-1- UNITED STATES 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, 1999 Commission file number 1-6028 LINCOLN NATIONAL CORPORATION (Exact name of registrant as specified in its charter) Indiana 35-1140070 (State of incorporation) (I.R.S. Employer Identification No.) 200 East Berry Street, Fort Wayne, Indiana 46802-2706* (Address of principal executive offices) Registrant's telephone number (219) 455-2000* As of July 23, 1999 LNC had 198,816,323 shares of Common Stock outstanding. 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 [ ] *Effective August 16, 1999, the principal executive offices will be located at Centre Square, 1500 Market Street, Suite 3900, Philadelphia, Pennsylvania 19102-2112. The telephone number for these offices which will also be effective August 16, 1999 is (215) 448-1400. The exhibit index to this report is located on page 22.
-2- PART I FINANCIAL INFORMATION Item 1 Financial Statements LINCOLN NATIONAL CORPORATION CONSOLIDATED BALANCE SHEETS <TABLE> <CAPTION> June 30 December 31 (000s omitted) 1999 1998 -------------- ---- ---- ASSETS Investments: <S> <C> <C> Securities available-for-sale, at fair value: Fixed maturity (cost 1999 -$29,493,730; 1998 - $28,639,558)......................................... $29,579,290 $30,232,892 Equity (cost 1999 - $385,016; 1998 - $436,718)............................................ 505,662 542,843 Mortgage loans on real estate................................... 4,570,451 4,393,082 Real estate..................................................... 449,783 488,722 Policy loans.................................................... 1,847,444 1,839,970 Other investments............................................... 409,932 431,964 ----------- ----------- Total Investments............................................. 37,362,562 37,929,473 Investment in unconsolidated affiliates........................... 22,335 18,811 Cash and invested cash............................................ 2,151,089 2,433,350 Property and equipment............................................ 180,659 174,762 Deferred acquisition costs........................................ 2,398,309 1,964,366 Premiums and fees receivable...................................... 268,984 246,203 Accrued investment income......................................... 569,062 528,500 Assets held in separate accounts.................................. 47,864,349 43,408,858 Federal income taxes.............................................. 478,402 204,075 Amounts recoverable from reinsurers............................... 3,121,344 3,127,093 Goodwill.......................................................... 1,428,283 1,484,343 Other intangible assets........................................... 1,764,946 1,848,442 Other assets...................................................... 651,113 467,984 ---------- ------------ Total Assets.................................................. $98,261,437 $93,836,260 </TABLE> See notes to consolidated financial statements on pages 7 - 12
-3- LINCOLN NATIONAL CORPORATION CONSOLIDATED BALANCE SHEETS -CONTINUED- <TABLE> <CAPTION> June 30 December 31 (000s omitted) 1999 1998 -------------- ---- ---- LIABILITIES AND SHAREHOLDERS' EQUITY Liabilities: <S> <C> <C> Insurance and Investment Contract Liabilities: Insurance policy and claim reserves.................................. $20,198,234 $20,139,982 Contractholder funds................................................. 20,579,499 20,753,064 Liabilities related to separate accounts............................. 47,864,349 43,408,858 ---------- ---------- Total Insurance and Investment Contract Liabilities............... 88,642,082 84,301,904 Short-term debt........................................................ 380,194 314,610 Long-term debt......................................................... 712,066 712,171 Minority interest-preferred securities of subsidiary companies......... 745,000 745,000 Other liabilities...................................................... 2,964,717 2,374,634 ------------- ----------- Total Liabilities................................................. 93,444,059 88,448,319 Shareholders' Equity: Series A preferred stock-10,000,000 shares authorized (6/30/99 liquidation value - $2,463................................... 1,012 1,083 Common stock - 800,000,000 shares authorized........................... 1,005,060 994,472 Retained earnings...................................................... 3,791,768 3,790,038 Accumulated Other Comprehensive Income: Foreign currency translation adjustment.............................. 20,661 49,979 Net unrealized gain (loss) on securities available-for-sale.......... (1,123) 552,369 ------------ ---------- Total Accumulated Other Comprehensive Income...................... 19,538 602,348 ----------- ----------- Total Shareholders' Equity........................................ 4,817,378 5,387,941 ----------- ---------- Total Liabilities and Shareholders' Equity ....................... $98,261,437 $93,836,260 </TABLE> See notes to consolidated financial statements on pages 7 - 12.
-4- LINCOLN NATIONAL CORPORATION CONSOLIDATED STATEMENTS OF INCOME <TABLE> <CAPTION> Six Months Ended Three Months Ended June 30 June 30 (000s omitted, except per share amounts) 1999 1998 1999 1998 ---------------------------------------- ---- ---- ---- ---- Revenue: <S> <C> <C> <C> <C> Insurance premiums .................................. $ 873,379 $ 721,565 $ 434,316 $ 373,976 Insurance fees....................................... 758,828 628,301 380,827 328,407 Investment advisory fees............................. 115,100 117,040 56,310 59,161 Net investment income................................ 1,410,376 1,317,079 700,838 658,720 Equity in earnings of unconsolidated affiliates...... 2,719 1,538 1,113 41 Realized gain (loss) on investments.................. (2,122) 49,463 (4,049) 25,540 Other revenue and fees............................... 195,406 120,526 108,973 61,648 --------- ------- --------- ---------- Total Revenue..................................... 3,353,686 2,955,512 1,678,328 1,507,493 Benefits and Expenses: Benefits............................................. 1,797,459 1,583,140 906,225 795,903 Underwriting, acquisition, insurance and other expenses........................ 1,084,293 942,274 537,758 471,273 Interest and debt expense............................ 65,736 51,040 32,632 27,672 ------------ ---------- --------- --------- Total Benefits and Expenses ...................... 2,947,488 2,576,454 1,476,615 1,294,848 --------- --------- --------- --------- Net Income Before Federal Income Taxes............ 406,198 379,058 201,713 212,645 Federal income taxes................................. 112,786 108,336 53,363 63,966 --------- --------- --------- ---------- Net Income........................................ $ 293,412 $ 270,722 $ 148,350 $ 148,679 Net Income Per Common Share-Basic...................... $1.47 $1.35 $.74 $ .74 Net Income Per Common Share-Diluted.................... $1.45 $1.33 $.73 $ .73 </TABLE> See notes to consolidated financial statements on pages 7 - 12.
