SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q QUARTERLY REPORT UNDER SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For quarter ended March 31, 1996 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 (I.R.S. Employer incorporation or organization) Identification No.) 200 East Berry Street, Fort Wayne, Indiana 46802-2706 (Address of Principal Executive Offices) Registrant's telephone number (219) 455-2000 Common stock outstanding April 26, 1996 104,265,407 Indicate by check mark whether 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 [ ] The exhibit index to this report is located on page 18. Page 1 of 31
-2- <TABLE> <CAPTION> PART I - FINANCIAL INFORMATION Item 1 Financial Statements LINCOLN NATIONAL CORPORATION CONSOLIDATED BALANCE SHEETS March 31 December 31 (000'S omitted) 1996 1995 ASSETS Investments: <S> <C> <C> Securities available-for-sale, at fair value: Fixed maturity (cost 1996 - $24,347,837; 1995 - $23,935,527) ------------------ $25,215,793 $25,834,476 Equity (cost 1996 - $758,765; 1995 - $936,124) --------------------- 946,798 1,164,844 Mortgage loans on real estate ------------ 3,286,970 3,186,872 Real estate ------------------------------ 742,655 775,912 Policy loans ----------------------------- 604,537 602,573 Other investments ------------------------ 317,814 371,765 Total Investments ---------------------- 31,114,567 31,936,442 Investment in unconsolidated affiliates ---- 19,512 5,562 Cash and invested cash --------------------- 1,340,955 1,572,855 Property and equipment --------------------- 242,032 243,763 Deferred acquisition costs ----------------- 1,886,781 1,436,685 Premiums and fees receivable --------------- 619,957 537,979 Accrued investment income ------------------ 451,270 462,737 Assets held in separate accounts ----------- 24,245,316 22,769,068 Federal income taxes ----------------------- 32,287 -- Amounts recoverable from reinsurers -------- 2,457,656 2,495,189 Goodwill ----------------------------------- 462,431 471,465 Other intangible assets -------------------- 503,186 528,934 Other assets ------------------------------- 887,973 797,054 Total Assets ----------------------------- $64,263,923 $63,257,733 See notes to consolidated financial statements on page 7. </TABLE>
-3- <TABLE> <CAPTION> LINCOLN NATIONAL CORPORATION CONSOLIDATED BALANCE SHEETS -CONTINUED- March 31 December 31 (000's omitted) 1996 1995 LIABILITIES AND SHAREHOLDERS' EQUITY Liabilities: <S> <C> <C> Policy liabilities and accruals: Future policy benefits, claims and claim expenses -------------------- $12,919,815 $12,922,547 Unearned premiums ----------------------- 800,977 813,380 Total Policy Liabilities and Accruals - 13,720,792 13,735,927 Contractholder funds ---------------------- 18,684,492 18,784,508 Liabilities related to separate accounts -- 24,245,316 22,769,068 Federal income taxes ---------------------- -- 128,426 Short-term debt --------------------------- 430,226 426,848 Long-term debt ---------------------------- 658,894 659,303 Other liabilities ------------------------- 2,378,157 2,375,531 Total Liabilities ----------------------- 60,117,877 58,879,611 </TABLE> <TABLE> <CAPTION> Shareholders' Equity: <S> <C> <C> Series A preferred stock (3/31/96 liquidation value - $3,143) ----- 1,309 1,335 Common stock ------------------------------ 890,970 889,476 Retained earnings ------------------------- 2,867,951 2,775,718 Foreign currency translation adjustment --- 11,523 13,413 Net unrealized gain (loss) on securities available-for-sale ----------------------- 374,293 698,180 Total Shareholders' Equity -------------- 4,146,046 4,378,122 Total Liabilities and Shareholders' Equity -------------- $64,263,923 $63,257,733 See notes to consolidated financial statements on page 7. </TABLE>
