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, 2004
Commission file number 1-6028
LINCOLN NATIONAL CORPORATION
(Exact name of registrant as specified in its charter)
1500 Market Street, Suite 3900,
Philadelphia, Pennsylvania 19102-2112
(Address of principal executive offices)
Registrant’s telephone number (215) 448-1400
Indicate the number of shares outstanding for each issuer’s classes of common stock, as of the last practicable date:
As of July 30, 2004 LNC had 175,986,186 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 ¨
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No ¨
The exhibit index to this report is located on page 68.
PART I - FINANCIAL INFORMATION
CONSOLIDATED BALANCE SHEETS
(000s omitted)
June 30,
2004
ASSETS
Investments:
Securities available-for-sale, at fair value:
Fixed maturity (cost: 2004 - $31,801,647; 2003 - $30,959,445)
Equity (cost: 2004 - $160,139; 2003 - $173,519)
Trading securities
Mortgage loans on real estate
Real estate
Policy loans
Derivative investments
Other investments
Total Investments
Cash and invested cash
Property and equipment
Deferred acquisition costs
Premiums and fees receivable
Accrued investment income
Assets held in separate accounts
Federal income taxes
Amounts recoverable from reinsurers
Goodwill
Other intangible assets
Other assets
Total Assets
See notes to consolidated financial statements.
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-CONTINUED-
LIABILITIES AND SHAREHOLDERS’ EQUITY
Liabilities:
Insurance and investment contract liabilities:
Insurance policy and claim reserves
Contractholder funds
Liabilities related to separate accounts
Total Insurance and Investment Contract Liabilities
Short-term debt
Long-term debt
Junior subordinated debentures issued to affiliated trusts
Reinsurance related derivative liability
Funds withheld reinsurance liabilities
Other liabilities
Deferred gain on indemnity reinsurance
Total Liabilities
Shareholders’ Equity:
Series A preferred stock - 10,000,000 shares authorized (2004 liquidation value - $1,414.2)
Common stock - 800,000,000 shares authorized
Retained earnings
Accumulated other comprehensive income:
Foreign currency translation adjustment
Net unrealized gain on securities available-for-sale
Net unrealized gain on derivative instruments
Minimum pension liability adjustment
Total Accumulated Other Comprehensive Income
Total Shareholders’ Equity
Total Liabilities and Shareholders’ Equity
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CONSOLIDATED STATEMENTS OF INCOME
(000s omitted except for per share amounts)
Revenue:
Insurance premiums
Insurance fees
Investment advisory fees
Net investment income
Realized loss on investments and derivative instruments (net of amounts restored against balance sheet accounts)
Gain on sale of subsidiaries/business
Amortization of deferred gain on indemnity reinsurance
Gain on reinsurance embedded derivative/trading securities
Other revenue and fees
Total Revenue
Benefits and Expenses:
Benefits
Underwriting, acquisition, insurance and other expenses
Interest and debt expense
Total Benefits and Expenses
Income before Federal Income Taxes and Cumulative Effect of Accounting Change
Income before Cumulative Effect of Accounting Change
Cumulative Effect of Accounting Change (net of Federal Income Taxes)
Net Income
Earnings Per Common Share-Basic
Earnings Per Common Share-Diluted:
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CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(000s omitted from dollar amounts)
Series A Preferred Stock:
Balance at beginning-of-year
Conversion into common stock
Balance at June 30
Common Stock:
Conversion of series A preferred stock
Stock compensation/issued for benefit plans
Retirement of common stock
Retained Earnings:
Comprehensive income (loss)
Less other comprehensive income (loss):
Net unrealized gain (loss) on securities available-for-sale
Net unrealized gain (loss) on derivative instruments
Dividends declared:
Series A preferred ($1.50 per share)
Common stock (2004-$0.70; 2003-$0.67)
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CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY (Continued)
Foreign Currency Translation Adjustment:
Accumulated adjustment at beginning-of-year
Change during the period
Net Unrealized Gain on Securities Available-for-Sale:
Net Unrealized Gain on Derivative Instruments:
Minimum Pension Liability Adjustment:
Total Shareholders’ Equity at June 30
Common Stock at End of Quarter:
Assuming conversion of preferred stock
Diluted basis
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CONSOLIDATED STATEMENTS OF CASH FLOWS
Six Months Ended
Cash Flows from Operating Activities:
Net income
Adjustments to reconcile net income to net cash provided by operating activities:
Policy liabilities and accruals
Net trading securities purchases, sales and maturities
Cumulative effect of accounting change
