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 September 30,1997 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 October 31, 1997 101,374,775 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 328
2 PART I - FINANCIAL INFORMATION Item 1 Financial Statements LINCOLN NATIONAL CORPORATION CONSOLIDATED BALANCE SHEETS September 30 December 31 (000'S omitted) 1997 1996 ASSETS Investments: Securities available-for-sale, at fair value: Fixed maturity (cost 1997 - $22,979,144; 1996 - $23,250,897) ------------------ $24,253,418 $24,096,669 Equity (cost 1997 - $499,381; 1996 - $434,502) --------------------- 684,378 557,565 Mortgage loans on real estate ------------ 3,216,760 3,240,686 Real estate ------------------------------ 601,288 655,024 Policy loans ----------------------------- 754,240 734,773 Other investments ------------------------ 352,335 445,279 Total Investments ---------------------- 29,862,419 29,729,996 Investment in unconsolidated affiliates ---- 4,856 21,004 Cash and invested cash --------------------- 1,246,992 1,144,766 Property and equipment --------------------- 193,060 196,044 Deferred acquisition costs ----------------- 1,595,010 1,689,716 Premiums and fees receivable --------------- 240,899 237,345 Accrued investment income ------------------ 452,025 417,582 Assets held in separate accounts ----------- 36,762,309 28,809,137 Amounts recoverable from reinsurers -------- 2,295,230 2,328,514 Goodwill ----------------------------------- 403,157 351,707 Other intangible assets -------------------- 592,032 708,446 Other assets ------------------------------- 643,882 596,420 Discontinued operations-investment assets -- 4,433,287 4,314,968 Discontinued operations-other assets ------- 1,238,341 1,167,760 Total Assets ----------------------------- $79,963,499 $71,713,405 See notes to consolidated financial statements on pages 7 - 10.
3 LINCOLN NATIONAL CORPORATION CONSOLIDATED BALANCE SHEETS -CONTINUED- September 30 December 31 (000's omitted) 1997 1996 LIABILITIES AND SHAREHOLDERS' EQUITY Liabilities: Insurance and Investment Contract Liabilities: Insurance policy and claim reserves ------- $10,783,747 $10,457,896 Contractholder funds ---------------------- 20,438,945 21,165,410 Liabilities related to separate accounts -- 36,762,309 28,809,137 Total Insurance and Investment Contract Liabilities ------------------- 67,985,001 60,432,443 Federal income taxes ---------------------- 84,967 161,501 Short-term debt --------------------------- 463,763 188,960 Long-term debt ---------------------------- 513,703 626,311 Minority interest - preferred securities of subsidiary companies ----------------- 315,000 315,000 Other liabilities ------------------------- 1,809,498 1,417,377 Discontinued operations-insurance liabilities ------------------------------ 3,627,828 3,650,805 Discontinued operations-other liabilities - 522,681 451,052 Total Liabilities ----------------------- 75,322,441 67,243,449 Shareholders' Equity: Series A preferred stock (9/30/97 liquidation value - $2,818) ----- 1,157 1,212 Common stock ------------------------------ 962,487 901,671 Retained earnings ------------------------- 3,045,958 3,085,028 Foreign currency translation adjustment --- 34,042 66,454 Net unrealized gain (loss) on securities available-for-sale for continuing operations ------------------------------- 420,811 279,161 Net unrealized gain (loss) on securities available-for-sale for discontinued operations ------------------------------- 176,603 136,430 Total Shareholders' Equity -------------- 4,641,058 4,469,956 Total Liabilities and Shareholders' Equity ------------------- $79,963,499 $71,713,405 See notes to consolidated financial statements on pages 7 - 10.
4 LINCOLN NATIONAL CORPORATION CONSOLIDATED STATEMENTS OF INCOME Nine Months Ended Three Months Ended September 30 September 30 (000's omitted) 1997 1996 1997 1996 Revenue: Insurance premiums ------------- $ 983,546 $1,148,159 $ 353,132 $ 411,529 Insurance fees ----------------- 533,936 437,773 189,545 150,339 Investment advisory fees ------- 152,334 134,954 51,871 44,959 Net investment income ---------- 1,665,655 1,516,939 548,470 519,988 Realized gain (loss) on investments ------------------- 71,602 71,617 56,966 (703) Other revenue and fees --------- 186,094 168,953 67,041 81,262 Total Revenue -------------- 3,593,167 3,478,395 1,267,025 1,207,374 Benefits and Expenses: Benefits and settlement expenses ---------------------- 2,149,555 1,980,881 730,357 700,504 Underwriting, acquisition, insurance and other expenses -- 1,175,760 1,060,661 338,800 369,488 Interest and debt expense ------ 70,017 60,676 24,482 23,529 Total Benefits and Expenses -------------- 3,395,332 3,102,218 1,093,639 1,093,521 Net Income From Continuing Operations Before Federal Income Taxes -------------- 197,835 376,177 173,386 113,853 Federal income taxes ----------- 37,886 114,472 48,499 30,897 Net Income From Continuing Operations ---------------- 159,949 261,705 124,887 82,956 Discontinued Operations (Net of income taxes): Net income prior to disposal --- 134,886 109,072 46,367 36,354 Gain on sale ------------------- -- -- -- -- Net Income ----------------- $ 294,835 $ 370,777 $171,254 $119,310 Per Share Data: Net Income From Continuing Operations ---------------------- $1.55 $2.50 $1.22 $ .79 Discontinued Operations ---------- 1.30 1.05 .45 .35 Net Income ----------------- $2.85 $3.55 $1.67 $1.14 Cash Dividends on Common Stock --- $1.47 $1.38 $ .49 $ .46 See notes to consolidated financial statements on pages 7 - 10.