-4- <TABLE> <CAPTION> LINCOLN NATIONAL CORPORATION CONSOLIDATED STATEMENTS OF INCOME Three Months Ended March 31 (000's omitted) 1996 1995 Revenue: <S> <C> <C> Insurance premiums ----------- $ 775,353 $ 739,716 Insurance fees --------------- 144,203 122,043 Investment advisory fees ----- 49,253 -- Net investment income -------- 571,232 530,147 Equity in earnings of unconsolidated affiliates -- -- 5,107 Realized gain on investments - 71,258 44,100 Other ------------------------ 29,218 42,617 Total Revenue ------------ 1,640,517 1,483,730 </TABLE> <TABLE> <CAPTION> Benefits and Expenses: <S> <C> <C> Benefits and settlement expenses ------------------- 935,750 887,131 Underwriting, acquisition, insurance and other expenses 492,384 403,161 Interest expense ------------- 18,494 13,973 Total Benefits and Expenses ----------- 1,446,628 1,304,265 Net Income Before Federal Income Taxes ----------- 193,889 179,465 Federal income taxes ----------- 53,865 44,652 Net Income --------------- $ 140,024 $ 134,813 Net Income Per Share ----------- $1.34 $1.30 Cash Dividends Per Share Common Stock ----------------- $ .46 $ .43 See notes to consolidated financial statements on page 7. </TABLE>
-5- <TABLE> <CAPTION> LINCOLN NATIONAL CORPORATION CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY Three Months Ended March 31 Number of Shares Issued Amounts (000's omitted from dollar amounts) 1996 1995 1996 1995 <S> <C> <C> <C> <C> Preferred Stock: (Shares authorized: 10,000,000) Series A Preferred Stock: Balance at beginning of year -------- 40,646 43,218 $ 1,335 $ 1,420 Conversion into common stock ------------- (787) (1,160) (26) (38) Balance at March 31 ----- 39,859 42,058 1,309 1,382 Series E and F Preferred Stock: Balance at beginning of year -- 4,417,897 -- 309,913 Conversion into common stock ------------- -- -- -- -- Balance at March 31 ----- -- 4,417,897 -- 309,913 Common Stock: (Shares authorized: 800,000,000) Balance at beginning of year -104,185,117 94,477,942 889,476 555,382 Conversion of series A preferred stock ------------ 6,296 9,280 26 38 Issued for benefit plans ----- 56,338 88,189 1,468 2,165 Balance at March 31 --- 104,247,751 94,575,411 890,970 557,585 Retained Earnings: Balance at beginning of year - 2,775,718 2,479,532 Net income ------------------- 140,024 134,813 Cash dividends declared ------ (47,791) (44,965) Balance at March 31 ----- 2,867,951 2,569,380 Foreign Currency Translation Adjustment: Accumulated adjustment at beginning of year ---------- 13,413 6,890 Change during period --------- (1,890) 8,454 Balance at March 31 ----- 11,523 15,344 Net Unrealized Gain (Loss) on Securities Available-for-Sale: Balance at beginning of year - 698,180 (311,077) Change during period --------- (323,887) 509,199 Balance at March 31 ----- 374,293 198,122 Total Shareholders' Equity at March 31 ----------- $4,146,046 $3,651,726 Common Stock (assuming conversion of series A, E & F preferred stock): End of Period ----------- 104,566,623 103,747,669 Average for the Period -- 104,532,461 103,678,382 See notes to consolidated financial statements on page 7. </TABLE>
-6- <TABLE> <CAPTION> LINCOLN NATIONAL CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS Three Months Ended March 31 (000's omitted) 1996 1995 Operating Activities: <S> <C> <C> Net income ---------------------------------------- $ 140,024 $ 134,813 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Deferred acquisition costs -------------------- 42,985 40,803 Premiums and fees receivable ------------------ (82,190) (142,908) Accrued investment income --------------------- 11,305 (14,700) Policy liabilities and accruals --------------- (205,729) 137,879 Contractholder funds -------------------------- 577,131 349,840 Amounts recoverable from reinsurers ----------- (24,213) (138,318) Federal income taxes -------------------------- 7,044 181,598 Equity in undistributed earnings of unconsolidated affiliates ------------------- -- -- Provisions for depreciation ------------------- 14,186 15,302 Amortization of goodwill and other intangible assets ---------------------------- 29,975 -- Realized (gain) loss on investments ----------- (71,258) (44,705) (Gain) loss on sale of affiliate/ operating property -------------------------- -- -- Other ----------------------------------------- (92,593) (37,014) Net Adjustments ----------------------------- 206,643 347,777 Net Cash Provided by Operating Activities --- 346,667 482,590 </TABLE> <TABLE> <CAPTION> Investing Activities: <S> <C> <C> Securities-available-for-sale: Purchases -------------------------------------- (3,843,320) (4,449,100) Sales ------------------------------------------ 3,507,420 3,951,078 Maturities ------------------------------------- 238,238 182,774 Purchase of other investments -------------------- (577,470) (301,429) Sale or maturity of other investments ------------ 475,069 340,700 Sale of affiliates/operating property ------------ -- -- Purchase of affiliates --------------------------- -- -- Increase (decrease) in cash collateral on loan securities ----------------------------- 145,910 (244,080) Other -------------------------------------------- (195,147) 111,999 Net Cash Used in Investing Activities ------ (249,300) (408,058) </TABLE> <TABLE> <CAPTION> Financing Activities: <S> <C> <C> Principal payments on long-term debt ------------- (1,561) (455) Issuance of long-term debt ----------------------- 1,152 1 Net increase in short-term debt ------------------ 3,378 27,466 Universal life and investment contract deposits -- 290,780 786,828 Universal life and investment contract withdrawals --------------------------- (576,720) (565,451) Common stock issued for benefit plans ------------ 1,468 2,165 Dividends paid to shareholders ------------------- (47,762) (44,802) Net Cash Provided by Financing Activities -- (329,265) 205,752 Net Increase in Cash ----------------------- (231,900) 280,284 Cash at Beginning of Year -------------------------- 1,572,855 1,041,583 Cash at March 31 --------------------------- $1,340,955 $1,321,867 See notes to consolidated financial statements on page 7. </TABLE>
-7- LINCOLN NATIONAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Basis of Presentation The accompanying consolidated financial statements include Lincoln National Corporation ("LNC") and its majority-owned subsidiaries. Less than majority- owned entities in which LNC has at least a 20% interest are reported on the equity basis. These unaudited consolidated statements have been prepared in conformity with generally accepted accounting principles, except that they do not contain complete notes. However, in the opinion of management, these statements include all normal recurring adjustments necessary for a fair presentation of the results. These financial statements should be read in conjunction with the financial statements and the related notes included in LNC's latest annual report on Form 10-K for the year ended December 31, 1995. Operating results for the three months ended March 31, 1996 are not necessarily indicative of the results that may be expected for the full year ending December 31, 1996. 2. Federal Income Taxes The effective tax rate on net income is lower than the prevailing corporate federal income tax rate. The difference for both 1995 and 1996 resulted principally from tax-exempt investment income. 3. Earnings Per Share Earnings per share are computed based on the average number of common shares outstanding (104,532,461 and 103,678,382 for the first three months of 1996 and 1995, respectively) after assuming conversion of the series A, E and F preferred stock. 4. Potential Sale of Minority Interest in Subsidiary During the first quarter of 1996, LNC announced that it would be offering up to 18.7% of its principal subsidiary within its Property-Casualty segment (American States Insurance Company) to the public in the form of an initial public offering of its common stock. The filing of a registration statement with the Securities and Exchange Commission, marketing of the shares and receiving the necessary approvals is expected to result in a closing of this transaction in the second quarter of 1996. Following the completion of this transaction, LNC will continue to fully consolidate this operation within its financial statements and tax reporting. A minority interest will be established for the portion of the company that was sold.