-5- LINCOLN NATIONAL CORPORATION CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY <TABLE> <CAPTION> Six Months Ended June 30 Number of Shares Amounts (000s omitted from dollar amounts) 1999 1998 1999 1998 ---------------------------------- ----- ---- ---- ---- Series A Preferred Stock: <S> <C> <C> <C> <C> Balance at beginning-of-year.................. 32,959 35,091 $ 1,083 $ 1,153 Conversion into common stock.................. (2,168) (983) (71) (33) ------- ------- ------- ------- Balance at June 30....................... 30,791 34,108 1,012 1,120 Common Stock: Balance at beginning-of-year.................. 202,111,174 201,718,956 994,472 966,461 Conversion of series A preferred stock........ 34,688 15,728 71 33 Issued for benefit plans...................... 626,953 555,388 27,169 8,902 Issued for acquisition of subsidiaries........ 86,228 -- 3,547 -- Retirement of common stock ................... (4,090,000) (1,246,562) (20,199) (5,972) ----------- ---------- -------- --------- Balance at June 30....................... 198,769,043 201,043,510 1,005,060 969,424 Retained Earnings: Balance at beginning-of-year.................. 3,790,038 3,533,105 Comprehensive income (loss)................... (289,398) 309,882 Less other comprehensive income (loss): Foreign currency translation................. (29,318) 5,604 Net unrealized gain (loss) on securities available-for-sale............... (553,492) 33,556 --------- ---------- Net Income............................... 293,412 270,722 Retirement of common stock.................... (182,489) (40,899) Dividends declared: Series A preferred ($.75 per share)........... (47) (51) Common stock (1999-$.55; 1998-$.52)........... (109,146) (103,930) --------- -------- Balance at June 30....................... 3,791,768 3,658,947 Foreign Currency Translation Adjustment: Accumulated adjustment at beginning-of-year............................ 49,979 46,204 Change during the period...................... (29,318) 5,604 -------- ---------- Balance at June 30....................... 20,661 51,808 Net Unrealized Gain (Loss) on Securities Available-for-Sale: Balance at beginning-of-year.................. 552,369 435,992 Change during the period...................... (553,492) 33,556 ---------- ----------- Balance at June 30....................... (1,123) 469,548 Total Shareholders' Equity at June 30.... $4,817,378 $5,150,847 Common Stock at End of Quarter: Assuming conversion of preferred stock........ 199,261,699 201,589,238 Diluted basis................................. 200,914,470 204,509,630 </TABLE> See notes to consolidated financial statements on pages 7 - 12.
-6- LINCOLN NATIONAL CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS <TABLE> <CAPTION> Six Months Ended June 30 (000s omitted) 1999 1998 -------------- ---- ---- Cash Flows from Operating Activities: <S> <C> <C> Net income.............................................................. $ 293,412 $ 270,722 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Deferred acquisition costs.......................................... (127,557) (72,684) Premiums and fees receivable........................................ (22,781) (55,548) Accrued investment income........................................... (40,562) (7,492) Policy liabilities and accruals..................................... (101,683) 192,605 Contractholder funds................................................ 503,208 395,020 Amounts recoverable from reinsurers................................. 5,750 (23,268) Federal income taxes................................................ 22,029 (92,873) Equity in earnings of unconsolidated affiliates..................... (2,719) (1,538) Provisions for depreciation ........................................ 35,046 29,700 Amortization of goodwill and other intangible assets................ 68,892 63,342 Realized gain on investments........................................ 2,122 (49,463) Other............................................................... 54,093 (32,270) -------- ------- Net Adjustments................................................... 395,838 345,531 ------- --------- Net Cash Provided by Operating Activities......................... 689,250 616,253 Cash Flows from Investing Activities: Securities-available-for-sale: Purchases............................................................. (3,978,743) (5,484,270) Sales................................................................. 1,989,395 4,268,177 Maturities............................................................ 1,176,673 1,045,495 Purchase of other investments........................................... (952,583) (662,783) Sale or maturity of other investments................................... 813,729 873,285 Purchase of affiliates/blocks of business............................... - (1,426,000) Increase in cash collateral on loaned securities........................ 541,447 110,509 Other................................................................... (142,049) 106,081 --------- ------------- Net Cash Used in Investing Activities............................. (552,131) (1,169,506) Cash Flows from Financing Activities: Decrease in long-term debt (includes payments and transfer to short-term debt)........................................... (240) (74) Issuance of long-term debt.............................................. -- 299,198 Net increase (decrease) in short-term debt.............................. 65,584 (20,127) Universal life and investment contract deposits......................... 1,014,832 492,069 Universal life and investment contract withdrawals...................... (1,218,444) (1,455,908) Common stock issued for benefit plans................................... 27,052 8,902 Retirement of common stock.............................................. (197,773) (46,871) Dividends paid to shareholders.......................................... (110,391) (104,528) --------- -------- Net Cash Used in Financing Activities............................. (419,380) (827,339) --------- -------- Net Decrease in Cash and Invested Cash............................ (282,261) (1,380,592) Cash and Invested Cash at Beginning-of-Year............................... 2,433,350 3,794,706 ---------- ----------- Cash and Invested Cash at June 30................................. $2,151,089 $2,414,114 </TABLE> See notes to consolidated financial statements on pages 7 - 12.