5 LINCOLN NATIONAL CORPORATION CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY Nine Months Ended September 30 Number of Shares Amounts (000's omitted from dollar amounts) 1997 1996 1997 1996 Preferred Stock: (Shares authorized: 10,000,000) Series A Preferred Stock: Balance at beginning-of-year -------- 36,885 40,646 $ 1,212 $ 1,335 Conversion into common stock ------------- (1,659) (3,066) (55) (100) Balance at September 30 - 35,226 37,580 1,157 1,235 Common Stock: (Shares authorized: 800,000,000) Balance at beginning-of-year - 103,658,575 104,185,117 901,671 904,754 Conversion of series A preferred stock ------------ 13,272 24,528 55 100 Issued for benefit plans ----- 527,466 151,335 19,572 3,997 Issued for purchase of subsidiary ----------------- 1,320,902 -- 68,688 -- Retirement of common stock --- (3,318,000) -- (27,499) -- Balance at September 30 - 102,202,215 104,360,980 962,487 908,851 Retained Earnings: Balance at beginning-of-year - 3,085,028 2,760,440 Net income ------------------- 294,835 370,777 Realized gain (loss) on sale of minority interest in subsidiary ----------------- -- 34,371 Retirement of common stock --- (182,625) -- Cash dividends declared ------ (151,280) (143,443) Balance at September 30 - 3,045,958 3,022,145 Foreign Currency Translation Adjustment: Accumulated adjustment at beginning-of-year ---------- 66,454 13,413 Change during the period ----- (32,412) 678 Balance at September 30 - 34,042 14,091 Net Unrealized Gain (Loss) on Securities Available-for-Sale: Balance at beginning-of-year - 415,591 698,180 Realized gain (loss) on sale of minority interest in subsidiary ----------------- -- (19,101) Change during the period ----- 181,823 (337,528) Balance at September 30 - 597,414 341,551 Total Shareholders' Equity at September 30 ------- $4,641,058 $4,287,873 Common Stock (assuming conversion of series A, preferred stock): End of Period ----------- 102,484,023 104,661,620 Average for the Period -- 103,480,259 104,587,473 See notes to consolidated financial statements on pages 7 - 10.
6 LINCOLN NATIONAL CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS Nine Months Ended September 30 (000's omitted) 1997 1996 Operating Activities: Net income from continuing operations ------------ $159,949 $ 261,705 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Deferred acquisition costs ------------------- 350 40,345 Premiums and fees receivable ----------------- (3,555) (208,784) Accrued investment income -------------------- (34,443) (12,071) Policy liabilities and accruals -------------- 124,855 (146,448) Contractholder funds ------------------------- 524,545 1,186,819 Amounts recoverable from reinsurers ---------- 33,283 (61,419) Federal income taxes ------------------------- (138,295) (278) Provisions for depreciation ------------------ 43,626 33,231 Amortization of goodwill and other intangible assets --------------------------- 153,145 55,902 Realized (gain) loss on investments ---------- (71,602) (71,206) Other (used in) ------------------------------ 144,823 (151,166) Net Adjustments ---------------------------- 776,732 664,925 Net Cash Provided by Continuing Operations - 936,681 926,630 Net Cash Provided by (Used in) Discontinued Operations --------------------- 7,799 (9,607) Net Cash Provided by Operating Activities -- 944,480 917,023 Investing Activities: Securities-available-for-sale: Purchases -------------------------------------- (8,045,600) (9,708,300) Sales ------------------------------------------ 7,279,137 8,737,107 Maturities ------------------------------------- 1 084,569 749,353 Purchase of other investments -------------------- (1,595,145) (1,823,037) Sale or maturity of other investments ------------ 1,647,524 1,580,528 Sale of subsidiaries (discontinued operations) --- -- -- Increase (decrease) in cash collateral on loaned securities --------------------------- 126,818 159,774 Other -------------------------------------------- 60,377 (126,265) Net Cash Provided by (Used in) Investing Activities ---------------------- 557,680 (430,840) Financing Activities: Principal payments on long-term debt ------------- (113,550) (9,766) Issuance of long-term debt ----------------------- 943 1,715 Net increase (decrease) in short-term debt ------- 274,804 (197,576) Issuance of preferred securities of subsidiary companies ---------------------------- -- 315,000 Universal life and investment contract deposits -- 775,128 817,653 Universal life and investment contract withdrawals --------------------------- (1,994,749) (1,636,782) Common stock issued for benefit plans ------------ 19,572 3,997 Retirement of common stock ----------------------- (210,124) -- Proceeds from sale of minority interest in subsidiary ----------------------------------- -- 215,481 Dividends paid to shareholders ------------------- (151,958) (143,373) Net Cash Used in Financing Activities ------ (1,399,934) (633,651) Net Increase (Decrease) in Cash------------- 102,226 (147,468) Cash at Beginning-of-Year -------------------------- 1,144,766 1,452,170 Cash at September 30 ----------------------- $1,246,992 $1,304,702 See notes to consolidated financial statements on pages 7 - 10.