-8- LINCOLN NATIONAL CORPORATION Item 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL INFORMATION The pages to follow review LNC's results of consolidated operations and financial condition. Historical financial information is presented and analyzed. Where appropriate, factors that may affect future financial performance are identified and discussed. Actual results could differ materially from those indicated in forward-looking statements due to, among other specific changes currently not known, subsequent significant changes in: the company (e.g. acquisitions and divestitures), financial markets (e.g. interest rates and securities markets), legislation (e.g. taxes and product taxation), regulations (e.g. insurance and securities regulations), acts of God (e.g. hurricanes, earthquakes and storms), other insurance risks (e.g. policyholder mortality and morbidity) and competition. REVIEW OF CONSOLIDATED OPERATIONS The discussion that follows focuses on the results for the three months ended March 31, 1996 compared to the results for the three months ended March 31, 1995. Insurance Premiums Life and annuity premiums for the first three months of 1996 increased $23.2 million or 15% compared with the first three months of 1995. This increase is the result of increases in business volume from the Life Insurance and Annuities segment. Health premiums increased $27.1 million or 17% for the first three months of 1996 compared with the first three months of 1995 as a result of increased volumes of business in the Reinsurance segment. Property- casualty premiums decreased by $14.7 million or 3% compared with the three months ended March 31, 1995 due to reduced volumes of business primarily from workers compensation coverages. Insurance Fees Insurance fees in the Life Insurance and Annuities segment from universal life, other interest-sensitive life insurance contracts and variable life insurance contracts increased $22.2 million or 18% compared to the first three months of 1995. This increase was the result of increases in the volume of transactions and a market-driven increase in the value of existing customer accounts upon which some of the fees are based. Investment Advisory Fees This line was added to the statements of income in the second quarter of 1995 following LNC's purchase of Delaware Management Holdings, Inc. This acquisition also led to the formation of a new business segment entitled "Investment Management." Net Investment Income Net investment income increased $41.1 million or 8% when compared with the first three months of 1995. This increase is the net result of an 11% increase in mean invested assets and a decrease in the overall yield on investments from 7.71% to 7.48% (all calculations on a cost basis). Net investment income for the first three months of 1996 included a charge of $9.2 million versus a benefit of $5.6 million in the first quarter of 1995 from the recurring adjustment of discount on mortgage-backed securities. The increase in mean invested assets is the result of increased volumes of business in the Life Insurance and Annuities and Reinsurance segments. Equity in Earnings of Unconsolidated Affiliates This line was added to the statements of income in 1994 following LNC's sale of 71% of its direct writer of health coverages. Most of the amount shown for the three months ended March 31, 1995 represent LNC's share of the total earnings of this company. Due to the October 11, 1995 sale of the remaining 29% ownership in this company, no activity is shown in this account for the three months ended March 31, 1996.
-9- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL INFORMATION (continued) REVIEW OF CONSOLIDATED OPERATIONS (continued) Realized Gain on Investments The first three months of 1996 and 1995 had pre-tax realized gain on investments of $71.3 million and $44.1 million, respectively. These gains, which are net of related deferred acquisition costs and amounts needed to satisfy policyholder commitments, were the result of net gains on sale of investments, less some modest write-downs and provisions for losses. Securities available-for-sale, mortgage loans on real estate and real estate holdings that were deemed to have declines in fair value that were other than temporary were written down. In addition to the write-downs, LNC established allowances for losses on select mortgage loans on real estate, real estate investments and other investments where the carrying value was determined not to be recoverable. The pre-tax write-down of securities available-for-sale for the first three months of 1996 and 1995 was $3.1 million and $4.3 million, respectively. With the exception of interest only mortgage-backed securities, the fixed maturity securities to which these write-downs apply were generally of investment grade quality at the time of purchase, but were classified as "below investment grade" at the time of the write-downs. The net pre-tax write-downs and additions to the allowances for losses on real estate and mortgage loans on real estate for the first three months of 1996 and 1995 were $8.2 million and $7.3 million, respectively. The pre-tax addition (reduction) to the allowance for losses for other investments for the first three months of 1996 and 1995 was $.3 million and $(.6) million, respectively. Other Revenue Other revenue decreased $13.4 million when compared to the first three months of 1995 as the net result of an increase in the volume of transactions within the Life Insurance and Annuities business segment being more than offset by the absence of revenues from the investment management companies that were being recorded in this account until the start of the new business segment in the second quarter of 1995. Insurance Benefits and Settlement Expenses Life and annuity benefits and settlement expenses increased $33.2 million or 7% when compared to the first three months of 1995. This increase is the result of increases in business volume from the Life Insurance and Annuities segment and average mortality in the Reinsurance segment versus exceptionally low mortality a year ago. Health benefits increased by $2.7 million or 2% when compared to the first three months of 1995 as a net result of increased volumes of business and decreased claims in the Reinsurance segment. In light of the reserve strengthening that occurred in 1995 the amount of disability income claims which is within the health benefits number was higher than anticipated. An analysis of the disability income claims indicated the first quarter 1996 claims were at the high end of the expected range of fluctuation. Property-casualty benefits increased by $12.7 million or 4% when compared with the first three months of 1995 as a net result of a small decrease in business being more than offset with increases in catastrophe losses and weather related claims. Underwriting, Acquisition, Insurance and Other Expenses This expense increased $89.2 million or 22% for the three months ended March 31, 1996 compared to the first three months of 1995. The primary driver behind this increase, beyond the general inflation rate, was the higher volume related expenses in the Life Insurance and Annuity and Reinsurance segments due to the increase in business volumes and the addition of the operating expenses of the companies acquired in the second quarter of 1995. These expenses for the Property-Casualty segment decreased $9.4 million or 6% compared with a year ago as the impact of consolidating 20 divisional offices into four regional offices started to be realized and the adjusting of staff levels to the current level of business continued.