-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. Through subsidiary companies, LNC operates multiple insurance and investment management businesses. The collective group of companies uses "Lincoln Financial Group" as its marketing identity. Operations are divided into four business segments. 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 audited consolidated financial statements and the accompanying notes included in LNC's latest annual report on Form 10-K for the year ended December 31, 1998. Operating results for the six months ended June 30, 1999 are not necessarily indicative of the results that may be expected for the full year ending December 31, 1999. 2. Changes in Accounting Principle In June 1998, the Financial Accounting Standards Board ("FASB"), issued Statement of Financial Accounting Standard No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("FAS 133"), which may be adopted at the beginning of any fiscal quarter but no later than the first quarter of 2000. In July 1999, the FASB issued Statement of Financial Accounting Standard No. 137, "Accounting for Derivative Instruments and Hedging Activities-Deferral of the Effective Date of FASB Statement No. 133" ("FAS 137"), which delays the effective date of FAS 133 one year (i.e., adoption required no later than the first quarter of 2000). LNC has not completed the analysis necessary to provide a precise estimate of the effects of or to specify the quarter in which it plans to adopt the standard. On January 1, 1999, LNC implemented the Statement of Position ("SOP") 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use". SOP 98-1 defines internal use software and when the costs associated with internal use software should be capitalized. The implementation did not have a material impact on LNC's financial statements. 3. Federal Income Taxes The effective tax rate on net income is lower than the prevailing corporate federal income tax rate. The difference for both 1999 and 1998 resulted principally from tax-preferred investment income. 4. Common Stock Split On May 13, 1999, LNC's Board of Directors approved a two-for-one stock split for its common stock. The record date for the stock split was June 4, 1999 and the additional shares were distributed to shareholders on June 21, 1999. All shares and per share amounts in the consolidated financial statements have been adjusted to reflect the effects of the common stock split for all periods presented. Following this common stock split, the conversion rate of LNC's preferred stock series A changed from eight shares of common stock to sixteen shares of common stock for each series A preferred stock. 5. Restrictions, Commitments and Contingencies Statutory Restriction. LNC's insurance subsidiaries are subject to certain insurance department regulatory restrictions as to the transfer of funds and payments of dividends to LNC. LNC's primary insurance subsidiary, Lincoln National Life Insurance Company ("Lincoln Life") acquired a block of individual life insurance and annuity business from CIGNA in January 1998 and the domestic individual life insurance business from Aetna in October 1998. These acquisitions were structured as indemnity reinsurance transactions. Statutory accounting regulations do not allow goodwill to be recognized on indemnity reinsurance transactions and therefore, the related ceding commission flows through the statutory statement of operations as an expense resulting in a reduction of earned surplus. As a result of these acquisitions and the dividends declared, Lincoln Life's statutory earned surplus is negative. It is necessary for Lincoln Life to obtain the prior approval of the Indiana Insurance Commissioner before paying any dividends to LNC until such time as statutory earned surplus is positive. Although no assurance can be given that additional dividends to LNC will be approved, during the second quarter 1999, Lincoln Life received regulatory approval and paid an extraordinary dividend
-8- of $350 million to LNC. Statutory earned surplus could return to a positive position within 2 1/2 years from the closing of the Aetna transaction described above assuming a level of statutory earnings coinciding with recent earnings patterns. If statutory earnings are less than recent patterns due, for example, to adverse operating conditions or further indemnity reinsurance transactions of this nature or if dividends are approved or paid at amounts higher than recent history, the statutory earned surplus may not return to a positive position in a 2 1/2 half year time frame. In the event such approvals are not obtained, management believes that LNC can obtain the funds required to satisfy its obligations from its existing credit facilities and other sources. Disability Income Claims. The liability for disability income claims net of the related asset for amounts recoverable from reinsurers at June 30, 1999 and December 31, 1998 is a net liability of $1.822 billion and $1.813 billion, respectively, excluding deferred acquisition costs. The liability is based on the assumption that recent experience will continue in the future. 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. In May 1999, LNC reached an agreement to transfer a block of direct individual disability income business to MetLife. Under an indemnity reinsurance agreement, LNC will transfer to MetLIfe cash equal to statutory reserves, net of ceding commissions of approximately $500 million. The transaction is expected to close later in 1999. United Kingdom Pension Products. Operations in the UK 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 June 30, 1999 and December 31, 1998, liabilities of $139.5 million and $202.1 million, respectively, were carried on the books for this issue. The decrease in the level of the reserve reflects the settlement payouts that have occurred during the six months ended June 30, 1999. 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. The expected recoveries from previous owners of companies acquired over the last few years as specified in the indemnification clauses of the purchase agreements were $80.2 million and $84.9 million at June 30, 1999 and December 31, 1998, respectively. These liabilities and recoveries are based on various estimates that are subject to considerable uncertainty. Also, there is further uncertainty from the regulatory perspective as additional guidelines were issued in December of 1998 that extend the review to a wider range client population. These guidelines specify actions expected from the companies that issued such products. 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. Personal Accident Programs. In the past, LNC's Reinsurance segment accepted personal accident reinsurance programs from other insurance companies. Most of these programs are presented to the Reinsurance segment by independent brokers who represent the ceding companies. Certain excess of loss personal accident reinsurance programs created in the London market from 1993 to 1996 have produced and have potential to produce significant losses. The liabilities for these programs, net of related assets recoverable from reinsurers were $176.4 million and $177.4 million at June 30, 1999 and December 31, 1998, respectively. These amounts are based on various estimates that are subject to considerable uncertainty. Accordingly, the liabilities may prove to be deficient or excessive. However, it is management's opinion that future developments in these programs will not materially affect the consolidated financial position of LNC. LNC continues its investigation into its participation in workers' compensation carve out (i.e., life and health risks associated with workers' compensation coverage) programs managed by Unicover Managers, Inc. One of Unicover's retrocessionaires has initiated arbitration to attempt to rescind its reinsurance coverage to the carriers participating in Unicover programs. LNC denies the validity of this action. At this time, LNC (1) does not have sufficient information to determine whether or not it is probable that additional losses have been incurred in relation to these programs, and (2) can not accurately estimate the ultimate cost or timing of the outcome on these programs.
-9- 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 future developments related to marketing and compliance issues will not materially affect the consolidated financial position of LNC. Group Pension Annuities. The liabilities for guaranteed interest and group pension annuity contracts 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 the future development in this business will not materially affect the consolidated financial position of LNC. Other Contingency Matters. 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. LNC maintains professional liability insurance coverage for claims in excess of $5 million. The degree of applicability of this coverage will depend on the specific facts of each proceeding. In some instances, these proceedings include claims for compensatory and punitive 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. With the recent filing of a lawsuit alleging fraud in the sale of interest sensitive universal and whole life insurance policies, Lincoln Life now has three such actions pending. While they each seek class action status, the court has not certified a class in any of these cases. Two other similar lawsuits have been resolved and dismissed. Plaintiffs seek unspecified damages and penalties for themselves and on behalf of the putative class. While the relief sought in these cases is substantial, the cases are in the discovery stages of litigation, and it is premature to make assessments about potential loss, if any. Management intends to defend these suits vigorously. The amount of liability, if any, which may arise as a result of these suits cannot be reasonably estimated at this time. UK regulatory authorities have completed a review of Lincoln UK selling practices. This review does not include matters related to the pension product mis-selling investigations. Management is currently working with the regulators to address compliance issues that have been raised in the course of this review. The extent of corrective measures and potential disciplinary actions, if any, that may result from this review are actively being discussed with the regulatory authorities. It is not possible to provide a meaningful estimate of the potential outcome of this matter at the present time. However, it is management's opinion that the resolution of these matters will not materially affect the consolidated financial position of LNC. In December 1997, LNC invested $85 million for a 49% share of Seguros Serfin Lincoln ("SSL"), a Mexican bancassurance company, that sells life, auto and homeowners insurance to the customers of Banca Serfin. Grupo Financiero Serfin S.A. ("GFS") owns 51% of SSL and 100% of Banca Serfin. On July 8, 1999, the private shareholders of GFS declined to contribute additional capital to Banca Serfin as required by the Mexican Government. Accordingly, the Bank Savings Protection Institute ("IPAB"), a government agency, took control of GFS. IPAB has stated that it will inject the required capital into Banca Serfin and place GFS up for auction. At present, both Banca Serfin and SSL continue to conduct business as usual, and LNC expects this status to continue through the auction process. LNC is monitoring developments closely; however, at this time management does not believe these changes will have a material adverse financial impact on LNC's 49% investment in SSL or on the consolidated financial condition of LNC.