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, 1996. Operating results for the nine months ended September 30, 1997 are not necessarily indicative of the results that may be expected for the full year ending December 31, 1997. 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 1997 and 1996 resulted principally from tax-exempt investment income. 3. Earnings Per Share Earnings per share is computed based on the average number of common shares outstanding (103,480,259 and 104,587,473 for the first nine months of 1997 and 1996, respectively) after assuming conversion of the series A preferred stock. Financial Accounting Standard 128 entitled "Earnings per Share" ("FAS 128") which was issued in February 1997, is required to be adopted on December 31, 1997. The impact of FAS 128 on the calculation of earnings per share for the nine months ended September 30, 1997 and 1996 is not material. 4. Discontinued Operations On June 9, 1997, LNC announced that it agreed to sell its 83.3% ownership in American States Financial Corporation for $2.65 billion (including the repayment of $300 million of intercompany debt). As this sale resulted in an exit from the property-casualty business (previously a business segment), the financial data from the units being sold is shown as discontinued operations in the accompanying financial statements. June 9, 1997 is the measurement date for purposes of reporting the units sold as discontinued operations. The gain on sale resulting from the October 1, 1997 closing will be reported with discontinued operations in the fourth quarter of 1997. The estimated gain on sale is $1.220 billion ($775 million after-tax). LNC expects to invest the proceeds from this sale to expand its other businesses (see note 7 on page 9) and also may repurchase up to $500 million of its own common stock as authorized by the Board of Directors in June of 1997. Earnings from discontinued operations were as follows: Nine Months Ended Three Months Ended September 30 September 30 (in millions) 1997 1996 1997 1996 Revenue -------------------------- $1,538.5 $1,490.9 $524.7 $477.5 Benefits and Expenses ------------ 1,363.6 1,363.6 463.6 434.2 Pre-tax Net Income ------------ 174.9 127.3 61.1 43.3 Federal Income Taxes ------------- 40.0 18.2 14.7 6.9 Net Income -------------------- $ 134.9 $ 109.1 $ 46.4 $ 36.4
8 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 5. Change in Estimate for Disability Income Reserve During the second quarter of 1997, LNC completed an in-depth review of experience on its disability income business. As a result of this study, LNC's Reinsurance segment strengthened its disability income reserve by $92.8 million, wrote-off deferred acquisition costs of $71.1 million and reduced related assets by $36.1 million. Combined, these actions reduced net income for the second quarter of 1997 by $130.0 million or $1.25 share ($200 million pre-tax). 6. Contingencies Disability Income Claims. The liability for disability income claims net of the related asset for amounts recoverable from reinsurers at September 30, 1997 and December 31, 1996 is a net liability of $1.650 billion and $1.561 billion, respectively, excluding deferred acquisition costs. The September 30, 1997 amount includes a special addition in the second quarter 1997 (see note 5 on page 8). If incidence levels and/or claim termination rates fluctuate significantly from the assumptions underlying the reserves, adjustments to reserves could be required in the future. Accordingly, this liability may prove to be deficient or excessive. However, it is management's opinion that such future development will not materially affect the consolidated financial position of LNC. LNC reviews reserve levels on an on-going basis. United Kingdom Pension Products. Operations in the U.K. include the sale of pension products to individuals. Regulatory agencies have raised questions as to what constitutes appropriate advice to individuals who bought pension products as an alternative to participation in an employer sponsored plan. In cases of inappropriate advice, an extensive investigation may have to be done and the individuals put in a position similar to what would have been attained if they had remained in the employer sponsored plan. At September 30, 1997 and December 31, 1996 liabilities of $82.2 million and $86.7 million, respectively, had been established for this issue. These liabilities, which are net of expected recoveries, have been established for the estimated cost of this issue following regulatory guidance as to activities to be undertaken. These liabilities were booked net of expected recoveries of $33.4 million and $31.4 million respectively, from previous owners of companies acquired over the last few years as specified in the indemnification clauses of the purchase agreements. These liabilities and recoveries are based on various estimates that are subject to considerable uncertainty. Accordingly, these liabilities may prove to be deficient. However, it is management's opinion that such future development will not materially affect the consolidated financial position of LNC. Marketing and Compliance Issues. Regulators continue to focus on market conduct and compliance issues. Under certain circumstances companies operating in the insurance and financial services markets have been held responsible for providing incomplete or misleading sales materials and for replacing existing policies with policies that were less advantageous to the policyholder. LNC's management continues to monitor the company's sales materials and compliance procedures and is making an extensive effort to minimize any potential liability. Due to the uncertainty surrounding such matters, it is not possible to provide a meaningful estimate of the range of potential outcomes at this time; however, it is management's opinion that such future development will not materially affect the consolidated financial position of LNC. Group Pension Annuities. The liabilities for guaranteed interest and group pension annuity contracts, which are no longer sold by LNC, are supported by a single portfolio of assets that attempts to match the duration of these liabilities. Due to the 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. Accordingly, these liabilities may prove to be deficient or excessive. However, it is management's opinion that such future development will not materially affect the consolidated financial position of LNC.