Stock-based compensation expense
Provisions for depreciation
Amortization of other intangible assets
Amortization of deferred gain
Realized loss on investments, derivative instruments and gain on sale of subsidiaries/business
Other
Net Adjustments
Net Cash Provided by Operating Activities
Cash Flows from Investing Activities:
Securities-available-for-sale:
Purchases
Sales
Maturities
Purchase of other investments
Sale or maturity of other investments
Increase in cash collateral on loaned securities
Net Cash Used in Investing Activities
Cash Flows from Financing Activities:
Issuance of long-term debt
Net decrease in short-term debt
Universal life and investment contract deposits
Universal life and investment contract withdrawals
Investment contract transfers
Increase in funds withheld liability
Common stock issued for benefit plans
Dividends paid to shareholders
Net Cash Provided by Financing Activities
Net Increase in Cash and Invested Cash
Cash and Invested Cash at Beginning-of-Year
Cash and Invested Cash at June 30
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
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 accounting principles generally accepted in the United States, 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 incorporated by reference into LNC’s latest annual report on Form 10-K for the year ended December 31, 2003.
Operating results for the three and six months ended June 30, 2004 are not necessarily indicative of the results that may be expected for the full year ending December 31, 2004.
2. Change in Accounting Principle and New Accounting Pronouncements
Statement of Accounting Position 03-1
In July 2003, the Accounting Standards Executive Committee (“AcSEC”) of the American Institute of Certified Public Accountants issued Statement of Position 03-1, “Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts” (“the SOP”). LNC implemented the provisions of the SOP as of January 1, 2004. Adjustments arising from implementation, as discussed below, have been recorded in net income as a cumulative effect of accounting change.
The SOP provides guidance related to the reporting and disclosure of certain insurance contracts and separate accounts, including guidance for computing reserves for products with guaranteed benefits, such as guaranteed minimum death benefits (“GMDB”), and for products with annuitization benefits such as guaranteed minimum income benefits. In addition, the SOP addresses the presentation and reporting of separate accounts, the capitalization and amortization of sales inducements, and secondary guarantees on universal-life type contracts.
GMDB Reserves. Although there was no method prescribed under generally accepted accounting principles for GMDB reserving until the issuance of the SOP, LNC’s Retirement segment has been recording a reserve for GMDB’s. At December 31, 2003 LNC’s GMDB reserve was $46.4 million. Based upon a comparison of the requirements of the SOP to LNC’s established practice of reserving for GMDB, the adoption of the GMDB reserving methodology under the SOP resulted in a decrease to reserves of $9.7 million pre-tax. Under the SOP GMDB reserves were $41.9 million at June 30, 2004.
Under the SOP, the reserve is calculated by multiplying the current benefit ratio (present value of total expected GMDB payments over the life of the contract divided by the present value of total expected assessments over the life of the contract) by the cumulative assessments recorded from the contract inception through the balance sheet date less the cumulative GMDB payments plus interest. The change in the reserve for a quarter is then the benefit ratio multiplied by the assessments recorded for the quarter less GMDB claims paid in the quarter plus interest. If experience or assumption changes result in a new benefit ratio, the reserves are unlocked to reflect the changes in a manner similar to deferred acquisition costs (“DAC”).
Application of the new GMDB methodology changes estimated gross profits (“EGPs”) used to calculate amortization of DAC, the present value of acquired blocks of in-force policies (“ PVIF”), deferred sales inducements (“DSI”), and the liability for deferred front-end loads (“DFEL”). The new benefit ratio approach under the SOP will result in a portion of future GMDB fees accrued as a liability for future GMDB reserves; therefore, EGPs are reduced, relative to the pre-SOP calculations. As a result, an unfavorable DAC/PVIF/DSI/DFEL unlocking was reported upon adoption of the SOP, and resulted in a negative cumulative effect adjustment of $43.2 million pre-tax.
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The combined effects of the GMDB reserve requirements and related unlocking adjustments from implementation of the SOP resulted in a charge to net income for the cumulative effect of accounting change of $33.5 million pre-tax ($21.8 million after-tax).