-10- 6. Segment Disclosures The following tables show financial data by segment: <TABLE> <CAPTION> Six Months Three Months Ended June 30 Ended June 30 (in millions) 1999 1998 1999 1998 ------------- ---- ---- ---- ---- Revenue: (Reclassified) (Reclassified) <S> <C> <C> <C> <C> Life Insurance and Annuities............................... $2,065.0 $1,774.5 $1,033.7 $ 899.4 Lincoln UK................................................. 232.2 227.7 113.1 124.2 Reinsurance................................................ 840.3 729.6 423.1 376.8 Investment Management...................................... 231.1 236.1 114.3 118.0 Other Operations (includes consolidating adjustments)...... (14.9) (12.4) (5.9) (10.9) -------- -------- --------- -------- Total.................................................... $3,353.7 $2,955.5 $1,678.3 $1,507.5 Net Income (Loss) before Federal Income Taxes: Life Insurance and Annuities............................... $323.1 $261.3 $161.1 $162.4 Lincoln UK................................................. 52.2 58.8 25.3 32.0 Reinsurance................................................ 84.4 79.2 34.1 35.1 Investment Management...................................... 9.3 20.0 11.6 10.4 Other Operations (includes interest expense)............... (62.8) (40.3) (30.4) (27.3) ------ ------ -------- ------- Total.................................................... $406.2 $379.0 $201.7 $212.6 Federal Income Taxes (Credits): Life Insurance and Annuities............................... $ 86.5 $ 65.3 $43.6 $44.4 Lincoln UK................................................. 14.2 24.1 5.3 14.7 Reinsurance................................................ 29.8 27.8 12.0 12.3 Investment Management...................................... 5.1 8.8 4.1 4.6 Other Operations........................................... (22.8) (17.7) (11.7) (12.1) ------ ------ ------ ----- Total.................................................... $112.8 $108.3 $53.3 $63.9 Net Income (Loss): Life Insurance and Annuities............................... $236.6 $196.0 $117.5 $118.0 Lincoln UK................................................. 38.0 34.7 20.0 17.3 Reinsurance................................................ 54.6 51.4 22.1 22.8 Investment Management...................................... 4.2 11.2 7.5 5.8 Other Operations (includes interest expense)............... (40.0) (22.6) (18.7) (15.2) ------ ----- ------ ----- Total.................................................... $293.4 $270.7 $148.4 $148.7 </TABLE> <TABLE> <CAPTION> June 30 December 31 (in millions) 1999 1998 ------------- ---- ---- Assets: <S> <C> <C> Life Insurance and Annuities............................... $77,291.2 $73,966.1 Lincoln UK................................................. 8,909.6 8,757.3 Reinsurance................................................ 6,449.9 6,408.0 Investment Management...................................... 1,508.6 1,622.6 Other Operations........................................... 4,102.1 3,082.3 ------- --------- Total.................................................... $98,261.4 $93,836.3 </TABLE> Select data shown above for the Investment Management segment, Life Insurance & Annuities segment and Other Operations for the three months and six months ended June 30, 1998 has been reclassified due to a change in the reporting relationship for LNC's internal investment advisor and 401(k) pension unit.
-11- 7. Earnings Per Share Per share amounts for net income are shown in the income statement using 1) an earnings per common share basic calculation and 2) an earnings per common share-assuming dilution calculation, after consideration of the June 1999 two-for-one stock split (see note 4). Reconciliations of the factors used in the two calculations are as follows: <TABLE> <CAPTION> Six Months Ended Three Months Ended June 30 June 30 Numerator: [in millions] 1999 1998 1999 1998 ---- ---- ---- ---- <S> <C> <C> <C> <C> Net income as used in basic calculation.............. $293.4 $270.6 $148.4 $148.7 Dividends on convertible preferred stock............ * .1 * * ------ ------ ------ ------ Net income as used in diluted calculation....... $293.4 $270.7 $148.4 $148.7 * Less than $100,000. </TABLE> <TABLE> <CAPTION> Denominator: [number of shares] <S> <C> <C> <C> <C> Weighted average shares, as used in basic calculation............................ 200,146,975 200,520,000 199,119,557 200,608,448 Shares to cover conversion of preferred stock................................. 509,045 551,556 501,912 547,428 Shares to cover non-vested stock................. 510,629 349,244 500,381 326,294 Average stock options outstanding during the period............................... 7,364,108 6,419,968 9,315,306 6,428,438 Assumed acquisition of shares with assumed proceeds and tax benefits from exercising stock options (at average market price during the period) .... (5,858,867) (3,896,680) (7,514,657) (3,976,078) ---------- ------------- ----------- ------------- Weighted-average shares, as used in diluted calculation............. 202,671,890 203,944,088 201,922,499 203,934,530 </TABLE> In the event the average market price of LNC's common stock exceeds the issue price of stock options, such options would be dilutive to LNC's earnings per share and will be shown in the table above. Also, LNC has purchase contracts outstanding which require the holder to purchase LNC common stock by August 16, 2001. These purchase contracts were issued in conjunction with the FELINE PRIDES financing. The common shares involved are not dilutive to LNC's earnings per share as of June 30, 1999 and will not be dilutive in the future except during periods when the average market price of LNC's common stock exceeds a threshold price of $55.725 per share. 8. Comprehensive Income <TABLE> <CAPTION> Six Months Ended Three Months Ended June 30 June 30 (in millions) 1999 1998 1999 1998 ------------- ---- ---- ---- ---- <S> <C> <C> <C> <C> Net income...................................... $ 293.4 $270.7 $ 148.4 $148.7 Foreign currency translation.................... (29.3) 5.6 (9.4) (.6) Net unrealized gain (loss) on securities........ (553.5) 33.6 (255.8) (5.5) ------- ------- ------- ------ Comprehensive Income (Loss)................ $(289.4) $309.9 $(116.8) $142.6 </TABLE> 9. Acquisition of Individual Life Insurance and Annuity Business and Organizational Reviews On January 2, 1998, LNC acquired a block of individual life insurance and annuity business from CIGNA Corporation for $1.414 billion. Additional funds of $228.5 million were required to cover expenses associated with the purchase and to provide additional capital for the Life Insurance and Annuities segment to support this business. Funding used to complete this acquisition was from the proceeds of LNC's sale of the property-casualty business in 1997. This transaction was accounted for using purchase accounting and, accordingly, operating results generated by this block of business after the closing date are included in LNC's consolidated financial statements. At the time of closing, this block of business had liabilities, measured on a statutory basis, of approximately $5.5 billion that became LNC's obligations. LNC also received assets, measured on a historical statutory basis, equal to the liabilities. Subsequent to this acquisition, LNC announced that it had reached an agreement to sell the administration rights to a variable annuity portfolio that had been acquired as a part of the block of business acquired January 2, 1998. The sale closed on October 12, 1998 with an effective date of August 1, 1998. As of June 30, 1999, the application of purchase accounting to this block of business, net of the administration rights sold and net of amortization, resulted in goodwill and other intangible