9 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Personal Accident Programs. Certain "excess of loss personal accident reinsurance" programs created in the London market have produced pre-tax losses totaling approximately $20 million in the last two years. If recent experience continues or deteriorates further, future losses on these programs could be significant. LNC is investigating the way the programs were designed and evaluating all legal and other remedies which may exist to minimize future losses. It is not possible to provide a meaningful estimate of the range of potential liability (recovery) at this time. Legal Proceedings. LNC and its subsidiaries are involved in various pending or threatened legal proceedings arising from the conduct of business. Most of this litigation is routine in the ordinary course of business. In some instances, these proceedings include claims for unspecified or substantial damages and similar types of relief in addition to amounts for alleged contractual liability or requests for equitable relief. After consultation with legal counsel and a review of available facts, it is management's opinion that the ultimate liability, if any, under these suits will not have a material adverse effect on the consolidated financial condition of LNC. Two lawsuits are not routine. They involve alleged fraud in the sale of interest sensitive universal and whole life insurance policies and purport to be class actions, although the court has not certified a class in either case. Plaintiffs seek unspecified damages and penalties for themselves and on behalf of the putative class. While the relief sought in these cases is substantial, they are in the early stages of litigation and it is premature to determine their materiality. Management intends to defend these suits vigorously. The amount of liability which may arise as a result of these suits, if any, cannot be reasonably estimated at this time and no provision for loss has been made in LNC's financial statements. 7. Acquisition of Individual Life Insurance and Annuity Business On July 28, 1997, LNC announced that it signed a definitive agreement to acquire a block of individual life insurance and annuity business from CIGNA Corporation for approximately $1.4 billion. The total cash commitment for this acquisition will be slightly higher than the $1.4 billion because of expenses associated with the purchase and capital that will be added to the Life Insurance and Annuities segment to support this business. This transaction, which is expected to close in the fourth quarter of 1997, will be accounted for using purchase accounting. The operating results generated by this block of business after the closing date will be included in LNC's consolidated financial statements. As of September 30, 1997, this block of business had liabilities, measured on a statutory basis, of $5.5 billion that will become LNC's obligations at the time of closing. LNC will also receive assets, measured on a historical statutory basis, equal to the liabilities. For the year ended December 31, 1996 this block produced premiums, fees and deposits of $1.3 billion and net income of $80 million. This financial data is on the basis of generally accepted accounting principles, and is prior to any adjustments that will be required by purchase accounting.
