (“VOBA”), deferred sales inducements (“DSI”), deferred front-end loads (“DFEL”) and changes in other contract holder funds, after-tax, to retained earnings. The overall adjustment recorded our allowance for credit losses (“ACL”) as of the date of adoption, primarily related to commercial and residential mortgage loans, as well as reinsurance recoverables. Upon adoption of the standard, the concept of other-than-temporary impairment (“OTTI”) no longer exists; however, our prior period presentation herein is reflective of OTTI recorded in those periods.
ASU 2019-04, Codification Improvements to Topic 326, Financial Instruments – Credit Losses, Topic 815, Derivatives and Hedging and Topic 825, Financial Instruments
These amendments clarify the measurement, recognition and presentation of the allowance for credit losses on accrued interest receivable balances; the inclusion of recoveries when estimating the allowance for credit losses; the inclusion of all ASC Topic 944 – Financial Services – Insurance reinsurance recoverables within the scope of ASC 326-20; and provide additional targeted clarifications on the calculation of the allowance for credit losses.These amendments also make targeted clarifications to ASC Topics 815 and 825. Early adoption is permitted.
Our adoption of ASU 2016-13 and related amendments is discussed above. The adoption of the remainder of this guidance did not have a material impact on our consolidated financial condition and results of operations.
ASU 2019-05, Financial Instruments – Credit Losses (Topic 326): Targeted Transition Relief
The amendments provide entities that have certain instruments within the scope of Subtopic 326-20, Financial Instruments – Credit Losses – Measured at Amortized Cost, with an option to irrevocably elect the fair value option in Subtopic 825-10, Financial Instruments – Overall, applied on an instrument-by-instrument basis for eligible instruments, upon adoption of ASC Topic 326.
We recognized a cumulative effect increase to retained earnings of $15 million, after-tax, by electing the fair value option for certain mortgage loans in connection with our adoption of ASC Topic 326.
Future Adoption of New Accounting Standards
The following table provides a description of future adoptions of new accounting standards that may have an impact on our financial statements when adopted:
Projected Date of Adoption
ASU 2018-12, Targeted Improvements to the Accounting for Long-Duration Contracts and related amendments
These amendments make changes to the accounting and reporting for long-duration contracts issued by an insurance entity that will significantly change how insurers account for long-duration contracts, including how they measure, recognize and make disclosures about insurance liabilities and DAC. Under this ASU, insurers will be required to review cash flow assumptions at least annually and update them if necessary. They also will have to make quarterly updates to the discount rate assumptions they use to measure the liability for future policyholder benefits. The ASU creates a new category of market risk benefits (i.e., features that protect the contract holder from capital market risk and expose the insurer to that risk) that insurers will have to measure at fair value. The ASU provides various transition methods by topic that entities may elect upon adoption. The ASU is currently effective January 1, 2022, and early adoption is permitted.
January 1, 2022
We are currently evaluating the impact of adopting this ASU on our consolidated financial condition and results of operations.
ASU 2020-04, Reference Rate Reform (Topic 848)
The amendments in this update provide optional guidance for a limited period of time to ease the potential burden in accounting for (or recognizing the effects of) reference rate reform on financial reporting. The amendments provide optional expedients and exceptions for applying GAAP to contracts, hedging relationships and other transactions impacted by reference rate reform. If certain criteria are met, an entity will not be required to remeasure or reassess contracts impacted by reference rate reform. Additionally, changes to the critical terms of a hedging relationship affected by reference rate reform will not require entities to de-designate the relationship if certain requirements are met. The expedients and exceptions provided by the amendments do not apply to contract modifications made and hedging relationships entered into or evaluated after December 31, 2022, except for hedging relationships existing as of December 31, 2022, that an entity has elected certain optional expedients for and that are retained through the end of the hedging relationship. Early adoption was permitted at the time of issuance.
Not yet determined
3. Variable Interest Entities
Consolidated VIEs
Asset information (dollars in millions) for the consolidated variable interest entities (“VIEs”) included on our Consolidated Balance Sheets was as follows:
As of March 31, 2020
As of December 31, 2019
Number
of
Notional
Carrying
Instruments
Amounts
Value
Assets
Total return swap
596
613
As of March 31, 2020, and December 31, 2019, there were no gains or losses for consolidated VIEs recognized on our Consolidated Statements of Comprehensive Income (Loss).
Unconsolidated VIEs
Structured Securities
Through our investment activities, we make passive investments in structured securities issued by VIEs for which we are not the manager. These structured securities include our asset-backed securities (“ABS”), residential mortgage-backed securities (“RMBS”), commercial mortgage-backed securities (“CMBS”) and collateralized loan obligations (“CLOs”). We have not provided financial or other support with respect to these VIEs other than our original investment. We have determined that we are not the primary beneficiary of these VIEs due to the relative size of our investment in comparison to the principal amount of the structured securities issued by the VIEs and the level of credit subordination that reduces our obligation to absorb losses or right to receive benefits. Our maximum exposure to loss on these structured securities is limited to the amortized cost for these investments. We recognize our variable interest in these VIEs at fair value on our Consolidated Balance Sheets. For information about these structured securities, see Note 4.
Limited Partnerships and Limited Liability Companies
We invest in certain limited partnerships (“LPs”) and limited liability companies (“LLCs”), including qualified affordable housing projects, that we have concluded are VIEs. We do not hold any substantive kick-out or participation rights in the LPs and LLCs, and we do not receive any performance fees or decision maker fees from the LPs and LLCs. Based on our analysis of the LPs and LLCs, we are not the primary beneficiary of the VIEs as we do not have the power to direct the most significant activities of the LPs and LLCs.
The carrying amounts of our investments in the LPs and LLCs are recognized in other investments on our Consolidated Balance Sheets and were $2.0 billion and $1.9 billion as of March 31, 2020, and December 31, 2019, respectively. Included in these carrying amounts are our investments in qualified affordable housing projects, which were $11 million and $13 million as of March 31, 2020, and December 31, 2019, respectively. We do not have any contingent commitments to provide additional capital funding to these qualified affordable housing projects. We received returns from these qualified affordable housing projects in the form of income tax credits and other tax benefits of less than $1 million for the three months ended March 31, 2020 and 2019, which were recognized in federal income tax expense (benefit) on our Consolidated Statements of Comprehensive Income (Loss).
Our exposure to loss is limited to the capital we invest in the LPs and LLCs, and there have been no indicators of impairment that would require us to recognize an impairment loss related to the LPs and LLCs as of March 31, 2020.
4. Investments
Fixed Maturity AFS Securities
In 2020, we adopted ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”), which resulted in a new recognition and measurement of credit losses on most financial assets. See Note 2 for additional information.
The amortized cost, gross unrealized gains, losses, ACL and fair value of fixed maturity AFS securities (in millions) were as follows:
Amortized
Gross Unrealized
Fair
Cost
Gains
Losses
ACL
Fixed maturity AFS securities:
Corporate bonds
80,785
7,031
1,999
20
85,797
U.S. government bonds
380
102
482
State and municipal bonds
4,797
1,123
14
5,906
Foreign government bonds
329
63
3
389
RMBS
3,014
277
3,271
CMBS
1,089
39
1,119
ABS
5,259
59
232
5,086
Hybrid and redeemable preferred securities
564
556
Total fixed maturity AFS securities
96,217
8,745
2,336
The amortized cost, gross unrealized gains, losses, OTTI and fair value of fixed maturity AFS securities (in millions) were as follows:
OTTI (1)
79,417
9,479
184
(4
88,716
384
435
4,778
1,113
7
5,884
64
393
3,042
190
10
(19
3,241
1,038
45
(1
1,083
4,810
62
18
(35
4,889
497
82
559
94,295
11,086
240
(59
(1)Prior to the adoption of ASU 2016-13, we recognized the OTTI attributed to noncredit factors as a separate component in other comprehensive income (loss) (“OCI”) referred to as unrealized OTTI on fixed maturity AFS securities. This includes unrealized (gains) and losses on credit-impaired securities related to changes in the fair value of such securities subsequent to the impairment measurement date.
The amortized cost and fair value of fixed maturity AFS securities by contractual maturities (in millions) as of March 31, 2020, were as follows:
Due in one year or less
3,008
2,980
Due after one year through five years
14,806
14,836
Due after five years through ten years
17,319
17,804
Due after ten years
51,722
57,510
Subtotal
86,855
93,130
Structured securities (RMBS, CMBS, ABS)
9,362
9,476
Actual maturities may differ from contractual maturities because issuers may have the right to call or pre-pay obligations.
The fair value and gross unrealized losses of fixed maturity AFS securities (dollars in millions) for which an allowance for credit losses has not been recorded, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, were as follows:
Less Than or Equal
Greater Than
to Twelve Months
Twelve Months
Total
Gross
Unrealized
Losses (1)
21,648
1,745
828
254
22,476
364
27
352
19
5
357
250
2
4,160
196
255
36
4,415
Hybrid and redeemable
preferred securities
178
22
78
37
256
26,979
2,008
1,168
328
28,147
Total number of fixed maturity AFS securities in an unrealized loss position
2,724
(1)We recognized $22 million of gross unrealized losses in OCI for fixed maturity AFS securities for which an allowance for credit losses has been recorded.
The fair value and gross unrealized losses, including the portion of OTTI recognized in OCI, of fixed maturity AFS securities (dollars in millions), aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, were as follows:
Losses and
OTTI
2,935
46
1,406
141
4,341
187
333
351
551
48
4
1,792
303
2,095
29
73
1,848
170
7,521
243
895
The fair value, gross unrealized losses (in millions) and number of fixed maturity AFS securities where the fair value had declined and remained below amortized cost by greater than 20% were as follows:
Securities (1)
Less than six months
1,528
803
185
Twelve months or greater
60
23
1,578
863
208
(1)We may reflect a security in more than one aging category based on various purchase dates.
The fair value, gross unrealized losses, the portion of OTTI recognized in OCI (in millions) and number of fixed maturity AFS securities where the fair value had declined and remained below amortized cost by greater than 20% were as follows:
Six months or greater, but less than nine months
132
31
157
84
42
Our gross unrealized losses on fixed maturity AFS securities increased by $2.1 billion for the three months ended March 31, 2020. As discussed further below, we believe the unrealized loss position as of March 31, 2020, did not require an impairment recognized in earnings as (i) we did not intend to sell these fixed maturity AFS securities; (ii) it is not more likely than not that we will be required to sell the fixed maturity AFS securities before recovery of their amortized cost basis; and (iii) the difference in the fair value compared to the amortized cost was due to factors other than credit loss. Based upon this evaluation as of March 31, 2020, management believes we have the ability to generate adequate amounts of cash from our normal operations (e.g., insurance premiums, fee income and investment income) to meet cash requirements with a prudent margin of safety without requiring the sale of our impaired securities.
The disruption in the financial markets related to the coronavirus, or COVID-19, pandemic in the first quarter of 2020 caused credit spreads to widen since December 31, 2019, resulting in an increase in our gross unrealized losses.
As of March 31, 2020, the unrealized losses associated with our corporate, state and municipal and foreign government bond securities were attributable primarily to widening credit spreads and rising interest rates since purchase. We performed a detailed analysis of the financial performance of the underlying issuers and determined that we expected to recover the entire amortized cost of each impaired security.
As of March 31, 2020, the unrealized losses associated with our mortgage-backed securities (“MBS”) and ABS were attributable primarily to widening credit spreads and rising interest rates since purchase. We assessed for credit impairment using a cash flow model that incorporates key assumptions including default rates, severities and prepayment rates. We estimated losses for a security by forecasting the underlying loans in each transaction. The forecasted loan performance was used to project cash flows to the various tranches in the structure, as applicable. Our forecasted cash flows also considered, as applicable, independent industry analyst reports and forecasts and other independent market data. Based upon our assessment of the expected credit losses of the security given the performance of the underlying collateral compared to our subordination or other credit enhancement, we expected to recover the entire amortized cost of each impaired security.
As of March 31, 2020, the unrealized losses associated with our hybrid and redeemable preferred securities were attributable primarily to wider credit spreads caused by illiquidity in the market and subordination within the capital structure, as well as credit risk of underlying issuers. For our hybrid and redeemable preferred securities, we evaluated the financial performance of the underlying issuers based upon credit performance and investment ratings and determined that we expected to recover the entire amortized cost of each impaired security.
Evaluation for Credit Loss Impairment
We regularly review our fixed maturity AFS securities (also referred to as “debt securities”) for declines in fair value that we determine to be impairment-related, including those attributable to credit risk factors that may require an allowance for credit loss.
For our fixed maturity AFS securities, we generally consider the following to determine whether our debt securities with unrealized losses are credit impaired:
The estimated range and average period until recovery;
The estimated range and average holding period to maturity;
Remaining payment terms of the security;
Current delinquencies and nonperforming assets of underlying collateral;
Expected future default rates;
Collateral value by vintage, geographic region, industry concentration or property type;
Subordination levels or other credit enhancements as of the balance sheet date as compared to origination; and
Contractual and regulatory cash obligations.
For a debt security, if we intend to sell a security, or it is more likely than not we will be required to sell a debt security before recovery of its amortized cost basis and the fair value of the debt security is below amortized cost, we conclude that an impairment has occurred and the amortized cost is written down to current fair value with a corresponding charge to realized gain (loss) on our Consolidated Statements of Comprehensive Income (Loss). If we do not intend to sell a debt security, or it is not more likely than not we will be required to sell a debt security before recovery of its amortized cost basis but the present value of the cash flows expected to be collected is less than the amortized cost of the debt security (referred to as the credit loss), we conclude that an impairment has occurred, and an allowance for credit losses is recorded, with a corresponding charge to realized gain (loss) on our Consolidated Statements of Comprehensive Income (Loss). The remainder of the decline to fair value related to factors other than credit loss is recorded in OCI to unrealized losses on fixed maturity AFS securities on our Consolidated Statements of Stockholders’ Equity, as this amount is considered a non-credit impairment.
When assessing our intent to sell a debt security, or if it is more likely than not we will be required to sell a debt security before recovery of its cost basis, we evaluate facts and circumstances such as, but not limited to, decisions to reposition our security portfolio, sales of securities to meet cash flow needs and sales of securities to capitalize on favorable pricing. Management considers the following as part of the evaluation:
The current economic environment and market conditions;
Our business strategy and current business plans;
The nature and type of security, including expected maturities and exposure to general credit, liquidity, market and interest rate risk;
Our analysis of data from financial models and other internal and industry sources to evaluate the current effectiveness of our hedging and overall risk management strategies;
The current and expected timing of contractual maturities of our assets and liabilities, expectations of prepayments on investments and expectations for surrenders and withdrawals of life insurance policies and annuity contracts;
The capital risk limits approved by management; and
Our current financial condition and liquidity demands.
Calculation of Credit Impairment
In order to determine the amount of the credit loss for a debt security, we calculate the recovery value by performing a discounted cash flow analysis based on the current cash flows and future cash flows we expect to recover. The discount rate is the effective interest rate implicit in the underlying debt security. The effective interest rate is the original yield, or the coupon if the debt security was previously impaired. See the discussion below for additional information on the methodology and significant inputs, by security type, that we use to determine the amount of a credit loss.
To determine the recovery period of a debt security, we consider the facts and circumstances surrounding the underlying issuer including, but not limited to, the following:
Historical and implied volatility of the security;
The extent to which the fair value has been less than amortized cost;
Adverse conditions specifically related to the security or to specific conditions in an industry or geographic area;
Failure, if any, of the issuer of the security to make scheduled payments; and
Recoveries or additional declines in fair value subsequent to the balance sheet date.
In periods subsequent to the recognition of a credit loss impairment through an ACL, we continue to reassess the expected cash flows of the fixed maturity AFS security at each subsequent measurement date as necessary. If the measurement of credit loss changes, we recognize a provision for (or reversal of) credit loss expense through realized gain (loss) on our Consolidated Statements of Comprehensive Income (Loss), limited by the amount that amortized cost exceeds fair value. Losses are charged against the ACL when management believes the uncollectibility of a fixed maturity AFS security is confirmed or when either of the criteria regarding intent or requirement to sell is met. Accrued interest on fixed maturity AFS securities is written off when deemed uncollectible.
Determination of Credit Losses on Corporate Bonds
To determine recovery value of a corporate bond, CLO or CDO, we perform additional analysis related to the underlying issuer including, but not limited to, the following:
Fundamentals of the issuer to determine what we would recover if they were to file bankruptcy versus the price at which the market is trading;
Fundamentals of the industry in which the issuer operates;
Earnings multiples for the given industry or sector of an industry that the underlying issuer operates within, divided by the outstanding debt to determine an expected recovery value of the security in the case of a liquidation;
Expected cash flows of the issuer (e.g., whether the issuer has cash flows in excess of what is required to fund its operations);
Expectations regarding defaults and recovery rates;
Changes to the rating of the security by a rating agency; and
Additional market information (e.g., if there has been a replacement of the corporate debt security).
Credit ratings express opinions about the credit quality of a security. Securities rated investment grade (those rated BBB- or higher by Standard & Poor’s (“S&P”) Rating Services or Baa3 or higher by Moody’s Investors Service (“Moody’s”)) are generally considered by the rating agencies and market participants to be low credit risk. As of March 31, 2020, and December 31, 2019, 96% of the fair value of our corporate bond portfolio was rated investment grade. As of March 31, 2020, and December 31, 2019, the portion of our corporate bond portfolio rated below investment grade had an amortized cost of $3.9 billion and $3.2 billion, respectively, and a fair value of $3.5 billion and $3.3 billion, respectively. Based upon the analysis discussed above, we believe that as of March 31, 2020, and December 31, 2019, we would have recovered the amortized cost of each corporate bond.
Determination of Credit Losses on MBS and ABS
Each quarter, we review the cash flows for the MBS portfolio, including current credit enhancements and trends in the underlying collateral performance, to determine whether or not they are sufficient to provide for the recovery of our amortized cost. To determine recovery value of a MBS, we perform additional analysis related to the underlying issuer including, but not limited to, the following:
Discounted cash flow analysis based on the current cash flows and future cash flows we expect to recover;
Level of borrower creditworthiness of the home equity loans or residential mortgages that back an RMBS or commercial mortgages that back a CMBS;
Susceptibility to fair value fluctuations for changes in the interest rate environment;
Susceptibility to reinvestment risks, in cases where market yields are lower than the securities’ book yield earned;
Susceptibility to reinvestment risks, in cases where market yields are higher than the book yields earned on a security;
Expectations of sale of such a security where market yields are higher than the book yields earned on a security; and
Susceptibility to variability of prepayments.
When evaluating MBS and mortgage-related ABS, we consider a number of pool-specific factors as well as market level factors when determining whether or not the impairment on the security requires an ACL. The most important factor is the performance of the underlying collateral in the security and the trends of that performance in the prior periods. We use this information about the collateral to forecast the timing and rate of mortgage loan defaults, including making projections for loans that are already delinquent and for those loans that are currently performing but may become delinquent in the future. Other factors used in this analysis include the credit characteristics of borrowers, geographic distribution of underlying loans and timing of liquidations by state. Once default rates and timing assumptions are determined, we then make assumptions regarding the severity of a default if it were to occur. Factors that impact the severity assumption include expectations for future home price appreciation or depreciation, loan size, first lien versus second lien, existence of loan level private mortgage insurance, type of occupancy and geographic distribution of loans. Second lien loans are assigned 100% severity, if defaulted. For first lien loans, we assume a minimum of 30% severity, with higher severity assumed for investor properties and further adjusted by housing price assumptions. Once default and severity assumptions are determined for the security in question, cash flows for the underlying collateral are projected including expected defaults and prepayments. These cash flows on the collateral are then translated to cash flows on our tranche based on the cash flow waterfall of the entire capital security structure. If this analysis indicates the entire principal on a particular security will not be returned, the security is reviewed for a credit loss by comparing the expected cash flows to amortized cost. To the extent that the security has already been impaired through a recognized ACL or was purchased at a discount, such that the amortized cost of the security is less than or equal to the present value of cash flows expected to be collected, no ACL is required. Otherwise, if the amortized cost of the security is greater than the present value of the cash flows expected to be collected, and the security was not purchased at a discount greater than the expected principal loss, then an impairment through an ACL is recognized.
We further monitor the cash flows of all of our fixed maturity AFS securities backed by mortgages on an ongoing basis. We also perform detailed analysis on all of our subprime, Alt-A, non-agency residential MBS and on a significant percentage of our fixed maturity AFS securities backed by pools of commercial mortgages. The detailed analysis includes revising projected cash flows by updating the cash flows for actual cash received and applying assumptions with respect to expected defaults, foreclosures and recoveries in the future. These revised projected cash flows are then compared to the amount of credit enhancement (subordination) in the structure to determine whether the amortized cost of the security is recoverable. If it is not recoverable, we record an impairment through an ACL for the security.
Changes in the allowance for credit losses on fixed maturity AFS securities (in millions) for the three months ended March 31, 2020, aggregated by investment category, were as follows:
Corporate
Bonds
Additions for securities for which credit losses were not
previously recognized
Additions from purchases of PCD debt securities (1)
Balance as of end-of-period (2)
(1)Represents purchased credit-deteriorated (“PCD”) fixed maturity AFS securities.
(2)Accrued interest receivable on fixed maturity AFS securities totaled $1.0 billion as of March 31, 2020, and was excluded from the estimate of credit losses.
Changes in the amount of credit loss of OTTI recognized in net income (loss) where the portion related to other factors was recognized in OCI (in millions) on fixed maturity AFS securities were as follows:
355
Increases attributable to:
Credit losses on securities for which an
OTTI was not previously recognized
6
OTTI was previously recognized
Decreases attributable to:
Securities sold, paid down or matured
359
Mortgage Loans on Real Estate
Mortgage loans on real estate consist of commercial and residential mortgage loans and are generally carried at unpaid principal balances adjusted for amortization of premiums and accretion of discounts and are net of allowances for credit losses. We carry certain commercial mortgage loans at fair value where the fair value option has been elected. Interest income is accrued on the principal balance of the loan based on the loan’s contractual interest rate. Premiums and discounts are amortized using the effective yield method over the life of the loan. Interest income and amortization of premiums and discounts are reported in net investment income on our Consolidated Statements of Comprehensive Income (Loss) along with mortgage loan fees, which are recorded as they are incurred.
Our policy for commercial mortgage loans is to report loans that are 60 or more days past due, which equates to two or more payments missed, as delinquent. Our policy for residential mortgage loans is to report loans that are 90 or more days past due, which equates to three or more payments missed, as delinquent. We do not accrue interest on loans 90 days past due, and any interest received on these loans is either applied to the principal or recorded in net investment income on our Consolidated Statements of Comprehensive Income (Loss) when received, depending on the assessment of the collectability of the loan. We resume accruing interest once a loan complies with all of its original terms or restructured terms. Mortgage loans deemed uncollectible are charged against the allowance for credit losses, and subsequent recoveries, if any, are likewise credited to the allowance for credit losses. Accrued interest on mortgage loans is written off when deemed uncollectible.
The following provides the current and past due composition of our mortgage loans on real estate (in millions):
Commercial
Residential
Current
16,168
707
16,875
15,620
659
16,279
30 to 59 days past due
30
60 to 89 days past due
90 or more days past due
Allowance for credit losses
(126
(161
(2
Unamortized premium (discount)
(16
(17
Mark-to-market gains (losses) (1)
26
Total carrying value
16,052
739
15,606
733
(1)Represents the mark-to-market on certain commercial mortgage loans on real estate for which we have elected the fair value option. See Note 14 for additional information.
Our commercial mortgage loan portfolio has the largest concentrations in California, which accounted for 24% of commercial mortgage loans on real estate as of March 31, 2020, and December 31, 2019, and Texas, which accounted for 11% of commercial mortgage loans on real estate as of March 31, 2020, and December 31, 2019.
Our residential mortgage loan portfolio has the largest concentrations in California, which accounted for 34% of residential mortgage loans on real estate as of March 31, 2020, and December 31, 2019, and Florida, which accounted for 18% and 20% of residential mortgage loans on real estate as of March 31, 2020, and December 31, 2019, respectively.
