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 June 30, 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 July 26, 1996 104,316,268 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 periods 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 19. Page 1 of 22
-2- <TABLE> <CAPTION> PART I - FINANCIAL INFORMATION Item 1 Financial Statements LINCOLN NATIONAL CORPORATION CONSOLIDATED BALANCE SHEETS June 30 December 31 (000'S omitted) 1996 1995 ASSETS Investments: <S> <C> <C> Securities available-for-sale, at fair value: Fixed maturity (cost 1996 - $24,359,245; 1995 - $23,935,527) ------------------ $25,022,192 $25,834,476 Equity (cost 1996 - $769,224; 1995 - $936,124) --------------------- 953,308 1,164,844 Mortgage loans on real estate ------------ 3,366,492 3,186,872 Real estate ------------------------------ 789,783 775,912 Policy loans ----------------------------- 618,034 602,573 Other investments ------------------------ 336,954 371,765 Total Investments ---------------------- 31,086,763 31,936,442 Investment in unconsolidated affiliates ---- 21,334 5,562 Cash and invested cash --------------------- 1,351,094 1,572,855 Property and equipment --------------------- 244,969 243,763 Deferred acquisition costs ----------------- 2,030,089 1,436,685 Premiums and fees receivable --------------- 687,630 537,979 Accrued investment income ------------------ 442,482 462,737 Assets held in separate accounts ----------- 25,571,224 22,769,068 Federal income taxes ----------------------- 120,155 -- Amounts recoverable from reinsurers -------- 2,480,798 2,495,189 Goodwill ----------------------------------- 456,967 471,465 Other intangible assets -------------------- 498,215 528,934 Other assets ------------------------------- 1,092,891 797,054 Total Assets ----------------------------- $66,084,611 $63,257,733 See notes to consolidated financial statements on page 7. </TABLE>
-3- <TABLE> <CAPTION> LINCOLN NATIONAL CORPORATION CONSOLIDATED BALANCE SHEETS -CONTINUED- June 30 December 31 (000's omitted) 1996 1995 LIABILITIES, MINORITY INTEREST AND SHAREHOLDERS' EQUITY Liabilities: <S> <C> <C> Policy liabilities and accruals: Future policy benefits, claims and claim expenses -------------------- $12,912,879 $12,922,547 Unearned premiums ----------------------- 808,693 813,380 Total Policy Liabilities and Accruals - 13,721,572 13,735,927 Contractholder funds ---------------------- 18,719,427 18,784,508 Liabilities related to separate accounts -- 25,571,224 22,769,068 Federal income taxes ---------------------- -- 128,426 Short-term debt --------------------------- 460,112 426,848 Long-term debt ---------------------------- 651,508 659,303 Minority interest in consolidated subsidiaries ---------------------------- 203,993 -- Other liabilities ------------------------- 2,573,751 2,375,531 Total Liabilities ----------------------- 61,901,587 58,879,611 Minority interest - preferred securities of a subsidiary --------------------------- -- -- </TABLE> <TABLE> <CAPTION> Shareholders' Equity: <S> <C> <C> Series A preferred stock (6/30/96 liquidation value - $3,101) ----- 1,273 1,335 Common stock ------------------------------ 892,528 889,476 Retained earnings ------------------------- 2,965,947 2,775,718 Foreign currency translation adjustment --- 13,197 13,413 Net unrealized gain (loss) on securities available-for-sale ----------------------- 310,079 698,180 Total Shareholders' Equity -------------- 4,183,024 4,378,122 Total Liabilities, Minority Interest and Shareholders' Equity -------------- $66,084,611 $63,257,733 See notes to consolidated financial statements on page 7. </TABLE>
-4- <TABLE> <CAPTION> LINCOLN NATIONAL CORPORATION CONSOLIDATED STATEMENTS OF INCOME Six Months Ended Three Months Ended June 30 June 30 (000's omitted) 1996 1995 1996 1995 Revenue: Insurance premiums ----------- $1,568,424 $1,524,889 $ 793,071 $ 785,173 <S> <C> <C> <C> <C> Insurance fees --------------- 298,622 251,909 154,419 129,866 Investment advisory fees ----- 99,105 42,579 49,852 42,579 Net investment income -------- 1,133,416 1,101,055 562,184 570,908 Equity in earnings of unconsolidated affiliates -- 291 8,799 291 3,692 Realized gain on investments - 100,787 106,411 29,529 62,311 Other ------------------------ 83,786 94,279 54,568 51,662 Total Revenue ------------ 3,284,431 3,129,921 1,643,914 1,646,191 </TABLE> <TABLE> <CAPTION> Benefits and Expenses: <S> <C> <C> <C> <C> Benefits and settlement expenses ------------------- 1,939,974 1,904,281 1,004,224 1,017,150 Underwriting, acquisition, insurance