10 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 8. Disclosures about Segments of an Enterprise and Related Information Financial Accounting Standard 131 entitled "Disclosures about Segments of an Enterprise and Related Information" ("FAS 131") issued in June 1997, was adopted by LNC in the second quarter of 1997 on a retroactive basis, as permitted. Under FAS 131 segments are defined on the same basis that the company is managed versus the product or market approach previously used. For LNC this redefinition involved moving LNC's major United Kingdom operation from within the Life Insurance and Annuities segment into a separate segment entitled "Lincoln UK." Data shown for all prior periods has been restated to conform to the current period presentation. The following tables show the revised financial data by segment: Nine Months Year Ended Year Ended Ended Dec 31, Dec 31, (in millions) September 30,1997 1996 1995 Revenue: Life Insurance and Annuities ----------- $2,064.6 $2,563.1 $2,615.3 Lincoln UK ----------------------------- 314.8 393.2 351.5 Reinsurance ---------------------------- 1,024.4 1,561.0 1,362.4 Investment Management ------------------ 199.2 210.2 145.2 Other Operations (includes consolidating adjustments) -- (9.8) 6.1 112.1 Total -------------------------------- $3,593.2 $4,733.6 $4,586.5 Net income (loss) from continuing operations before Federal income taxes: Life Insurance and Annuities ----------- $ 279.6 $346.7 $378.1 Lincoln UK ----------------------------- 75.1 101.5 72.5 Reinsurance ---------------------------- (84.7) 131.1 (65.5) Investment Management ------------------ 15.8 32.4 33.8 Other Operations (includes interest expense) ----------- (88.0) (107.6) (4.5) Total -------------------------------- $ 197.8 $504.1 $414.4 Federal income taxes (credits): Life Insurance and Annuities ----------- $ 69.4 $ 95.7 $104.1 Lincoln UK ----------------------------- 24.4 35.5 26.8 Reinsurance ---------------------------- (29.6) 45.4 (23.5) Investment Management ------------------ 9.9 17.0 16.2 Other Operations ----------------------- (36.2) (45.9) (10.6) Total -------------------------------- $ 37.9 $147.7 $113.0 Net income (loss) from continuing operations: Life Insurance and Annuities ----------- $ 210.2 $251.0 $274.0 Lincoln UK ----------------------------- 50.7 66.0 45.7 Reinsurance ---------------------------- (55.1) 85.7 (42.0) Investment Management ------------------ 5.9 15.4 17.6 Other Operations (includes interest expense) ----------- (51.8) (61.7) 6.1 Total Net Income from Continuing Operations -------------------------- 159.9 356.4 301.4 Discontinued Operations ---------------- 134.9 157.2 180.8 Total Net Income --------------------- $ 294.8 $513.6 $482.2 Assets (End of Period): Life Insurance and Annuities ----------- $60,208.9 $53,089.3 $45,791.4 Lincoln UK ----------------------------- 7,924.0 7,331.8 6,114.1 Reinsurance ---------------------------- 5,321.3 5,196.1 5,220.3 Investment Management ------------------ 709.1 623.4 616.2 Other Operations ----------------------- 128.6 (9.9) (170.6) Sub-total ---------------------------- 74,291.9 66,230.7 57,571.4 Discontinued Operations ---------------- 5,671.6 5,482.7 5,686.3 Total -------------------------------- $79,963.5 $71,713.4 $63,257.7
11 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. On June 9, 1997, LNC announced that it had agreed to sell its 83.3% ownership in American States Financial Corporation. The financial data for these operations has been designated as "Discontinued Operations" for all historical and current periods shown in the accompanying financial statements. Following the completion of the sale on October 1, 1997, LNC recorded an estimated gain of $775 million, net of federal income taxes. As a result of this sale the fourth quarter of 1997 and subsequent quarters will show reduced operating earnings. The amount of the reduction will depend on the timing and placement of the proceeds from disposition. In the short run, the proceeds are expected to be invested in liquid securities, used to pay down short-term debt and to repurchase LNC common stock (see discontinued operations note on page 7). It is expected that the bulk of the proceeds will ultimately be used to make acquisitions of additional companies or blocks of business (life insurance, annuities, investment management). Note 7 on page 9 references an acquisition that will use the bulk of the proceeds. REVIEW OF CONSOLIDATED OPERATIONS The discussion that follows focuses on net income from continuing operations for the nine months ended September 30, 1997 compared to the results for the nine months ended September 30, 1996. 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 nine months of 1997 decreased $15.6 million or 3% compared with the first nine months of 1996. This decrease is the net result of increases in business volume from the Life Insurance & Annuities segment, being more than offset by a reduction in the premiums for the Reinsurance and Lincoln UK segments. Health premiums decreased $149.1 million or 25% for the first nine months of 1997 compared with the first nine months of 1996 as a result of decreased volumes of business in the Reinsurance segment. Insurance Fees Insurance fees in the Life Insurance & Annuities and Lincoln UK segments from universal life, other interest-sensitive life insurance contracts and variable life insurance contracts increased $96.2 million or 22% compared with the first nine months of 1996. This increase was the result of increases in the volume of transactions, the fourth quarter 1996 purchase of a block of group tax-qualified annuity business and a market-driven increase in the value of existing customer accounts upon which some of the fees are based. Investment Advisory Fees Investment advisory fees increased by $17.4 million or 13% for the first nine months of 1997 as a net result of increased volumes of business being offset by lower participation fees than were experienced in a strong first half of 1996.