Sales Inducements. LNC’s Retirement segment variable annuity product offerings include contracts that offer a bonus credit, typically ranging from 2% to 5% of each deposit. LNC also offers enhanced interest rates to variable annuity contracts that are under dollar cost averaging (“DCA”) funding arrangements. Bonus credits and excess DCA interest are considered sales inducements under the SOP and, as such, are to be deferred as a sales inducement asset and amortized as a benefit expense over the expected life of the contract. Amortization is computed using the same methodology and assumptions used in amortizing DAC.
LNC previously deferred bonus credits as part of the DAC asset and reported the amortization of bonus credits as part of DAC amortization. Upon implementation of the SOP, LNC reclassified bonus credits of $45.2 million from DAC to deferred sales inducements, which are reported in other assets on the balance sheet. Amortization of the deferred sales inducement asset is reported as part of benefit expense. Prior period balance sheet and income statement line item presentation has been reclassified to conform to the new basis of presentation.
LNC previously reported excess DCA interest as benefit expense when the excess interest was earned under the contract. As required by the SOP, during the first quarter of 2004, LNC began deferring excess DCA interest as deferred sales inducements and amortizing these deferred sales inducements as benefit expense over the expected life of the contract. While over the long run the same amount of excess DCA interest expense will emerge under the SOP as under LNC’s previous accounting method, because of the prospective treatment of new deferred sales inducements, LNC’s net income was slightly higher under the SOP for the first six months and second quarter of 2004 relative to the approach used for the same periods last year. This pattern is expected to continue for near term financial reporting periods. Net income for the three and six-month periods ended June 30, 2004 increased $2.0 million and $3.5 million after-tax, respectively, compared to same periods in 2003 due to excess DCA interest capitalized under the SOP.
Separate Accounts. LNC’s current accounting is consistent with the provisions of the SOP relating to the reporting and measuring of separate account product assets and liabilities as general account assets and liabilities when specific criteria are not met, as well as for the reporting and measuring seed money in separate accounts as general account assets, and for recognizing contract holder liabilities. The adoption of these provisions of the SOP did not have an effect on LNC’s financial statements.
Universal Life Contracts. LNC’s Life Segment offers an array of individual and survivor-life universal life insurance products that contain features for which the SOP might apply. A review of the products and their features for possible SOP implications concluded that no additional reserves would be necessary with the exception of the MoneyGuard product. MoneyGuard is a universal life insurance product with an acceleration of death benefit feature that provides convalescent care benefit payments when the insured becomes chronically ill. There is an optional extension of benefit rider available that will provide continuation of the convalescent care benefit payments once the total benefits from the base policy have been exhausted. The optional extended benefit payments can be for 2 years, 4 years, or the remaining life of the insured. Charges for the extension rider are deducted from the base policy account value and vary by the length of extension period selected. For the first quarter of 2004, the adoption of the SOP resulted in a cumulative effect of accounting change equal to $(2.7) million after-tax for the extension of benefit feature in MoneyGuard.
As discussed in the 2003 annual report on Form 10-K, there have been questions raised by LNC and the life insurance industry as to the applicability of certain aspects of the SOP to universal life insurance contracts. In the event that further guidance is issued in the future to address these industry-wide implementation issues, future adjustments could be required to the extent the guidance differs from LNC’s interpretation of the SOP.
FASB Staff Position No. FAS 97-1 - Situations in Which Paragraphs of FASB Statement No. 97 Permit or Require Accrual of an Unearned Revenue Liability
In June 2004, the staff of the Financial Accounting Standards Board (“FASB”) issued Financial Staff Position No. FAS 97-1 (“FSP 97-1”), which is effective for the third quarter 2004. FSP 97-1 clarifies that the SOP did not restrict the recording of a liability for unearned revenue as defined in accordance with paragraphs 17(b) and 20 of Statement of Accounting Standards No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments” to only those situations where profits
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are followed by expected losses. LNC will be reviewing the applicability of FSP 97-1 to its life insurance business. LNC does not expect that the adoption of FSP 97-1 should have a material effect on LNC’s financial statements.