As of March 31, 2020, and December 31, 2019, we had 44 and 38 residential mortgage loans, respectively, that were either delinquent or in foreclosure.
Evaluation for Credit Losses on Mortgage Loans on Real Estate
In connection with our recognition of an allowance for credit losses for mortgage loans on real estate, we perform a quantitative analysis using a probability of default/loss given default/exposure at default approach to estimate expected credit losses in our mortgage loan portfolio as well as unfunded commitments related to commercial mortgage loans, exclusive of certain mortgage loans held at fair value. Our model estimates expected credit losses over the contractual terms of the loans, which are the periods over which we are exposed to credit risk, adjusted for expected prepayments. Credit loss estimates are segmented by commercial mortgage loans, residential mortgage loans, and unfunded commitments related to commercial mortgage loans.
The allowance for credit losses for pooled loans of similar risk (i.e., commercial and residential mortgage loans) is estimated using relevant historical credit loss information adjusted for current conditions and reasonable and supportable forecasts of future conditions. Historical credit loss experience provides the basis for the estimation of expected credit losses with adjustments for differences in current loan-specific risk characteristics, such as differences in underwriting standards, portfolio mix, delinquency level, or term lengths as well as adjustments for changes in environmental conditions, such as unemployment rates, property values, or other factors that management deems relevant. We apply probability weights to the positive, base and adverse scenarios we use. For periods beyond our reasonable and supportable forecast, we use implicit mean reversion over the remaining life of the recoverable, meaning our model will inherently revert to the baseline scenario as the baseline is representative of the historical average over a longer period of time.
Allowances for credit losses are maintained at a level we believe is adequate to absorb current expected lifetime credit losses. Our periodic evaluation of the adequacy of the allowances for credit losses is based on historical loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay (including the timing of future payments), the estimated value of the underlying collateral, composition of the loan portfolio, current economic conditions, reasonable and supportable forecasts about the future and other relevant factors.
Loans are considered impaired when it is probable that, based upon current information and events, we will be unable to collect all amounts due under the contractual terms of the loan agreement. When we determine that a loan is impaired, a specific allowance for credit losses is established for the excess carrying value of the loan over its estimated value. The loan’s estimated value is based on: the present value of expected future cash flows discounted at the loan’s effective interest rate; the loan’s observable market price; or the fair value of the loan’s collateral.
Mortgage loans on real estate are presented net of the allowance for credit losses on our Consolidated Balance Sheets. Changes in the allowance are reported in realized gain (loss) on our Consolidated Statements of Comprehensive Income (Loss). Mortgage loans on real estate deemed uncollectible are charged against the ACL, and subsequent recoveries, if any, are credited to the ACL, limited to the aggregate of amounts previously charged-off and expected to be charged-off.
Determination of Credit Losses on Commercial Mortgage Loans on Real Estate
Our commercial loan portfolio is primarily comprised of long-term loans secured by existing commercial real estate. We believe all of the commercial loans in our portfolio share three primary risks: borrower credit worthiness; sustainability of the cash flow of the property; and market risk; therefore, our methods of monitoring and assessing credit risk are consistent for our entire portfolio.
For our commercial mortgage loan portfolio, trends in market vacancy and rental rates are incorporated into the analysis that we perform for monitored loans and may contribute to the establishment of (or an increase or decrease in) an allowance for credit losses. In addition, we review each loan individually in our commercial mortgage loan portfolio on an annual basis to identify emerging risks. We focus on properties that experienced a reduction in debt-service coverage or that have significant exposure to tenants with deteriorating credit profiles. Where warranted, we establish or increase an allowance for credit losses for a specific loan based upon this analysis.
We measure and assess the credit quality of our commercial mortgage loans by using loan-to-value and debt-service coverage ratios. The loan-to-value ratio compares the principal amount of the loan to the fair value at origination of the underlying property collateralizing the loan and is commonly expressed as a percentage. Loan-to-value ratios greater than 100% indicate that the principal amount is greater than the collateral value. Therefore, all else being equal, a lower loan-to-value ratio generally indicates a higher quality loan. The debt-service coverage ratio compares a property’s net operating income to its debt-service payments. Debt-service coverage ratios of less than 1.0 indicate that property operations do not generate enough income to cover its current debt payments. Therefore, all else being equal, a higher debt-service coverage ratio generally indicates a higher quality loan. These credit quality metrics are monitored and reviewed at least annually.
For our commercial mortgage loans, there were two specifically identified impaired loans with an aggregate carrying value of less than $1 million as of March 31, 2020. There was one specifically identified impaired loan with a carrying value of less than $1 million as of December 31, 2019.
Most of our off-balance sheet commitments relate to commercial mortgage loans. As such, the estimate is developed based on the commercial mortgage loan process outlined above, along with an internally developed conversion factor.
Determination of Credit Losses on Residential Mortgage Loans on Real Estate
Our residential loan portfolio is primarily comprised of first lien mortgages secured by existing residential real estate. Residential mortgage loans are primarily smaller-balance homogenous loans that share similar risk characteristics. Therefore, these pools of loans are collectively evaluated for inherent credit losses. Such evaluations consider numerous factors, including, but not limited to borrower credit scores, collateral values, loss forecasts, geographic location, delinquency rates and economic trends. These evaluations and assessments are revised as conditions change and new information becomes available, including updated forecasts, which can cause the allowances for credit losses to increase or decrease over time as such evaluations are revised. Generally, residential mortgage loan pools exclude loans that are nonperforming as those loans are evaluated individually using the evaluation framework for specific allowances for credit losses described above.
For residential mortgage loans, our primary credit quality indicator is whether the loan is performing or nonperforming. We generally define nonperforming residential mortgage loans as those that are 90 or more days past due and/or in nonaccrual status. There is generally a higher risk of experiencing credit losses when a residential mortgage loan is nonperforming. We monitor and update aging schedules and nonaccrual status on a monthly basis.
For our residential mortgage loans, there were 24 specifically identified impaired loans with an aggregate carrying value of $6 million as of March 31, 2020. There were four specifically identified impaired loans with an aggregate carrying value of $1 million as of December 31, 2019.
Additional information related to impaired mortgage loans on real estate (in millions) was as follows:
Average carrying value for impaired mortgage
loans on real estate
Interest income recognized on impaired mortgage
Interest income collected on impaired mortgage
The amortized cost of mortgage loans on real estate on nonaccrual status (in millions) was as follows:
As of January 1, 2020
Nonaccrual
with no
Commercial mortgage loans on real estate
Residential mortgage loans on real estate
17
We use loan-to-value and debt-service coverage ratios as credit quality indicators for our commercial mortgage loans on real estate (dollars in millions) as follows:
Debt-
Service
% of
Coverage
Loan-to-Value Ratio
Ratio
Less than 65%
14,723
91.2%
2.40
14,206
91.0%
2.35
65% to 74%
1,428
8.8%
1.85
1,399
9.0%
1.87
75% to 100%
0.0%
0.90
1.09
16,152
100.0%
The amortized cost of commercial mortgage loans on real estate (in millions) by year of origination and credit quality indicator was as follows:
Less
65%
75%
than 65%
to 74%
to 100%
Origination Year
654
3.57
1.47
715
2,964
2.29
493
1.78
3,457
2018
2,346
2.17
271
1.48
2,617
2017
1,798
2.34
202
2.67
2,000
2016
1,732
2.37
217
1.92
1,949
2015 and prior
5,229
2.43
1.68
5,414
We use loan performance status as the primary credit quality indicator for our residential mortgage loans on real estate (dollars in millions) as follows:
Performance Indicator
Cost (1)
Performing
750
96.9%
718
97.7%
Nonperforming
3.1%
2.3%
774
735
(1)A valuation allowance of $2 million was established on residential mortgage loans on real estate as of December 31, 2019.
The amortized cost of residential mortgage loans on real estate (in millions) by year of origination and credit quality indicator as of March 31, 2020, was as follows:
454
472
223
229
Changes in the allowance for credit losses on mortgage loans on real estate (in millions) for the three months ended March 31, 2020, were as follows:
Balance as of beginning-of-year, prior to adoption of ASU 2016-13
Impact of adopting ASU 2016-13
Additions from provision for credit loss expense (1)
Additions from purchases of PCD mortgage loans on real estate
126
35
161
(1)Due to changes in economic assumptions driven by the impact of the COVID-19 pandemic, the provision for credit loss expense increased by $71 million for the three months ended March 31, 2020.
(2)Accrued interest receivable on mortgage loans on real estate totaled $50 million as of March 31, 2020, and was excluded from the estimate of credit losses.
There were no changes in the allowance for credit losses associated with impaired commercial mortgage loans on real estate for the three months ended March 31, 2019.
Alternative Investments
As of March 31, 2020, and December 31, 2019, alternative investments included investments in 260 and 258 different partnerships, respectively, and represented approximately 1% of our total investments.
Impairments on Fixed Maturity AFS Securities
Details underlying credit loss expense incurred as a result of impairments that were recognized in net income (loss) and included in realized gain (loss) on fixed maturity AFS securities (in millions) were as follows:
Credit Loss Expense Recognized in Net Income (Loss) (1)
(20
(6
Gross credit loss expense recognized in net income (loss)
Associated amortization of DAC, VOBA, DSI and DFEL
Net credit loss expense recognized in net income (loss)
(1)For the three months ended March 31, 2020, we recognized credit loss expense incurred as a result of impairments through net income (loss), pursuant to ASU 2016-13. For the three months ended March 31, 2019, prior to the adoption of ASU 2016-13, we recognized write-downs taken as a result of OTTI through net income (loss).
During the three months ended March 31, 2019, we recorded $15 million of OTTI recognized in OCI.
Payables for Collateral on Investments
The carrying value of the payables for collateral on investments included on our Consolidated Balance Sheets and the fair value of the related investments or collateral (in millions) consisted of the following:
Collateral payable for derivative investments (1)
3,943
1,388
Securities pledged under securities lending agreements (2)
156
114
110
Investments pledged for Federal Home Loan Bank of
Indianapolis (“FHLBI”) (3)
4,330
6,970
3,580
5,480
Total payables for collateral on investments
11,069
6,978
(1)We obtain collateral based upon contractual provisions with our counterparties. These agreements take into consideration the counterparties’ credit rating as compared to ours, the fair value of the derivative investments and specified thresholds that if exceeded result in the receipt of cash that is typically invested in cash and invested cash. See Note 5 for additional information.
(2)Our pledged securities under securities lending agreements are included in fixed maturity AFS securities on our Consolidated Balance Sheets. We generally obtain collateral in an amount equal to 102% and 105% of the fair value of the domestic and foreign securities, respectively. We value collateral daily and obtain additional collateral when deemed appropriate. The cash received in our securities lending program is typically invested in cash and invested cash or fixed maturity AFS securities.
(3)Our pledged investments for FHLBI are included in fixed maturity AFS securities and mortgage loans on real estate on our Consolidated Balance Sheets. The collateral requirements are generally 105% to 115% of the fair value for fixed maturity AFS securities and 155% to 175% of the fair value for mortgage loans on real estate. The cash received in these transactions is primarily invested in cash and invested cash or fixed maturity AFS securities.
Increase (decrease) in payables for collateral on investments (in millions) consisted of the following:
Collateral payable for derivative investments
2,555
58
Securities pledged under securities lending agreements
47
Securities pledged under repurchase agreements
Investments pledged for FHLBI
450
Total increase (decrease) in payables for collateral on investments
3,352
557
We have elected not to offset our securities lending transactions in our financial statements. The remaining contractual maturities of securities lending transactions accounted for as secured borrowings (in millions) were as follows:
Overnight and Continuous
Up to 30 Days
30 - 90Days
Greater Than 90 Days
Securities Lending
160
Total gross secured borrowings
We accept collateral in the form of securities in connection with repurchase agreements. In instances where we are permitted to sell or re-pledge the securities received, we report the fair value of the collateral received and a related obligation to return the collateral in the
financial statements. In addition, we receive securities in connection with securities borrowing agreements that we are permitted to sell or re-pledge. As of March 31, 2020, the fair value of all collateral received that we are permitted to sell or re-pledge was $25 million. As of March 31, 2020, we have re-pledged $25 million of this collateral to cover initial margin and over-the-counter collateral requirements on certain derivative investments.
Investment Commitments
As of March 31, 2020, our investment commitments were $1.6 billion, which included $1.0 billion of LPs, $365 million of private placement securities and $197 million of mortgage loans on real estate.
Concentrations of Financial Instruments
As of March 31, 2020, and December 31, 2019, our most significant investments in one issuer were our investments in securities issued by the Federal Home Loan Mortgage Corporation with a fair value of $1.4 billion and $1.3 billion, respectively, or 1% of total investments, and our investments in securities issued by the Federal National Mortgage Association with a fair value of $1.1 billion and $1.0 billion, respectively, or 1% of total investments. These concentrations include fixed maturity AFS, trading and equity securities.
As of March 31, 2020, and December 31, 2019, our most significant investments in one industry were our investments in securities in the consumer non-cyclical industry with a fair value of $16.4 billion and $16.3 billion, respectively, or 12% of total investments, and our investments in securities in the financial services industry with a fair value of $15.7 billion and $16.4 billion, respectively, or 12% of total investments. These concentrations include fixed maturity AFS, trading and equity securities.
5. Derivative Instruments
We maintain an overall risk management strategy that incorporates the use of derivative instruments to minimize significant unplanned fluctuations in earnings that are caused by interest rate risk, foreign currency exchange risk, equity market risk, basis risk and credit risk. We assess these risks by continually identifying and monitoring changes in our exposures that may adversely affect expected future cash flows and by evaluating hedging opportunities.
Derivative activities are monitored by various management committees. The committees are responsible for overseeing the implementation of various hedging strategies that are developed through the analysis of financial simulation models and other internal and industry sources. The resulting hedging strategies are incorporated into our overall risk management strategies.
See Note 14 for additional disclosures related to the fair value of our derivative instruments.
Interest Rate Contracts
We use derivative instruments as part of our interest rate risk management strategy. These instruments are economic hedges unless otherwise noted and include:
Forward-Starting Interest Rate Swaps
We use forward-starting interest rate swaps designated and qualifying as cash flow hedges to hedge our exposure to interest rate fluctuations related to the forecasted purchases of certain assets and anticipated issuances of fixed-rate securities.
We also use forward-starting interest rate swaps to hedge the interest rate exposure within our life products related to the forecasted purchases of certain assets.
Interest Rate Cap Corridors
We use interest rate cap corridors to provide a level of protection from the effect of rising interest rates for certain life insurance products and annuity contracts. Interest rate cap corridors involve purchasing an interest rate cap at a specific cap rate and selling an interest rate cap with a higher cap rate. For each corridor, the amount of quarterly payments, if any, is determined by the rate at which the underlying index rate resets above the original capped rate. The corridor limits the benefit the purchaser can receive as the related interest rate index rises above the higher capped rate. There is no additional liability to us other than the purchase price associated with the interest rate cap corridor.
Interest Rate Futures
We use interest rate futures contracts to hedge the liability exposure on certain options in variable annuity products. These futures contracts require payment between our counterparty and us on a daily basis for changes in the futures index price.
Interest Rate Swap Agreements
We use interest rate swap agreements to hedge the liability exposure on certain options in variable annuity products.
We also use interest rate swap agreements designated and qualifying as cash flow hedges to hedge the interest rate risk of floating-rate bond coupon payments by replicating a fixed-rate bond.
Finally, we use interest rate swap agreements designated and qualifying as fair value hedges to hedge against changes in the fair value of certain fixed-rate long-term debt and fixed maturity securities due to interest rate risks.
Treasury and Reverse Treasury Locks
We use treasury locks designated and qualifying as cash flow hedges to hedge the interest rate exposure related to our issuance of fixed-rate securities or the anticipated future cash flows of floating-rate fixed maturity securities due to changes in interest rates. In addition, we use reverse treasury locks designated and qualifying as cash flow hedges to hedge the interest rate exposure related to the anticipated purchase of fixed-rate securities or the anticipated future cash flows of floating-rate fixed maturity securities due to changes in interest rates. These derivatives are primarily structured to hedge interest rate risk inherent in the assumptions used to price certain liabilities.
Foreign Currency Contracts
We use derivative instruments as part of our foreign currency risk management strategy. These instruments are economic hedges unless otherwise noted and include:
Currency Futures
We use currency futures to hedge foreign exchange risk associated with certain options in variable annuity products. Currency futures exchange one currency for another at a specified date in the future at a specified exchange rate.
Foreign Currency Swaps
We use foreign currency swaps to hedge foreign exchange risk of investments in fixed maturity securities denominated in foreign currencies. A foreign currency swap is a contractual agreement to exchange one currency for another at specified dates in the future at a specified exchange rate.
We also use foreign currency swaps designated and qualifying as cash flow hedges to hedge foreign exchange risk of investments in fixed maturity securities denominated in foreign currencies.
Foreign Currency Forwards
We use foreign currency forwards to hedge foreign exchange risk of investments in fixed maturity securities denominated in foreign currencies. A foreign currency forward is a contractual agreement to exchange one currency for another at specified dates in the future at a specified current exchange rate.
Equity Market Contracts
We use derivative instruments as part of our equity market risk management strategy that are economic hedges and include:
Call Options Based on the S&P 500 and Other Indices
We use call options to hedge the liability exposure on certain options in variable annuity products.
Our indexed annuity and IUL contracts permit the holder to elect an interest rate return or an equity market component, where interest credited to the contracts is linked to the performance of the Standard & Poor's 500 Index (“S&P 500”) or other indices. Contract holders may elect to rebalance index options at renewal dates. At the end of each indexed term, which can be up to six years, we have the opportunity to re-price the indexed component by establishing participation rates, caps, spreads and specified rates, subject to contractual guarantees. We use call options that are highly correlated to the portfolio allocation decisions of our contract holders, such that we are economically hedged with respect to equity returns for the current reset period.
Consumer Price Index Swaps
We use consumer price index swaps to hedge the liability exposure on certain options in fixed annuity products. Consumer price index swaps are contracts entered into at no cost and whose payoff is the difference between the consumer price index inflation rate and the fixed-rate determined as of inception.
Equity Futures
We use equity futures contracts to hedge the liability exposure on certain options in variable annuity products. These futures contracts
require payment between our counterparty and us on a daily basis for changes in the futures index price.
Put Options
We use put options to hedge the liability exposure on certain options in variable annuity products. Put options are contracts that require counterparties to pay us at a specified future date the amount, if any, by which a specified equity index is less than the strike rate stated in the agreement, applied to a notional amount.
Total Return Swaps
We use total return swaps to hedge the liability exposure on certain options in variable annuity products.
In addition, we use total return swaps to hedge a portion of the liability related to our deferred compensation plans. We receive the total return on a portfolio of indexes and pay a floating-rate of interest.
Credit Contracts
We use derivative instruments as part of our credit risk management strategy that are economic hedges and include:
Credit Default Swaps – Buying Protection
We use credit default swaps to hedge the liability exposure on certain options in variable annuity products.
We buy credit default swaps to hedge against a drop in bond prices due to credit concerns of certain bond issuers. A credit default swap allows us to put the bond back to the counterparty at par upon a default event by the bond issuer. A default event is defined as bankruptcy, failure to pay, obligation acceleration or restructuring.
Credit Default Swaps – Selling Protection
We sell credit default swaps to offer credit protection to contract holders and investors. The credit default swaps hedge the contract holders and investors against a drop in bond prices due to credit concerns of certain bond issuers. A credit default swap allows the investor to put the bond back to us at par upon a default event by the bond issuer. A default event is defined as bankruptcy, failure to pay, obligation acceleration or restructuring.
Embedded Derivatives
We have embedded derivatives that include:
GLB Reserves Embedded Derivatives
We use a hedging strategy designed to mitigate the risk and income statement volatility caused by changes in the equity markets, interest rates and volatility associated with guaranteed living benefits (“GLBs”) offered in our variable annuity products, including products with guaranteed withdrawal benefit (“GWB”) and guaranteed income benefit (“GIB”) features. Changes in the value of the hedge contracts due to changes in equity markets, interest rates and implied volatilities hedge the income statement effect of changes in embedded derivative GLB reserves caused by those same factors. We rebalance our hedge positions based upon changes in these factors as needed. While we actively manage our hedge positions, these hedge positions may not be totally effective in offsetting changes in the embedded derivative reserve due to, among other things, differences in timing between when a market exposure changes and corresponding changes to the hedge positions, extreme swings in the equity markets and interest rates, market volatility, contract holder behavior, divergence between the performance of the underlying funds and the hedging indices, divergence between the actual and expected performance of the hedge instruments and our ability to purchase hedging instruments at prices consistent with our desired risk and return trade-off.
Certain features of these guarantees have elements of both insurance benefits accounted for under the Financial Services – Insurance – Claim Costs and Liabilities for Future Policy Benefits Subtopic of the FASB ASC (“benefit reserves”) and embedded derivatives accounted for under the Derivatives and Hedging and the Fair Value Measurements and Disclosures Topics of the FASB ASC (“embedded derivative reserves”). We calculate the value of the benefit reserves and the embedded derivative reserves based on the specific characteristics of each GLB feature.
Indexed Annuity and IUL Contracts Embedded Derivatives
Our indexed annuity and IUL contracts permit the holder to elect an interest rate return or an equity market component, where interest credited to the contracts is linked to the performance of the S&P 500 or other indices. Contract holders may elect to rebalance index options at renewal dates. At the end of each indexed term, which can be up to six years, we have the opportunity to re-price the indexed component by establishing participation rates, caps, spreads and specified rates, subject to contractual guarantees. We use options that are highly correlated to the portfolio allocation decisions of our contract holders, such that we are economically hedged with respect to equity returns for the current reset period.
Reinsurance Related Embedded Derivatives
We have certain modified coinsurance (“Modco”) and coinsurance with funds withheld reinsurance agreements with embedded derivatives related to the withheld assets of the related funds. These derivatives are considered total return swaps with contractual returns that are attributable to various assets and liabilities associated with these reinsurance agreements.
We have derivative instruments with off-balance-sheet risks whose notional or contract amounts exceed the related credit exposure. Outstanding derivative instruments with off-balance-sheet risks (in millions) were as follows:
Fair Value
Asset
Liability
Qualifying Hedges
Cash flow hedges:
Interest rate contracts (1)
2,397
334
853
2,387
108
245
Foreign currency contracts (1)
2,912
606
13
2,874
191
Total cash flow hedges
5,309
940
866
5,261
299
296
Fair value hedges:
1,170
337
1,261
123
203
Non-Qualifying Hedges
119,681
1,890
140
112,921
1,082
219
166
262
Equity market contracts (1)
55,784
2,819
1,112
43,555
1,442
664
Credit contracts (1)
394
Embedded derivatives:
GLB direct (2)
4,596
GLB ceded (2)
728
Reinsurance related (3)
Indexed annuity and IUL contracts (2) (4)
799
1,380
927
2,585
Total derivative instruments
182,504
7,324
8,431
163,315
4,384
4,306
(1)Reported in derivative investments and other liabilities on our Consolidated Balance Sheets.
(2)Reported in other assets and other liabilities on our Consolidated Balance Sheets.
(3)Reported in reinsurance related embedded derivatives on our Consolidated Balance Sheets.
(4)Reported in future contract benefits on our Consolidated Balance Sheets.
The maturity of the notional amounts of derivative instruments (in millions) was as follows:
Remaining Life as of March 31, 2020
Less Than
1 - 5
6 - 10
11 - 30
Over 30
1 Year
Years
15,089
48,226
24,802
33,300
1,831
123,248
Foreign currency contracts (2)
146
370
1,013
1,507
3,078
Equity market contracts
30,822
14,314
4,343
6,294
Credit contracts
with notional amounts
46,057
62,910
30,552
34,818
8,167
(1)As of March 31, 2020, the latest maturity date for which we were hedging our exposure to the variability in future cash flows for these instruments was April 20, 2067.