12 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL INFORMATION (continued) REVIEW OF CONSOLIDATED OPERATIONS (continued) Net Investment Income Net investment income increased $148.7 million or 10% when compared with the first nine months of 1996. This increase is the result of a 8% increase in mean invested assets, an increase in the overall yield on investments from 7.43% to 7.48% (all calculations on a cost basis) and the relative impact of the adjustment of discount on mortgage-backed securities. Net investment income for the first nine months of 1997 included a charge of $.7 million versus a charge of $8.0 million in the first nine months of 1996 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 & Annuities and Reinsurance segments. Realized Gain on Investments The first nine months of 1997 and 1996 each had pre-tax realized gain on investments of $71.6 million. These gains, which are net of related deferred acquisition costs, amounts needed to satisfy policyholder commitments and capital gains expenses, were the result of net gains on sales of investments, less some modest write-downs and provisions for losses. Securities available- for-sale that were deemed to have declines in fair value that are other than temporary were written down. Also, write-downs and allowances on select mortgage loans on real estate, real estate and other investments are established when the underlying value of the property is deemed to be less than the carrying value. The pre-tax write-down of securities available-for-sale for the first nine months of 1997 and 1996 were each $10.3 million. 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. During the first nine months of 1997, LNC released $2.3 million in reserves on real estate and mortgage loans on real estate versus a pre-tax charge of $2.6 million in the first nine months of 1996. Other Revenue Other revenue increased $17.1 million or 10% when compared to the first nine months of 1996 as the result of increased volumes of fee income from the Lincoln UK and Investment Management segments. Insurance Benefits and Settlement Expenses Life and annuity benefits and settlement expenses increased $106.8 million or 7% when compared with the first nine months of 1996. This increase is the result of increases in business volume from the Life Insurance and Annuities segment. Health benefits increased $61.9 million or 13% for the first nine months of 1997 when compared with the first nine months of 1996 as a net result of decreased volumes of business being more than offset by additions to the reserves for the disability income business within the Reinsurance segment (see note 5 on page 7). Underwriting, Acquisition, Insurance and Other Expenses This expense increased $115.1 million or 11% for the first nine months of 1997 compared with the first nine months of 1996. The primary driver behind this increase, beyond the general inflation rate, was the additional operating expenses associated with 1) the block of tax-qualified annuity business acquired in the fourth quarter of 1996 in the Life Insurance and Annuities segment and 2) the acquisition of Voyageur Fund Managers, Inc. in the Investment Management segment and the write-off of deferred acquisition costs associated with the disability income business (see note 5 on page 8). Interest and Debt Expense Interest and debt expense increased $9.3 million or 15% as compared with the first nine months of 1996. This was the net result of reduced interest expense due to the use of short-term debt to retire a portion of the long-term debt and increases in the average short-term debt outstanding. Interest on short-term debt is expected to decrease in the fourth quarter of 1997 compared to the first three quarters of 1997 due to a reduction in the average short- term debt during that period due to the application of proceeds from the sale of a subsidiary (see note 4 on page 7). Federal Income Taxes Federal income taxes for the first nine months of 1997 decreased from $114.5 million in 1996 to $37.9 million in 1997. The decrease in federal income taxes is a result of a decrease in pre-tax earnings and a reduction in the effective tax rate for LNC's United Kingdom affiliate which resulted from the decision to indefinitely reinvest its earnings.
13 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL INFORMATION (continued) REVIEW OF CONSOLIDATED OPERATIONS (continued) Summary Net income for the first nine months of 1997 was $294.8 million or $2.85 per share compared with $370.8 million or $3.55 per share in the first nine months of 1996. Excluding realized gain on investments and discontinued operations LNC earned $115.9 million for the first nine months of 1997 compared with $216.1 million for the first nine months of 1996. The primary factor causing this decrease was the addition to the disability income reserve within the Reinsurance segment (see note 5 on page 8). Net income for the fourth quarter of 1997 will include the gain on sale of discontinued operations. As indicated in note 4 on page 7, this one time gain is expected to be approximately $775 million which converts to approximately $7.55 per share. As noted in the introduction to Management's Discussion and Analysis (see page 11) there will be a reduction in earnings from operations in the fourth quarter of 1997 due to the absence of earnings from the operations that were sold. REVIEW OF CONSOLIDATED FINANCIAL CONDITION Investments The total investment portfolio increased $132.4 million in the first nine months of 1997. This is the net result of fixed annuity contractholders opting to transfer funds to variable annuity contracts being more than offset by increases from the purchases of investments from cash flow generated by the business segments and the increase in the fair value of securities available- for-sale. The quality of LNC's fixed maturity securities portfolio as of September 30, 1997 was as follows: Treasuries and AAA 27.1% BBB 29.1% AA 7.3% BB 3.3% A 28.5% Less than BB 4.7% As of September 30, 1997, $1.9 billion or 8% of fixed maturity securities was invested in below investment grade securities (less than BBB). This represents 6.5% of the total investment portfolio. These percentages are approximately 1% higher than have been reported earlier in 1997. This increase is related to the fact that the operations moved to discontinued operations included a minimal amount of below investment grade securities. This percentage is expected to be lower once the proceeds of sale are received and invested. 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 nine months ended September 30, 1997, the aggregate cost of such investments purchased was $1.6 billion. Aggregate proceeds from such investments sold were $1.1 billion, resulting in a net realized pre-tax gain of $62.8 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. As of September 30, 1997, mortgage loans on real estate and real estate represented 10.8% and 2.0% of LNC's total investment portfolio. As of September 30, 1997, the underlying properties supporting the mortgage loans on real estate consisted of 21.6% in commercial office buildings, 28.9% in retail stores, 22.2% in apartments, 14.6% in industrial buildings, 4.3% in hotels/motels and 8.4% in other. In addition to the dispersion by property type, the mortgage loan portfolio is geographically diversified throughout the United States.