-12- assets of $747.2 million and $428.1 million, respectively. The goodwill amount shown includes adjustments to the amount shown at December 31, 1998. These first quarter 1999 adjustments resulted from reaching final agreement with the seller as to the value of the assets and liabilities transferred to LNC. During the first quarter of 1998, in connection with this acquisition, LNC recorded a charge to its Life Insurance and Annuities segment of $20.0 million ($30.8 million pre-tax). This charge was for certain costs of integrating the new block of business with existing operations. The pattern of actual expenses for integrating this block of business have matched the expected expenditures. On October 1, 1998, LNC acquired the domestic individual life insurance business from Aetna, Inc. for $1.0 billion. This transaction was accounted for using purchase accounting and, accordingly, the operating results generated by this block of business after the closing are included in LNC's consolidated financial statements. At the time of closing, this block of business had estimated liabilities, measured on a statutory basis, of $3.3 billion. These liabilities became LNC's obligations at the time of closing. At closing LNC received assets, measured on a historic statutory basis, equal to the liabilities. On August 7, 1998, LNC announced that it had reached an agreement to sell the sponsored life business acquired as part of the Aetna block of business. The sale closed on October 14, 1998 with an effective date of October 1, 1998 at a sales price of $99.5 million. During 1997, after deducting the sponsored life income statement amounts, the block of business being purchased produced premiums and fees of $227.8 million and net income of $65.0 million on the basis of generally accepted accounting principles (prior to adjustments required by purchase accounting). As of June 30, 1999, the application of purchase accounting to this block of business, net of the sponsored life business and net of amortization, resulted in goodwill and other intangible assets of $221.4 million and $792.6 million, respectively. The additional analysis of this block of business during 1999 could result in a change in the amounts or the shifting of amounts between goodwill and other intangible assets. Approximately one-half of the funding for this acquisition came from available funds within the consolidated group. The other half was from the proceeds of the third quarter 1998 public securities offerings from available shelf registrations. During the first quarter of 1999, LNC recorded a charge to its Investment Management segment of $12.1 million ($16.9 million pre-tax). The charge was for certain costs of downsizing and consolidation of back office operations at Lynch & Mayer.
-13- Item 2 Management's Discussion and Analysis of Financial Information The pages to follow review LNC's results of consolidated operations and financial condition. Historical financial information is presented and analyzed. Where appropriate, factors that may affect future financial performance are identified and discussed. Actual results could differ materially from those indicated in forward-looking statements due to, among other specific changes currently not known, subsequent significant changes in: the company (e.g., acquisitions and divestitures), financial markets (e.g., interest rates and securities markets), legislation (e.g., taxes and product taxation), regulations (e.g., insurance and securities regulations), acts of God (e.g., hurricanes, earthquakes and storms), other insurance risks (e.g., policyholder mortality and morbidity) and competition. REVIEW OF CONSOLIDATED OPERATIONS The discussion that follows focuses on net income for the six months ended June 30, 1999 compared to the results for the six months ended June 30, 1998. The factors affecting the current quarter to prior quarter comparisons are essentially the same as the year-to-date factors except as noted. As a result of the purchase of a block of individual life insurance business from Aetna in October 1998 (see note 9 on page 12) select income statement accounts increased in 1999 versus 1998. Such increases over comparable 1998 periods are expected to continue through the third quarter of 1999. Life Insurance and Annuity Premiums Life insurance and annuity premiums for the first six months of 1999 increased $151.4 million or 37% compared with the first six months of 1998. These increases were the result of increases in business volume from the Life Insurance & Annuities, Lincoln UK and Reinsurance segments. A portion of the increase from the Life Insurance and Annuities segment is the result of the acquisition of the block of business described above. Health Premiums Health premiums for the first six months of 1999 were essentially equal to the comparable 1998 period. This is the net result of increases in premiums from the group business being offset by decreases from areas where reinsurance is curtailing its writing of such coverages. Future periods are expected to have approximately $65 million less in health premiums (annual amount) due to the expected sale of a block of disability income business later in 1999 (see note 5 on page 8). 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 $130.5 million or 21% compared with the first six months of 1998. This increase was the result of increases in the volume of business (including the block of business purchased) 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 for the first six months of 1999 were essentially equal to the comparable 1998 period. This is the net result of an increase in fees from new sales and appreciation in existing accounts being offset by decreases in fees due to the withdrawal of funds. Net Investment Income Net investment income increased $93.3 million or 7% when compared with the first six months of 1998. This increase is the result of a 9% increase in mean invested assets, partially offset by a decrease in the overall yield on investments from 7.36% to 7.20% (all calculations on a cost basis). The increase in mean invested assets is the result of increased volumes of business in the Life Insurance & Annuities and Reinsurance segments and the acquisition of the block of business described above. Realized Gain (Loss) on Investments The first six months of 1999 and 1998 had realized gains (losses) on investments of $(2.1) million and $49.5 million, respectively. These gains (losses) which are net of related deferred acquisition costs and expenses, were the result of net gains on sales of investments, less write-downs and provisions for losses. The 1998 amount includes gains that resulted from LNC reducing its position in equity securities. Securities available-for-sale that were deemed to have declines in fair value that are other than temporary were written down.