and other expenses 956,965 857,198 464,581 454,037 Interest and debt expense ---- 37,147 33,947 18,653 19,974 Total Benefits and Expenses ----------- 2,934,086 2,795,426 1,487,458 1,491,161 Net Income Before Federal Income Taxes and Minority Interest ------ 350,345 334,495 156,456 155,030 Federal income taxes ----------- 94,877 81,770 41,012 37,118 Net Income before Minority Interest ------ 255,468 252,725 115,444 117,912 Minority interest in consolidated subsidiaries ---- 4,001 -- 4,001 -- Net Income --------------- $ 251,467 $ 252,725 $ 111,443 $ 117,912 Net Income Per Share ----------- $2.40 $2.43 $1.07 $1.13 Cash Dividends Per Share Common Stock ----------------- $ .92 $ .86 $ .46 $ .43 See notes to consolidated financial statements on page 7. </TABLE>
-5- <TABLE> <CAPTION> LINCOLN NATIONAL CORPORATION CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY Six Months Ended June 30 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 ------------- (1,878) (1,395) (62) (46) Balance at June 30 ------ 38,768 41,823 1,273 1,374 Series E and F Preferred Stock: Balance at beginning of year -- 4,417,897 -- 309,913 Conversion into common stock ------------- -- (4,417,897) -- (309,913) Balance at June 30 ------ -- -- -- -- 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 ------------ 15,024 11,160 62 46 Conversion of E and F preferred stock ------------ -- 8,835,794 -- 309,913 Issued for benefit plans ----- 101,134 579,176 2,990 20,772 Balance at June 30 ------104,301,275 103,904,072 892,528 886,113 Retained Earnings: Balance at beginning of year - 2,775,718 2,479,532 Net income ------------------- 251,467 252,725 Realized gain (loss) on sale of minority interest in subsidiary -------------- 34,371 -- Cash dividends declared ------ (95,609) (90,279) Balance at June 30 ------ 2,965,947 2,641,978 Foreign Currency Translation Adjustment: Accumulated adjustment at beginning of year ---------- 13,413 6,890 Change during period --------- (216) 6,000 Balance at June 30 ------ 13,197 12,890 Net Unrealized Gain (Loss) on Securities Available-for-Sale: Balance at beginning of year - 698,180 (311,077) Realized gain (loss) on sale of minority interest in subsidiary --------------- (19,101) -- Change during period --------- (369,000) 955,563 Balance at June 30 ------ 310,079 644,486 Total Shareholders' Equity at June 30 ------------ $4,183,024 $4,186,841 Common Stock (assuming conversion of series A, E & F preferred stock): End of Period ----------- 104,611,419 104,238,656 Average for the Period -- 104,563,359 103,844,782 See notes to consolidated financial statements on page 7. </TABLE>
-6- <TABLE> <CAPTION> LINCOLN NATIONAL CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS Six Months Ended June 30 (000's omitted) 1996 1995 Operating Activities: <S> <C> <C> Net income ---------------------------------------- $ 251,467 $ 252,725 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Deferred acquisition costs -------------------- (14,612) (16,073) Premiums and fees receivable ------------------ (149,863) (62,189) Accrued investment income --------------------- 20,093 (34,226) Policy liabilities and accruals --------------- (273,619) 265,350 Contractholder funds -------------------------- 989,826 520,454 Amounts recoverable from reinsurers ----------- (47,356) (215,239) Federal income taxes -------------------------- (51,434) 115,834 Equity in undistributed earnings of unconsolidated affiliates ------------------- (291) (7,495) Minority interest ----------------------------- 4,001 -- Provisions for depreciation ------------------- 29,057 31,701 Amortization of goodwill and other intangible assets ---------------------------- 39,297 21,144 Realized (gain) loss on investments ----------- (100,787) (106,411) (Gain) loss on sale of affiliate/ operating property -------------------------- -- -- Other ----------------------------------------- (144,305) (1,498) Net Adjustments ----------------------------- 300,007 511,352 Net Cash Provided by Operating Activities --- 551,474 764,077 </TABLE> <TABLE> <CAPTION> Investing Activities: <S> <C> <C> Securities-available-for-sale: Purchases -------------------------------------- (7,537,589) (8,355,472) Sales ------------------------------------------ 6,843,013 7,259,874 Maturities ------------------------------------- 555,571 416,632 Purchase of other investments -------------------- (1,245,004) (670,489) Sale or maturity of other investments ------------ 1,051,413 634,883 Sale of affiliates/operating property ------------ -- -- Purchase