-10- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL INFORMATION (continued) REVIEW OF CONSOLIDATED OPERATIONS (continued) Interest Expense Interest expense increased $4.5 million or 32% when compared with the first three months of 1995. This was the result of increases in the average debt outstanding and increases in short-term interest rates. Overall debt levels were higher due to debt related to the acquisitions of additional companies in the second quarter of 1995. While a portion of the interest expense is dependent upon future short-term borrowing rates, in the near term the total interest expense per quarter is expected to somewhat parallel the interest expense for the first quarter of 1996. Federal Income Taxes Federal income taxes increased $9.2 million when compared to the first three months of 1995. This is the result of an increase in pre-tax earnings and a reduction tax-exempt investment income. Summary Net income for the first three months of 1996 was $140.0 million or $1.34 per share compared with $134.8 million or $1.30 per share in the first three months of 1995. Excluding realized gain on investments, LNC earned $95.2 million for the first three months of 1996 compared with $106.5 million for the first three months of 1995. This decrease was the net result of an increase in earnings in the Life Insurance and Annuities segment being more than offset by reductions in earnings from the Reinsurance and Property- Casualty business segments. REVIEW OF CONSOLIDATED FINANCIAL CONDITION Investments The total investment portfolio decreased $.8 billion in the first three months of 1996. This decrease is the net result of decreases in the fair value of securities available-for-sale during the first three months of 1996 being partial offset by increases from the purchases of investments from cash flow generated by the business segments. The quality of LNC's fixed maturity securities portfolio as of March 31, 1996 was as follows: Treasuries and AAA 33.3% BBB 22.4% AA 10.9% BB 3.0% A 27.3% Less than BB 3.0% As of March 31, 1996, $1.5 billion or 6.0% of fixed maturity securities was invested in below investment grade securities (less than BBB). This represents 4.9% of the total investment portfolio. The interest rates available on these below investment grade securities are significantly higher than are available on other corporate debt securities. Also, the risk of loss due to default by the borrower is significantly greater with respect to such below investment grade securities, because these securities are generally unsecured, often subordinated to other creditors of the issuer and issued by companies that usually have high levels of indebtedness. LNC attempts to minimize the risks associated with these below investment grade securities by limiting the exposure to any one issuer and by closely monitoring the credit worthiness of such issuers. During the three months ended March 31, 1996, the aggregate cost of such investments purchased was $259.6 million. Aggregate proceeds from such investments sold were $259.7 million, resulting in a net realized pre-tax loss of $2.2 million. LNC's entire fixed maturity and equity securities portfolio is classified as "available-for-sale" and is carried at fair value. Changes in fair value, net of related deferred acquisition costs, amounts required to satisfy policyholder commitments and taxes, are charged or credited directly to shareholders' equity.