-14- Also, LNC records write-downs and allowances on select mortgage loans on real estate, real estate and other investments when the underlying value of the property is deemed to be less than the carrying value. The pre-tax write-downs of securities available-for-sale for the first six months of 1999 and 1998 were $19.5 million and $34.2 million, respectively. The fixed maturity securities to which 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 six months of 1999, LNC released $.5 million in reserves on real estate and mortgage loans on real estate compared to reserves released of $3.5 million for the first six months of 1998. Net write-downs and reserve releases for all investments for the six months ended June 30, 1999 and 1998 were $19.0 million and $30.7 million, respectively. Other Revenue and Fees Other revenue and fees increased $74.9 million when compared to the first six months of 1998 as the result of increased volumes of fee income from the Life Insurance & Annuities, Reinsurance and Investment Management segments. Life Insurance and Annuity Benefits Life insurance and annuity benefits increased $195.5 million or 15% when compared with the first six months of 1998. This increase is the result of increases in business volume from the Life Insurance & Annuities, Lincoln UK and Reinsurance segments. A portion of the increase from the Life Insurance and Annuities segment is the result of the acquisition of the block of business described above. Health Benefits Health benefits increased $18.8 million or 6% for the first six months of 1999 when compared with the first six months of 1998 as a result of increased volumes of business and higher claim activity within Reinsurance group markets. As noted under "health premiums" above, a block of disability income is in the process of being sold. This will result in a reduction in health benefits proportionate to the health premium reductions. Underwriting, Acquisition, Insurance and Other Expenses These expenses increased $142.0 million or 15% for the first six months of 1999 compared with the first six months of 1998. The increase is a result of increases in business volume in the Life Insurance & Annuities and Reinsurance segments and the acquisition of the block of business described above. Interest and Debt Expense Interest and debt expense increased $14.7 million or 29% as compared with the first six months of 1998. This was the result of higher average debt outstanding. Federal Income Taxes Federal income taxes increased $4.5 million in the first six months of 1999 as compared with the first six months of 1998. The increase in federal income taxes is a result of an increase in pre-tax earnings. Summary Net income for the first six months of 1999 was $293.4 million or $1.45 per diluted share compared with $270.7 million or $1.33 per diluted share in the first six months of 1998. Excluding realized gains and losses on investments and restructuring charges, LNC earned $307.5 million for the first six months of 1999 compared with $260.3 million for the first six months of 1998. This increase was the result of increased earnings from each of the business segments. Trends in the United Kingdom for pension and life insurance businesses are changing rapidly, due in large part to government mandated product design changes that are expected to be imposed upon the industry within the next year or two. In anticipation of these marketplace changes, a review of strategic alternatives for Lincoln UK was initiated earlier this year. From this review, it was determined that significant changes in Lincoln UK's operations are needed to enable Lincoln UK to continue its success in the United Kingdom marketplace. This conclusion resulted in a decision to engage external consultants and to devote internal resources to a transformation program encompassing Lincoln UK's products, distribution, investment performance and cost structure. At this early stage in the transformation program, management has not yet determined what restructuring actions might be taken and what impact, if any, these actions may have on future earnings. These decisions are expected to be made early 2000.
-15- Century Compliance The Year 2000 issue is pervasive and complex and affects virtually every aspect of LNC's businesses. LNC's computer systems and interfaces with the computer systems of vendors, suppliers, customers and business partners are particularly vulnerable. LNC and its operating subsidiaries have been redirecting a large portion of internal Information Technology ("IT") efforts and contracting with outside consultants to update systems to address Year 2000 issues. Experts have been engaged to assist in developing work plans, cost estimates and remediation activities. LNC identified expenditures for the first six months of 1999 of $31.8 million ($20.7 million after-tax) to address this issue. This brings the expenditures for 1996 through second quarter 1999 to $80.3 million ($52.2 million after-tax). LNC's financial plans for the remainder of 1999 and the year 2000 include expected expenditures of an additional $17.9 million ($11.6 million after-tax) bringing estimated overall Year 2000 expenditures to $98.2 million ($63.8 million after-tax). Because updating systems and procedures is an integral part of LNC's on-going operations, approximately 50% of the expenditures shown above are expected to continue after all Year 2000 issues have been resolved. All Year 2000 expenditures are expected to be funded from operating cash flows. The anticipated cost of addressing Year 2000 issues is based on management's current best estimates which were derived utilizing numerous assumptions of future events, including the continued availability of certain resources, third party modification plans and other factors. LNC's management continues to closely monitor these costs, but there can be no guarantee that actual costs will not be higher than these estimated costs. Specific factors that might cause such differences include, but are not limited to, the availability and cost of personnel trained in this area, the ability to locate and correct relevant computer problems and other uncertainties. The scope of the overall Year 2000 program includes the following four major project areas: 1) addressing the readiness of business applications, operating systems and hardware on mainframe, personal computer and Local Area Network platforms (IT); 2) addressing the readiness of embedded chips, end-user developed spreadsheets and software (non-IT); 3) addressing the readiness of key business partners and 4) establishing year 2000 contingency plans. The projects to address IT and non-IT readiness have four major phases. Phase one involves raising awareness and creating an inventory of all IT and non-IT assets. The second phase consists of assessing all items inventoried to initially determine whether they are affected by the Year 2000 issue and preparing general plans and strategies. The third phase entails the detailed planning and remediation of affected systems and equipment. The last phase consists of testing to verify Year 2000 readiness. LNC has completed these four phases for all of its high priority IT systems, including those provided by software vendors. As of June 30, 1999, the status of projects addressing readiness of high priority IT assets is: 100% of IT assets have been inventoried (Phase 1), assessed (Phase 2), and remediated (Phase 3); 99% of IT projects have completed the testing phase (Phase 4) with the last affiliate interface testing finished as part of related environmental testing in July. LNC defines the IT testing phase as comprehensive testing of Year 2000 systems changes for both Year 2000 functionality and regression testing to confirm that the Year 2000 changes have not inadvertently modified existing processing. This IT testing includes simulated future date unit tests, systems tests and integration tests with LNC affiliates and was completed in July, as noted above. Environmental and external agent/vendor testing, which are subject to external factors such as vendor readiness, will continue through the third quarter of 1999 as planned. Re-testing of systems as part of the pre-production quality assurance process (Aclean management@) as well as participation in industry-wide testing will continue throughout the year. As of June 30, 1999, the status of projects that address readiness of high priority non-IT assets is: 100% of non-IT assets have been inventoried (Phase 1), assessed (Phase 2), and remediated (Phase 3); 92% of non-IT projects have completed the testing phase (Phase 4). LNC expects to have all phases related to high priority non-IT completed by the end of October 1999. Concurrent with the IT and non-IT projects, the readiness of key business partners is being reviewed and Year 2000 contingency plans are being developed.