of affiliates --------------------------- -- (772,000) Increase (decrease) in cash collateral on loan securities ----------------------------- 123,362 312,511 Other -------------------------------------------- (171,250) (128,948) Net Cash Used in Investing Activities ------ (380,484) (1,303,009) </TABLE> <TABLE> <CAPTION> Financing Activities: <S> <C> <C> Principal payments on long-term debt ------------- (9,447) (528) Issuance of long-term debt ----------------------- 1,652 202,790 Net increase in short-term debt ------------------ 33,264 140,219 Universal life and investment contract deposits -- 546,882 1,452,756 Universal life and investment contract withdrawals --------------------------- (1,088,016) (1,116,837) Common stock issued for benefit plans ------------ 2,990 20,773 Proceeds from sale of minority interest in subsidiary ----------------------------------- 215,481 -- Dividends paid to shareholders ------------------- (95,557) (89,634) Net Cash Provided by Financing Activities -- (392,751) 609,539 Net Increase (Decrease) in Cash------------- (221,761) 70,607 Cash at Beginning of Year -------------------------- 1,572,855 1,041,583 Cash at June 30 ---------------------------- $1,351,094 $1,112,190 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 to shareholders for the year ended December 31, 1995. Operating results for the six months ended June 30, 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 (104,563,359 and 103,844,782 for the first six months of 1996 and 1995, respectively) after assuming conversion of the series A, E and F preferred stock. 4. Sale of Minority Interest in Subsidiary During the first quarter of 1996, LNC announced that it would be offering a minority interest position in its principal subsidiary within its Property- Casualty segment (American States Financial Corporation) to the public in the form of an initial public offering of common stock. During the second quarter of 1996 1) a registration statement was filed with the Securities and Exchange Commission, 2) the shares were marketed and 3) the transaction closed. As a result of this offering, American States Financial Corporation received $215.4 million in cash on May 29, 1996, net of expenses, for the sale of 16.7% of its common stock. LNC recorded a non-taxable realized gain of $15.3 million after expenses associated with the sale, directly in shareholders' equity. LNC continues to fully consolidate this operation within its financial statements and tax reporting.
-8- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL INFORMATION REVIEW OF CONSOLIDATED OPERATIONS 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. The discussion that follows focuses on the results for the six months ended June 30, 1996 compared to the results for the six months ended June 30, 1995. The factors affecting the current quarter to prior year quarter comparisons are essentially the same as the year-to-date factors except as noted. Insurance Premiums Life and annuity premiums for the first six months of 1996 increased $30.4 million or 9% compared with the first six months of 1995. This increase is the result of increases in business volume from the Reinsurance and Life Insurance and Annuities segments. Health premiums increased $35.0 million or 10% for the first six months of 1996 compared with the first six months of 1995 as a result of increased volumes of business in the Reinsurance segment. Property-casualty premiums decreased by $21.9 million or 3% compared with the six months ended June 30, 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 $46.8 million or 19% compared to the first six 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." Investment advisory fees for the second quarter of 1996 were $7.3 million (17%) higher than the comparable second quarter of 1995 due to increased volumes of business. Net Investment Income Net investment income increased $19.6 million or 2% when compared with the first six months of 1995. This increase is the net result of a 5.5% increase in mean invested assets and a decrease in the overall yield on investments from 7.72% to 7.42% (all calculations on a cost basis). Net investment income for the first six months of 1996 included a charge of $6.2 million versus a benefit of $17.9 million in the first six months 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 six months ended June 30, 1995 represents 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, minimal activity is shown in this account for the six months ended June 30, 1996.