-11- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL INFORMATION (continued) REVIEW OF CONSOLIDATED FINANCIAL CONDITION (continued) As of March 31, 1996, mortgage loans on real estate and real estate represented 10.5% and 2.4% of LNC's total investment portfolio. As of March 31, 1996, the underlying properties supporting the mortgage loans on real estate consisted of 19.9% in commercial office buildings, 28.8% in retail stores, 21.4% in apartments, 14.2% in industrial buildings, 6.0% in hotels/motels and 9.7% in other. In addition to the dispersion by property type, the mortgage loan portfolio is geographically diversified throughout the United States. Impaired loans included along with the related allowance for losses are as follows: March 31 December 31 (in millions) 1996 1995 Impaired loans with allowance for losses --------- $159.4 $150.9 Allowance for losses ----------------------------- (34.5) (29.6) Impaired loans with no allowance for losses ------ 8.0 2.2 Net Impaired Loans ----------------------------- $132.9 $123.5 Impaired loans with no allowance for losses are a result of 1)direct write-downs or 2)collateral dependent loans where the fair value of the collateral is greater than the recorded investment in loans. A reconciliation of the mortgage loan allowance for losses for these impaired mortgage loans is as follows: Three Months Ended March 31 (in millions) 1996 1995 Balance at beginning of year --------------------- $29.6 $ 62.7 Provisions for losses ---------------------------- 6.1 9.7 Releases due to sales ---------------------------- (.8) (15.7) Releases due to foreclosures --------------------- (.4) -- Balance at End of Quarter ---------------------- $34.5 $56.7 The average recorded investment in impaired loans and the interest income recognized on impaired loans were as follows: Three Months Ended March 31 (in millions) 1996 1995 Average recorded investment in impaired loans ---- $160.3 $251.8 Interest income recognized on impaired loans ----- 4.2 4.8 All interest income on impaired loans was recognized on the cash basis of income recognition. As of March 31, 1996 and 1995, LNC had restructured loans of $62.4 million and $42.2 million, respectively. LNC recorded $1.4 million and $.9 million interest income on these restructured loans for the three months ended March 31, 1996 and 1995, respectively, as compared to interest income of $1.7 million and $1.1 million that would have been recorded according to their original terms. As of March 31, 1996, LNC did not have any future commitments to lend funds for non-accrual, restructured or other problem loans. Fixed maturity securities available-for-sale, mortgage loans on real estate and real estate with a combined carrying value at March 31, 1996 of $8.2 million were non-income producing for the three months ended March 31, 1996.
-12- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL INFORMATION (continued) REVIEW OF CONSOLIDATED FINANCIAL CONDITION (continued) Cash and Invested Cash Cash and invested cash decreased by $231.9 million in the first three months of 1996. This decrease is the result of investing a portion of the operating cash flow that had previously been invested in short-term investments pending the placement of funds in longer term investments. Deferred Acquisition Costs Deferred acquisition costs increased $450.0 million during the quarter. One half of this increase was the result of a reclassification between deferred acquisitions costs and policy liabilities and accruals by LNC's United Kingdom subsidiary. This reclassification was made in order to more closely conform the United Kingdom classifications to the classifications used by LNC's U.S. life operations. The other half of the increase is the result of the growth in business and increases related to the reduction in the unrealized gain on securities available-for-sale during the quarter. Premiums and Fee Receivable Premiums and fees receivable increased $82.0 million in the first three months of 1996 as the result of increased volumes of business in the Reinsurance segment. Assets Held in Separate Accounts This asset account as well as the corresponding liability account increased by $1.5 billion in the first three months of 1996, reflecting an increase in annuity and pension funds under management. Amounts Recoverable from Reinsurers The decrease in amounts recoverable from reinsurers of $37.5 million was the result of decreases in the volume of business ceded in the Life Insurance and Annuities segment. Goodwill and Other Intangible Assets The decreases in the amounts during the quarter represent amortization for the quarter. Other Assets The increase in other assets of $90.9 million is the result of having a higher receivable related to investment securities sold in the last few days of the first quarter of 1996 versus the end of 1995. Total Liabilities Total liabilities increased by $1.2 billion in the first three months of 1996. This increase is the result of an increase of $1.5 billion in the liabilities related to separate accounts being partially by a reduction in federal income taxes payable and contractholder funds. An increase in policy liabilities and accruals related to increased levels of business in the Reinsurance and Life Insurance and Annuities segment was offset by the reclassification discussed above under the deferred acquisition costs heading. The slight reduction in contractholder funds is the net result of new deposits being more than a offset by 1) decreases in account values related to decreases in the fair value of securities available-for-sale and 2) the withdrawal of guaranteed interest contract funds because of the decision to exit this business.