FASB Staff Position No. FAS - 106-2 Accounting and Disclosure Requirements Related to the Medicare Prescription Drug Improvement and Modernization Act of 2003
In December 2003, the Medicare Prescription Drug Improvement and Modernization Act of 2003 (“the Medicare Act”) became law. Beginning in 2006, the Medicare Act provides various alternatives that could result in an offset to some portion of the costs of prescription drug benefits provided to retirees. In January 2004, the staff of the FASB issued Financial Staff Position No. FAS 106-1 (“FSP 106-1”), which permitted a sponsor of a post-retirement health care plan that provides retiree prescription drug benefits to make a one-time election to defer accounting for the effects of the Medicare Act. In May 2004, the staff of the FASB issued Financial Staff Position No. FAS 106-2 (“FSP 106-2”), which requires sponsors of a post-retirement health care plan that provides retiree prescription drug benefits to reflect the provisions of the Medicare Act in determining post-retirement benefit cost for the first annual or interim period starting after June 15, 2004.
As more fully discussed in LNC’s Annual Report on Form 10-K for the year ended December 31, 2003, there are several uncertainties that exist as to the eventual effects of the Medicare Act on the cost of the prescription drug benefits currently included in LNC’s retiree medical benefit plan. Generally, the Medicare Act provides a subsidy of 28% of retiree prescription drug benefits between $250 and $5,000 for those prescription drug plans that are actuarially equivalent to the Medicare Act’s prescription drug benefits. This subsidy is to be tax free to the sponsoring company and there are no restrictions as to how the company is to use the subsidy. Regulations and guidelines for determining actuarial equivalence or funding and payment of the subsidy have not been developed.
Due to these uncertainties about how participants in LNC’s post-retirement plan will elect to participate in the Medicare Act’s benefits, and the various uncertainties created by the current lack of guidelines for applying the Medicare Act’s provisions, LNC elected to defer accounting for the effects of the Medicare Act under the initial guidance provided by FSP 106-1. LNC has not completed its assessment of either the actuarial equivalence of its post-retirement prescription drug benefits with the provisions of the Medicare Act, or the effects of the other provisions of the Medicare Act on the future estimated post-retirement benefit obligation. LNC expects to complete these assessments and implement the provisions of FSP 106-2 during the third quarter of 2004.
Accordingly, the measures of accumulated post-retirement benefit obligation and periodic post-retirement benefit cost in LNC’s financial statements for the periods ended June 30, 2004 do not include the effects of the Medicare Act.
3. Federal Income Taxes
The effective tax rate on net income is lower than the prevailing corporate federal income tax rate principally from tax-preferred investment income. LNC earns tax-preferred investment income that does not change proportionately with the overall change in earnings or losses before federal income taxes.
4. Debt Issuance
In February 2004, LNC issued $200 million 4.75% Notes due 2014 with semi-annual interest payments in February and August. The notes were priced at 99.297% and net proceeds to the company were $197.3 million, which will be used for general corporate purposes. Until the funds are needed for such purposes, the net proceeds will be used to invest in short-term investment grade securities and to pay down short-term debt. LNC used a treasury lock to reduce exposure to interest rate changes prior to closing. The treasury lock was closed prior to the issuance of the Notes with a gain of approximately $1 million. This gain, along with the costs of issuance, is being amortized over the life of the Notes.
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5. Supplemental Financial Data
A roll forward of the balance sheet account, “Deferred Acquisition Costs,” is as follows:
(in millions)
Balance at beginning-of-period
Deferral
Amortization
Adjustments related to realized (gains) losses on securities available-for-sale
Adjustments related to unrealized (gains) losses on securities available-for-sale
Balance at end-of-period
Realized gains and losses on investments and derivative instruments on the Statements of Income for the six months ended June 30, 2004 and 2003 are net of amounts restored or (amortized) against deferred acquisition costs of $(23.7) million and $38.3 million, respectively. In addition, realized gains and losses for the six months ended June 30, 2004 and 2003 are net of adjustments made to policyholder reserves of $0.9 million and $44.8 million, respectively. LNC has either a contractual obligation or has a consistent historical practice of making allocations of investment gains or losses to certain policyholders.
Details underlying the income statement caption, “Underwriting, Acquisition, Insurance and Other Expenses,” are as follows:
Commissions
Other volume related expenses
Operating and administrative expenses
Deferred acquisition costs net of amortization
Other intangibles amortization
Restructuring charges
Total
The carrying amount of goodwill by reportable segment as of June 30, 2004 and December 31, 2003 was as follows:
Life Insurance
Investment Management
Lincoln Retirement
Lincoln UK
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The consolidated carrying value of goodwill as of June 30, 2004 changed from the balance as of December 31, 2003 as a result of the translation of the Lincoln UK balance from British pounds to U.S. dollars based on the prevailing exchange rate as of the balance sheet date.