-16- The most significant categories of key business partners are financial institutions, software vendors, and utility providers (gas, electric and telecommunications). Surveys have been mailed to key business partners. Based on responses received, current levels of readiness are being assessed, follow-up contacts are underway, alternative strategies are being developed and testing is being scheduled or is already underway where feasible. Some of LNC's business partners have indicated that they cannot test with all partners. In those instances where LNC is not testing with a high priority business partner, LNC will review test results of clients having similar systems and determine LNC's comfort level with their testing. This effort is expected to continue well into the third quarter of 1999. As noted above, software vendor assessments are considered part of the IT projects and, therefore, would follow the schedule shown above for such projects. The complexity of the Year 2000 issue gives rise to numerous uncertainties. Regardless of best efforts, LNC recognizes the possibility that failures may occur. LNC is putting significant emphasis on Year 2000 contingency planning. Year 2000 contingency plans are currently being developed. Testing of the plans and training will continue throughout the second half of 1999. Contingency plans consider failures due to either internal or external Y2K events ranging from such things as systems failures to utility outages to external provider failures. Alternative providers have been identified and in some cases contacted; year-end staffing plans are being finalized; manual work arounds are being documented and prioritization processes for problem resolution are being developed. While LNC is working to meet the various schedules outlined above, some uncertainty remains. Specific factors that give rise to this uncertainty include a possible loss of technical resources to perform the work, failure to identify all susceptible systems, non-compliance by third parties whose systems and operations impact LNC and other uncertainties. A worst case scenario might include LNC's inability to achieve Year 2000 readiness with respect to one or more of LNC's significant policyholder systems, resulting in a material disruption to LNC's operations. Specifically, LNC could experience an interruption in its ability to collect and process premiums or deposits, process claim payments, accurately maintain policyholder information, accurately maintain accounting records, and/or perform adequate customer service. Should the worst case scenario occur, it could, depending on its duration, have a material impact on LNC's results of operations and financial position. Simple failures might be repaired and returned to production within a matter of hours with no material impact. Unanticipated failures with a longer service disruption period might have a more serious impact. For this reason, LNC is placing significant emphasis on risk management and Year 2000 contingency planning. As noted above, LNC is in the process of modifying its contingency plans to address potential Year 2000 issues. Where these efforts identify either high risks due to unacceptable work around procedures or significant readiness risks, appropriate risk management techniques are being defined. These techniques, such as resource shifting or use of alternate providers, will be employed if needed to provide stronger assurances of readiness. LNC has gone through exercises to identify worst case scenario failures. At this time, LNC believes its plans are sufficient to mitigate identified worst case scenarios. REVIEW OF CONSOLIDATED FINANCIAL CONDITION Investments The total investment portfolio decreased $566.9 million in the first six months of 1999. This is the net result of purchases of investments from cash flow generated by the business segments being more than offset by the decrease in the fair value of securities available-for-sale, and by fixed annuity contractholders opting to transfer funds to variable annuity contracts. The quality of LNC's fixed maturity securities portfolio as of June 30, 1999 was as follows: Treasuries and AAA 25.5% BBB 32.5% AA 7.0% BB 4.1% A 28.0% Less than BB 2.9% As of June 30, 1999, $2.1 billion or 7.0% of fixed maturity securities was invested in below investment grade securities (less than BBB). This represents 6.0% 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
-17- 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, 1999, the aggregate cost of such investments purchased was $334.1 million. Aggregate proceeds from such investments sold were $367.7 million, resulting in a net realized pre-tax loss at the time of sale of $25.3 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 June 30, 1999, mortgage loans on real estate and real estate represented 12% and 1% of LNC's total investment portfolio, respectively. As of June 30, 1999, the underlying properties supporting the mortgage loans on real estate consisted of 28% in commercial office buildings, 31% in retail stores, 18% in apartments, 12% in industrial buildings, 6% in hotels/motels and 5% in other. In addition to the dispersion by property type, the mortgage loan portfolio is geographically diversified throughout the United States. The following summarizes key information on mortgage loans: <TABLE> <CAPTION> June 30 December 31 (in millions) 1999 1998 ------------- ---- ---- <S> <C> <C> Total Portfolio (net of reserves)...................................... $4,570.5 $4,393.1 Mortgage loans two or more payments delinquent (including in process of foreclosure)...................... 18.3 2.4 Restructured loans in good standing.................................... 30.0 32.0 Reserve for mortgage loans............................................. 4.3 4.8 </TABLE> Fixed maturity securities available-for-sale, mortgage loans on real estate and real estate that were non-income producing for the six months ended June 30, 1999 were not significant. Cash and Invested Cash Cash and invested cash decreased by $282.3 million in the first six months of 1999, primarily as a result of the purchase and retirement of common stock at a cost of $197.8 million. Deferred Acquisition Costs Deferred acquisition costs increased $433.9 million during the first six months of 1999 as the net result of increases in new business being partially offset by reductions related to the decrease in unrealized gain on securities available-for-sale. Premiums and Fees Receivable Premiums and fees receivable increased $22.8 million in the first six months of 1999 as a net result of increased volumes of business being partially offset by the collection of premium receipts from high fourth quarter 1998 sales in the Life Insurance and Annuities segment. Assets Held in Separate Accounts This asset account as well as the corresponding liability account increased by $4.5 billion in the first six months of 1999 reflecting an increase in annuity funds under management. This increase resulted from market appreciation and new deposits exceeding benefit payments and withdrawals. Goodwill and Other Intangible Assets The decrease in these amounts is the result of the amortization of account balances for the six months ended June 30, 1999 and the adjustment made to goodwill in the first quarter of 1999 resulting from reaching final settlement with the seller as to the value of assets and liabilities transferred to Lincoln on the business acquired January 2, 1998 (see note 9 on page 11). Other Assets The increase in other assets of $183.1 million is the result of having a higher receivable related to investment securities sold in the last few days of the second quarter of 1999 versus the end of 1998.
-18- Total Liabilities Total liabilities increased by $5.0 billion in the first six months of 1999. Insurance policy reserves increased $58.3 million. Contractholder funds decreased $173.6 million which is the net result of new deposits being more than offset by the withdrawal upon maturity of guaranteed interest contracts. Liabilities related to separate accounts increased $4.5 billion (see discussion of Assets Held in Separate Accounts above). Total debt increased $65.5 million and all other liabilities increased $590.1 million as a result of an increase in certain investing activities during the first six months of 1999. LNC's liabilities include some contingency items (see note 5 on page 7). Shareholders' Equity Total shareholders' equity decreased $570.6 million in the first six months of 1999. Excluding the decrease of $553.5 million related to a decrease in the unrealized gains on securities available-for-sale, shareholders' equity decreased $17.1 million. This decrease was the net result of increases due to $293.4 million from net income, $27.2 million from the issuance of common stock related to benefit plans and $3.5 million from the issuance of common stock related to the acquisition of subsidiaries being offset by a decrease of $29.3 million in the cumulative foreign currency translation adjustment, $202.7 million for the repurchase of common shares and $109.2 million for the declaration of dividends to shareholders. Due to reduced levels of net unrealized gains on securities available-for-sale, consolidated deferred taxes are in a net deferred tax asset position as of June 30, 1999. Realization of the deferred tax asset is based upon offsetting existing taxable temporary differences, carrybacks to prior years, and expectations of future taxable income. Existing levels of pre-tax earnings are sufficient to generate the minimum amount of future taxable income over the next few years necessary to fully support the realization of the net deferred tax asset. 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 $689.3 million during the first six months of 1999. 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 June 30, 1999, LNC has a shelf registration with an unused balance of $825 million that would allow LNC to issue a variety of securities, including debt, preferred stock, common stock and hybrid securities. Finally, cash funds are available from LNC's revolving credit agreement which provides for borrowing up to $750 million. Transactions that occurred recently include the purchase and retirement of shares of common stock at a cost of $197.8 million in the first six months of 1999. In May 1999, the LNC board authorized $500 million to repurchase shares of common stock. Since the May 1999 board authorization repurchases of $69.0 million through July 30, 1999 have reduced the board authorization to $431.0 million. LNC's insurance subsidiaries are subject to certain insurance department regulatory restrictions, as to the transfer of funds and payment of dividends to the holding company (LNC). Generally, these restrictions pose no short-term liquidity concerns for the holding company. However, as discussed in detail within note 5 on page 7, the acquisition of two blocks of business in 1998 placed further restrictions on the ability of LNC's primary insurance subsidiary, Lincoln National Life Insurance Company ("Lincoln Life"), to declare and pay dividends. As a result of these acquisitions and the dividends declared, Lincoln Life's statutory earned surplus is negative.