(2)As of March 31, 2020, the latest maturity date for which we were hedging our exposure to the variability in future cash flows for these instruments was June 17, 2050.
The following amounts (in millions) were recorded on the Consolidated Balance Sheets related to cumulative basis adjustments for fair value hedges:
Cumulative Fair Value
Hedging Adjustment Included
Amortized Cost of the
in the Amortized Cost of the
Hedged Assets/(Liabilities)
Hedged Asset/(Liabilities)
Line Item in the Consolidated Balance Sheets in
which the Hedged Item is Included
AFS fixed maturity securities, at fair value
890
776
Long-term debt (1)
(954
(1,035
(160
(1)The balance includes $(381) million and $(118) million of unamortized adjustments from discontinued hedges as of March 31, 2020 and December 31, 2019, respectively.
The change in our unrealized gain (loss) on derivative instruments within accumulated other comprehensive income (loss) (“AOCI”) (in millions) was as follows:
Unrealized Gain (Loss) on Derivative Instruments
139
Other comprehensive income (loss):
Interest rate contracts
(383
(47
Foreign currency contracts
312
Change in foreign currency exchange rate adjustment
153
(14
Change in DAC, VOBA, DSI and DFEL
(53
Income tax benefit (expense)
Less:
Reclassification adjustment for gains (losses)
included in net income (loss):
Interest rate contracts (2)
(3
Foreign currency contracts (3)
99
(1)The OCI offset is reported within net investment income on our Consolidated Statements of Comprehensive Income (Loss).
(2)The OCI offset is reported within interest and debt expense on our Consolidated Statements of Comprehensive Income (Loss).
(3)The OCI offset is reported within realized gain (loss) on our Consolidated Statements of Comprehensive Income (Loss).
The effects of qualifying and non-qualifying hedges (in millions) on the Consolidated Statements of Comprehensive Income (Loss) were as follows:
Gain (Loss) Recognized in Income
For the Three Months Ended March 31, 2020
Realized
Net
Interest
Gain
Investment
and Debt
(Loss)
Income
Expense
Total Line Items in which the Effects of Fair Value
or Cash Flow Hedges are Recorded
Gain or (loss) on fair value hedging relationships:
Interest rate contracts:
Hedged items
127
Derivatives designated as hedging instruments
(127
(82
Gain or (loss) on cash flow hedging relationships:
Amount of gain or (loss) reclassified from AOCI into income
Foreign currency contracts:
2,150
1,070
GLB
(4,369
Reinsurance related
463
Indexed annuity and IUL contracts
1,028
For the Three Months Ended March 31, 2019
(34
(458
286
(239
As of March 31, 2020, $33 million of the deferred net gains (losses) on derivative instruments in AOCI were expected to be reclassified to earnings during the next 12 months. This reclassification would be due primarily to interest rate variances related to our interest rate swap agreements.
For the three months ended March 31, 2020 and 2019, there were no material reclassifications to earnings due to hedged firm commitments no longer deemed probable or due to hedged forecasted transactions that had not occurred by the end of the originally specified time period.
Information related to our credit default swaps for which we are the seller (dollars in millions) was as follows:
Credit
Reason
Nature
Rating of
Maximum
for
Underlying
Potential
Credit Contract Type
Maturity
Entering
Recourse
Obligation (1)
Value (2)
Payout
Basket credit default swaps
6/20/2025
(3)
(4)
BBB+
12/20/2024
(1)Represents average credit ratings based on the midpoint of the applicable ratings among Moody’s, S&P and Fitch Ratings, as scaled to the corresponding S&P ratings.
(2)Broker quotes are used to determine the market value of our credit default swaps.
(3)Credit default swaps were entered into in order to hedge the liability exposure on certain variable annuity products.
(4)Sellers do not have the right to demand indemnification or compensation from third parties in case of a loss (payment) on the contract.
Details underlying the associated collateral of our credit default swaps for which we are the seller if credit risk-related contingent features were triggered (in millions) were as follows:
Maximum potential payout
Less: Counterparty thresholds
Maximum collateral potentially required to post
Certain of our credit default swap agreements contain contractual provisions that allow for the netting of collateral with our counterparties related to all of our collateralized financing transactions that we have outstanding. If these netting agreements were not in place, we would have been required to post $2 million of collateral as of March 31, 2020.
Credit Risk
We are exposed to credit losses in the event of non-performance by our counterparties on various derivative contracts and reflect assumptions regarding the credit or non-performance risk (“NPR”). The NPR is based upon assumptions for each counterparty’s credit spread over the estimated weighted average life of the counterparty exposure, less collateral held. As of March 31, 2020, the NPR adjustment was zero. The credit risk associated with such agreements is minimized by entering into agreements with financial institutions with long-standing, superior performance records. Additionally, we maintain a policy of requiring derivative contracts to be governed by an International Swaps and Derivatives Association (“ISDA”) Master Agreement. We are required to maintain minimum ratings as a matter of routine practice in negotiating ISDA agreements. Under some ISDA agreements, our insurance subsidiaries have agreed to maintain certain financial strength or claims-paying ratings. A downgrade below these levels could result in termination of derivative contracts, at which time any amounts payable by us would be dependent on the market value of the underlying derivative contracts. In certain transactions, we and the counterparty have entered into a credit support annex requiring either party to post collateral when net exposures exceed pre-determined thresholds. These thresholds vary by counterparty and credit rating. The amount of such exposure is essentially the net replacement cost or market value less collateral held for such agreements with each counterparty if the net market value is in our favor. We did not have any exposure as of March 31, 2020, or December 31, 2019.
The amounts recognized (in millions) by S&P credit rating of counterparty, for which we had the right to reclaim cash collateral or were obligated to return cash collateral, were as follows:
Collateral
Posted by
S&P
Counter-
Party
(Held by
Counterparty
LNC)
Party)
AA-
521
(599
441
(167
A+
2,674
(493
555
(339
A
A-
712
(397
(51
3,942
(1,489
1,387
(557
Balance Sheet Offsetting
Information related to the effects of offsetting (in millions) was as follows:
Embedded
Derivative
Financial Assets
Gross amount of recognized assets
5,634
1,664
7,298
Gross amounts offset
(1,217
Net amount of assets
6,081
Gross amounts not offset:
Cash collateral
(3,942
Non-cash collateral
(151
Net amount
324
1,988
Financial Liabilities
Gross amount of recognized liabilities
1,688
5,976
7,664
(25
Net amount of liabilities
1,663
7,639
174
6,150
2,619
1,437
4,056
(708
3,348
(1,387
(242
282
1,719
1,005
2,921
3,926
(138
867
3,788
310
3,231
6. Federal Income Taxes
The effective tax rate is the ratio of tax expense (benefit) over pre-tax income (loss). The effective tax rate was -53% and 6% for the three months ended March 31, 2020 and 2019, respectively. The effective tax rate on pre-tax income is typically lower than the prevailing corporate federal income tax rate of 21% due to benefits from preferential tax items including the separate accounts dividends-received deduction and tax credits. The current quarter’s effective tax rate was lower than the comparable quarter in the prior year primarily as a result of the effects of preferential tax items being additive to the tax benefit at 21% on unfavorable variable annuity net derivative results, resulting in a calculated tax benefit on pre-tax income and an associated negative tax rate.
7. Reinsurance
Adoption of ASU 2016-13
In 2020, we adopted ASU 2016-13, which resulted in a new recognition and measurement of credit losses on most financial assets. See Note 2 for additional information. We established an allowance for credit losses of $192 million as of January 1, 2020, for reinsurance-related assets for the risk of credit losses inherent in reinsurance transactions. We estimated an allowance for credit losses for all reinsurance recoverables and related reinsurance deposit assets held by our subsidiaries. As such, we performed a quantitative analysis using a probability of loss approach to estimate expected credit losses for reinsurance recoverables, inclusive of similar assets recognized using the deposit method of accounting. The ACL is a general allowance for credit losses for pools of receivables with similar risk characteristics segmented by credit risk ratings and receivables assessed on an individual basis that do not share similar risk characteristics where we anticipate a credit loss over the life of reinsurance-related assets.
Our model uses relevant internal or external historical loss information adjusted for current conditions and reasonable and supportable forecasts of future events and conditions in developing our loss estimate. We utilized historical credit rating data to form an estimation of probability of default of counterparties by means of a transition matrix that provides the rates of credit migration for credit ratings transitioning to impairment. We updated reinsurer credit ratings during the quarter to incorporate the most up-to-date information on the current state of the financial stability of our reinsurers. To simulate changes in economic conditions, we used positive, base and adverse scenarios that include varying levels of loss given default assumptions to reflect the impact of changes in severity of losses. We applied probability weights to the positive, base and adverse scenarios. For periods beyond our reasonable and supportable forecasts, we used implicit mean reversion over the remaining life of the recoverable. Additionally, we considered factors that impact our exposure at default that are driven by actuarial expectations around term and mortality assumptions rather than being directly driven by market or economic environment.
Our model estimates the expected credit losses over the life of the reinsurance asset. Credit loss estimates are segmented based on counterparty credit risk. Our modeling process utilizes counterparty credit ratings, collateral types and amounts, and term and run-off assumptions. For reinsurance recoverables that do not share similar risk characteristics, we assessed on an individual basis to determine a specific allowance for credit losses.
We estimated expected credit losses over the contractual term of the recoverable, which is the period during which we are exposed to the credit risk. Reinsurance recoverables may not have explicit contractual lives, but are tied to the underlying insurance products; as a result, we estimated the contractual life by utilizing actuarial estimates of the timing of payouts related to those underlying products.
Reinsurance treaties often require the reinsurer to collateralize the recoverable with funds in a trust account for the benefit of the ceding insurance entity that can reduce the expected credit losses on a given treaty. As such, we review reinsurance collateral by individual treaty to sensitize risk of loss based on level of collateralization. This review is driven by the assumption that non-collateralized reinsurance recoverables would have materially higher losses in time of default. Therefore, reinsurance recoverables are pooled as either fully-collateralized or non-collateralized.
Reinsurance recoverables are presented net of the allowance for credit losses on our Consolidated Balance Sheets. Changes in the ACL are reported in realized gain (loss) on our Consolidated Statements of Comprehensive Income (Loss). Reinsurance recoverables deemed uncollectible are charged against the ACL, and subsequent recoveries, if any, are credited to the ACL, limited to the aggregate of amounts previously charged-off and expected to be charged-off.
Modco Agreements
Some portions of our annuity business have been reinsured on a Modco basis with other companies. In a Modco agreement, we as the ceding company retain the reserves, as well as the assets backing those reserves, and the reinsurer shares proportionally in all financial terms of the reinsured policies based on their respective percentage of the risk. Effective October 1, 2018, we entered into one such Modco agreement with Athene Holding Ltd. (“Athene”) to reinsure fixed and fixed indexed annuity products, which resulted in a deposit asset of $6.3 billion and $6.6 billion as of March 31, 2020, and December 31, 2019, respectively, within other assets on our Consolidated Balance Sheets. We held investments of $6.2 billion as of March 31, 2020, in support of reserves associated with the transaction in a Modco investment portfolio. As of March 31, 2020, the portfolio included trading securities, fixed maturity AFS securities, commercial mortgage loans, cash and invested cash, other investments, derivative investments, accrued investment income and equity securities that had carrying values of $3.0 billion, $1.8 billion, $765 million, $378 million, $111 million, $49 million, $48 million and $14 million, respectively. In addition, the portfolio was supported by $175 million of over-collateralization and a $188 million letter of credit as of March 31, 2020.
8. Guaranteed Benefit Features
Information on the guaranteed death benefit (“GDB”) features outstanding (dollars in millions) was as follows:
2020 (1)
2019 (1)
Return of Net Deposits
Total account value
88,627
101,601
Net amount at risk (2)
1,563
Average attained age of contract holders
65 years
Minimum Return
78 years
77 years
Guaranteed minimum return
5%
Anniversary Contract Value
21,713
25,763
2,401
72 years
71 years
(1)Our variable contracts with guarantees may offer more than one type of guarantee in each contract; therefore, the amounts listed are not mutually exclusive.
(2)Represents the amount of death benefit in excess of the account balance that is subject to market fluctuations.
The determination of GDB liabilities is based on models that involve a range of scenarios and assumptions, including those regarding expected market rates of return and volatility, contract surrender rates and mortality experience. The following summarizes the balances of and changes in the liabilities for GDBs (in millions), which were recorded in future contract benefits on our Consolidated Balance Sheets:
117
Changes in reserves
106
(36
Benefits paid
215
119
Variable Annuity Contracts
Account balances of variable annuity contracts, including those with guarantees, (in millions) were invested in separate account investment options as follows:
Asset Type
Domestic equity
52,454
64,093
International equity
15,998
19,852
Fixed income
38,522
41,405
106,974
125,350
Percent of total variable annuity separate account values
98%
Secondary Guarantee Products
Future contract benefits and other contract holder funds include reserves for our secondary guarantee products sold through our Life Insurance segment. Reserves on UL and VUL products with secondary guarantees represented 37% of total life insurance in-force reserves as of March 31, 2020, and December 31, 2019. UL and VUL products with secondary guarantees represented 29% of total life insurance sales for the three months ended March 31, 2020 and 2019.
9. Liability for Unpaid Claims
The liability for unpaid claims consists primarily of long-term disability claims and is reported in future contract benefits on our Consolidated Balance Sheets. Changes in the liability for unpaid claims (in millions) were as follows:
5,552
5,335
Reinsurance recoverable
152
143
Net balance as of beginning-of-year
5,400
5,192
Incurred related to:
Current year
885
Prior years:
43
41
All other incurred (1)
(85
Total incurred
759
Paid related to:
(240
(215
Prior years
(518
(482
Total paid
(758
(697
Net balance as of end-of-period
5,505
5,254
150
5,655
5,397
(1)All other incurred is primarily impacted by the level of claim resolutions in the period compared to that which is expected by the reserve assumption. A negative number implies a favorable result where claim resolutions were more favorable than assumed. Our claim resolution rate assumption used in determining reserves is our expectation of the resolution rate we will experience over the long-term life of the block of claims. It will vary from actual experience in any one period, both favorably and unfavorably.
The interest rate assumption used for discounting long-term claim reserves is an important part of the reserving process due to the long benefit period for these claims. Interest accrued on prior years’ reserves has been calculated on the opening reserve balance less one-half of the prior years’ incurred claim payments at our average reserve discount rate.
Long-term disability benefits may extend for many years, and claim development schedules do not reflect these longer benefit periods. As a result, we use longer term retrospective runoff studies, experience studies and prospective studies to develop our liability estimates.
10. Debt
Changes in debt (in millions) were as follows:
6,367
LIBOR + 150 bps term loan issued, due 2022
500
Repayment of 6.25% senior notes, due 2020
Unamortized adjustments from discontinued hedges
263
Fair value hedge on interest rate swap agreements
11. Contingencies and Commitments
Contingencies
Regulatory and Litigation Matters
Regulatory bodies, such as state insurance departments, the SEC, Financial Industry Regulatory Authority and other regulatory bodies regularly make inquiries and conduct examinations or investigations concerning our compliance with, among other things, insurance laws, securities laws, laws governing the activities of broker-dealers, registered investment advisers and unclaimed property laws.
LNC is involved in various pending or threatened legal or regulatory proceedings, including purported class actions, arising from the conduct of business both in the ordinary course and otherwise. In some of the matters, very large and/or indeterminate amounts, including punitive and treble damages, are sought. Modern pleading practice in the U.S. permits considerable variation in the assertion of monetary damages or other relief. Jurisdictions may permit claimants not to specify the monetary damages sought or may permit claimants to state only that the amount sought is sufficient to invoke the jurisdiction of the trial court. In addition, jurisdictions may permit plaintiffs to allege monetary damages in amounts well exceeding verdicts obtained in the jurisdiction for similar matters. This variability in pleadings, together with the actual experiences of LNC in litigating or resolving through settlement numerous claims over an extended period of time, demonstrates to management that the monetary relief which may be specified in a lawsuit or claim bears little relevance to its merits or disposition value.
Due to the unpredictable nature of litigation, the outcome of a litigation matter and the amount or range of potential loss at particular points in time is normally difficult to ascertain. Uncertainties can include how fact finders will evaluate documentary evidence and the credibility and effectiveness of witness testimony, and how trial and appellate courts will apply the law in the context of the pleadings or evidence presented, whether by motion practice, or at trial or on appeal. Disposition valuations are also subject to the uncertainty of how opposing parties and their counsel will themselves view the relevant evidence and applicable law.
We establish liabilities for litigation and regulatory loss contingencies when information related to the loss contingencies shows both that it is probable that a loss has been incurred and the amount of the loss can be reasonably estimated. It is possible that some matters could require us to pay damages or make other expenditures or establish accruals in amounts that could not be estimated as of March 31, 2020. While the potential future charges could be material in the particular quarterly or annual periods in which they are recorded, based on information currently known by management, management does not believe any such charges are likely to have a material adverse effect on LNC’s financial condition.
For some matters, the Company is able to estimate a reasonably possible range of loss. For such matters in which a loss is probable, an accrual has been made. For such matters where a loss is believed to be reasonably possible, but not probable, no accrual has been made. Accordingly, the estimate contained in this paragraph reflects two types of matters. For some matters included within this estimate, an accrual has been made, but there is a reasonable possibility that an exposure exists in excess of the amount accrued. In these cases, the estimate reflects the reasonably possible range of loss in excess of the accrued amount. For other matters included within this estimation, no accrual has been made because a loss, while potentially estimable, is believed to be reasonably possible but not probable. In these cases, the estimate reflects the reasonably possible loss or range of loss. As of March 31, 2020, we estimate the aggregate range of reasonably possible losses, including amounts in excess of amounts accrued for these matters as of such date, to be up to approximately $90 million. Any estimate is not an indication of expected loss, if any, or of the Company’s maximum possible loss exposure on such matters.
For other matters, we are not currently able to estimate the reasonably possible loss or range of loss. We are often unable to estimate the possible loss or range of loss until developments in such matters have provided sufficient information to support an assessment of the range of possible loss, such as quantification of a damage demand from plaintiffs, discovery from other parties and investigation of factual allegations, rulings by the court on motions or appeals, analysis by experts and the progress of settlement negotiations. On a quarterly and annual basis, we review relevant information with respect to litigation contingencies and update our accruals, disclosures and estimates of reasonably possible losses or ranges of loss based on such reviews.
Certain reinsurers have sought rate increases on certain yearly renewable term treaties. We are disputing the requested rate increases under these treaties. We have initiated and will initiate arbitration proceedings, as necessary, under these treaties in order to protect our contractual rights. Additionally, reinsurers may initiate arbitration proceedings against us. We believe it is unlikely the outcome of these disputes will have a material adverse effect on our financial condition.
Cost of Insurance Litigation
Glover v. Connecticut General Life Insurance Company and The Lincoln National Life Insurance Company, filed in the U.S. District Court for the District of Connecticut, No. 3:16-cv-00827, is a putative class action that was served on The Lincoln National Life Insurance Company (“LNL”) on June 8, 2016. Plaintiff is the owner of a universal life insurance policy who alleges that LNL charged more for non-guaranteed cost of insurance than permitted by the policy. Plaintiff seeks to represent all universal life and variable universal life policyholders who owned policies containing non-guaranteed cost of insurance provisions that are similar to those of Plaintiff’s policy and seeks damages on behalf of all such policyholders. On January 11, 2019, the court dismissed Plaintiff’s complaint in its entirety. In response, Plaintiff filed a motion for leave to amend the complaint, which we have opposed.
Hanks v. Lincoln Life & Annuity Company of New York (“LLANY”) and Voya Retirement Insurance and Annuity Company (“Voya”), filed in the U.S. District Court for the Southern District of New York, No. 1:16-cv-6399, is a putative class action that was served on LLANY on August 12, 2016. Plaintiff owns a universal life policy originally issued by Aetna (now Voya) and alleges that (i) Voya breached the terms of the policy when it increased non-guaranteed cost of insurance rates on Plaintiff’s policy; and (ii) LLANY, as reinsurer and administrator of Plaintiff’s policy, engaged in wrongful conduct related to the cost of insurance increase and was unjustly enriched as a result. Plaintiff seeks to represent all owners of Aetna life insurance policies that were subject to non-guaranteed cost of insurance rate increases in 2016 and seeks damages on their behalf. On March 13, 2019, the court issued an order granting plaintiff’s motion for class certification for the breach of contract claim and denying such motion with respect to the unjust enrichment claim against LLANY, and, on September 12, 2019, the court issued an order approving the parties’ joint stipulation of dismissal with respect to the unjust enrichment claim and dismissed LLANY as a defendant in the case. In light of LLANY’s role as reinsurer and administrator under the 1998 coinsurance agreement with Aetna (now Voya), and of the parties’ rights and obligations thereunder, LLANY continues to be actively engaged in the vigorous defense of this action.
EFG Bank AG, Cayman Branch, et al. v. The Lincoln National Life Insurance Company, pending in the U.S. District Court for the Eastern District of Pennsylvania, No. 2:17-cv-02592, is a civil action filed on February 1, 2017. Plaintiffs own Legend Series universal life insurance policies originally issued by Jefferson-Pilot (now LNL). Plaintiffs allege that LNL breached the terms of policyholders’ contracts when it increased non-guaranteed cost of insurance rates beginning in 2016. We are vigorously defending this matter.
In re: Lincoln National COI Litigation, pending in the U.S. District Court for the Eastern District of Pennsylvania, Master File No. 2:16-cv-06605-GJP, is a consolidated litigation matter related to multiple putative class action filings that were consolidated by an order dated March 20, 2017. In addition to consolidating a number of existing matters, the order also covers any future cases filed in the same district related to the same subject matter. Plaintiffs own universal life insurance policies originally issued by Jefferson-Pilot (now LNL). Plaintiffs allege that LNL and LNC breached the terms of policyholders’ contracts by increasing non-guaranteed cost of insurance rates beginning in 2016. Plaintiffs seek to represent classes of policyowners and seek damages on their behalf. We are vigorously defending this matter.
In re: Lincoln National 2017 COI Rate Litigation, Master File No. 2:17-cv-04150 is a consolidated litigation matter related to multiple putative class action filings that were consolidated by an order of the court in March 2018. Plaintiffs own universal life insurance policies originally issued by former Jefferson-Pilot (now LNL). Plaintiffs allege that LNL and LNC breached the terms of policyholders’ contracts by increasing non-guaranteed cost of insurance rates beginning in 2017. Plaintiffs seek to represent classes of policyholders and seek damages on their behalf. We are vigorously defending this matter.
Iwanski v. First Penn-Pacific Life Insurance Company (“FPP”), No. 2:18-cv-01573 filed in the U.S. District Court for the District Court, Eastern District of Pennsylvania is a putative class action that was filed on April 13, 2018. Plaintiff alleges that defendant FPP breached the terms of his life insurance policy by deducting non-guaranteed cost of insurance charges in excess of what is permitted by the policies. Plaintiff seeks to represent all owners of universal life insurance policies issued by FPP containing non-guaranteed cost of insurance provisions that are similar to those of Plaintiff’s policy and seeks damages on their behalf. Breach of contract is the only cause of action asserted. We are vigorously defending this matter.
TVPX ARS INC., as Securities Intermediary for Consolidated Wealth Management, LTD. v. The Lincoln National Life Insurance Company, filed in the U.S. District Court for the Eastern District of Pennsylvania, No. 2:18-cv-02989, is a putative class action that was filed on July 17, 2018. Plaintiff alleges that LNL charged more for non-guaranteed cost of insurance than permitted by the policy. Plaintiff seeks to represent all universal life and variable universal life policyholders who own policies issued by LNL or its predecessors containing non-guaranteed cost of insurance provisions that are similar to those of Plaintiff’s policy and seeks damages on behalf of all such policyholders. We are vigorously defending this matter.