For intangible assets subject to amortization, the total gross carrying amount and accumulated amortization in total and for each major intangible asset class by segment are as follows:
Amortized Intangible Assets:
Present value of in-force:
Lincoln UK (1)
Client lists:
The aggregate amortization expense for other intangible assets for the six months ended June 30, 2004 and 2003 were $49.3 million and $40.3 million, respectively. The aggregate amortization expense for other intangible assets for the three months ended June 30, 2004 and 2003 were $22.5 million and $15.6 million, respectively.
Future estimated amortization of other intangible assets is as follows (in millions):
2004 - $47.0
2007 - $92.7
The amount shown above for 2004 is the amortization expected for the remainder of 2004 from June 30, 2004.
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A reconciliation of the present value of insurance business acquired included in other intangible assets is as follows:
Balance at beginning of period
Interest accrued on unamortized balance (Interest rates range from 5% to 7%)
Foreign exchange adjustment
Cumulative effect adjustment
Balance at end of period
Other intangible assets (non-insurance)
Total other intangible assets at end-of-period
Details underlying the balance sheet caption, “Contractholder Funds,” are as follows:
December 31,
2003
Premium deposit funds
Undistributed earnings on participating business
6. 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 payment of dividends to the holding company. Generally, these restrictions pose no short-term liquidity concerns for the holding company. In general, a dividend is not subject to prior approval from the Commissioner provided The Lincoln National Life Insurance Company’s (“LNL”) statutory earned surplus is positive and the proposed dividend, plus all other dividends made within the twelve consecutive months prior to the date of the proposed dividend, does not exceed the standard limitation of the greater of 10% of total statutory earned surplus or the amount of statutory earnings in the prior calendar year. As a result of the payment of dividends plus earnings in 2002, LNL’s statutory earned surplus was negative as of December 31, 2002. Due to the negative statutory earned surplus as of December 31, 2002, dividends paid by LNL in 2003 were subject to prior approval from the Commissioner.
Dividends of $200 million were paid by LNL to LNC in three quarterly installments during 2003. A special request was made for each payment and each was approved by the Commissioner. LNL also received approval from the Commissioner to classify $164.2 million of dividends approved and paid while statutory earned surplus was negative as a reduction to paid-in-capital. Statutory earned surplus was positive at December 31, 2003, and LNL’s dividends of $50 million each for the first and second quarter of 2004 did not require prior approval. Based upon anticipated on-going positive statutory earnings and favorable credit markets, LNL expects to be able to continue to pay dividends in 2004 without prior approval from the Commissioner.
Lincoln UK’s operations consist primarily of unit-linked life and pension products, which are similar to US produced variable life and annuity products. Lincoln UK’s insurance subsidiaries are regulated by the UK Financial Services Authority (“FSA”) and are subject to capital requirements as defined by the UK Required Minimum Solvency Margin (RMSM). Lincoln UK maintains approximately 1.5 to 2 times the required capital as prescribed by the regulatory margin. As is the case with regulated insurance companies in the US, changes to regulatory capital requirements can impact the dividend capacity of the UK insurance subsidiaries and cash flow to LNC.
LNL is recognized as an accredited reinsurer in the state of New York, which effectively enables it to conduct reinsurance business with unrelated insurance companies that are domiciled in the state of New York. As a result, in addition to regulatory restrictions imposed by the state of Indiana, LNL is also subject to the regulatory and risk based capital requirements that the state of New York imposes upon accredited reinsurers, which differ from the state of Indiana.
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Reinsurance Contingencies. LNC’s former reinsurance operation was acquired by Swiss Re in 2001. The transaction structure involved a series of indemnity reinsurance transactions combined with the sale of certain stock companies that comprised LNC’s reinsurance operation.
The indemnity reinsurance transactions do not relieve LNC of its legal liabilities to the underlying ceding companies. As required by FAS 113, the reserves for the underlying reinsurance contracts as well as a corresponding reinsurance recoverable from Swiss Re will continue to be carried on LNC’s balance sheet during the run-off period of the underlying reinsurance business. This is particularly relevant in the case of the exited personal accident and disability income reinsurance lines of business where the underlying reserves are based upon various estimates that are subject to considerable uncertainty.