-13- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL INFORMATION (continued) REVIEW OF CONSOLIDATED FINANCIAL CONDITION (continued) Total property-casualty liabilities for unpaid claims and claims expenses were $2.6 billion at March 31, 1996 and December 31, 1995. These liabilities include liabilities for environmental claims of $263 million and $256 million at March 31, 1996 and December 31, 1995, respectively. Because of the limited coverages that have been written by LNC, these reserves represent only 11% and 10%, respectively, of LNC's total property-casualty liabilities and only 2% of LNC's total policy liabilities. On a claims count basis these environmental losses represent only 3% of the direct property-casualty business. These percentages and amounts are at these levels due to LNC's concentration on writing coverages for small to medium size companies rather than the larger companies that tend to incur most of the environmental and product liability claims. LNC's management challenges environmental claims in cases of questionable liability and reviews the level of environmental liability on an on-going basis to help insure that the liability maintained is adequate. Nonetheless, establishing reserves for environmental losses is subject to significant uncertainties because of the long reporting delays, lack of historical data and the unresolved complex legal and regulatory issues that are involved. While it is management's judgement that, based on available information, the appropriate level of liabilities have been recorded, it is reasonably possible that a change in estimate of the required liability level could occur in the near term. The liability for disability income claims net of the related assets for amounts recoverable from reinsurers at March 31, 1996 and December 31, 1995 is a net liability of $1,520,000,000 and $1,541,000,000, respectively, excluding deferred acquisition costs. LNC reviews and updates the level of these reserves on an on-going basis. These reserves were established on the assumption that recent experience will continue in the future. If incidence levels or claim termination rates vary significantly form these assumptions, further adjustments to reserves may be required in the future. Tax authorities continue to focus on compliance of qualified annuity plans marketed by insurance companies. If sponsoring employers cannot demonstrate compliance and the insurance company is held responsible due to its marketing efforts, LNC and other insurers may be subject to potential liability. It is not possible to provide a meaningful estimate of the range of possible liability at this time. Management continues to monitor this matter and to take steps to minimize any potential liability. The liabilities for guaranteed interest and group pension annuity contracts, which are no longer being sold, are supported by a single portfolio of assets which attempts to match the duration of these liabilities. Due to the very long-term nature of group pension annuities and the resulting inability to exactly match cash flows, a risk exists that future cash flows from investments will not be reinvested at rates as high as currently earned by the portfolio. This situation could cause losses which would be recognized at some future time. Shareholders' Equity Total shareholders' equity decreased $232.1 million in the first three months of 1996. Excluding the decrease of $316.4 million related to unrealized gains on securities available-for-sale, shareholders' equity increased $84.3 million. This increase was the net result of $140.0 million from net income and $1.5 million from the issuance of common stock related to benefit plans, being partially offset by a decrease in the accumulated foreign exchange gain of $9.4 million and the declaration of dividends to shareholders of $47.8 million.