14 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL INFORMATION (continued) REVIEW OF CONSOLIDATED FINANCIAL CONDITION (continued) Impaired loans along with the related allowance for losses are as follows: September 30 December 31 (in millions) 1997 1996 Impaired loans with allowance for losses --------- $107.8 $ 71.9 Allowance for losses ----------------------------- (6.4) (12.4) Impaired loans with no allowance for losses ------ -- 2.3 Net Impaired Loans ----------------------------- $101.4 $ 61.8 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 the loan. A reconciliation of the mortgage loan allowance for losses for these impaired mortgage loans is as follows: Nine Months Ended September 30 (in millions) 1997 1996 Balance at beginning of year --------------------- $12.4 $ 29.6 Provisions for losses ---------------------------- 2.2 2.5 Releases due to sales ---------------------------- (4.8) (1.6) Releases due to foreclosures --------------------- (3.4) (.4) Balance at End of Period ----------------------- $ 6.4 $30.1 The average recorded investment in impaired loans and the interest income recognized on impaired loans were as follows: Nine Months Ended September 30 (in millions) 1997 1996 Average recorded investment in impaired loans ---- $ 86.1 $161.4 Interest income recognized on impaired loans ----- 6.1 11.2 All interest income on impaired loans was recognized on the cash basis of income recognition. As of September 30, 1997 and 1996, LNC had restructured loans of $38.9 million and $62.5 million, respectively. LNC recorded $2.8 million and $4.2 million interest income on these restructured loans for the nine months ended September 30, 1997 and 1996, respectively, as compared to interest income of $3.9 million and $4.9 million that would have been recorded according to their original terms. As of September 30, 1997, 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 that were non-income producing for the nine months ended September 30, 1997 were not significant. Cash and Invested Cash Cash and invested cash increased by $102.2 million in the first nine months of 1997. This increase is the result of a portion of the operating cash flow being invested temporarily in short-term investments pending the placement of funds in longer term investments. Deferred Acquisition Costs Deferred acquisition costs decreased $94.7 million during the first nine months of 1997 as the net result of increases related to new business being more than offset by the second quarter 1997 write-off of such costs in conjunction with the strengthening of disability income reserves (see note 5 on page 8). Premiums and Fee Receivable Premiums and fees receivable increased $3.6 million in the first nine months of 1997 as the net result of increased volumes of business in the Investment Management segment being partially offset by a decrease in the Reinsurance segment.
15 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL INFORMATION (continued) REVIEW OF CONSOLIDATED FINANCIAL CONDITION (continued) Assets Held in Separate Accounts This asset account as well as the corresponding liability account increased by $8.0 billion in the first nine months of 1997, reflecting an increase in annuity funds under management. This increase resulted from new deposits, market appreciation and the continuation of fixed annuity contractholders opting to transfer funds to variable annuity contracts. Goodwill The increase in the amount is the net result of additions related to the purchase of a subsidiary being more than the on-going amortization for the nine months ended September 30, 1997. Other Intangible Assets The decrease is the net result of additions related to the purchase of a subsidiary being more than offset by the on-going amortization and an adjustment to the Lincoln UK amount to more closely conform this segment to the classification used for LNC's U.S. operations. Other Assets The increase in other assets of $47.5 million is the result of having a higher receivable related to investment securities sold in the last few days of the third quarter of 1997 versus the end of 1996. Total Liabilities Total liabilities from continuing operations increased by $8.0 billion in the first nine months of 1997. The primary item underlying this increase is the increase of $8.0 billion in the liabilities related to separate accounts. As noted above, the increase in separate accounts related to increased levels of business and the acquisition of the block of group tax-qualified annuity business in the Life Insurance and Annuities segment. The reduction in contractholder funds is the net result of new deposits being more than offset by the withdrawal of guaranteed interest contract funds because of the decision to exit this business. Increases in the other liability categories essentially offset the reduction in contractholder funds. LNC's liabilities includes some contingency items (see note 6 on page 8). Shareholders' Equity Total shareholders' equity increased $171.1 million in the first nine months of 1997. Excluding the increase of $181.8 million related to an increase in the unrealized gains on securities available-for-sale, shareholders' equity decreased $10.7 million. This decrease was the net result of increases due to $294.8 million from net income, $68.7 million from issuance of common stock to purchase a subsidiary company and $19.6 million from the issuance of common stock related to benefit plans, being more than offset by the repurchase of common shares ($210.1 million), a decrease in the accumulated foreign exchange gain ($32.4 million) and the declaration of dividends to shareholders ($151.3 million). Derivatives As discussed in note 7 to the consolidated financial statements for the year ended December 31, 1996 (see page 59 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 (hedged transactions). Changes in the value of these derivatives are generally offset by changes in the value of the items being hedged. Modifications to LNC's derivative strategy are initiated periodically upon review of the company's overall risk assessments. During the first nine months of 1997, LNC has made modifications in its derivative positions as follows: 1. Decreased its use of interest rate cap agreements that are used to hedge its annuity business from the effect of fluctuating interest rates from $5.5 billion notional to $5.1 billion notional. 2. Added $1.1 billion in notional amount of swaptions to hedge a portfolio of interest rate sensitive assets.