-9- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL INFORMATION (continued) REVIEW OF CONSOLIDATED OPERATIONS (continued) Realized Gain on Investments The first six months of 1996 and 1995 had pre-tax realized gain on investments of $100.8 million and $106.4 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 sales 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 six months of 1996 and 1995 was $4.2 million and $11.6 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 six months of 1996 and 1995 were $5.5 million and $6.0 million, respectively. The pre-tax addition (reduction) to the allowance for losses for other investments for the first six months of 1996 and 1995 was $(.4) million and $(2.8) million, respectively. Other Revenue Other revenue decreased $10.5 million when compared to the first six 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 $34.5 million or 4% when compared to the first six 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 $19.2 million or 7% when compared to the first six months of 1995 as a net result of increased volumes of business and decreased claims in the Reinsurance segment. Property-casualty benefits decreased by $18.1 million or 3% when compared with the first six months of 1995 as a result of a decrease in business. Underwriting, Acquisition, Insurance and Other Expenses This expense increased $99.8 million or 12% for the six months ended June 30, 1996 compared to the first six 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 early in the second quarter of 1995. These expenses for the Property-Casualty segment decreased $17.2 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. Interest and Debt Expense Interest and debt expense increased $3.2 million or 9% when compared with the first six 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.
-10- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL INFORMATION (continued) REVIEW OF CONSOLIDATED OPERATIONS (continued) Federal Income Taxes Federal income taxes increased $13.1 million when compared to the first six months of 1995. This is the result of an increase in pre-tax earnings and a reduction in tax-exempt investment income. Minority Interest in Consolidated Subsidiaries This line was added to the income statement to record the earnings applicable to the minority shareholders following the sale of 16.7% of LNC's principal subsidiary within its Property-Casualty segment (see note 4 on page 7). Summary Net income for the first six months of 1996 was $251.5 million or $2.40 per share compared with $252.7 million or $2.43 per share in the first six months of 1995. Excluding realized gain on investments, affiliates and operating property, LNC earned $189.8 million for the first six months of 1996 compared with $185.0 million for the first six months of 1995. This increase was the net result of an increase in earnings in the Life Insurance and Annuities, Property-Casualty and Investment Management segments being partially offset by reductions in earnings from the Reinsurance segment and Corporate and Other. REVIEW OF CONSOLIDATED FINANCIAL CONDITION Investments The total investment portfolio decreased $849.7 million in the first six months of 1996. This decrease is the net result of decreases in the fair value of securities available-for-sale during the first six months of 1996 being partially 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 June 30, 1996 was as follows: Treasuries and AAA 34.1% BBB 20.8% AA 10.5% BB 3.3% A 28.1% Less than BB 3.2% As of June 30, 1996, $1.6 billion or 6.5% of fixed maturity securities was invested in below investment grade securities (less than BBB). This represents 5.3% 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 six months ended June 30, 1996, the aggregate cost of such investments purchased was $558.5 million. Aggregate proceeds from such investments sold were $580.5 million, resulting in a net realized pre-tax gain of $11.8 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 June 30, 1996, mortgage loans on real estate and real estate represented 10.9% and 2.6% of LNC's total investment portfolio. As of June 30, 1996, the underlying properties supporting the mortgage loans on real estate consisted of 21.4% in commercial office buildings, 29.0% in retail stores, 21.1% in apartments, 13.6% in industrial buildings, 5.9% in hotels/motels and 9.0% 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: June 30 December 31 (in millions) 1996 1995 Impaired loans with allowance for losses --------- $148.3 $150.9 Allowance for losses ----------------------------- (31.2) (29.6) Impaired loans with no allowance for losses ------ 7.2 2.2 Net Impaired Loans ----------------------------- $124.3 $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: Six Months Ended June 30 (in millions) 1996 1995 Balance at beginning of year --------------------- $29.6 $ 62.7 Provisions for losses ---------------------------- 3.5 10.5 Releases due to sales ---------------------------- (1.5) (16.1) Releases due to foreclosures --------------------- (.4) (4.8) Balance at End of Quarter ---------------------- $31.2 $52.3 The average recorded investment in impaired loans and the interest income recognized on impaired loans were as follows: Six Months Ended June 30 (in millions) 1996 1995 Average recorded investment in impaired loans ---- $161.4 $223.4 Interest income recognized on impaired loans ----- 7.7 9.4 All interest income on impaired loans was recognized on the cash basis of income recognition. As of June 30, 1996 and 1995, LNC had restructured loans of $61.5 million and $49.4 million, respectively. LNC recorded $2.7 million and $3.1 million