-19- It is necessary for Lincoln Life to obtain the prior approval of the Indiana Insurance Commissioner before paying any dividends to LNC until such time as statutory earned surplus is positive. Although no assurance can be given that additional dividends will be approved, during the second quarter 1999, Lincoln Life received regulatory approval and paid an extraordinary dividend of $350 million to LNC. Statutory earned surplus could return to a positive position within 2 1/2 years from the closing of the Aetna transaction described above assuming a level of statutory earnings coinciding with recent earnings patterns. If statutory earnings are less than recent patterns due, for example, to adverse operating conditions or further indemnity reinsurance transactions of this nature or if dividends are approved or paid at amounts higher than recent history, the statutory earned surplus may not return to a positive position in a 2 1/2 half year time frame. In the event such approvals are not obtained, management believes that LNC can obtain the funds required to satisfy its obligations from its existing credit facilities and other sources. Item 3 Quantitative and Qualitative Disclosure of Market Risk In Item 7A of Part II for the year ended December 31, 1998 (see page 28 of LNC's Form 10-K), LNC provided a discussion of its market risk. During the first six months of 1999, there was no substantive change to LNC's market risk. The following is a discussion of changes to LNC's derivative positions. Derivatives As discussed in note 7 to the consolidated financial statements for the year ended December 31, 1998 (see page 57 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, increased liabilities associated with certain reinsurance agreements, foreign exchange risks and fluctuations in the FTSE and S&P indexes. In addition, LNC is subject to risks associated with changes in the value of its derivatives; however, such changes in value are generally offset by changes in the value of the items being hedged by such contracts. Modifications to LNC's derivative strategy are initiated periodically upon review of the company's overall risk assessment. During the first six months of 1999, the more significant changes in LNC's derivative positions are 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 $4.1 billion notional to $3.5 billion notional. The decrease in notional is a result of expirations and, therefore, no gain or loss has been recognized. 2. Increased its use of interest rate swap agreements from $258.3 million notional to $377.0 million notional. During the first six months, $.6 million notional expired with no gain or loss recognized. These interest rate swap agreements are part of a replication strategy which will result in a higher yield on bonds held by LNC. 3. Decreased its use of foreign exchange forward contracts from $1.5 million notional to $.3 million notional. This reduction was initiated as the result of the U.S. dollar strengthening against the foreign currencies hedged. LNC entered into $30.0 million notional of foreign exchange forward contracts to hedge LNC's exposure to currency fluctuations associated with its commercial paper program in the United Kingdom. 4. Decreased its use of foreign currency swaps that are hedging the foreign currency risk of its portfolio of foreign bonds from $47.2 million notional to $44.8 million notional. This reduction in notional resulted in a recognized gain of $.3 million. These foreign currency swaps are part of a replication strategy. LNC owns various foreign issue securities. Interest payments from these securities are received in a foreign currency and then swapped into U.S. dollars, replicating a foreign issue, U.S. dollar paying security. 5. Decreased its use of FTSE index call options from $11.1 million notional to $6.4 million notional. As a result of this termination, a $.7 million gain was recognized. The purpose of LNC's FTSE index call option program is to offset the cost of increases in the liabilities of certain single premium investment contracts which are tied to the appreciation of the FTSE index.
-20- 6. Increased its use of S&P 500 index options from $79.9 million notional to $97.7 million notional. New options in the amount of $20.6 million were entered into during the first six months and $2.8 million were terminated, resulting in a $.2 million gain. These call options continue to offset LNC's increased liabilities resulting from certain reinsurance agreements which guarantee payment for a specified portion of the appreciation of the S&P 500 index on certain underlying annuity products. LNC is exposed to credit loss in the event of non-performance by counterparties on interest rate cap agreements, swaptions, spread-lock agreements, interest rate swaps, put options, foreign exchange forward contracts, foreign currency options, foreign currency swaps, commodity swaps and call options. However, LNC does not anticipate non-performance by any of the counterparties. The credit risk associated with such agreements is minimized by purchasing such agreements from financial institutions with long-standing superior performance records. PART II - OTHER INFORMATION AND EXHIBITS Items 1, 2, 3 and 5 of 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 Securityholders (a) The matters discussed below were submitted to and voted on by Shareholders of the Registrant at the Annual Meeting of Shareholders of the Registrant on May 13, 1999. 1. To elect four directors for three year terms J. Patrick Barrett Daniel R. Efroymson Votes cast for = 86,804,940 Votes cast for = 86,867,806 Votes withheld = 963,359 Votes withheld = 900,493 Thomas D. Bell, Jr. Roel Pieper Votes cast for = 86,803,963 Votes cast for = 75,182,356 Votes withheld = 964,336 Votes withheld = 12,585,943 2. To approve Shareholders Proposal relating to Tobacco Investments Votes cast for = 8,434,627 Votes cast against = 71,058,276 Number of abstentions = 3,003,709 Number of non-votes = 5,271,687 (Note: The number of shares voted for both matters above were before the two-for-one common stock split.) Item 6 Exhibits and Reports on Form 8-K (a) The following Exhibits of the Registrant are included in this report. (Note: The number preceding the exhibit corresponds to the specific number within Item 601 of Regulation S-K.) 10(a) 1997 Incentive Compensation Plan 10(b) Descriptions of Compensation with Executive Officers 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, 1999.
-21- 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 By /S/Casey J.Trumble Casey J. Trumble Senior Vice President and Chief Accounting Officer Date August 4, 1999
-22- LINCOLN NATIONAL CORPORATION Exhibit Index for the Report on Form 10-Q for the Quarter Ended June 30, 1999 Exhibit Number Description Page Number 10(a) Lincoln National Corporation 1997 Incentive Compensation Plan 23 10(b) Descriptions of Compensations with Executive Officers 40 12 Historical Ratio of Earnings to Fixed Charges 73 27 Financial Data Schedule 74