LSH Co. and Wells Fargo Bank, National Association, as securities intermediary for LSH Co. v. Lincoln National Corporation and The Lincoln National Life Insurance Company, pending in the U.S. District Court for the Eastern District of Pennsylvania, No. 2:18-cv-05529, is a civil action filed on December 21, 2018. Plaintiffs own universal life insurance policies originally issued by Jefferson-Pilot (now LNL). Plaintiffs allege that LNL breached the terms of policyholders’ contracts when it increased non-guaranteed cost of insurance rates in 2016 and 2017. We are vigorously defending this matter.
Vida Longevity Fund, LP v. Lincoln Life & Annuity Company of New York, pending in the U.S. District Court for the Southern District of New York, No. 1:19-cv-06004, is a putative class action that was filed on June 27, 2019. Plaintiff alleges that LLANY charged more for non-guaranteed cost of insurance than was permitted by the policies. Plaintiff seeks to represent all current and former owners of universal life (including variable universal life) policies who own or owned policies issued by LLANY and its predecessors in interest that were in force at any time on or after June 27, 2013, and which contain non-guaranteed cost of insurance provisions that are similar to those of Plaintiff’s policies. Plaintiff also seeks to represent a sub-class of such policyholders who own or owned “life insurance policies issued in the State of New York.” Plaintiff seeks damages on behalf of the policyholder class and sub-class. We are vigorously defending this matter.
12. Shares and Stockholders’ Equity
Common Shares
The changes in our common stock (number of shares) were as follows:
196,668,532
205,862,760
Stock issued for exercise of warrants
203,530
349,636
809,670
Retirement/cancellation of shares
(3,809,924
(3,888,731
193,208,244
202,987,229
Common Stock as of End-of-Period
Basic basis
Diluted basis
195,027,909
204,200,031
Our common stock is without par value.
Average Shares
A reconciliation of the denominator (number of shares) in the calculations of basic and diluted earnings (loss) per common share was as follows:
Weighted-average shares, as used in basic calculation
195,076,797
204,290,759
Shares to cover exercise of outstanding warrants
173,837
Shares to cover non-vested stock
853,597
1,049,556
Average stock options outstanding during the period
996,248
1,519,184
Assumed acquisition of shares with assumed proceeds
from exercising outstanding warrants
(29,176
Assumed acquisition of shares with assumed
proceeds and benefits from exercising stock
options (at average market price for the period)
(703,600
(1,041,630
Shares repurchasable from measured but
unrecognized stock option expense
(867
Average deferred compensation shares
1,041,800
Weighted-average shares, as used in diluted calculation
197,264,842
205,961,663
In the event the average market price of LNC common stock exceeds the issue price of stock options and the options have a dilutive effect to our earnings per share (“EPS”), such options will be shown in the table above.
We have participants in our deferred compensation plans who selected LNC stock as the measure for the investment return attributable to all or a portion of their deferral amounts. For the three months ended March 31, 2020, the effect of settling this obligation in LNC stock (“equity classification”) was more dilutive than the scenario of settling in cash (“liability classification”). Therefore, for our EPS calculation for this period, we added these shares to the denominator and adjusted the numerator to present net income as if the shares had been accounted for under equity classification by removing the mark-to-market adjustment included in net income attributable to these deferred units of LNC stock. The amount of this adjustment was $23 million for the three months ended March 31, 2020.
AOCI
The following summarizes the components and changes in AOCI (in millions):
Unrealized Gain (Loss) on AFS Securities
5,983
Cumulative effect from adoption of new accounting standard
Unrealized holding gains (losses) arising during the period
(4,498
3,556
Change in DAC, VOBA, DSI, future contract benefits and other contract holder funds
1,264
(928
720
(563
Reclassification adjustment for gains (losses) included in net income (loss)
(15
3,340
2,649
Unrealized OTTI on AFS Securities
33
(Increases) attributable to:
(45
Gross OTTI recognized in OCI during the period
Changes in fair value, sales, maturities or other settlements of AFS securities
25
(71
Foreign Currency Translation Adjustment
Foreign currency translation adjustment arising during the period
(10
(27
Funded Status of Employee Benefit Plans
(327
Adjustment arising during the period
The following summarizes the reclassifications out of AOCI (in millions) and the associated line item in the Consolidated Statements of Comprehensive Income (Loss):
Gross reclassification
Associated amortization of DAC,
VOBA, DSI and DFEL
Reclassification before income
Income (loss) from continuing
tax benefit (expense)
operations before taxes
Reclassification, net of income tax
(13
Gross reclassifications:
Total gross reclassifications
Reclassifications before income
Reclassifications, net of income tax
13. Realized Gain (Loss)
Realized gain (loss) on our Consolidated Statements of Comprehensive Income (Loss) includes realized gains and losses from the sale of investments, write-downs for impairments of investments and changes in the allowance for credit losses for financial assets, changes in fair value for mortgage loans on real estate accounted for under the fair value option, changes in fair value of equity securities, certain derivative and embedded derivative gains and losses, gains and losses on the sale of subsidiaries and businesses and net gains and losses on reinsurance embedded derivatives and trading securities. Realized gains and losses on the sale of investments are determined using the specific identification method. Realized gain (loss) is recognized in net income, net of associated amortization of DAC, VOBA, DSI and DFEL. Realized gain (loss) is also net of allocations of investment gains and losses to certain contract holders and certain funds withheld on reinsurance arrangements for which we have a contractual obligation. Details underlying realized gain (loss) (in millions) were as follows:
Gross gains
Gross losses
Credit loss expense, net
Gross OTTI
Gain (loss) on equity securities (1)
Credit loss expense on mortgage loans on real estate
Other gain (loss) on investments
and changes in other contract holder funds
Total realized gain (loss) related to certain financial assets
(86
Realized gain (loss) on the mark-to-market on certain instruments (2)(3)
(121
Indexed annuity and IUL contracts net derivatives results: (4)
Gross gain (loss)
(49
Variable annuity net derivatives results: (5)
40
28
(1)Includes market adjustments on equity securities still held of $(18) million and $6 million for the three months ended March 31, 2020 and 2019, respectively.
(2)Represents changes in the fair values of certain derivative investments (not including those associated with our variable and indexed annuity and IUL contracts net derivative results), reinsurance related embedded derivatives, mortgage loans on real estate accounted for under the fair value option and trading securities. See Note 7 for information regarding modified coinsurance.
(3)Includes gains and losses from fair value changes on mortgage loans on real estate accounted for under the fair value option of $7 million for the three months ended March 31, 2020.
(4)Represents the net difference between the change in fair value of the index options that we hold and the change in the fair value of the embedded derivative liabilities of our indexed annuity and IUL contracts along with changes in the fair value of embedded derivative liabilities related to index options we may purchase or sell in the future to hedge contract holder index allocations applicable to future reset periods for our indexed annuity products.
(5)Includes the net difference in the change in embedded derivative reserves of our GLB riders and the change in the fair value of the derivative instruments we own to hedge the change in embedded derivative reserves on our GLB riders and the benefit ratio unlocking on our GLB and GDB riders, including the cost of purchasing the hedging instruments.
14. Fair Value of Financial Instruments
The carrying values and estimated fair values of our financial instruments (in millions) were as follows:
Fixed maturity AFS securities
Mortgage loans on real estate
18,556
16,872
Derivative investments (1)
4,755
2,983
Other assets:
GLB direct embedded derivatives
GLB ceded embedded derivatives
Indexed annuity ceded embedded derivatives
Future contract benefits – indexed annuity
and IUL contracts embedded derivatives
(1,380
(2,585
Other contract holder funds:
Remaining guaranteed interest and similar contracts
(1,884
(1,900
Account values of certain investment contracts
(39,744
(54,761
(38,639
(46,822
(304
(6,748
(5,770
(6,067
(6,217
Other liabilities:
Derivative liabilities (1)
(1,212
(349
(4,596
(1)We have master netting agreements with each of our derivative counterparties, which allow for the netting of our derivative asset and liability positions by counterparty.
Valuation Methodologies and Associated Inputs for Financial Instruments Not Carried at Fair Value
The following discussion outlines the methodologies and assumptions used to determine the fair value of our financial instruments not carried at fair value on our Consolidated Balance Sheets. Considerable judgment is required to develop these assumptions used to measure fair value. Accordingly, the estimates shown are not necessarily indicative of the amounts that would be realized in a one-time, current market exchange of all of our financial instruments.
The fair value of mortgage loans on real estate, including mortgage loans accounted for using the fair value option, is established using a discounted cash flow method based on credit rating, maturity and future income. The ratings for mortgages in good standing are based on property type, location, market conditions, occupancy, debt-service coverage, loan-to-value, quality of tenancy, borrower and payment record. The fair value for impaired mortgage loans is based on the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s market price or the fair value of the collateral if the loan is collateral dependent. The inputs used to measure the fair value of our mortgage loans on real estate are classified as Level 2 within the fair value hierarchy.
Other Investments
The carrying value of our assets classified as other investments approximates fair value. Other investments includes primarily LPs and other privately held investments that are accounted for using the equity method of accounting and the carrying value is based on our proportional share of the net assets of the LPs. Other investments also includes Federal Home Loan Bank (“FHLB”) stock carried at cost and periodically evaluated for impairment based on ultimate recovery of par value. The inputs used to measure the fair value of our LPs, other privately held investments and FHLB stock are classified as Level 3 within the fair value hierarchy. The remaining assets in
other investments include cash collateral receivables and securities that are not LPs or other privately held investments. The inputs used to measure the fair value of these assets are classified as Level 1 within the fair value hierarchy.
Separate Account Assets
Separate account assets are primarily carried at fair value. A portion of our separate account assets includes LPs, which are accounted for using the equity method of accounting. The carrying value is based on our proportional share of the net assets of the LPs and approximates fair value. The inputs used to measure the fair value of the separate account asset LPs are classified as Level 3 within the fair value hierarchy.
Other Contract Holder Funds
Other contract holder funds include remaining guaranteed interest and similar contracts and account values of certain investment contracts. The fair value for the remaining guaranteed interest and similar contracts is estimated using discounted cash flow calculations as of the balance sheet date. These calculations are based on interest rates currently offered on similar contracts with maturities that are consistent with those remaining for the contracts being valued. As of March 31, 2020, and December 31, 2019, the remaining guaranteed interest and similar contracts carrying value approximated fair value. The fair value of the account values of certain investment contracts is based on their approximate surrender value as of the balance sheet date. The inputs used to measure the fair value of our other contract holder funds are classified as Level 3 within the fair value hierarchy.
Short-Term and Long-Term Debt
The fair value of short-term and long-term debt is based on quoted market prices. The inputs used to measure the fair value of our short-term and long-term debt are classified as Level 2 within the fair value hierarchy.
Fair Value Option
Mortgage loans on real estate, net of ACL, as reported on our Consolidated Balance Sheets, includes commercial mortgage loans for which the fair value option was elected. The fair value option allows us to elect fair value as an alternative measurement for mortgage loans not otherwise reported at fair value. We have made these elections for certain mortgage loans associated with Modco arrangements to help mitigate the inconsistency in earnings that would otherwise result from the use of embedded derivatives included with these loans. Changes in fair value are reflected in realized gain (loss) on our Consolidated Statement of Comprehensive Income (Loss) for commercial mortgage loans. Changes in fair value due to instrument-specific credit risk are estimated using changes in credit spreads and quality ratings for the period reported.
The fair value and aggregate contractual principal for mortgage loans where the fair value option was elected (in millions) was as follows:
As of March 31,
Commercial mortgage loans: (1)
Fair value as of end-of-period
765
Aggregate contractual principal as of end-of-period
(1)As of March 31, 2020, no loans for which the fair value option has been elected were in non-accrual status and none were more than 90 days past due and still accruing.
Financial Instruments Carried at Fair Value
We did not have any assets or liabilities measured at fair value on a nonrecurring basis as of March 31, 2020, or December 31, 2019, and we noted no changes in our valuation methodologies between these periods.
The following summarizes our financial instruments carried at fair value (in millions) on a recurring basis by the fair value hierarchy levels:
Quoted
Prices
in Active
Markets for
Significant
Identical
Observable
Unobservable
Inputs
(Level 1)
(Level 2)
(Level 3)
81,694
4,103
470
302
87
3,270
1,118
4,890
416
3,319
651
2,447
3,213
5,660
539
130,068
130,607
1,138
240,582
9,886
251,606
(1,269
(1,186
(2,455
(7,162
(8,431
84,435
4,281
424
90
3,230
4,621
77
404
3,957
666
1,212
1,735
2,947
639
152,916
153,555
1,215
260,661
8,602
270,478
(1,385
(845
(3,461
(4,306
(1)Derivative investment assets and liabilities are presented within the fair value hierarchy on a gross basis by derivative type and not on a master netting basis by counterparty.
The following summarizes changes to our financial instruments carried at fair value (in millions) and classified within Level 3 of the fair value hierarchy. This summary excludes any effect of amortization of DAC, VOBA, DSI and DFEL. The gains and losses below may include changes in fair value due in part to observable inputs that are a component of the valuation methodology.
Issuances,
Transfers
Items
(Losses)
Sales,
Into or
Included
in
Maturities,
Out
Beginning
OCI
Settlements,
Ending
and
Calls,
Level 3,
Other (1)
Net (2)
Investments: (3)
(385
165
(90
(32
868
997
279
(117
2,027
Other assets: (4)
(450
668
(115
and IUL contracts embedded derivatives (4)
1,143
Other liabilities: (4)
Total, net
5,141
(2,376
(119
113
3,269
70
200
3,521
109
(7
134
149
(105
75
67
206
236
534
267
316
439
(22
902
(107
872
(1,305
(316
(109
(1,730
Other liabilities – GLB ceded embedded
derivatives (4)
4,014
(337
120
409
(166
4,040
(1)The changes in fair value of the interest rate swaps are offset by an adjustment to derivative investments (see Note 5).
(2)Transfers into or out of Level 3 for fixed maturity AFS and trading securities are reported at amortized cost as of the beginning-of-year. For fixed maturity AFS and trading securities, the difference between beginning-of-year amortized cost and beginning-of-year fair value was included in OCI and earnings, respectively, in the prior period.
(3)Amortization and accretion of premiums and discounts are included in net investment income on our Consolidated Statements of Comprehensive Income (Loss). Gains (losses) from sales, maturities, settlements and calls and credit loss expense are included in realized gain (loss) on our Consolidated Statements of Comprehensive Income (Loss).
(4)Gains (losses) from the changes in fair value are included in realized gain (loss) on our Consolidated Statements of Comprehensive Income (Loss).
The following provides the components of the items included in issuances, sales, maturities, settlements and calls, net, excluding any effect of amortization of DAC, VOBA, DSI and DFEL and changes in future contract benefits, (in millions) as reported above:
Issuances
Sales
Maturities
Settlements
Calls
336
(73
118
(123
(112
Other assets – indexed annuity ceded
embedded derivatives
548
(221
(110
(55
207
(46
(148
625
(139
The following summarizes changes in unrealized gains (losses) included in net income, excluding any effect of amortization of DAC, VOBA, DSI and DFEL and changes in future contract benefits, related to financial instruments carried at fair value classified within Level 3 that we still held (in millions):
(4,867
481
(287
Total, net (1)
(4,033
162
(1)Included in realized gain (loss) on our Consolidated Statements of Comprehensive Income (Loss).
The following summarizes changes in unrealized gains (losses) included in OCI, net of tax, excluding any effect of amortization of DAC, VOBA, DSI and DFEL and changes in future contract benefits, related to financial instruments carried at fair value classified within Level 3 that we still held (in millions):
(325
(335
The following provides the components of the transfers into and out of Level 3 (in millions) as reported above:
March 31, 2020
March 31, 2019
Into
Out of
Level 3
(95
(182
(249
Transfers into and out of Level 3 are generally the result of observable market information on a security no longer being available or becoming available to our pricing vendors. For the three months ended March 31, 2020 and 2019, transfers in and out of Level 3 were attributable primarily to the securities’ observable market information no longer being available or becoming available.
The following summarizes the fair value (in millions), valuation techniques and significant unobservable inputs of the Level 3 fair value measurements as of March 31, 2020:
Weighted
Average
Valuation
Assumption or
Input
Technique
Unobservable Inputs
Input Ranges
Range (1)
Fixed maturity AFS and
trading securities:
2,690
Discounted cash flow
Liquidity/duration adjustment (2)
0.7
%
18.8
2.9
Foreign government
bonds
5.3
8.0
6.8
6.0
3.0
4.5
7.3
6.7
Other assets – GLB ceded
Long-term lapse rate (3)
(10)
Utilization of guaranteed withdrawals (4)
85
100
Claims utilization factor (5)
Premiums utilization factor (5)
80
115
NPR (6)
0.03
0.35
Mortality rate (7)
(9)
Volatility (8)
13.72
Indexed annuity ceded
Lapse rate (3)
Future contract benefits –
indexed annuity and IUL
contracts embedded
derivatives
Other liabilities –
GLB direct embedded
(1)Unobservable inputs were weighted by the relative fair value of the instruments, unless otherwise noted.
(2)The liquidity/duration adjustment input represents an estimated market participant composite of adjustments attributable to liquidity premiums, expected durations, structures and credit quality that would be applied to the market observable information of an investment.
(3)The lapse rate input represents the estimated probability of a contract surrendering during a year, and thereby forgoing any future benefits. The range for indexed annuity and IUL contracts represents the lapse rates during the surrender charge period.
(4)The utilization of guaranteed withdrawals input represents the estimated percentage of contract holders that utilize the guaranteed withdrawal feature.
(5)The utilization factors are applied to the present value of claims or premiums, as appropriate, in the GLB reserve calculation to estimate the impact of inefficient withdrawal behavior, including taking less than or more than the maximum guaranteed withdrawal.
(6)The NPR input represents the estimated additional credit spread that market participants would apply to the market observable discount rate when pricing a contract. The NPR input was weighted by the absolute value of the sensitivity of the reserve to the NPR assumption.
(7)The mortality rate input represents the estimated probability of when an individual belonging to a particular group, categorized according to age or some other factor such as gender, will die.
(8)The volatility input represents overall volatilities assumed for the underlying variable annuity funds, which include a mixture of equity and fixed-income assets. Fair value of the variable annuity GLB embedded derivatives would increase if higher volatilities were used for valuation. Volatility assumptions vary by fund due to the benchmarking of different indices. The volatility input was weighted by the relative account value assigned to each index.
(9)The mortality rate is based on a combination of company and industry experience, adjusted for improvement factors.
(10)A weighted average input range is not a meaningful measurement for lapse rate, utilization factors or mortality rate.
From the table above, we have excluded Level 3 fair value measurements obtained from independent, third-party pricing sources. We do not develop the significant inputs used to measure the fair value of these assets and liabilities, and the information regarding the significant inputs is not readily available to us. Independent broker-quoted fair values are non-binding quotes developed by market makers or broker-dealers obtained from third-party sources recognized as market participants. The fair value of a broker-quoted asset or liability is based solely on the receipt of an updated quote from a single market maker or a broker-dealer recognized as a market participant as we do not adjust broker quotes when used as the fair value measurement for an asset or liability. Significant increases or decreases in any of the quotes received from a third-party broker-dealer may result in a significantly higher or lower fair value measurement.
Changes in any of the significant inputs presented in the table above would have resulted in a significant change in the fair value measurement of the asset or liability as follows:
Investments – An increase in the liquidity/duration adjustment input would have resulted in a decrease in the fair value measurement.
Indexed annuity and IUL contracts embedded derivatives – For direct embedded derivatives, an increase in the lapse rate or mortality rate inputs would have resulted in a decrease in the fair value measurement.
GLB embedded derivatives – Assuming our GLB direct embedded derivatives are in a liability position: an increase in our lapse rate, NPR or mortality rate inputs would have resulted in a decrease in the fair value measurement; and an increase in the utilization of guaranteed withdrawal or volatility inputs would have resulted in an increase in the fair value measurement.
For each category discussed above, the unobservable inputs are not inter-related; therefore, a directional change in one input would not have affected the other inputs.
As part of our ongoing valuation process, we assess the reasonableness of our valuation techniques or models and make adjustments as necessary.
15. Segment Information
We provide products and services and report results through our Annuities, Retirement Plan Services, Life Insurance and Group Protection segments. We also have Other Operations, which includes the financial data for operations that are not directly related to the business segments. Our reporting segments reflect the manner by which our chief operating decision makers view and manage the business. A discussion of these segments and Other Operations is found in Note 21 of our 2019 Form 10-K.
Segment operating revenues and income (loss) from operations are internal measures used by our management and Board of Directors to evaluate and assess the results of our segments. Income (loss) from operations is GAAP net income excluding the after-tax effects of the following items, as applicable:
Realized gains and losses associated with the following (“excluded realized gain (loss)”):
Sales or disposals and impairments of financial assets;
Changes in the fair value of equity securities;
Changes in the fair value of derivatives, embedded derivatives within certain reinsurance arrangements and trading securities (“gain (loss) on the mark-to-market on certain instruments”);
Changes in the fair value of the derivatives we own to hedge our GDB riders within our variable annuities;
Changes in the fair value of the embedded derivatives of our GLB riders reflected within variable annuity net derivative results accounted for at fair value;
Changes in the fair value of the derivatives we own to hedge our GLB riders reflected within variable annuity net derivative results; and
Changes in the fair value of the embedded derivative liabilities related to index options we may purchase or sell in the future to hedge contract holder index allocations applicable to future reset periods for our indexed annuity products accounted for at fair value (“indexed annuity forward-starting option”);
Changes in reserves resulting from benefit ratio unlocking on our GDB and GLB riders (“benefit ratio unlocking”);
Income (loss) from reserve changes, net of related amortization, on business sold through reinsurance;
Gains (losses) on early extinguishment of debt;
Losses from the impairment of intangible assets;
Income (loss) from discontinued operations;
Acquisition and integration costs related to mergers and acquisitions; and
Income (loss) from the initial adoption of new accounting standards, regulations, and policy changes including the net impact from the Tax Cuts and Jobs Act.
Operating revenues represent GAAP revenues excluding the pre-tax effects of the following items, as applicable:
Excluded realized gain (loss);
Revenue adjustments from the initial adoption of new accounting standards;
Amortization of DFEL arising from changes in GDB and GLB benefit ratio unlocking; and
Amortization of deferred gains arising from reserve changes on business sold through reinsurance.
The tables below reconcile our segment measures of performance to the GAAP measures presented in our Consolidated Statements of Comprehensive Income (Loss) (in millions):
Operating revenues:
Annuities
1,129
1,174
Retirement Plan Services
297
293
Life Insurance
1,821
1,700
Group Protection
1,224
Other Operations
38
Excluded realized gain (loss), pre-tax
(75
(400
Amortization of DFEL associated
with benefit ratio unlocking, pre-tax
Net Income (Loss)
Income (loss) from operations:
261
171
(60
Excluded realized gain (loss), after-tax
Benefit ratio unlocking, after-tax
142
Acquisition and integration costs related to
mergers and acquisitions, after-tax
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following Management’s Discussion and Analysis (“MD&A”) is intended to help the reader understand the financial condition as of March 31, 2020, compared with December 31, 2019, and the results of operations for the three months ended March 31, 2020, compared with the corresponding period in 2019 of Lincoln National Corporation and its consolidated subsidiaries. Unless otherwise stated or the context otherwise requires, “LNC,” “Company,” “we,” “our” or “us” refers to Lincoln National Corporation and its consolidated subsidiaries.
The MD&A is provided as a supplement to, and should be read in conjunction with, our consolidated financial statements and the accompanying notes to the consolidated financial statements (“Notes”) presented in “Part I – Item 1. Financial Statements”; our Form 10-K for the year ended December 31, 2019 (“2019 Form 10-K”); and other reports filed with the Securities and Exchange Commission
(“SEC”). For more detailed information on the risks and uncertainties associated with the Company’s business activities, see the risks described in “Part I – Item 1A. Risk Factors” in our 2019 Form 10-K and “Part II – Item 1A. Risk Factors” herein.