-14- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL INFORMATION (continued) REVIEW OF CONSOLIDATED FINANCIAL CONDITION (continued) Derivatives As indicated in note 7 to the consolidated financial statements for the year ended December 31, 1995 (see page 58 of LNC's Form 10-K), LNC has entered into derivative transactions to reduce its exposure to fluctuations in interest rates, the widening of bond yield spreads over comparable maturity U.S. Government obligations and foreign exchange risks. In addition, LNC is subject to the risks associated with changes in the value of its derivatives; however, such changes in the value generally are offset by changes in the value of the items being hedged by such contracts. During the first three months of 1996, LNC has made changes in its derivative positions as follows: 1. Terminated the $600 million of spread-lock agreements. Gains totalling $1.6 million resulting from these transactions are being deferred over the lives of the hedged assets. 2. Entered into a foreign currency spread-lock agreement with a notional amount of $15 million to hedge against a widening of the spread on two currencies. 3. Terminated the $106.7 million of long financial futures that were being used to hedge interest rate risks. 4. Added $2.1 billion of long financial futures to hedge the anticipated purchase of a portfolio of assets to support the group tax-sheltered annuity business from UNUM Corporation. This transaction is expected to be consummated in the second half of 1996. 5. Increased foreign currency options by a notional amount of $207.2 million to hedge the currency risk of increased holdings of foreign bonds. With the exception of one counterparty that has a Baal rating from one rating agency all counterparties hold A ratings or above. As of March 31, 1996, LNC's cap agreements with that counterparty have an aggregate notional amount of $500 million and an aggregate replacement value of approximately $200,000. 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. Because of the interval of time from receipt of a deposit or premium until payment of benefits or claims, LNC and other insurers employ investment portfolios as an integral element of operations. By segmenting its investment portfolios along product lines, LNC enhances the focus and discipline it can apply to managing the liquidity as well as the interest rate and credit risk of each portfolio commensurate with the profile of the liabilities. For example, portfolios backing products with less certain cash flows and/or withdrawal provisions are kept more liquid than portfolios backing products with more predictable cash flows. The Consolidated Statement of Cash Flows on page 6, indicates that operating activities provided cash of $346.7 million during the first three months of 1996. This statement also classifies the other sources and uses of cash by investing activities and financing activities and discloses the total amount of cash available to meet LNC's obligations. Although LNC generates adequate cash flow to meet the needs of its normal operations, periodically LNC may issue debt or equity securities to fund internal expansion, acquisitions, investment opportunities and the retirement of LNC's debt and equity. In 1995, LNC filed a shelf registration for $600
-15- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL INFORMATION (continued) REVIEW OF CONSOLIDATED FINANCIAL CONDITION (continued) million with the Securities and Exchange Commission that would allow LNC to issue debt or equity securities. This registration included an aggregate of $100 million of securities which had not been utilized from a 1994 registration. Also, cash funds are available from LNC's revolving credit agreement which provides for borrowing up to $500 million. Transactions such as those described in the preceding paragraph that occurred recently included the issuance of $200 million in debt in May 1995. Proceeds from this offering were used to pay down short-term debt that had been incurred in April 1995 related to the acquisition of additional operating businesses. As described in note 4 to the accompanying financial statements, LNC is offering up to 18.7% of its principal subsidiary within the Property-Casualty segment to the public in the form of an initial public offering of common stock. In conjunction with this offering this subsidiary will assume $100 million of existing LNC debt and issue $200 million of term debt payable to LNC. The cash proceeds from the sale of common stock (approximately $225-$275 million) will be used to support the capital base of the property casualty operations and to meet working capital needs. Prior to closing, this subsidiary will make a one-time, special dividend distribution of $300 million to LNC. This distribution will consist primarily of tax-exempt municipal securities that are currently in the subsidiary's investment portfolio. Following the completion of the transaction this subsidiary will discontinue its recent practice of declaring dividends essentially equal to its prior years statutory earnings and adopt a dividend policy more in line with the policy followed by other publicly traded property casualty companies.
-16- PART II - OTHER INFORMATION AND EXHIBITS Items 1, 2, 3, 4 and 5 of this Part II are either inapplicable or are answered in the negative and are omitted pursuant to the instructions to Part II. Item 6. Exhibits and Reports on Form 8-K (a) The following Exhibits of the Registrant are included in this report. (Note: The number preceding the exhibit corresponds to the specific number within Item 601 of Regulation S-K.) 10(a) Lincoln National Corporation Directors' Value Sharing Plan 11 Computation of Per Share Earnings 12 Historical Ratio of Earnings to Fixed Charges 27 Financial Data Schedule (b) No reports on Form 8-K were filed during the quarter ended March 31, 1996.
-17- SIGNATURE PAGE 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. LINCOLN NATIONAL CORPORATION By /S/ Richard C. Vaughan Richard C. Vaughan, Executive Vice President and Chief Financial Officer /S/ Donald L. Van Wyngarden Donald L. Van Wyngarden, Second Vice President and Controller Date May 9, 1996
-18- LINCOLN NATIONAL CORPORATION Exhibit Index for the Report on Form 10-Q for the Quarter Ended March 31, 1996 Exhibit Number Description Page Number 10(a) Lincoln National Corporation Directors' Value Sharing Plan 19 11 Computation of Per Share Earnings 29 12 Historical Ratio of Earnings to Fixed Charges 30 27 Financial Data Schedule 31