interest income on these restructured loans for the six months ended June 30, 1996 and 1995, respectively, as compared to interest income of $3.2 million and $2.7 million that would have been recorded according to their original terms. The $3.1 million recorded for 1995 included $1.0 million in interest income that was due LNC prior to January 1, 1995. As of June 30, 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 June 30, 1996 of $8.3 million were non-income producing for the six months ended June 30, 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 $221.8 million in the first six 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 $593.4 million during the six months ended June 30, 1996. A portion of this increase ($215.3 million) 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 remainder 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 six months ended June 30, 1996. Premiums and Fee Receivable Premiums and fees receivable increased $149.7 million in the first six 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 $2.8 billion in the first six months of 1996, reflecting an increase in annuity funds under management. Amounts Recoverable from Reinsurers The decrease in amounts recoverable from reinsurers of $14.4 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 six months ended June 30, 1996 represent amortization for the period. Other Assets The increase in other assets of $295.8 million is the result of having a higher receivable related to investment securities sold in the last few days of the second quarter of 1996 versus the end of 1995. Total Liabilities Total liabilities increased by $3.0 billion in the first six months of 1996. This increase is the result of increases of $2.8 billion in the liabilities related to separate accounts, $204.0 million minority interest in consolidated subsidiaries and $198.2 million in other liabilities being partially offset 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 Life Insurance and Annuities and Reinsurance segments was more than 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
-13- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL INFORMATION (continued) REVIEW OF CONSOLIDATED FINANCIAL CONDITION (continued) value of securities available-for-sale and 2) the withdrawal of guaranteed interest contract funds because of the decision to exit this business. During the second quarter of 1996, a new liability line entitled "Minority Interest in Consolidated Subsidiaries" was established (see note 4 on page 7). Other liabilities increased as the result of a higher level of securities purchased during the last few days of the second quarter of 1996 versus the end of 1995. Total property-casualty liabilities for unpaid claims and claims expenses were $2.6 billion at June 30, 1996 and December 31, 1995. These liabilities include liabilities for environmental claims of $259 million and $256 million at June 30, 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 was $1.5 billion at both June 30, 1996 and December 31, 1995. 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 from 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 in excess of amounts provided to be recognized at some future time. Minority Interest - Preferred Securities of a Subsidiary This line was added to the balance sheet to accommodate the financing activity described within the Liquidity and Cash Flow section on page 15.
-14- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL INFORMATION (continued) REVIEW OF CONSOLIDATED FINANCIAL CONDITION (continued) Shareholders' Equity Total shareholders' equity decreased $195.1 million in the first six months of 1996. Excluding the decrease of $369.0 million related to unrealized gains on securities available-for-sale, shareholders' equity increased $173.9 million. This increase was the net result of $251.5 million from net income, $15.3 million from the gain on sale of a minority interest in a subsidiary and $3.0 million from the issuance of common stock related to benefit plans, being partially offset by a decrease in the accumulated foreign exchange gain of $.2 million and the declaration of dividends to shareholders of $95.6 million. 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 six months of 1996, LNC has made changes in its derivative positions as follows: 1. Added $300 million notional amount of interest rate caps to protect its annuity line of business from the effect of fluctuating interest rates. LNC also added $68 million notional amount of interest rate caps to hedge a portfolio of interest rate sensitive assets. As a result, LNC has increased its interest rate cap position from $5.1 billion to $5.4 billion. 2. Terminated $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. 3. 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. 4. Terminated $106.7 million of long financial futures that were being used to hedge interest rate risks. 5. Added $2.1 billion face amount 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 sometime in the fourth quarter of 1996. As of June 30, 1996, losses on these long financial futures totalled $107 million. These losses are being deferred until the transaction closes and at that time the losses will be recorded as an adjustment to the carrying value of the assets acquired. 6. Increased the use of foreign exchange forward contracts to $507.4 million notional from $398.8 million to hedge the company's net investment in its foreign subsidiary, Lincoln National(UK). 7. Terminated $15.7 million notional amount of foreign exchange forward contracts that were hedging the foreign currency risk of its portfolio of foreign bonds.