FORWARD-LOOKING STATEMENTS – CAUTIONARY LANGUAGE
Certain statements made in this report and in other written or oral statements made by us or on our behalf are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 (“PSLRA”). These forward-looking statements are intended to enhance the reader’s ability to assess our future financial performance. A forward-looking statement is a statement that is not a historical fact and, without limitation, includes any statement that may predict, forecast, indicate or imply future results, performance or achievements. Forward-looking statements may contain words like: “anticipate,” “believe,” “estimate,” “expect,” “project,” “shall,” “will” and other words or phrases with similar meaning in connection with a discussion of future operating or financial performance. In particular, these include statements relating to future actions, trends in our businesses, prospective services or products, future performance or financial results and the outcome of contingencies, such as legal proceedings. We claim the protection afforded by the safe harbor for forward-looking statements provided by the PSLRA.
Forward-looking statements are subject to risks and uncertainties. Actual results could differ materially from those expressed in or implied by such forward-looking statements due to a variety of factors, including:
The continuation of the coronavirus, or COVID-19, pandemic, or future outbreaks of COVID-19, and uncertainty surrounding the length and severity of future impacts on the global economy and on our business, results of operations and financial condition;
Continued deterioration in general economic and business conditions that may affect account values, investment results, guaranteed benefit liabilities, premium levels and claims experience;
Adverse global capital and credit market conditions could affect our ability to raise capital, if necessary, and may cause us to realize impairments on investments and certain intangible assets, including goodwill and the valuation allowance against deferred tax assets, which may reduce future earnings and/or affect our financial condition and ability to raise additional capital or refinance existing debt as it matures;
Because of our holding company structure, the inability of our subsidiaries to pay dividends to the holding company in sufficient amounts could harm the holding company’s ability to meet its obligations;
Legislative, regulatory or tax changes, both domestic and foreign, that affect: the cost of, or demand for, our subsidiaries’ products; the required amount of reserves and/or surplus; our ability to conduct business and our captive reinsurance arrangements as well as restrictions on the payment of revenue sharing and 12b-1 distribution fees; the impact of U.S. federal tax reform legislation on our business, earnings and capital; and the impact of any “best interest” standards of care adopted by the SEC or other regulations adopted by federal or state regulators or self-regulatory organizations relating to the standard of care owed by investment advisers and/or broker-dealers;
Actions taken by reinsurers to raise rates on in-force business;
Continued declines in or sustained low interest rates causing a reduction in investment income, the interest margins of our businesses, estimated gross profits (“EGPs”) and demand for our products;
Rapidly increasing interest rates causing contract holders to surrender life insurance and annuity policies, thereby causing realized investment losses, and reduced hedge performance related to variable annuities;
Uncertainty about the effect of continuing promulgation and implementation of rules and regulations under the Dodd-Frank Wall Street Reform and Consumer Protection Act on us, the economy and the financial services sector in particular;
The initiation of legal or regulatory proceedings against us, and the outcome of any legal or regulatory proceedings, such as: adverse actions related to present or past business practices common in businesses in which we compete; adverse decisions in significant actions including, but not limited to, actions brought by federal and state authorities and class action cases; new decisions that result in changes in law; and unexpected trial court rulings;
A continued decline in the equity markets causing a reduction in the sales of our subsidiaries’ products; a reduction of asset-based fees that our subsidiaries charge on various investment and insurance products; an acceleration of the net amortization of deferred acquisition costs (“DAC”), value of business acquired (“VOBA”), deferred sales inducements (“DSI”) and deferred front-end loads (“DFEL”); and an increase in liabilities related to guaranteed benefit features of our subsidiaries’ variable annuity products;
Ineffectiveness of our risk management policies and procedures, including various hedging strategies used to offset the effect of changes in the value of liabilities due to changes in the level and volatility of the equity markets and interest rates;
A deviation in actual experience regarding future persistency, mortality, morbidity, interest rates or equity market returns from the assumptions used in pricing our subsidiaries’ products, in establishing related insurance reserves and in the net amortization of DAC, VOBA, DSI and DFEL, which may reduce future earnings;
Changes in accounting principles that may affect our financial statements;
Lowering of one or more of our debt ratings issued by nationally recognized statistical rating organizations and the adverse effect such action may have on our ability to raise capital and on our liquidity and financial condition;
Lowering of one or more of the insurer financial strength ratings of our insurance subsidiaries and the adverse effect such action may have on the premium writings, policy retention, profitability of our insurance subsidiaries and liquidity;
Significant credit, accounting, fraud, corporate governance or other issues that may adversely affect the value of certain financial assets, as well as counterparties to which we are exposed to credit risk, requiring that we realize losses on financial assets;
Inability to protect our intellectual property rights or claims of infringement of the intellectual property rights of others;
Interruption in telecommunication, information technology or other operational systems or failure to safeguard the confidentiality or privacy of sensitive data on such systems from cyberattacks or other breaches of our data security systems;
The effect of acquisitions and divestitures, restructurings, product withdrawals and other unusual items, including the successful implementation of integration strategies or the achievement of anticipated synergies and operational efficiencies related to an acquisition;
The adequacy and collectability of reinsurance that we have purchased;
The continuation of the COVID-19 pandemic, or future outbreaks of COVID-19 or other pandemics, acts of terrorism, war or other man-made and natural catastrophes that may adversely affect our businesses and the cost and availability of reinsurance;
Competitive conditions, including pricing pressures, new product offerings and the emergence of new competitors, that may affect the level of premiums and fees that our subsidiaries can charge for their products;
The unknown effect on our subsidiaries’ businesses resulting from evolving market preferences and the changing demographics of our client base; and
The unanticipated loss of key management, financial planners or wholesalers.
The risks and uncertainties included here are not exhaustive. Our most recent Form 10-K and “Part II – Item 1A. Risk Factors” herein as well as other reports that we file with the SEC include additional factors that could affect our businesses and financial performance. Moreover, we operate in a rapidly changing and competitive environment. New risk factors emerge from time to time, and it is not possible for management to predict all such risk factors.
Further, it is not possible to assess the effect of all risk factors on our businesses or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements. Given these risks and uncertainties, investors should not place undue reliance on forward-looking statements as a prediction of actual results. In addition, we disclaim any obligation to update any forward-looking statements to reflect events or circumstances that occur after the date of this report.
INTRODUCTION
We are a holding company that operates multiple insurance and retirement businesses through subsidiary companies. We sell a wide range of wealth protection, accumulation, retirement income and group protection products and solutions through our four business segments:
Annuities;
Retirement Plan Services;
Life Insurance; and
Group Protection
We also have Other Operations, which includes the financial data for operations that are not directly related to the business segments. See “Part I – Item 1. Business” in our 2019 Form 10-K for a discussion of our business segments and products.
In this report, in addition to providing consolidated revenues and net income (loss), we also provide segment operating revenues and income (loss) from operations because we believe they are meaningful measures of revenues and the profitability of our operating segments. Operating revenues and income (loss) from operations are the financial performance measures we use to evaluate and assess the results of our segments. Accordingly, we define and report operating revenues and income (loss) from operations by segment in Note 15. Our management believes that operating revenues and income (loss) from operations explain the results of our ongoing businesses in a manner that allows for a better understanding of the underlying trends in our current businesses. Certain items are excluded from operating revenue and income (loss) from operations because they are unpredictable and not necessarily indicative of current operating fundamentals or future performance of the business segments, and, in many instances, decisions regarding these items do not necessarily relate to the operations of the individual segments. In addition, we believe that our definitions of operating revenues and income (loss) from operations will provide investors with a more valuable measure of our performance because it better reveals trends in our businesses.
We provide information about our segments’ and Other Operations’ operating revenue and expense line items and realized gain (loss), key drivers of changes and historical details underlying the line items below. For factors that could cause actual results to differ materially from those set forth, see “Forward-Looking Statements – Cautionary Language” above, “Part I – Item 1A. Risk Factors” in our 2019 Form 10-K and “Part II – Item 1A. Risk Factors” herein.
Significant operational matters, industry trends and outlook are described in “Part II – Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Introduction – Executive Summary” of our 2019 Form 10-K, and is further updated by the discussion of the current market conditions that follows.
Current Market Conditions
The COVID-19 pandemic that emerged in the first quarter of 2020 has led to an extreme downturn in and volatility of the capital markets, record-low interest rates and wide-ranging changes in consumer behavior, including as a result of quarantines, shelter-in-place orders and limitations on business activity. The severe restriction in economic activity caused by the COVID-19 pandemic and increased level of unemployment in the United States have contributed to increased volatility and diminished expectations for the economy and markets going forward. As the economic and regulatory environment continues to react and evolve, we cannot yet predict the full impact of the pandemic and ensuing conditions on our business and financial condition. For more information on the expected and potential impacts of the COVID-19 pandemic on our business and financial condition, see “Forward-Looking Statements – Cautionary Language” above and “Part II – Item 1A. Risk Factors.” We expect unfavorable impacts related to, but not limited to, the following areas in 2020:
Mortality and Morbidity
As a result of the impacts of the COVID-19 pandemic, we expect higher mortality in our Life Insurance and Group Protection segments during the remainder of 2020. We also expect increased disability claims and delays in resolving disability claims in our Group Protection segment due to difficulties in obtaining required information or documentation as a result of closure and/or limited operations of businesses and medical offices.
Investment Portfolio
Since the vast majority of our alternative investment portfolio is reported on a one quarter lag, we expect unfavorable investment income on alternative investments in 2020 given the significant decline in equity markets and energy prices. See “Consolidated Investments – Alternative Investments” for additional information on our alternative investment portfolio. In addition, continued weakness in the current environment, including, but not limited to, falling global energy and oil prices that have contributed to destabilization of the energy industry, could lead to increased credit defaults, resulting in additional write-downs of financial assets for impairments in our broader investment portfolio.
Earnings from Account Values
Our Annuities and Retirement Plan Services segments are the most sensitive to the equity markets, as well as, to a lesser extent, our Life Insurance segment. Earnings are affected by equity market movements on account values and the related fees we earn on those assets. The value of the Standard & Poor’s (“S&P”) 500 Index® (“S&P 500”) decreased 20% between December 31, 2019 and March 31, 2020. Variable account values in our Annuities and Retirement Plan Services segments decreased by approximately 10% during the same period. We expect income from operations in our Annuities and Retirement Plan Services segments to be negatively impacted by lower asset-based earnings and expect our net flows to be pressured by these unfavorable equity market conditions as well as potential distribution disruption in the second quarter of 2020.
Low Interest Rate Environment
Because the profitability of our business depends in part on interest rate spreads, interest rate fluctuations can negatively affect our profitability. Changes in interest rates may impact both our profitability from spread businesses and our return on invested capital. In response to the economic impact of the COVID-19 pandemic, the Federal Reserve cut interest rates to near zero in March 2020. We expect the continuation of the low interest rate environment to continue to adversely affect the interest margins of our businesses.
We continue to be proactive in our investment strategies, product designs, crediting rate strategies and overall asset-liability practices
to mitigate the risk of unfavorable consequences in this type of environment, declines in our spread, or instances where the returns on
our general account investments are not enough to support the interest rate guarantees on these products. See “Item 7A. Quantitative and Qualitative Disclosures About Market Risk – Interest Rate Risk” in our 2019 Form 10-K for additional information on interest rate risk.
The MD&A included in our 2019 Form 10-K contains a detailed discussion of our critical accounting policies and estimates. The following information updates the “Critical Accounting Policies and Estimates” provided in our 2019 Form 10-K, and therefore, should be read in conjunction with that disclosure.
DAC, VOBA, DSI and DFEL
Reversion to the Mean
As variable fund returns do not move in a systematic manner, we reset the baseline of account values from which EGPs are projected, which we refer to as our reversion to the mean (“RTM”) process, as discussed in our 2019 Form 10-K.
If we had unlocked our RTM assumption as of March 31, 2020, we would have recorded unfavorable unlocking of approximately $100 million, pre-tax, for our Annuities segment and favorable unlocking of approximately $5 million, pre-tax, for our Life Insurance segment and approximately $1 million, pre-tax, for our Retirement Plan Services segment.
Investments
Investment Valuation
The following summarizes investments on our Consolidated Balance Sheets carried at fair value by pricing source and fair value hierarchy level (in millions) as of March 31, 2020:
Priced by third-party pricing services
599
89,480
90,365
Priced by independent broker quotations
4,106
Priced by matrices
13,426
Priced by other methods (1)
2,781
102,906
7,173
110,678
Percent of total
1%
93%
6%
100%
(1)Represents primarily securities for which pricing models were used to compute fair value.
For more information about the valuation of our financial instruments carried at fair value, see “Part II – Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Introduction – Critical Accounting Policies and Estimates – Investments – Investment Valuation” in our 2019 Form 10-K and Note 14 herein.
Write-Downs for Impairment and Allowance for Credit Losses
As of January 1, 2020, we adopted ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”), which replaced the historical incurred credit loss methodology with an expected credit loss methodology and impacts the way we recognize and measure impairment. See Note 2 for additional information.
We regularly review our fixed maturity AFS securities for declines in fair value that we determine to be an indication of impairment. Realized gains and losses generally originate from asset sales to reposition the portfolio or to respond to product experience. In the process of evaluating whether a security with an unrealized loss reflects declines that are related to credit losses, we consider our ability and intent to sell the security prior to a recovery of value. However, subsequent decisions on securities sales are made within the context of overall risk monitoring, assessing value relative to other comparable securities and overall portfolio maintenance. Although our portfolio managers may, at a given point in time, believe that the preferred course of action is to hold securities with unrealized losses that are considered temporary until such losses are recovered, the dynamic nature of portfolio management may result in a subsequent decision to sell. These subsequent decisions are consistent with the classification of our investment portfolio as AFS. We expect to continue to manage all non-trading investments within our portfolios in a manner that is consistent with the AFS classification.
We consider economic factors and circumstances within industries and countries where recent write-downs have occurred in our assessment of the position of securities we own of similarly situated issuers. While it is possible for realized or unrealized losses on a particular investment to affect other investments, our risk management strategy has been designed to identify correlation risks and other risks inherent in managing an investment portfolio. Once identified, strategies and procedures are developed to effectively monitor and manage these risks. The areas of risk correlation that we pay particular attention to are risks that may be correlated within specific financial and business markets, risks within specific industries and risks associated with related parties. When the detailed analysis by our external asset managers and investment portfolio managers leads us to the conclusion that a security’s decline in fair value is other-than-temporary indicative of an impairment, the security is written down to estimated recovery value. In instances where declines are considered temporary, the security will continue to be carefully monitored.
There are risks and uncertainties associated with determining whether an investment shows indications of impairment. These include subsequent significant changes in general overall economic conditions, as well as specific business conditions affecting particular issuers, future financial market effects such as interest rate spreads, stability of foreign governments and economies, future rating agency actions and significant accounting, fraud or corporate governance issues that may adversely affect certain investments. In addition, there are often significant estimates and assumptions that we use to estimate the fair values of securities as described in “Investment Valuation” above. We continually monitor developments and update underlying assumptions and financial models based upon new information.
For certain securitized fixed maturity AFS securities with contractual cash flows, including asset-backed securities (“ABS”), we use our best estimate of cash flows for the life of the security to determine whether there is an impairment of the security. In addition, we review
for other indicators of impairment as required by the Investments – Debt and Equity Securities Topic of the Financial Accounting Standards Board (“FASB”) Accounting Standards CodificationTM (“ASC”).
Write-downs and allowances on commercial mortgage loans, real estate and other investments are established when the underlying value of the property is deemed to be less than the carrying value. All commercial mortgage loans that are impaired are individually reviewed to determine an appropriate allowance for credit losses (“ACL”). Changing economic conditions affect our valuation of commercial mortgage loans. Increasing vacancies, declining rents and the like are incorporated into the ACL analysis that we perform for monitored loans and may contribute to an increase in the ACL. In addition, we continue to monitor the entire commercial mortgage loan portfolio to identify both current and projected future risk based on reasonable and supportable forecasts. Areas of emphasis include properties that have deteriorating credits or have experienced debt-service coverage and/or loan-to-value reduction. Where warranted, we have increased our ACL based upon this analysis.
We have also established an ACL on our residential mortgage loan portfolio that includes a specific ACL for loans that are deemed to be impaired as well as a general ACL for pools of loans with similar risk characteristics. The ACL for the performing population of loans is based on historical performance for similar loans, as well as projected future losses based on modeling, which includes reasonable and supportable forecasts. The historical data utilized in the ACL calculation process is adjusted for current economic conditions.
Amortization of DAC, VOBA, DSI and DFEL and changes in other contract holder funds reflect an assumption for an expected level of credit-related investment losses. When actual credit-related investment losses are realized, we recognize a true-up to our DAC, VOBA, DSI and DFEL amortization and changes in other contract holder funds within realized losses reflecting the incremental effect of actual versus expected credit-related investment losses. These actual to expected amortization adjustments could create volatility in net realized gains and losses.
Derivatives
Our accounting policies for derivatives and the potential effect on interest spreads in a falling rate environment are discussed in Note 5 of this report and “Part II – Item 7A. Quantitative and Qualitative Disclosures About Market Risk” in our 2019 Form 10-K.
Guaranteed Living Benefits
Within our individual annuity business, 63% and 64% of our variable annuity account values contained GLB features as of March 31, 2020 and 2019, respectively. Underperforming equity markets increase our exposure to potential benefits with the GLB features. A contract with a GLB feature is “in the money” if the contract holder’s account balance falls below the present value of guaranteed withdrawal or income benefits, assuming no lapses. As of March 31, 2020 and 2019, 40% and 14%, respectively, of all in-force contracts with a GLB feature were “in the money,” and our exposure, after reinsurance, as of March 31, 2020 and 2019, was $2.5 billion and $758 million, respectively. However, the only way the contract holder can realize the excess of the present value of benefits over the account value of the contract is through a series of withdrawals or income payments that do not exceed a maximum amount. If, after the series of withdrawals or income payments, the account value is exhausted, the contract holder will continue to receive a series of annuity payments. The account value can also fluctuate with equity market returns on a daily basis resulting in increases or decreases in the excess of the present value of benefits over account value.
For information on our variable annuity hedge program performance, see our discussion in “Realized Gain (Loss) and Benefit Ratio Unlocking – Variable Annuity Net Derivatives Results” below.
For information on our estimates of the potential instantaneous effect to net income (loss) that could result from sudden changes that may occur in equity markets, interest rates and implied market volatilities, see our discussion in “Part II – Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Introduction – Critical Accounting Policies and Estimates – Derivatives – GLB” in our 2019 Form 10-K.
For information about acquisitions and dispositions, see Note 3 in our 2019 Form 10-K.
RESULTS OF CONSOLIDATED OPERATIONS
Details underlying the consolidated results, deposits, net flows and account values (in millions) were as follows:
Deposits
3,508
2,779
2,496
1,450
1,537
Total deposits
7,926
7,541
Net Flows
528
492
671
(381
963
1,020
Total net flows
2,162
1,131
Account Values
125,897
130,458
69,636
71,799
51,475
51,120
Total account values
247,008
253,377
Comparison of the Three Months Ended March 31, 2020 to 2019
Net income decreased due primarily to the following:
Higher benefits driven by a decline in equity market performance and growth in business in force.
Higher total loss ratio in our Group Protection segment.
Spread compression due to average new money rates trailing our current portfolio yields, partially offset by actions implemented to reduce interest crediting rates.
The decrease in net income was partially offset by the following:
Lower realized losses.
Higher investment income on alternative investments.
Growth in average account values, business in force and group earned premiums.
Lower deferred compensation plan expense and other expense efficiencies.
Federal income tax benefit in 2020 as compared to expense in 2019.
See “Introduction – Executive Summary” and “Part II – Item 1A. Risk Factors” for a discussion on the volatility in the capital markets in the first quarter of 2020 and the expected and potential impacts of the COVID-19 pandemic.
RESULTS OF ANNUITIES
Income (Loss) from Operations
Details underlying the results for Annuities (in millions) were as follows:
Operating Revenues
Insurance premiums (1)
53
593
568
326
257
Operating realized gain (loss) (2)
Amortization of deferred gain on
business sold through reinsurance
Other revenues (3)
Total operating revenues
Operating Expenses
192
Benefits (1)
284
Total operating expenses
827
887
Income (loss) from operations before taxes
287
Income (loss) from operations
(1)Insurance premiums include primarily our income annuities that have a corresponding offset in benefits. Benefits include changes in income annuity reserves driven by premiums.
(2)See “Realized Gain (Loss) and Benefit Ratio Unlocking” below.
(3)Consists primarily of revenues attributable to broker-dealer services that are subject to market volatility.
Income from operations for this segment increased due primarily to the following:
Higher net investment income, net of interest credited, driven by higher average gross fixed account values and higher investment income on alternative investments within our surplus portfolio.
Higher fee income driven by higher average daily variable account values.
The increase in income from operations was partially offset by the following:
Higher benefits, net of changes in income annuity reserves, due to an increase in the growth in benefit reserves driven primarily by lower equity market performance as of March 31, 2020, as compared to higher equity market performance as of March 31, 2019.
Higher commissions and other expenses driven by an increase in amortization expense as a result of higher actual gross profits, and higher average account values resulting in higher trail commissions.
Additional Information
Due to the equity market decline as a result of the impacts of the COVID-19 pandemic, our end-of-period variable account values decreased 9% from March 31, 2019. We expect declines in average variable account values in the second quarter of 2020. For more information on the expected and potential impacts to our business, see “Introduction – Executive Summary” above and “Part II – Item 1A. Risk Factors.”
New deposits are an important component of net flows and key to our efforts to grow our business. Although deposits do not significantly affect current period income from operations, they can significantly impact future income from operations.
The other component of net flows relates to the retention of the business. An important measure of retention is the reduction in account values caused by full surrenders, deaths and other contract benefits. These outflows as a percentage of average gross account values were 8% for the three months ended March 31, 2020 and 2019.
Our fixed annuity business includes products with discretionary crediting rates that are reset on an annual basis and are not subject to surrender charges. Our ability to retain annual reset annuities will be subject to current competitive conditions at the time interest rates for these products reset. We expect to manage the effects of spreads on near-term income from operations through portfolio management and, to a lesser extent, crediting rate actions, which assumes no significant changes in net flows into or out of our fixed accounts or other changes that may cause interest rate spreads to differ from our expectations. For information on interest rate spreads and interest rate risk, see “Part II – Item 7A. Quantitative and Qualitative Disclosures About Market Risk – Interest Rate Risk – Interest Rate Risk on Fixed Insurance Businesses – Falling Rates” and “Part I – Item 1A. Risk Factors – Market Conditions – Changes in interest rates and sustained low interest rates may cause interest rate spreads to decrease and make it more challenging to meet certain statutory requirements and changes in interest rates may also result in increased contract withdrawals” in our 2019 Form 10-K.
Fee Income
Details underlying fee income, account values and net flows (in millions) were as follows:
Mortality, expense and other assessments
588
Surrender charges
DFEL:
Deferrals
Amortization, net of interest
Total fee income
As of or For the Three
Variable Account Value Information
Variable annuity deposits (1)
982
Increases (decreases) in variable annuity
account values:
Net flows (1)
(1,145
(1,363
Change in market value (1)
(15,397
8,931
Contract holder assessments (1)
(631
(600
Transfers to the variable portion
of variable annuity products
from the fixed portion of
variable annuity products
577
Variable annuity account values (1)
102,136
112,284
Average daily variable annuity account
values (1)
114,434
109,778
Average daily S&P 500 (2)
3,068
2,719
(1)Excludes the fixed portion of variable.
(2)We generally use the S&P 500 as a benchmark for the performance of our variable account values. The account values of our variable annuity contracts are invested by our policyholders in a variety of investment options including, but not limited to, domestic and international equity securities and fixed income, which do not necessarily align with S&P 500 performance. See Note 8 for additional information.
We charge contract holders mortality and expense assessments on variable annuity accounts to cover insurance and administrative expenses. These assessments are a function of the rates priced into the product and the average daily variable account values. Average daily variable account values are driven by net flows and variable fund returns. Charges on GLB riders are assessed based on a
contractual rate that is applied either to the account value or the guaranteed amount. We may collect surrender charges when our fixed and variable annuity contract holders surrender their contracts during the surrender charge period to protect us from premature withdrawals. Fee income includes charges on both our variable and fixed annuity products, but excludes the attributed fees on our GLB riders; see “Part II – Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Realized Gain (Loss) and Benefit Ratio Unlocking – Operating Realized Gain (Loss)” in our 2019 Form 10-K for discussion of these attributed fees.