16 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL INFORMATION (continued) REVIEW OF CONSOLIDATED FINANCIAL CONDITION (continued) 3. Terminated the remaining $147.7 million face amount of long financial futures contracts that were hedging the anticipated purchase of a portfolio of assets to support the group tax-qualified annuity business acquired in October of 1996. The termination of these futures contracts resulted in total losses of $1.8 million, of which, $1.7 million were recognized and $100,000 were deferred. 4. Entered into an interest rate swap with a notional amount of $10 million. This swap is part of a replication trade, which will result in a higher bond yield for LNC. 5. Decreased its use of foreign exchange forward contracts that are hedging the foreign currency risk of its portfolio of foreign bonds from $251.6 million notional to $234.0 million notional. The termination of these foreign exchange forward contracts resulted in the recognition of gains of $30.2 million. 6. Terminated the $50.2 million notional amount of foreign currency options that were outstanding at year end. The terminations of these foreign currency options resulted in net gains of $200,000. LNC generally limits its selection of counterparties that are obligated under these derivative contacts to counterparties that have an A credit rating or above. 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 $944.5 million during the first nine months of 1997. 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. As of September 30, 1997 LNC has a shelf registration with an unused balance of $600 million that would allow LNC to issue debt or equity securities. As of September 30, 1997 LNC also had an unused balance of $185 million related to a registration that included the right to offer various forms of hybrid securities. Finally, cash funds are available from LNC's revolving credit agreement which provides for borrowing up to $750 million. Transactions such as those described in the preceding paragraph that occurred recently include LNC's purchase and retirement of 3,318,000 and 694,582 shares of common stock at a cost of $210.1 million and $35.0 million in the first nine months of 1997 and fourth quarter of 1996, respectively. The 3,318,000 shares purchased in 1997 includes 2,739,100 shares at a cost of $179.6 million that have been purchased since the June 1997 board authorization (see note 4 on page 7). In the period from October 1, 1997 through October 31, 1997 an additional 900,200 shares were purchased at a cost of $63.4 million. After subtracting the purchases through October 31, LNC has an open authorization to pay out an additional $257.0 million to repurchase LNC common stock. Also, LNC issued 1,320,902 shares of common stock in April 1997 valued at $68.7 million to purchase a subsidiary company. Finally, in the second quarter of 1997, LNC repurchased and retired $86.7 million of its long-term debt at a cost of $98.1 million. This retirement of long-term debt resulted in additional short-term debt which is expected to be repaid as noted below.
17 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL INFORMATION (continued) REVIEW OF CONSOLIDATED FINANCIAL CONDITION (continued) Based on the terms of the sale of a subsidiary (see discontinued operations note on page 7), LNC received $2.65 billion on October 1, 1997. LNC and its subsidiaries will use approximately $445 million of these proceeds to pay the taxes related to the sale and, as noted above, up to $500 million to purchase LNC common stock. The remaining balance will be applied to pay off a portion of LNC's short-term debt and invested for general corporate purposes pending the purchase of additional subsidiary companies or blocks of business. As shown in note 8 (see page 10), LNC has signed an agreement to purchase a block of individual life and annuity business from CIGNA Corporation for approximately $1.4 billion. Select transactions as noted occurred in advance of the October 1, 1997 closing of the sale of this subsidiary and as a result short-term debt was higher as of September 30, 1997 than it was as of June 30, 1997 or December 31, 1996. 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.) 02 Second Amended and Restated Asset Transfer and Acquisition Agreement Dated July 27, 1997 11 Computation of Per Share Earnings 12 Historical Ratio of Earnings to Fixed Charges 27 Financial Data Schedule (b) During the quarter ended September 30, 1997, a Form 8-K was filed with the Commission regarding LNC's press release announcing its signing of a definitive agreement to acquire a block of individual life insurance and annuity business from CIGNA Corporation. This filing received a filing date of July 30, 1997.
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 November 12, 1997
19 LINCOLN NATIONAL CORPORATION Exhibit Index for the Report on Form 10-Q for the Quarter Ended September 30, 1997 Exhibit Number Description Page Number 02 Second Amended and Restated Asset 20 Transfer and Acquisition Agreement Dated as of July 27, 1997 11 Computation of Per Share Earnings 326 12 Historical Ratio of Earnings to Fixed Charges 327 27 Financial Data Schedule 328