-15- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL INFORMATION (continued) REVIEW OF CONSOLIDATED FINANCIAL CONDITION (continued) 8. Increased the use of foreign currency options from $99.2 million to $548.7 million notional as a hedge of the currency risk of foreign bonds. 9. Entered into an interest rate swap totalling $140 million notional to hedge interest rate risk associated with a portfolio of assets. 10. Entered into $327 million notional amount of swaptions to hedge a portfolio of interest rate sensitive assets. 11. Entered into $703 million notional amount of interest rate floors to hedge the interest rate risk associated with a portfolio of assets. With the exception of one counterparty that has a Baal rating from one rating agency all counterparties hold A ratings or above. As of June 30, 1996, LNC's cap agreements with that counterparty have an aggregate notional amount of $500 million and an aggregate replacement value of approximately $900,000. 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 statements of cash flows on page 6, indicates that operating activities provided cash of $551.5 million during the first six 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 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. In May 1996, LNC filed another shelf registration for $500 million which included the right to offer various forms of hybrid securities (i.e. securities having a combination of both debt and equity characteristics) including Quarterly Income Preferred Securities ("QUIPS") on a series of three newly formed trusts, all of whose common securities are owned by LNC (Lincoln National Capital I, II and III). 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, 7 1/4% debt in May 1995. Proceeds from this offering were used to pay down short-term debt that had been incurred in 1995 related to the acquisition of additional operating businesses. On July 2, 1996, LNC closed a transaction involving $215 million, 8 3/4% QUIPS due in 2026 (callable in 2001). The proceeds from this transaction was also used near term to pay down short-term debt.
-16- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL INFORMATION (continued) REVIEW OF CONSOLIDATED FINANCIAL CONDITION (continued) As described in note 4 to the accompanying financial statements, LNC sold 16.7% of its principal subsidiary within the Property-Casualty segment to the public in the form of an initial public offering of common stock. The net cash proceeds after expenses from the sale of common stock in this subsidiary of $215.4 million is being used to support the capital base of the property casualty operations and to meet working capital needs of the related holding company. In conjunction with this offering this subsidiary issued $200 million of term debt payable to LNC plus $100 million, 7 1/8% debt due in 1999. Also, prior to closing, this subsidiary made a one-time, special dividend distribution of $300 million to LNC. This dividend distribution consisted primarily of tax-exempt municipal securities that were previously in the subsidiary's investment portfolio. Following the completion of the transaction, this subsidiary adopted a policy of declaring regular quarterly cash dividends, commencing with $.21 per share in the third quarter of 1996. LNC owns 50,000,000 of the 60,000,000 outstanding shares of this subsidiary.
-17- PART II - OTHER INFORMATION AND EXHIBITS Items 1, 2, 3 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 4. Submission of Matters to Vote to Securityholders (a) The matter discussed in (c) below was submitted to a vote at the Annual Meeting of Shareholders of the Registrant on May 9, 1996. (c) At the meeting referred to in (a) above, Shareholders of the Registrant voted on the election of five directors for three year terms. The results of the voting was as follows: J. Patrick Barrett Votes Cast for = 87,242,585 Votes Withheld = 1,006,624 Thomas D. Bell, Jr. Votes Cast for = 87,234,230 Votes Withheld = 1,014,979 Daniel R. Efroymson Votes Cast for = 87,251,198 Votes Withheld = 998,011 Roel Pieper Votes Cast for = 87,157,678 Votes Withheld = 1,091,531 Ian M. Rolland Votes Cast for = 87,237,796 Votes Withheld = 1,011,413 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.) 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 June 30, 1996.
-18- 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 August 1, 1996
-19- LINCOLN NATIONAL CORPORATION Exhibit Index for the Report on Form 10-Q for the Quarter Ended June 30, 1996 Exhibit Number Description Page Number 11 Computation of Per Share Earnings 20 12 Historical Ratio of Earnings to Fixed Charges 21 27 Financial Data Schedule 22