Net Investment Income and Interest Credited
Details underlying net investment income, interest credited, our interest rate spread and fixed account values (dollars in millions) were as follows:
Net Investment Income
Fixed maturity AFS securities,
mortgage loans on real estate and
other, net of investment expenses
290
228
Commercial mortgage loan prepayment and
bond make-whole premiums (1)
Surplus investments (2)
Total net investment income
Interest Credited
Amount provided to contract holders
189
164
DSI deferrals
Interest credited before DSI amortization
155
DSI amortization
Total interest credited
(1)See “Consolidated Investments – Commercial Mortgage Loan Prepayment and Bond Make-Whole Premiums” below for additional information.
(2)Represents net investment income on the required statutory surplus for this segment and includes the effect of investment income on alternative investments for such assets that are held in the portfolios supporting statutory surplus versus the portfolios supporting product liabilities. See “Consolidated Investments – Alternative Investments” below for more information on alternative investments.
Interest Rate Spread
3.73%
3.97%
bond make-whole premiums
0.03%
0.05%
Net investment income yield on reserves
3.76%
4.02%
Interest rate credited to contract holders
2.31%
2.41%
Interest rate spread
1.45%
1.61%
Fixed Account Value Information
Fixed annuity deposits (1)
2,291
2,526
Increases (decreases) in fixed annuity
1,673
1,855
Transfers from the fixed portion
of variable annuity products to
the variable portion of variable
annuity products
(263
(577
Reinvested interest credited (1)
(923
428
Fixed annuity account values (1)(2)
23,761
18,174
Average fixed account values (1)(2)
23,488
17,407
(1)Includes the fixed portion of variable.
(2)Net of reinsurance ceded.
A portion of our investment income earned is credited to the contract holders of our deferred fixed annuity products, including the fixed portion of variable annuity contracts. We expect to earn a spread between what we earn on the underlying general account investments supporting the fixed annuity product line, including the fixed portion of variable annuity contracts, and what we credit to our fixed annuity contract holders’ accounts, including the fixed portion of variable annuity contracts. Changes in commercial mortgage loan prepayments and bond make-whole premiums, investment income on alternative investments and surplus investment income can vary significantly from period to period due to a number of factors and, therefore, may contribute to investment income results that are not indicative of the underlying trends.
Benefits for this segment include changes in income annuity reserves driven by premiums, changes in benefit reserves and costs associated with the hedging of our benefit ratio unlocking on benefit reserves associated with our variable annuity guaranteed death benefit and GLB riders. For a corresponding offset of changes in income annuity reserves, see footnote 1 of “Income (Loss) from Operations” above.
Commissions and Other Expenses
Details underlying commissions and other expenses (in millions) were as follows:
Commissions:
Deferrable
Non-deferrable
136
General and administrative expenses
111
104
Inter-segment reimbursement associated
with reserve financing and
LOC expenses (1)
Taxes, licenses and fees
Total expenses incurred, excluding
broker-dealer
433
385
DAC deferrals
(191
(147
Total pre-broker-dealer expenses
incurred, excluding amortization,
net of interest
238
DAC and VOBA amortization,
Broker-dealer expenses incurred
128
Total commissions and other
expenses
DAC Deferrals
As a percentage of sales/deposits
5.2%
4.2%
(1)Includes reimbursements to Annuities from the Life Insurance segment for reserve financing, net of expenses incurred by Annuities for its use of letters of credit (“LOCs”). The inter-segment amounts are not reported on our Consolidated Statements of Comprehensive Income (Loss).
Commissions and other costs that result directly from and are essential to the successful acquisition of new or renewal business are deferred to the extent recoverable and are amortized over the lives of the contracts in relation to EGPs. Certain types of commissions, such as trail commissions that are based on account values, are expensed as incurred rather than deferred and amortized. Broker-dealer expenses that vary with and are related to sales are expensed as incurred and not deferred and amortized. Fluctuations in these expenses correspond with fluctuations in other revenues.
RESULTS OF RETIREMENT PLAN SERVICES
Details underlying the results for Retirement Plan Services (in millions) were as follows:
226
Other revenues (1)
145
105
(1)Consists primarily of mutual fund account program revenues from mid to large employers.
Income from operations for this segment increased modestly due primarily to lower commissions and other expenses driven by lower incentive compensation as a result of production performance and expense efficiencies. The increase in income from operations was partially offset by lower net investment income, net of interest credited, driven by spread compression due to average new money rates trailing our current portfolio yields, partially offset by higher investment income on alternative investments within our surplus portfolio and higher fixed account values.
Due to the equity market decline as a result of the impacts of the COVID-19 pandemic, our end of period variable account values decreased 13% from March 31, 2019. We expect declines in average variable account values in the second quarter of 2020. For more information on the expected and potential impacts to our business, see “Introduction – Executive Summary” above and “Part II – Item 1A. Risk Factors.”
Net flows in this business fluctuate based on the timing of larger plans being implemented and terminating over the course of the year.
New deposits are an important component of net flows and key to our efforts to grow our business. Although deposits do not significantly affect current period income from operations, they can significantly impact future income from operations. The other component of net flows relates to the retention of the business. An important measure of retention is the reduction in account values caused by plan sponsor terminations and participant withdrawals. These outflows as a percentage of average account values were 11% and 16% for the three months ended March 31, 2020 and 2019, respectively.
Our net flows are negatively affected by the continued net outflows from our oldest blocks of annuities business (as presented on our Net Flows By Market table below as “Multi-Fund® and other”), which are among our higher margin product lines in this segment, due to the fact that they are mature blocks with low distribution and servicing costs. The proportion of these products to our total account values was 21% and 23% as of March 31, 2020 and 2019, respectively. Due to this expected overall shift in business mix toward products with lower returns, new deposit production continues to be necessary to maintain earnings at current levels.
Our fixed annuity business includes products with discretionary and index-based crediting rates that are reset on either a quarterly or semi-annual basis. Our ability to retain quarterly or semi-annual reset annuities will be subject to current competitive conditions at the time interest rates for these products reset. We expect to manage the effects of spreads on near-term income from operations through portfolio management and, to a lesser extent, crediting rate actions, which assumes no significant changes in net flows into or out of our fixed accounts or other changes that may cause interest rate spreads to differ from our expectations. For information on interest rate spreads and interest rate risk, see “Item 7A. Quantitative and Qualitative Disclosures About Market Risk – Interest Rate Risk – Interest Rate Risk on Fixed Insurance Businesses – Falling Rates” and “Part I – Item 1A. Risk Factors – Market Conditions – Changes in interest rates and sustained low interest rates may cause interest rate spreads to decrease and make it more challenging to meet certain statutory requirements and changes in interest rates may also result in increased contract withdrawals” in our 2019 Form 10-K.
Details underlying fee income, net flows and account values (in millions) were as follows:
\
Annuity expense assessments
Mutual fund fees
Net Flows By Market
Small market
Mid – large market
790
(283
Multi-Fund® and other
(260
525
458
(130
(2,974
1,640
(40
13,726
15,820
16,068
15,393
Average daily S&P 500
Mutual Fund Account Value Information
Mutual fund deposits
1,645
1,580
Mutual fund net flows
(189
Mutual fund account values (1)
34,575
36,065
(1)Mutual funds are not included in the separate accounts reported on our Consolidated Balance Sheets as we do not have any ownership interest in them.
We charge expense assessments to cover insurance and administrative expenses. Expense assessments are generally equal to a percentage of the daily variable account values. Average daily account values are driven by net flows and the equity markets. Our expense assessments include fees we earn for the services that we provide to our mutual fund programs. We may collect surrender charges when our fixed and variable annuity contract holders surrender their contracts during the surrender charge period to protect us from premature withdrawals.
3.95%
4.18%
4.00%
4.23%
2.87%
2.92%
1.13%
1.31%
609
44
Fixed annuity account values (1)
21,335
19,914
Average fixed account values (1)
20,809
19,841
A portion of our investment income earned is credited to the contract holders of our fixed annuity products, including the fixed portion of variable annuity contracts. We expect to earn a spread between what we earn on the underlying general account investments
supporting the fixed annuity product line, including the fixed portion of variable annuity contracts, and what we credit to our fixed annuity contract holders’ accounts, including the fixed portion of variable annuity contracts. Commercial mortgage loan prepayments and bond make-whole premiums, investment income on alternative investments and surplus investment income can vary significantly from period to period due to a number of factors and, therefore, may contribute to investment income results that are not indicative of the underlying trends.
Total expenses incurred
101
Total expenses recognized before
amortization
As a percentage of annuity sales/deposits
0.5%
Commissions and other costs that result directly from and are essential to the successful acquisition of new or renewal business are deferred to the extent recoverable and are amortized over the lives of the contracts in relation to EGPs. Certain types of commissions, such as trail commissions that are based on account values, are expensed as incurred rather than deferred and amortized. Distribution expenses associated with the sale of mutual fund products are expensed as incurred.
RESULTS OF LIFE INSURANCE
Details underlying the results for Life Insurance (in millions) were as follows:
224
213
893
844
697
643
371
354
954
249
1,612
1,505
209
195
(1)Includes term insurance premiums, which have a corresponding partial offset in benefits for changes in reserves.
Higher fee income due to growth in business in force.
Higher net investment income, net of interest credited, driven by higher investment income on alternative investments, partially offset by spread compression due to average new money rates trailing our current portfolio yields.
Higher benefits due to growth in business in force.
Higher commissions and other expenses driven by higher amortization rates, partially offset by expense efficiencies.
Strategies to Address Statutory Reserve Strain
Our insurance subsidiaries have statutory surplus and risk-based capital (“RBC”) levels above current regulatory required levels. Term products and other products containing secondary guarantees require reserves calculated pursuant to the Valuation of Life Insurance Policies Model Regulation (“XXX”), Actuarial Guideline 38 (“AG38”) and the newly adopted principles-based reserving framework. For information on strategies we use to reduce the statutory reserve strain, see “Review of Consolidated Financial Condition – Liquidity and Capital Resources – Sources of Liquidity and Cash Flow – Insurance Subsidiaries’ Statutory Capital and Surplus” below.
We expect higher mortality and lower investment income on alternative investments in 2020 as a result of the impacts of the COVID-19 pandemic. For more information on the expected and potential impacts to our business, see “Introduction – Executive Summary” above and “Part II – Item 1A. Risk Factors.”
For information on interest rate spreads and interest rate risk, see “Part II – Item 7A. Quantitative and Qualitative Disclosures About Market Risk – Interest Rate Risk – Interest Rate Risk on Fixed Insurance Businesses – Falling Rates” and “Part I – Item 1A. Risk Factors – Market Conditions – Changes in interest rates and sustained low interest rates may cause interest rate spreads to decrease and make it more challenging to meet certain statutory requirements and changes in interest rates may also result in increased contract withdrawals” in our 2019 Form 10-K.
Insurance Premiums
Insurance premiums relate to traditional products and are a function of the rates priced into the product and the level of business in force. Business in force, in turn, is driven by sales, persistency and mortality experience.
Details underlying fee income, sales, net flows, account values and in-force face amount (in millions) were as follows:
Cost of insurance assessments
591
565
Expense assessments
372
376
(232
(214
Amortization, net of interest:
Sales by Product
UL
MoneyGuard®
IUL
21
VUL
Term
Total individual life sales
Executive Benefits
Total sales
169
Withdrawals and deaths
(487
(517
Net flows
Contract Holder Assessments
1,279
1,236
General account
37,405
36,606
Separate account
14,070
14,514
Average General Account Values
37,802
37,003
In-Force Face Amount
UL and other
356,889
346,292
Term insurance
486,311
416,789
Total in-force face amount
843,200
763,081
Fee income relates only to interest-sensitive products and includes cost of insurance assessments, expense assessments and surrender charges. Both cost of insurance and expense assessments can have deferrals and amortization related to DFEL. Cost of insurance and expense assessments are deducted from our contract holders’ account values. These amounts are a function of the rates priced into the product and premiums received, face amount in force and account values. Business in force, in turn, is driven by sales, persistency and mortality experience.
Sales are not recorded as a component of revenues (other than for traditional products) and do not have a significant effect on current quarter income from operations but are indicators of future profitability. Generally, we have higher sales during the second half of the year with the fourth quarter being our strongest.
Sales in the table above and as discussed above were reported as follows:
MoneyGuard®, our linked-benefit product – 15% of total expected premium deposits;
UL, IUL and variable universal life insurance (“VUL”) – first-year commissionable premiums plus 5% of excess premiums received;
Executive Benefits – single premium bank-owned UL and VUL, 15% of single premium deposits, and corporate-owned UL and VUL, first-year commissionable premiums plus 5% of excess premium received; and
Term – 100% of annualized first-year premiums.
We monitor the business environment, including but not limited to the regulatory and interest rate environments, and make changes to our product offerings and in-force products as needed, and as permitted under the terms of the policies, to sustain the future profitability of our segment.
Details underlying net investment income, interest credited (in millions) and our interest rate spread were as follows:
601
Commercial mortgage loan prepayment
and bond make-whole premiums (1)
Alternative investments (2)
Surplus investments (3)
(2)See “Consolidated Investments – Alternative Investments” below for additional information.
(3)Represents net investment income on the required statutory surplus for this segment and includes the effect of investment income on alternative investments for such assets that are held in the portfolios supporting statutory surplus versus the portfolios supporting product liabilities.
Interest Rate Yields and Spread
Attributable to interest-sensitive products:
4.77%
4.85%
and bond make-whole premiums
Alternative investments
0.28%
0.01%
5.08%
4.91%
3.80%
3.69%
1.28%
1.22%
A portion of the investment income earned for this segment is credited to contract holder accounts. Statutory reserves will typically grow at a faster rate than account values because of the AG38 reserve requirements. Investments allocated to this segment are based upon the statutory reserve liabilities and are affected by various reserve adjustments, including financing transactions providing relief from AG38 reserve requirements. These financing transactions lead to a transfer of investments from this segment to Other Operations. We expect
to earn a spread between what we earn on the underlying general account investments and what we credit to our contract holders’ accounts. We use our investment income to offset the earnings effect of the associated growth of our policy reserves for traditional products. Commercial mortgage loan prepayments and bond make-whole premiums and investment income on alternative investments can vary significantly from period to period due to a number of factors, and, therefore, may contribute to investment income results that are not indicative of the underlying trends.
Details underlying benefits (dollars in millions) were as follows:
Death claims direct and assumed
1,351
1,166
Death claims ceded
(513
(427
Reserves released on death
(218
Net death benefits
620
573
Change in secondary guarantee life
insurance product reserves
Change in MoneyGuard® reserves
Other benefits (1)
66
Total benefits
Death claims per $1,000 of in-force
2.96
3.04
(1)Includes primarily changes in reserves and dividends on traditional and other products.
Benefits for this segment include claims incurred during the period in excess of the associated reserves for its interest-sensitive and traditional products. In addition, benefits include the change in secondary guarantee and linked-benefit life insurance product reserves. These reserves are affected by changes in expected future trends of assessments and benefits causing unlocking adjustments to these liabilities similar to DAC, VOBA and DFEL. Generally, we have higher mortality in the first quarter of the year due to the seasonality of claims. See “Future Contract Benefits and Other Contract Holder Funds” in Note 1 of our 2019 Form 10-K for additional information.
Commissions
186
Expenses associated with reserve financing
400
398
DAC and VOBA deferrals
(216
(220
Other intangible amortization
Total commissions and
other expenses
DAC and VOBA Deferrals
As a percentage of sales
127.8%
115.2%
Commissions and costs that result directly from and are essential to successful acquisition of new or renewal business are deferred to the extent recoverable and for our interest-sensitive products are generally amortized over the life of the contracts in relation to EGPs. For our traditional products, DAC and VOBA are amortized on either a straight-line basis or as a level percent of premium of the related
contracts, depending on the block of business. When comparing DAC and VOBA deferrals as a percentage of sales for the three months ended March 31, 2020, to the corresponding period in 2019, the increase was primarily a result of changes in sales mix to products with higher commission rates.
RESULTS OF GROUP PROTECTION
Details underlying the results for Group Protection (in millions) were as follows:
1,094
1,023
81
862
753
314
1,068
(1)Consists of revenue from third parties for administrative services performed, which has a corresponding partial offset in commissions and other expenses. In the first quarter of 2020, we recaptured certain disability business that was originally ceded to a third-party reinsurer, which has a corresponding offset in benefits.
Income (Loss) from Operations by
Product Line
Life
Disability
Dental
Income from operations for this segment decreased due primarily to higher benefits driven by unfavorable mortality and life waiver experience in our life business, and higher incidence and new claims severity in our disability business.
The decrease in income from operations was partially offset by the following:
Higher insurance premiums due to favorable persistency experience.
Lower commissions and other expenses driven by lower commission rates as a result of changes in our business mix to products with lower commission rates, expense efficiencies and lower incentive compensation as a result of production performance.
Higher net investment income, net of interest credited, driven by higher investment income on alternative investments within our surplus portfolio.
We expect unfavorable loss ratios in our life and disability businesses in 2020 as a result of the impacts of the COVID-19 pandemic. For more information on the expected and potential impacts to our business, see “Introduction – Executive Summary” above and “Part II – Item 1A. Risk Factors.”
For information about the effect of the loss ratio sensitivity on our income (loss) from operations, see “Part II – Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Results of Group Protection – Additional Information” in our 2019 Form 10-K.
For information on the effects of current interest rates on our long-term disability claim reserves, see “Item 7A. Quantitative and Qualitative Disclosures About Market Risk – Interest Rate Risk – Effect of Interest Rate Sensitivity” in our 2019 Form 10-K.
Details underlying insurance premiums (in millions) were as follows:
Insurance Premiums by Product Line
412
Total insurance premiums
Sales by Product Line
Our cost of insurance and policy administration charges are embedded in the premiums charged to our customers. The premiums are a function of the rates priced into the product and our business in force. Business in force, in turn, is driven by sales and persistency experience.
Sales relate to new contract holders and new programs sold to existing contract holders. We believe that the trend in sales is an important indicator of development of business in force over time. Sales in the table above are the combined annualized premiums for our products.
We use our investment income to offset the earnings effect of the associated build of our reserves, which are a function of our insurance premiums and the yields on our investments.
Benefits and Interest Credited
Details underlying benefits and interest credited (in millions) and loss ratios by product line were as follows:
Benefits and Interest Credited by
265
485
Total benefits and interest credited
864
754
Loss Ratios by Product Line
79.4%
71.4%
78.3%
75.4%
74.6%
72.2%
78.5%
73.7%
Generally, we experience higher mortality in the first quarter of the year and higher disability claims in the fourth quarter of the year due to the seasonality of claims. The total loss ratio for the three months ended March 31, 2020, was driven by unfavorable mortality and life waiver experience in our life business, and higher incidence and new claims severity in our disability business.
168
173
295
272
DAC and VOBA amortization, net of
interest
As a percentage of insurance premiums
1.7%
2.2%
Commissions and other costs that result directly from and are essential to the successful acquisition of new or renewal business are deferred to the extent recoverable and are amortized as a level percent of insurance premiums of the related contracts, depending on the block of business. Certain broker commissions that vary with and are related to paid premiums are expensed as incurred rather than deferred and amortized. Generally, we have higher amortization in the first quarter of the year due to a significant number of policies renewing in the quarter.
RESULTS OF OTHER OPERATIONS
Details underlying the results for Other Operations (in millions) were as follows:
Other expenses
86
(88
(28
(1)Includes our disability income business, which has a corresponding offset in benefits for changes in reserves.
Loss from operations for Other Operations decreased due primarily to the following:
Lower other expenses attributable to the effect of changes in our stock price on liabilities related to our deferred compensation plans, as our stock price decreased significantly during the first quarter of 2020, compared to a significant increase during the first quarter of 2019.
The decrease in loss from operations was partially offset by the following:
Lower other revenues due to the effect of market fluctuations on certain assets held as part of compensation arrangements, which decreased during the first quarter of 2020, compared to an increase during the first quarter of 2019.
Less favorable income tax benefits driven by lower excess tax benefits associated with stock-based compensation and unfavorable market impacts on tax preferred investment income.
Lower net investment income, net of interest credited, related to lower allocated investments driven by a decline in excess capital retained by Other Operations.
For information on our strategic digitization initiative, see “Part II – Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Introduction – Executive Summary – Significant Operational Matters – Strategic Digitization Initiative” in our 2019 Form 10-K.
We utilize an internal formula to determine the amount of capital that is allocated to our business segments. Investment income on capital in excess of the calculated amounts is reported in Other Operations. If our business segments require increases in statutory reserves, surplus or investments, the amount of excess capital that is retained by Other Operations would decrease and net investment income would be negatively affected.
Write-downs for impairments decrease the recorded value of investments owned by the business segments. These write-downs are not included in the income from operations of our business segments. When impairment occurs, assets are transferred to the business segments’ portfolios and will reduce the future net investment income for Other Operations. Statutory reserve adjustments for our business segments can also cause allocations of investments between the business segments and Other Operations.
The majority of our interest credited relates to our reinsurance operations sold to Swiss Re Life & Health America, Inc. (“Swiss Re”) in 2001. A substantial amount of the business was sold through indemnity reinsurance transactions, which is still recorded in our consolidated financial statements. The interest credited corresponds to investment income earnings on the assets we continue to hold for this business. There is no effect to income or loss in Other Operations or on a consolidated basis for these amounts because interest earned on the blocks that continue to be reinsured is passed through to Swiss Re in the form of interest credited.
Benefits are recognized when incurred for institutional pension products and disability income business.
Other Expenses
Details underlying other expenses (in millions) were as follows:
General and administrative expenses:
Branding
Total general and administrative expenses
Taxes, licenses and fees (2)
LOC expenses (3)
Total other expenses
(1)Includes expenses that are corporate in nature including charitable contributions, the portion of our deferred compensation plan expense attributable to participants’ selection of LNC stock as the measure for their investment return and other expenses not allocated to our business segments.
(2)Includes state guaranty funds assessments to cover losses to contract holders of insolvent or rehabilitated insurance companies. Mandatory assessments may be partially recovered through a reduction in future premium taxes in some states.
(3)Consists of reimbursements to Other Operations from the Life Insurance segment for the use of proceeds from certain issuances of senior notes that were used as long-term structured solutions, net of expenses incurred by Other Operations for its use of LOCs.
Interest and Debt Expense
Our current level of interest expense may not be indicative of the future due to, among other things, the timing of the use of cash, the availability of funds from our inter-company cash management program and the future cost of capital. For additional information on our financing activities, see “Review of Consolidated Financial Condition – Liquidity and Capital Resources – Sources of Liquidity and Cash Flow – Financing Activities” below.
REALIZED GAIN (LOSS) AND BENEFIT RATIO UNLOCKING
Details underlying realized gain (loss), after-DAC (1) and benefit ratio unlocking (in millions) were as follows:
Components of Realized Gain (Loss), Pre-Tax
Total operating realized gain (loss)
Total excluded realized gain (loss)
Total realized gain (loss), pre-tax
Reconciliation of Excluded Realized Gain (Loss)
Net of Benefit Ratio Unlocking, After-Tax
Benefit ratio unlocking
Excluded realized gain (loss) net of benefit
ratio unlocking, after-tax
(409
Components of Excluded Realized Gain (Loss)
Realized gain (loss) related to certain financial assets
(68
Gain (loss) on the mark-to-market on certain instruments (2)
Variable annuity net derivatives results:
Hedge program performance, including unlocking
for GLB reserves hedged
(496
GLB NPR component
Total variable annuity net derivatives results
(42
Indexed annuity forward-starting option
(30
(1)DAC refers to the associated amortization of DAC, VOBA, DSI and DFEL and changes in other contract holder funds and funds withheld reinsurance assets and liabilities.