Because of ongoing uncertainty related to personal accident and disability income businesses, the reserves related to these exited business lines carried on LNC’s balance sheet at June 30, 2004 may ultimately prove to be either excessive or deficient. For instance, in the event that future developments indicate that these reserves should be increased, under FAS 113, LNC would record a current period non-cash charge to record the increase in reserves. Because Swiss Re is responsible for paying the underlying claims to the ceding companies, LNC would record a corresponding increase in the reinsurance recoverable from Swiss Re. However, FAS 113 does not permit LNC to take the full benefit in earnings for the recording of the increase in the reinsurance recoverable in the period of the change. Rather, LNC would increase the deferred gain recognized upon the closing of the indemnity reinsurance transaction with Swiss Re and would report a cumulative amortization “catch-up” adjustment to the deferred gain balance as increased earnings recognized in the period of change. Any amount of additional increase to the deferred gain above the cumulative amortization “catch-up” adjustment must continue to be deferred and will be amortized into net income in future periods over the remaining period of expected run-off of the underlying business. No cash would be transferred between LNC and Swiss Re as a result of these developments.
Accordingly, even though LNC has no continuing underwriting risk, and no cash would be transferred between LNC and Swiss Re, in the event that future developments indicate LNC’s June 30, 2004 personal accident or disability income reserves are deficient or redundant, FAS 113 requires LNC to adjust earnings in the period of change, with only a partial offset to earnings for the cumulative deferred gain amortization adjustment in the period of change. The remaining amount of increased gain would be amortized into earnings over the remaining run-off period of the underlying business.
United Kingdom Selling Practices. Various selling practices of the Lincoln UK operations have come under scrutiny by the U.K. regulators. These include the sale and administration of individual pension products, mortgage endowments and the selling practices of City Financial Partners Limited (“CFPL”), a subsidiary company purchased in December 1997. Regarding the sale and administration 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 alleged inappropriate advice, an extensive investigation has been or is being carried out and the individual put in a position similar to what would have been attained if the individual had remained in an employer-sponsored plan.
With regard to mortgage endowments, an agreed upon resolution with regulatory authorities, in connection with a subsidiary company, resulted in redress payments to the policyholders of the respective subsidiary company of about $1.8 million during 2003. Regulatory reviews of other subsidiary companies marketing mortgage endowments are currently in abeyance.
Following allegations made by the U.K. Consumers’ Association (an organization which acts on behalf of consumers of goods and services provided in the U.K.) concerning various selling practices of CFPL, LNC conducted an internal review of 5,000 ten-year savings plans sold by CFPL during the period September 1, 1998 to August 31, 2000 and, following discussions with the U.K. regulator, LNC extended this review to all customers with a ten-year savings plan sold by CFPL to determine whether the sales of those policies were appropriate. The agreed upon redress process was concluded in September of 2003, with offers of redress to approximately 5,400 contractholders, and payment of a $762,600 fine for the mis-selling of ten-year savings plans by CFPL covering the period between September 1, 1998 and August 31, 2000.
The Treasury Select Committee published a report in the first quarter of 2004 on various issues associated with mortgage endowment contracts. In response to this report, in the second quarter of 2004 the FSA revised its
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rules relating to the time limits for making a complaint regarding the sale of these contracts. The heightened publicity surrounding these matters has contributed to an increase in the level of customer complaints, which have been in excess of expected levels in the first six months of 2004. As a direct result of this experience and the likely impact of the FSA’s revised rules on time limits, Lincoln UK increased its reserves for these matters during the second quarter of 2004.
Also in the second quarter of 2004, Lincoln UK reached a favorable settlement with a liability carrier for reimbursement of certain costs incurred in connection with certain United Kingdom selling practices. The combined effect of the increase to mis-selling reserves and the favorable settlement resulted in minimal impact to net income. At June 30, 2004 and December 31, 2003, the aggregate liability associated with Lincoln UK selling practices was $37.1 million and $25.0 million, respectively.