(2)The modified coinsurance (“Modco”) investment portfolio includes fixed maturity securities classified as AFS with changes in fair value recorded in OCI. Since the corresponding and offsetting changes in fair value of the embedded derivatives related to the Modco investment portfolio are recorded in realized gain (loss), volatility can occur within net income (loss).
We had higher realized losses due primarily to the following:
Unfavorable variable annuity net derivatives results attributable to unfavorable hedge program performance due to significantly higher volatility in capital markets, partially offset by favorable GLB NPR component due to our associated reserves increasing and a widening of our credit spread. For more information on market volatility during the quarter, see “Introduction – Executive Summary” above.
Higher realized losses related to certain financial assets due to an increase in our allowance for credit losses as a result of the adoption of ASU 2016-13.
The higher realized losses were partially offset by gains on the mark-to-market on certain instruments due primarily to favorable changes in the fair value of embedded derivatives related to certain Modco arrangements.
The above components of excluded realized gain (loss) are described net of benefit ratio unlocking, after-tax.
Operating Realized Gain (Loss)
See “Part II – Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Realized Gain (Loss) and Benefit Ratio Unlocking – Operating Realized Gain (Loss)” in our 2019 Form 10-K for a discussion of our operating realized gain (loss).
Realized Gain (Loss) Related to Certain Financial Assets
See “Part II – Item 7. Management’s Narrative Analysis of the Results of Operations – Realized Gain (Loss) – Realized Gain (Loss) Related to Certain Investments” in our 2019 Form 10-K for a discussion of our realized gain (loss) related to certain financial assets. For additional information on realized gain (loss) related to certain financial assets, see Note 13.
Gain (Loss) on the Mark-to-Market on Certain Instruments
See “Part II – Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Realized Gain (Loss) and Benefit Ratio Unlocking – Gain (Loss) on the Mark-to-Market on Certain Instruments” in our 2019 Form 10-K for a discussion of the mark-to-market on certain instruments. We also recognize the mark-to-market on certain commercial mortgage loans on real estate for which we have elected the fair value option. See Note 14 for additional information.
Variable Annuity Net Derivatives Results
See “Part II – Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Realized Gain (Loss) and Benefit Ratio Unlocking – Variable Annuity Net Derivatives Results” in our 2019 Form 10-K for a discussion of our variable annuity net derivatives results and how our NPR adjustment is determined.
Details underlying our variable annuity hedging program (dollars in millions) were as follows:
September 30,
June 30,
Variable annuity hedge program assets (liabilities)
6,529
1,998
3,292
2,418
1,967
Variable annuity reserves – asset (liability):
Embedded derivative reserves, pre-NPR (1)
(3,968
(568
211
578
NPR
(120
(101
(98
Embedded derivative reserves
(3,869
(605
480
Insurance benefit reserves
(1,525
(958
(1,026
(911
(916
Total variable annuity reserves – asset (liability)
(5,394
(1,631
(801
(436
10-year credit default swap ("CDS") spread
1.56%
1.14%
1.36%
1.17%
1.43%
NPR factor related to 10-year CDS spread
0.22%
0.13%
0.19%
0.15%
0.18%
(1)Embedded derivative reserves in an asset (liability) position indicate that we estimate the present value of future benefits to be less (greater) than the present value of future net valuation premiums.
For information about the effect of changes in the NPR factor on our net income (loss), see “Part II – Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Realized Gain (Loss) and Benefit Ratio Unlocking – Variable Annuity Net Derivatives Results” in our 2019 Form 10-K.
See “Critical Accounting Policies and Estimates – Derivatives – GLB” above for additional information about our guaranteed benefits.
Indexed Annuity Forward-Starting Option
See “Part II – Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Realized Gain (Loss) and Benefit Ratio Unlocking – Indexed Annuity Forward-Starting Option” in our 2019 Form 10-K for a discussion of our indexed annuity forward-starting option.
CONSOLIDATED INVESTMENTS
Details underlying our consolidated investment balances (in millions) were as follows:
Percentage of
Total Investments
75.9%
78.7%
3.0%
3.5%
0.1%
12.4%
12.2%
Real estate
1.9%
1.8%
3.3%
1.4%
1,841
1.3%
2,913
1,162
2.1%
0.9%
Investment Objective
Investments are an integral part of our operations. We follow a balanced approach to investing for both current income and prudent risk management, with an emphasis on generating sufficient current income, net of income tax, to meet our obligations to customers, as well as other general liabilities. This balanced approach requires the evaluation of expected return and risk of each asset class utilized, while still meeting our income objectives. This approach is important to our asset-liability management because decisions can be made based upon both the economic and current investment income considerations affecting assets and liabilities. For a discussion of our risk management process, see “Part II – Item 7A. Quantitative and Qualitative Disclosures About Market Risk” in our 2019 Form 10-K.
Investment Portfolio Composition and Diversification
Fundamental to our investment policy is diversification across asset classes. Our investment portfolio, excluding cash and invested cash, is composed of fixed maturity securities, mortgage loans on real estate, real estate (either wholly-owned or in joint ventures) and other long-term investments. We purchase investments for our segmented portfolios that have yield, duration and other characteristics that take into account the liabilities of the products being supported.
We have the ability to maintain our investment holdings throughout credit cycles because of our capital position, the long-term nature of our liabilities and the matching of our portfolios of investment assets with the liabilities of our various products.
Fixed Maturity and Equity Securities Portfolios
In 2020, we adopted ASU 2016-13, which resulted in a new recognition and measurement of credit losses on most financial assets. See Note 2 for additional information. Fixed maturity securities consist of portfolios classified as available-for-sale (“AFS”) and trading. Details underlying our fixed maturity AFS securities by industry classification (in millions) are presented in the tables below. These tables agree in total with the presentation of fixed maturity AFS securities in Note 4; however, the categories below represent a more detailed breakout of the fixed maturity AFS portfolio. Therefore, the investment classifications listed below do not agree to the investment categories provided in Note 4.
Industry corporate bonds:
Financial services
14,209
1,086
315
14,980
14.6%
Basic industry
4,620
319
4,826
4.7%
Capital goods
6,747
7,204
7.0%
Communications
4,284
4,732
4.6%
Consumer cyclical
5,540
392
5,766
5.6%
Consumer non-cyclical
14,614
1,672
16,113
15.7%
Energy
6,045
769
5,460
5.3%
Technology
4,216
356
4,536
4.4%
Transportation
3,380
3,529
3.4%
Industrial other
1,575
1,614
1.6%
Utilities
13,687
1,376
112
14,951
Government related entities
2,086
2.0%
Collateralized mortgage and other obligations ("CMOs"):
Agency backed
1,921
216
2,137
Non-agency backed
505
502
Mortgage pass through securities ("MPTS"):
632
0.6%
Commercial mortgage-backed securities ("CMBS"):
1,069
1,098
1.1%
ABS:
Collateralized loan obligations ("CLOs")
4,022
3,869
3.8%
Credit card
Equipment receivables
Home equity
361
0.4%
Manufactured housing
Student loans
710
0.7%
Municipals:
Taxable
4,688
1,103
5,777
Tax-exempt
129
Government:
United States
Foreign
96,197
Trading Securities (2)
4,101
308
Equity Securities
121
Total fixed maturity AFS, trading and equity securities
100,419
8,974
2,685
106,708
OTTI (3)
13,991
1,632
15,580
14.8%
4,570
491
5,055
4.8%
6,700
760
7,450
7.1%
4,314
4,961
5,862
14,215
1,813
16,007
15.2%
6,080
649
6,685
6.4%
4,039
382
3,283
309
3,590
98
1,659
13,533
1,861
15,374
1,794
294
2,076
CMOs:
1,893
1,992
527
594
MPTS:
622
655
CMBS:
1,018
1,062
1.0%
CLOs
3,612
3,611
369
411
692
4,675
1,091
5,759
5.5%
125
181
353
98,748
11,444
109,976
(1)Represents amortized cost, net of the allowance for credit losses.
(2)Certain of our trading securities support our Modco reinsurance agreements and the investment results are passed directly to the reinsurers. Refer to “Part II – Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Consolidated Investments – Fixed Maturity and Equity Securities Portfolios – Trading Securities” in our 2019 Form 10-K for further details.
(3)Other-than-temporary impairment includes unrealized (gains) and losses on credit-impaired securities related to changes in the fair value of such securities subsequent to the impairment measurement date.
In accordance with the fixed maturity AFS accounting guidance, we reflect stockholders’ equity as if unrealized gains and losses were actually recognized and consider all related accounting adjustments that would occur upon such a hypothetical recognition of unrealized gains and losses. Such related balance sheet effects include adjustments to the balances of DAC, VOBA, DFEL, future contract benefits, other contract holder funds and deferred income taxes. Adjustments to each of these balances are charged or credited to AOCI. For instance, DAC is adjusted upon the recognition of unrealized gains or losses because the amortization of DAC is based upon an assumed emergence of gross profits on certain insurance business. Deferred income tax balances are also adjusted because unrealized gains or losses do not affect actual taxes currently paid.
The quality of our fixed maturity AFS securities portfolio, as measured at estimated fair value and by the percentage of fixed maturity AFS securities invested in various ratings categories, relative to the entire fixed maturity AFS security portfolio (in millions) was as follows:
Rating Agency
NAIC
Equivalent
Designation (1)
Investment Grade Securities
AAA / AA / A
52,229
57,934
56.5%
51,367
58,235
55.4%
BBB
39,913
40,966
39.9%
39,473
43,460
41.3%
Total investment grade securities
92,142
98,900
96.4%
90,840
101,695
96.7%
Below Investment Grade Securities
BB
2,825
2.5%
2,309
2,388
B
1,022
960
955
CCC and lower
158
In or near default
Total below investment grade securities
4,055
3,706
3.6%
3,455
3,505
Total securities below investment
grade as a percentage of total
fixed maturity AFS securities
3.7%
(1)Based upon the rating designations determined and provided by the National Association of Insurance Commissioners (“NAIC”) or the major credit rating agencies (Fitch Ratings (“Fitch”), Moody’s Investors Service (“Moody’s”) and S&P). For securities where the ratings assigned by the major credit rating agencies are not equivalent, the second lowest rating assigned is used. For those securities where ratings by the major credit rating agencies are not available, which does not represent a significant amount of our total fixed maturity AFS securities, we base the ratings disclosed upon internal ratings. The average credit quality was A- as of March 31, 2020.
Comparisons between the NAIC designations and rating agency designations are published by the NAIC. The NAIC assigns securities quality designations and uniform valuations, which are used by insurers when preparing their annual statements. The NAIC designations are similar to the rating agency designations of the Nationally Recognized Statistical Rating Organizations for marketable bonds. NAIC designations 1 and 2 include bonds generally considered investment grade (rated Baa3 or higher by Moody’s, or rated BBB- or higher by S&P and Fitch) by such ratings organizations. However, securities designated NAIC 1 and 2 could be deemed below investment grade by the rating agencies as a result of the current RBC rules for residential mortgage-backed securities (“RMBS”) and CMBS for statutory reporting. NAIC designations 3 through 6 include bonds generally considered below investment grade (rated Ba1 or lower by Moody’s, or rated BB+ or lower by S&P and Fitch).
As of March 31, 2020, and December 31, 2019, 91% and 87%, respectively, of the total fixed maturity AFS securities in an unrealized loss position were investment grade. Our gross unrealized losses recognized in other comprehensive income (loss) (“OCI”) on fixed maturity AFS securities as of March 31, 2020, increased by $2.1 billion since December 31, 2019. For further information on our unrealized losses on fixed maturity AFS securities, see “Composition by Industry Categories of our Unrealized Losses on Fixed Maturity AFS Securities” below.
As more fully described in Note 1 in our 2019 Form 10-K and Note 4 herein, we regularly review our investment holdings for impairment. We believe the unrealized loss position as of March 31, 2020, did not require an impairment recognized in earnings as (i) we did not intend to sell these fixed maturity AFS securities; (ii) it is not more likely than not that we will be required to sell the fixed maturity AFS securities before recovery of their amortized cost basis; and (iii) the difference in the fair value compared to the amortized cost was due to factors other than credit loss. This conclusion is consistent with our asset-liability management process. Management considers the following as part of the evaluation:
To determine the recoverability of a debt security, we consider the facts and circumstances surrounding the underlying issuer including, but not limited to, the following:
As reported on our Consolidated Balance Sheets, we had $141.5 billion of investments and cash, which exceeded the liabilities for our future obligations under insurance policies and contracts, net of amounts recoverable from reinsurers, which totaled $119.7 billion as of March 31, 2020. If it were necessary to liquidate fixed maturity AFS securities prior to maturity or call to meet cash flow needs, we would first look to those fixed maturity AFS securities that are in an unrealized gain position, which had a fair value of $74.5 billion as of March 31, 2020, rather than selling fixed maturity AFS securities in an unrealized loss position. The amount of cash that we have on hand at any point in time takes into account our liquidity needs in the future, other sources of cash, such as the maturities of investments, interest and dividends we earn on our investments and the ongoing cash flows from new and existing business.
See “Fixed Maturity AFS Securities – Evaluation for Recovery of Amortized Cost” in Note 1 in our 2019 Form 10-K and Note 4 herein for additional discussion.
As of March 31, 2020, and December 31, 2019, the estimated fair value for all private placement securities was $16.4 billion and $17.0 billion, respectively, representing 12% and 13% of total investments, respectively.
Mortgage-Backed Securities (Included in Fixed Maturity AFS and Trading Securities)
See “Part II – Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Consolidated Investments – Mortgage-Backed Securities” in our 2019 Form 10-K for a discussion of our mortgage-backed securities (“MBS”).
The market value of fixed maturity AFS and trading securities backed by subprime loans was $334 million and represented less than 1% of our total investment portfolio as of March 31, 2020. Fixed maturity AFS securities represented $322 million, or 96%, and trading securities represented $12 million, or 4%, of the subprime exposure as of March 31, 2020. The table below summarizes our investments in fixed maturity AFS securities backed by pools of residential mortgages (in millions) as of March 31, 2020:
Subprime/
Agency
Prime
Alt-A
Option ARM (1)
Type
2,509
2,770
130
214
ABS home equity
274
Total by type (2)(3)
2,510
2,771
177
498
3,366
3,632
Rating
AAA
2,264
2,052
2,270
AA
464
507
509
550
BB and below
148
422
719
Total by rating (2)(3)(4)
2010 and prior
670
172
176
1,508
1,598
2011
91
2012
2013
2014
79
2015
193
572
616
617
288
322
182
183
197
Total by origination
year (2)(3)
Total fixed maturity AFS securities backed by pools of
residential mortgages as a percentage of total fixed maturity AFS securities
Total prime, Alt-A and subprime/option ARM as a percentage of total fixed maturity AFS securities
0.8%
(1)Includes the net amortized cost and fair value of option adjustable rate mortgages (“ARM”) within RMBS, totaling $181 million and $176 million, respectively.
(2)Does not include the amortized cost of trading securities totaling $158 million that primarily support our Modco reinsurance agreements because investment results for these agreements are passed directly to the reinsurers. The $158 million in trading securities consisted of $144 million prime, $1 million Alt-A and $13 million subprime.
(3)Does not include the fair value of trading securities totaling $154 million that primarily support our Modco reinsurance agreements because investment results for these agreements are passed directly to the reinsurers. The $154 million in trading securities consisted of $141 million prime, $1 million Alt-A and $12 million subprime.
(4)Based upon the rating designations determined and provided by the major credit rating agencies (Fitch, Moody’s and S&P). For securities where the ratings assigned by the major credit rating agencies are not equivalent, the second lowest rating assigned is used. For those securities where ratings by the major credit rating agencies are not available, which does not represent a significant amount of our total fixed maturity AFS securities, we base the ratings disclosed upon internal ratings.
None of these investments included any direct investments in subprime lenders or mortgages. We are not aware of material exposure to subprime loans in our alternative investment portfolio.
The following summarizes our investments in fixed maturity AFS securities backed by pools of commercial mortgages (in millions) as of March 31, 2020:
Multiple Property
Single Property
CMBS (1)(2)
1,100
1,041
1,074
1,045
1,078
Total by rating (1)(2)(3)
335
167
276
Total by origination year (1)(2)
commercial mortgages as a percentage of total fixed maturity AFS securities
(1)Does not include the amortized cost of trading securities totaling $157 million that primarily support our Modco reinsurance agreements because investment results for these agreements are passed directly to the reinsurers. The $157 million in trading securities consisted of $66 million of multiple property CMBS and $91 million of single property CMBS.
(2)Does not include the fair value of trading securities totaling $130 million that primarily support our Modco reinsurance agreements because investment results for these agreements are passed directly to the reinsurers. The $130 million in trading securities consisted of $54 million of multiple property CMBS and $76 million of single property CMBS.
(3)Based upon the rating designations determined and provided by the major credit rating agencies (Fitch, Moody’s and S&P). For securities where the ratings assigned by the major credit agencies are not equivalent, the second lowest rating assigned is used. For those securities where ratings by the major credit rating agencies are not available, which does not represent a significant amount of our total fixed maturity AFS securities, we base the ratings disclosed upon internal ratings.
As of March 31, 2020, the net amortized cost and fair value of our fixed maturity AFS exposure to monoline insurers was $349 million and $407 million, respectively.
Composition by Industry Categories of our Unrealized Losses on Fixed Maturity AFS Securities
When considering unrealized gain and loss information, it is important to recognize that the information relates to the position of securities at a particular point in time and may not be indicative of the position of our investment portfolios subsequent to the balance sheet date. Further, because the timing of the recognition of realized investment gains and losses through the selection of which securities are sold is largely at management’s discretion, it is important to consider the information provided below within the context of the overall unrealized gain or loss position of our investment portfolios. These are important considerations that should be included in any evaluation of the potential effect of securities in an unrealized loss position on our future earnings.
The composition by industry categories of all fixed maturity AFS securities in an unrealized loss position (in millions) as of March 31, 2020, was as follows:
Independent
1,381
410
17.6%
971
Midstream
1,951
239
10.2%
6.1%
4,632
9.8%
4,404
15.6%
Banking
1,585
116
5.0%
1,469
Finance companies
586
4.5%
Chemicals
1,064
988
Oil field services
Automotive
2.8%
798
Healthcare
1,153
2.7%
1,090
3.9%
Food and beverage
1,260
4.1%
1,205
4.3%
Electric
1,434
1,382
4.9%
Government owned, no guarantee
301
Transportation services
949
900
3.2%
Integrated
434
391
Property and casualty
442
405
Aerospace and defense
397
Industrial – other
727
2.4%
690
977
Entertainment
Project finance
Manufacturing
741
711
Consumer products
1.2%
381
Metals and mining
417
390
Retail
Industries with unrealized losses
less than $25 million
6,564
21.5%
15.3%
6,207
22.1%
Total by industry
30,483
Total by industry as a percentage of
total fixed maturity AFS securities
31.7%
27.4%
As of March 31, 2020, the net amortized cost and fair value of securities subject to enhanced analysis and monitoring for potential changes in unrealized loss position was $98 million and $75 million, respectively.
The following tables summarize key information on mortgage loans on real estate (in millions):
Credit Quality Indicator
16,178
16,928
99.8%
Delinquent (1)
Foreclosure (2)
Total mortgage loans on real estate before ACL
16,952
Total mortgage loans on real estate
16,324
99.9%
16,341
(1)As of March 31, 2020, 1 commercial loan and 19 residential loans were delinquent. As of December 31, 2019, 3 commercial loans and 24 residential loans were delinquent.
(2)As of March 31, 2020, no commercial mortgage loans and 25 residential loans were in foreclosure. As of December 31, 2019, no commercial mortgage loans and 14 residential mortgage loans were in foreclosure.
As of March 31, 2020, there were 2 specifically identified impaired commercial mortgage loan on real estate with a carrying value of less than $1 million and 24 specifically identified impaired residential mortgage loans on real estate also with an aggregate carrying value of $6 million. As of December 31, 2019, there was 1 specifically identified impaired commercial mortgage loan on real estate with a carrying value of less than $1 million and four specifically identified impaired residential mortgage loans on real estate with an aggregate carrying value of $1 million.
The total outstanding principal and interest on the commercial mortgage loans on real estate that were two or more payments delinquent as of March 31, 2020, and December 31, 2019, was less than $1 million. The total outstanding principal and interest on the residential mortgage loans on real estate that were three or more payments delinquent as of March 31, 2020, and December 31, 2019, was $24 million and $9 million, respectively. See Note 4 herein for more information regarding our accounting policy relating to the impairment of mortgage loans on real estate.
The carrying value of mortgage loans on real estate by business segment (in millions) was as follows:
Segment
5,762
5,453
4,136
4,096
4,130
1,398
1,361
1,365
1,333
The composition of commercial mortgage loans (in millions) by property type, geographic region and state is shown below:
Property Type
State
Apartment
5,150
32.1%
CA
3,771
23.5%
Office building
3,996
24.9%
TX
1,814
11.3%
Industrial
3,001
18.7%
NY
1,154
7.2%
2,669
16.6%
FL
772
Other commercial
MD
737
Hotel/Motel
241
1.5%
GA
685
Mixed use
WA
580
TN
575
Geographic Region
OH
Pacific
4,680
29.2%
PA
South Atlantic
3,487
21.7%
VA
466
2.9%
West South Central
1,961
NC
2.6%
Middle Atlantic
1,948
12.1%
IL
367
East North Central
1,463
9.1%
330
Mountain
AZ
East South Central
724
MA
West North Central
WI
New England
479
Non U.S.
0.2%
All other states
2,275
14.1%
The following table shows the principal amount (in millions) of our commercial and residential mortgage loans by year in which the principal is contractually obligated to be repaid:
Principal Repayment Year
478
2021
1,034
1,042
6.2%
2022
947
956
2023
903
913
5.4%
2024
1,254
7.5%
2025 and thereafter
11,558
706
12,264
72.5%
749
16,917
See Note 4 for information regarding our loan-to-value and debt-service coverage ratios and our allowance for credit losses.
Investment income (loss) on alternative investments by business segment (in millions) was as follows:
Total (1)
(1)Includes net investment income on the alternative investments supporting the required statutory surplus of our insurance businesses.
As of March 31, 2020, and December 31, 2019, alternative investments included investments in 260 and 258 different partnerships, respectively, and the portfolio represented approximately 1% of total investments. The partnerships do not represent off-balance sheet financing and generally involve several third-party partners. Some of our partnerships contain capital calls, which require us to contribute capital upon notification by the general partner. These capital calls are contemplated during the initial investment decision and are planned for well in advance of the call date. The capital calls are not material in size and are not material to our liquidity. Alternative investments are accounted for using the equity method of accounting and are included in other investments on our Consolidated Balance Sheets.
Non-Income Producing Investments
The carrying amount of fixed maturity securities, mortgage loans on real estate and real estate that were non-income producing as of March 31, 2020, and December 31, 2019, was $7 million and $9 million, respectively.
Details underlying net investment income (in millions) and our investment yield were as follows:
1,075
1,072
Invested cash
Consent fees
Investment income
1,426
1,314
Investment expense
(63
(1)See “Commercial Mortgage Loan Prepayment and Bond Make-Whole Premiums” below for additional information.
(2)See “Alternative Investments” above for additional information.
Interest Rate Yield
Fixed maturity AFS securities, mortgage loans on
real estate and other, net of investment expenses
4.29%
4.33%
0.16%
Net investment income yield on invested assets
4.48%
4.39%
We earn investment income on our general account assets supporting fixed annuity, term life, whole life, UL, interest-sensitive whole life and the fixed portion of retirement plan and VUL products. The profitability of our fixed annuity and life insurance products is affected by our ability to achieve target spreads, or margins, between the interest income earned on the general account assets and the interest credited to the contract holder on our average fixed account values, including the fixed portion of variable. Net investment income and the interest rate yield table each include commercial mortgage loan prepayments and bond make-whole premiums, alternative investments and contingent interest and standby real estate equity commitments. These items can vary significantly from period to period due to a number of factors and, therefore, can provide results that are not indicative of the underlying trends.
Commercial Mortgage Loan Prepayment and Bond Make-Whole Premiums
Prepayment and make-whole premiums are collected when borrowers elect to call or prepay their debt prior to the stated maturity. A prepayment or make-whole premium allows investors to attain the same yield as if the borrower made all scheduled interest payments until maturity. These premiums are designed to make investors indifferent to prepayment.
See “Critical Accounting Policies and Estimates – Investments – Write-downs for Impairment and Allowances for Credit Losses” above for information on our portfolio management strategy. Details underlying credit loss expense incurred as a result of impairments that were recognized in net income (loss) and included in realized gain (loss) on fixed maturity AFS securities (in millions) were as follows:
(1)Upon adoption of ASU 2016-13, we recognized credit loss expense incurred as a result of impairments through net income (loss) for the three months ended March 31, 2020. Prior to the adoption of ASU 2016-13, we recognized write-downs taken as a result of OTTI through net income (loss) for the three months ended March 31, 2019.
The $20 million of impairments recognized in net income during the three months ended March 31, 2020, were all credit-related impairments. The increase in credit losses was primarily attributable to the destabilization of the energy industry. For more information on current market conditions, see “Introduction – Executive Summary.”
REVIEW OF CONSOLIDATED FINANCIAL CONDITION
Sources of Liquidity and Cash Flow
Liquidity refers to the ability of an enterprise to generate adequate amounts of cash from its normal operations to meet cash requirements with a prudent margin of safety. Our principal sources of cash flow from operating activities are insurance premiums and fees and investment income, while sources of cash flows from investing activities result from maturities and sales of investments. Our operating activities provided (used) cash of $455 million and $(1.3) billion for the three months ended March 31, 2020 and 2019, respectively. When considering our liquidity and cash flow, it is important to distinguish between the needs of our insurance subsidiaries and the needs of the holding company, LNC. As a holding company with no operations of its own, LNC derives its cash primarily from its operating subsidiaries.
The sources of liquidity of the holding company are principally comprised of dividends and interest payments from subsidiaries, augmented by holding company short-term investments, bank lines of credit and the ongoing availability of long-term public financing under an SEC-filed shelf registration statement. These sources of liquidity and cash flow support the general corporate needs of the holding company, including its common stock dividends, interest and debt service, funding of callable securities, securities repurchases, acquisitions and investment in core businesses.
Details underlying the primary sources of our holding company cash flows (in millions) were as follows:
Dividends from Subsidiaries
The Lincoln National Life Insurance Company
305
Lincoln National Reinsurance Company (Barbados) Limited
Total dividends from subsidiaries
Loan Repayments and Interest from Subsidiaries
Interest on inter-company notes
Other Cash Flow Items
Amounts received from (paid for taxes on)
stock option exercises and restricted stock, net
The table above focuses on significant and recurring cash flow items and excludes the effects of certain financing activities, namely the periodic issuance and retirement of debt and cash flows related to our inter-company cash management program (discussed below). Taxes have been eliminated from the analysis due to a tax sharing agreement among our primary subsidiaries resulting in a modest effect on net cash flows at the holding company. Also excluded from this analysis is the modest amount of investment income on short-term investments of the holding company. For information regarding limits on the dividends that our insurance subsidiaries may pay without prior approval, see “Part II – Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Review of Consolidated Financial Condition – Liquidity and Capital Resources – Restrictions on Subsidiaries’ Dividends and Other Payments” in our 2019 Form 10-K.
Insurance Subsidiaries’ Statutory Capital and Surplus
Our regulatory capital levels are also affected by statutory accounting rules, which are subject to change by each applicable insurance regulator. Our term products and UL products containing secondary guarantees require reserves calculated pursuant to XXX and AG38, respectively. As discussed in “Part I – Item 1A. Risk Factors – Legislative, Regulatory, and Tax – Attempts to mitigate the impact of Regulation XXX and Actuarial Guideline 38 may fail in whole or in part resulting in an adverse effect on our financial condition and result of operations” in our 2019 Form 10-K, our insurance subsidiaries employ strategies to reduce the strain caused by XXX and AG38 by reinsuring the business to reinsurance captives. Our captive reinsurance and reinsurance subsidiaries provide a mechanism for financing a portion of the excess reserve amounts in a more efficient manner. We use long-dated LOCs and debt financing as well as other financing strategies to finance those reserves. Included in the LOCs issued as of March 31, 2020, was approximately $1.9 billion of long-dated LOCs issued to support inter-company reinsurance arrangements for UL products containing secondary guarantees ($1.9 billion relates to arrangements that will expire by 2031). For information on the LOCs, see the credit facilities table in Note 13 in our 2019 Form 10-K. Our captive reinsurance and reinsurance subsidiaries have also issued long-term notes of $3.5 billion to finance a portion of the excess reserves as of March 31, 2020; of this amount, $2.6 billion involve exposure to VIEs. For information on these long-term notes issued by our captive reinsurance and reinsurance subsidiaries, see Note 4 in our 2019 Form 10-K. We have also used the proceeds from senior note issuances of $875 million to execute long-term structured solutions primarily supporting reinsurance of UL products containing secondary guarantees. LOCs and related capital market solutions lower the capital effect of term products and UL products containing secondary guarantees.
Our captive reinsurance and reinsurance subsidiaries free up capital the insurance subsidiaries can use for any number of purposes, including paying dividends to the holding company. The NAIC’s adoption of the Valuation Manual that defines a principles-based reserving framework for newly issued life insurance policies was effective January 1, 2017. We adopted the framework for our newly issued term business in 2017 and phased in the framework through January 1, 2020, for all other newly issued life insurance products. We continue to analyze the effects of principles-based reserving on the use of captive reinsurance and reinsurance subsidiaries and third-party reinsurance for reserve financing transactions for our life insurance business. For more information on the NAIC’s adoption of principles-based reserving, see “Part I – Item 1. Business – Regulatory – Insurance Regulation” in our 2019 Form 10-K.
Statutory reserves established for variable annuity contracts and riders are sensitive to changes in the equity markets and interest rates, and are affected by the level of account values relative to the level of any guarantees, product design and reinsurance arrangements. As a result, the relationship between reserve changes and equity market performance is non-linear during any given reporting period. Market conditions greatly influence the ultimate capital required due to its effect on the valuation of reserves and derivative assets hedging these reserves. We also utilize inter-company reinsurance arrangements to manage our hedge program for variable annuity guarantees.
We implemented the NAIC’s changes to the statutory reserving, capital and accounting framework for variable annuities as of January 1, 2020, which did not have a material impact on our statutory capital position or RBC ratios. The NAIC is also considering modifications to the NAIC RBC C-1 capital charges for bonds, which may impact the level of the C-1 related RBC we are required to hold.
For more information, see “Part I – Item 1A. Risk Factors – Federal Regulation – Changes in accounting standards issued by the Financial Accounting Standards Board or other standard-setting bodies may adversely affect our financial statements” in our 2019 Form 10-K.
We continue to analyze the use of our existing captive reinsurance structures, as well as additional third-party reinsurance arrangements, and our current hedging strategies relative to managing the effects of equity markets and interest rates on the statutory reserves, statutory capital and the dividend capacity of our life insurance subsidiaries.
Financing Activities
Although our subsidiaries currently generate adequate cash flow to meet the needs of our normal operations, periodically we may issue debt or equity securities to maintain ratings and increase liquidity, as well as to fund internal growth, acquisitions and the retirement of our debt and equity securities.
We currently have an effective shelf registration statement, which allows us to issue, in unlimited amounts, securities, including debt securities, preferred stock, common stock, warrants, stock purchase contracts, stock purchase units and depository shares.
Details underlying debt and financing activities (in millions) for the three months ended March 31, 2020, were as follows:
Change
Repayments
in Fair
Balance
Issuance
Refinancing
Hedges
Changes (1)
Short-Term Debt
Current maturities of long-term debt
Long-Term Debt
Senior notes
4,610
4,792
Bank borrowings
748
Capital securities (2)
1,207
1,208
Total long-term debt
(1)Includes the net increase (decrease) in commercial paper, non-cash reclassification of long-term debt to current maturities of long-term debt, accretion (amortization) of discounts and premiums, amortization of debt issuance costs and amortization of adjustments from discontinued hedges, as applicable.
(2)To hedge the variability in rates, we purchased interest rate swaps to lock in a fixed rate of approximately 5% over the remaining terms of the capital securities.
During March 2020, we entered into a $500 million floating-rate loan maturing on March 30, 2022. In addition, during March 2020, we unwound the fair value hedge on our 7.00% senior notes due 2040 and entered into two fair value hedges on the same notes, which generated capital deployed for general corporate purposes. For more information on the discontinued hedge, see Note 10. As of March 31, 2020, the holding company had available liquidity of $760 million. Available liquidity consists of cash and invested cash, excluding cash held as collateral, and certain short-term investments that can be readily converted into cash, net of commercial paper outstanding. We continue to operate with adequate available liquidity and have access to alternate sources of liquidity, as discussed below in “Alternative Sources of Liquidity.”
For more information about our short-term and long-term debt and our credit facilities and LOCs, see Note 10 herein and Note 13 in our 2019 Form 10-K.
We have not accounted for securities lending transactions or other transactions involving the transfer of financial assets with an obligation to repurchase the transferred assets as sales. For information about our collateralized financing transactions on our investments, see “Payables for Collateral on Investments” in Note 4.
If current credit ratings or claims-paying ratings were downgraded in the future, terms in our derivative agreements may be triggered, which could negatively affect overall liquidity. For the majority of our derivative counterparties, there is a termination event with respect to LNC if its long-term senior debt ratings drop below BBB-/Baa3 (S&P/Moody’s); or with respect to The Lincoln National Life Insurance Company (“LNL”) if its financial strength ratings drop below BBB-/Baa3 (S&P/Moody’s). Our long-term senior debt held a rating of A-/Baa1 (S&P/Moody’s) as of March 31, 2020. In addition, contractual selling agreements with intermediaries could be negatively affected, which could have an adverse effect on overall sales of annuities, life insurance and investment products. See “Part I – Item 1A. Risk Factors – Liquidity and Capital Position – A decrease in the capital and surplus of our insurance subsidiaries may result in a downgrade to our credit and insurer financial strength ratings” and “Part I – Item 1A. Risk Factors – Covenants and Ratings – A downgrade in our financial strength or credit ratings could limit our ability to market products, increase the number or value of policies being surrendered and/or hurt our relationships with creditors” in our 2019 Form 10-K for more information. See “Part I – Item 1. Business – Financial Strength Ratings” in our 2019 Form 10-K for additional information on our current financial strength ratings.
See “Part II – Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Review of Consolidated Financial Condition – Liquidity and Capital Resources – Financing Activities” in our 2019 Form 10-K for information on our credit ratings.
Alternative Sources of Liquidity
In order to manage our capital more efficiently, we have an inter-company cash management program where certain subsidiaries can lend to or borrow from the holding company to meet short-term borrowing needs. The cash management program is essentially a series of demand loans between LNC and participating subsidiaries that reduces overall borrowing costs by allowing LNC and its subsidiaries to access internal resources instead of incurring third-party transaction costs. As of March 31, 2020, the holding company had a net outstanding receivable (payable) of $(1.4) billion from (to) certain subsidiaries resulting from loans made by subsidiaries in excess of amounts placed (borrowed) by the holding company and subsidiaries in the inter-company cash management account. Any change in holding company cash management program balances is offset by the immediate and equal change in holding company cash and invested cash. The holding company had an average borrowing balance of $697 million from the cash management program during the first quarter of 2020. The holding company had a maximum and minimum amount of financing from the cash management program during the first quarter of 2020 of $1.4 billion and $322 million, respectively. Loans under the cash management program are permitted under applicable insurance laws subject to certain restrictions. For our Indiana and New Hampshire-domiciled insurance subsidiaries, the borrowing and lending limit is currently 3% of the insurance company’s admitted assets as of its most recent year end. For our New York-domiciled insurance subsidiary, it may borrow from LNC less than 2% of its admitted assets as of its most recent year end but may not lend any amounts to LNC.
Our insurance subsidiaries, by virtue of their general account fixed-income investment holdings, can access liquidity through securities lending programs and repurchase agreements. Our primary insurance subsidiary, LNL, is a member of the Federal Home Loan Bank of Indianapolis (“FHLBI”). Membership allows LNL access to the FHLBI’s financial services, including the ability to obtain loans and to issue funding agreements as an alternative source of liquidity that are collateralized by qualifying mortgage-related assets, agency securities or U.S. Treasury securities. LNL had an estimated maximum borrowing capacity of $5.0 billion under the FHLBI facility as of March 31, 2020. Borrowings under this facility are subject to the FHLBI’s discretion and require the availability of qualifying assets at LNL. As of March 31, 2020, our insurance subsidiaries had investments with a carrying value of $4.5 billion out on loan or subject to repurchase agreements. The cash received in our securities lending programs and repurchase agreements is typically invested in cash and invested cash, short-term investments or fixed maturity securities. For additional details, see “Payables for Collateral on Investments” in Note 4.
Cash Flows from Collateral on Derivatives
Our cash flows associated with collateral received from and posted with counterparties change as the market value of the underlying derivative contract changes. As the value of a derivative asset decreases (or increases), the collateral required to be posted by our counterparties would also decrease (or increase). Likewise, when the value of a derivative liability decreases (or increases), the collateral we are required to post to our counterparties would also decrease (or increase). For the three months ended March 31, 2020, our collateral payable for derivative investments increased due primarily to decreasing interest rates that increased the fair values of our associated over-the-counter derivative investments. In the event of adverse changes in fair value of our derivative instruments, we may need to post collateral with a counterparty if our net derivative liability position reaches certain contractual levels. If we do not have sufficient high quality securities or cash and invested cash to provide as collateral, we have liquidity sources, as discussed above, to leverage that would be eligible for collateral posting. For additional information, see “Credit Risk” in Note 5.
Uses of Capital
Our principal uses of cash are to pay policy claims and benefits, operating expenses, commissions and taxes, to purchase new investments, to purchase reinsurance, to fund policy surrenders and withdrawals, to pay dividends to our stockholders, to repurchase our stock and to repay debt.
Return of Capital to Common Stockholders
One of the Company’s primary goals is to provide a return to our common stockholders through share price accretion, dividends and stock repurchases. In determining dividends, the Board of Directors takes into consideration items such as current and expected earnings, capital needs, rating agency considerations and requirements for financial flexibility. The amount and timing of share repurchases depends on key capital ratios, rating agency expectations, the generation of free cash flow and an evaluation of the costs and benefits associated with alternative uses of capital. Free cash flow for the holding company generally represents the amount of dividends and interest received from subsidiaries less interest paid on debt.
Details underlying this activity (in millions) were as follows:
Dividends to common stockholders
225
Total cash returned to stockholders
304
Number of shares repurchased
3.8
3.9
For more information regarding share repurchases, see “Part II – Item 2(c)” below.
Other Uses of Capital
In addition to the amounts in the table above in “Return of Capital to Common Stockholders,” other uses of holding company cash flow (in millions) were as follows:
Debt service (interest paid)
Capital contribution to subsidiaries
475
The above table focuses on significant and recurring cash flow items and excludes the effects of certain financing activities, namely the periodic retirement of debt and cash flows related to our inter-company cash management account. Taxes have been eliminated from the analysis due to a tax sharing agreement among our primary subsidiaries resulting in a modest effect on net cash flows at the holding company.
Significant Trends in Sources and Uses of Cash Flow
As stated above, LNC’s cash flow, as a holding company, is largely dependent upon the dividend capacity of its insurance company subsidiaries as well as their ability to advance funds to it through inter-company borrowing arrangements, which may be affected by factors influencing the insurance subsidiaries’ RBC and statutory earnings performance. Although we currently expect to be able to meet the holding company’s ongoing cash needs and to have sufficient capital to offer downside protection, a continuation of or an acceleration of poor capital market conditions, which reduces our insurance subsidiaries’ statutory surplus and RBC, may require them to retain more capital and may pressure our subsidiaries’ dividends to the holding company, which may lead us to take steps to preserve or raise additional capital.
For factors that could cause actual results to differ materially from those set forth in this section and that could affect our expectations for liquidity and capital, see “Part I – Item 1A. Risk Factors” in our 2019 Form 10-K, “Forward-Looking Statements – Cautionary Language” above and “Part II – Item 1A. Risk Factors” herein.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
We analyze and manage the risks arising from market exposures of financial instruments, as well as other risks, in an integrated asset-liability management process that considers diversification. We have exposures to several market risks including interest rate risk, equity market risk, credit risk and, to a lesser extent, foreign currency exchange risk. For information on these market risks, see “Item 7A. Quantitative and Qualitative Disclosures About Market Risk” in our 2019 Form 10-K. See also “Part I – Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Introduction – Executive Summary – Current Market Conditions” herein.
Item 4. Controls and Procedures
Conclusions Regarding Disclosure Controls and Procedures
We maintain disclosure controls and procedures, which are designed to ensure that information required to be disclosed in the reports we file or submit under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to the Company’s management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. As of the end of the period required by this report, we, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) of the Exchange Act). Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are effective in timely alerting them to material information relating to us and our consolidated subsidiaries required to be disclosed in our periodic reports under the Exchange Act.
Changes in Internal Control Over Financial Reporting
There was no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that occurred during the quarter ended March 31, 2020, that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
A control system, no matter how well designed and operated, can provide only reasonable assurance that the control system’s objectives will be met. Further, because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, within the Company have been detected. Projections of any evaluation of controls effectiveness to future periods are subject to risks. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures.
PART II – OTHER INFORMATION
Item 1. Legal Proceedings
Information regarding reportable legal proceedings is contained in Note 11 in “Part I. – Item 1.”
Item 1A. Risk Factors
Reference is made to “Part I – Item 1A. Risk Factors” in the 2019 Form 10-K for information concerning risk factors. We are updating the risk factors contained in the 2019 Form 10-K to include the risk factor below.
The following risk factor should be read in conjunction with the factors set forth in “Part I – Item 1A. Risk Factors” of the 2019 Form 10-K, in addition to the factors set forth in “Part I – Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Forward-Looking Statements – Cautionary Language” above. You should carefully consider such factors. Such risks and uncertainties are not the only ones facing our Company. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also impair our business operations. If any of these risks actually occur, our business, financial condition and results of operations could be materially affected. In that case, the value of our securities could decline substantially.
The impacts of the COVID-19 pandemic, including difficult conditions in the global capital markets and the economy generally, have adversely affected and are expected to continue to adversely affect our business and results of operations, and the future impacts of the COVID-19 pandemic on the global economy and the company’s business, results of operations and financial condition remain uncertain.
Our results of operations are materially affected by conditions in the global capital markets and the economy generally, both in the U.S. and elsewhere around the world. The coronavirus, or COVID-19, pandemic that emerged in the first quarter of 2020 has led to an extreme downturn in and volatility of the financial markets, record-low interest rates and wide-ranging changes in consumer behavior, including as a result of quarantines, shelter-in-place orders and limitations on business activity. The severe restriction in economic activity caused by the COVID-19 pandemic and increased levels of unemployment in the United States have contributed to increased volatility and diminished expectations for the economy and the markets going forward. These factors are expected to precipitate a recession, the length and severity of which cannot be predicted.
These economic and business conditions have negatively impacted, and are expected to continue to negatively impact, our account values, investment results, the interest margins of our businesses, estimated gross profits and capital position. Beginning in the second quarter of 2020, we expect that these conditions will negatively impact our sales and demand for certain of our products. Given our credit and equity market exposure, we are exposed to substantial risk of loss and downgrades due to market volatility, which we have already experienced to some degree and expect to continue to experience. In addition, as a result of the pandemic and ensuing conditions, we expect to experience higher mortality, leading to an elevated incidence and level of life insurance claims, as well as increased morbidity, leading to increased disability claims. The closure and/or limited operations of businesses and medical offices has also led to delays in resolving disability claims, which we expect to continue. We may also experience an increase in activity such as surrenders of policies, missed premium payments or 401(k) hardship withdrawals due to changes in consumer behavior as a result of financial stress. Because the vast majority of our employees are currently working from home, along with many of our vendors and customers, and such conditions may continue or may in the future need to be reinstituted, our business operations may be adversely impacted, among other things, due to cybersecurity incidents, technological issues or operational disruptions on the part of our vendors, and we may experience distribution disruptions as we continue to sell our products virtually.
Ultimately, the impacts of the COVID-19 pandemic discussed above are expected to adversely affect earnings as well as our business, results of operations and financial condition. The impacts of the pandemic may also have the effect of increasing the likelihood and/or magnitude of the other risks described in “Part I – Item 1A. Risk Factors” of the 2019 Form 10-K. The severity and duration of the current COVID-19 pandemic, and future outbreaks of COVID-19, and its future direct and indirect effects on the economy and our business and results of operations are uncertain. The COVID-19 pandemic may cause prolonged global or national recessionary economic conditions or longer lasting effects on economic conditions than currently exist, which could have a material adverse effect on our business, results of operations and financial condition.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
(c) The following table summarizes purchases of equity securities by the Company during the quarter ended March 31, 2020 (dollars in millions, except per share data):
(c) Total Number
(d) Approximate Dollar
(a) Total
of Shares
Value of Shares
(b) Average
Purchased as Part of
that May Yet Be
Price Paid
Publicly Announced
Purchased Under the
Period
Purchased (1)
per Share
Plans or Programs (2)
1/1/20 – 1/31/20
970
2/1/20 – 2/29/20
3,496,478
60.08
1,570
3/1/20 – 3/31/20
313,446
47.86
1,555
(1)Of the total number of shares purchased, no shares were received in connection with the exercise of stock options and related taxes. For the quarter ended March 31, 2020, there were 3,809,924 shares purchased as part of publicly announced plans or programs.
(2)On February 19, 2020, our Board of Directors authorized an increase in our securities repurchase authorization, bringing the total aggregate repurchase authorization to $1.66 billion. As of March 31, 2020, our remaining security repurchase authorization was $1.6 billion. The security repurchase authorization does not have an expiration date. The amount and timing of share repurchases depends on key capital ratios, rating agency expectations, the generation of free cash flow and an evaluation of the costs and benefits associated with alternative uses of capital. Our stock repurchases may be effected from time to time through open market purchases or in privately negotiated transactions and may be made pursuant to an accelerated share repurchase agreement or Rule 10b5-1 plan.
Item 6. Exhibits
The Exhibits included in this report are listed in the Exhibit Index beginning on page 96, which is incorporated herein by reference.
For the Quarter Ended March 31, 2020
3.1
Amended and Restated Bylaws of the Company (effective March 23, 2020) incorporated by reference to Exhibit 3.1 to the Company’s Form 8-K (File No. 1-6028) filed with the SEC on March 24, 2020.
10.1
Form of Nonqualified Stock Option Agreement for the Chief Executive Officer (“CEO”).*
10.2
Form of Long-Term Incentive Award Program Performance Cycle Agreement for CEO.*
10.3
Form of Restricted Stock Unit Award Agreement for CEO.*
10.4
Form of Nonqualified Stock Option Agreement for Senior Management Committee (“SMC”) (other than CEO).*
10.5
Form of Long-Term Incentive Award Program Performance Cycle Agreement for SMC (other than CEO).*
10.6
Form of Restricted Stock Unit Award Agreement for SMC (other than CEO).*
31.1
Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2
Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1
Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2
Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101.INS
XBRL Instance Document – the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document.
101.SCH
XBRL Taxonomy Extension Schema Document.
101.CAL
XBRL Taxonomy Extension Calculation Linkbase Document.
101.LAB
XBRL Taxonomy Extension Label Linkbase Document.
101.PRE
XBRL Taxonomy Extension Presentation Linkbase Document.
101.DEF
XBRL Taxonomy Extension Definition Linkbase Document.
Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101).
* This exhibit is a management contract or compensatory plan or arrangement.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
By:
/s/ RANDAL J. FREITAG
Randal J. Freitag
Executive Vice President and Chief Financial Officer
/s/ CHRISTINE A. JANOFSKY
Christine A. Janofsky
Senior Vice President and Chief Accounting Officer
Dated: May 7, 2020