On an ongoing basis, Lincoln UK evaluates various assumptions underlying these estimated liabilities, including the expected levels of future complaints and the potential implications with respect to the adequacy of the aggregate liability associated with UK selling practice matters. Any further changes in the regulatory position on time limits or a continuation of higher than expected levels of complaints may result in Lincoln UK revising its current estimate of the required level of these liabilities. See discussion in LNC’s Form 10-K for the year ended December 31, 2003 for background on these matters including pension mis-selling, mortgage endowment and other Lincoln UK selling practice issues. The reserves for these issues are based on various estimates that are subject to considerable uncertainty. Accordingly, the aggregate liability may prove to be deficient or excessive. However, it is management’s opinion that future developments regarding Lincoln UK selling practices will not materially affect the consolidated financial position of LNC.
In addition, LNC and its United Kingdom subsidiaries have pursued claims with their liability carriers for reimbursement of certain costs incurred in connection with certain United Kingdom selling practices. As discussed above, LNC and the United Kingdom subsidiaries agreed to a settlement with the major liability carrier. Negotiations with the remaining carriers continue.
Marketing and Compliance Issues. There continues to be a significant amount of federal and state regulatory activity in the industry relating to numerous issues including market timing and late trading of mutual fund and variable insurance products and broker-dealer access arrangements. Like others in the industry, LNC has received related inquiries including requests for information and/or subpoenas from various authorities including the SEC, NASD, the New York Attorney General and other authorities. LNC is in the process of responding to these inquiries and continues to cooperate fully with such authorities
Regulators also continue to focus on replacement and exchange issues. Under certain circumstances companies have been held responsible for replacing existing policies with policies that were less advantageous to the policyholder. LNC’s management continues to monitor compliance procedures to minimize any potential liability. Due to the uncertainty surrounding all of these matters, it is not possible to provide a meaningful estimate of the range of potential outcomes; however it is management’s opinion that future developments 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, including purported class actions, arising from the conduct of business. In some instances, these proceedings include claims for unspecified or substantial 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 these proceedings ultimately will be resolved without materially affecting the consolidated financial position of LNC.
LNC and LNL have pursued claims with their liability insurance carriers for reimbursement of certain costs incurred in connection with the settlement of the class action lawsuits alleging fraud in the sale of LNL non-variable universal life and participating whole life policies issued between January 1, 1981 and December 31, 1998, and the settlement of claims and litigation brought by owners that opted out of the class action settlement. During the fourth quarter of 2002, LNC and LNL settled their claims against three liability carriers on a favorable basis, and in the second quarter of 2004, they settled their claims with the remaining carrier on a favorable basis.
State guaranty funds assess insurance companies to cover losses to policyholders of insolvent or rehabilitated companies. Mandatory assessments may be partially recovered through a reduction in future premium taxes in some states. LNC has accrued for expected assessments net of estimated future premium tax deductions.
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Guarantees. LNC has guarantees with off-balance-sheet risks whose contractual amounts represent credit exposure. Outstanding guarantees with off-balance sheet risks had contractual values of $13.6 million and $14.2 million at June 30, 2004 and December 31, 2003, respectively.
Certain subsidiaries of LNC have invested in real estate partnerships that use industrial revenue bonds to finance their projects. LNC has guaranteed the repayment of principal and interest on these bonds. Certain subsidiaries of LNC are also involved in other real estate partnerships that use conventional mortgage loans. In case of default by the partnerships, LNC has recourse to the underlying real estate. In some cases, the terms of these arrangements involve guarantees by each of the partners to indemnify the mortgagor in the event a partner is unable to pay its principal and interest payments. These guarantees expire in 2005 through 2008.
In addition, certain subsidiaries of LNC have sold commercial mortgage loans through grantor trusts, which issued pass-through certificates. These subsidiaries have agreed to repurchase any mortgage loans which remain delinquent for 90 days at a repurchase price substantially equal to the outstanding principal balance plus accrued interest thereon to the date of repurchase. In case of default on the mortgage loans, LNC has recourse to the underlying real estate. It is management’s opinion that the value of the properties underlying these commitments is sufficient that in the event of default, the impact would not be material to LNC. These guarantees expire in 2006 through 2009.
Derivative Instruments. LNC maintains an overall risk management strategy that incorporates the use of derivative instruments to minimize significant unplanned fluctuations in earnings that are caused by interest rate risk, foreign currency risk, equity risk, and credit risk. LNC assesses these risks by continually identifying and monitoring changes in interest rate exposure, foreign currency exposure, equity market exposure, and credit exposure that may adversely impact expected future cash flows and by evaluating hedging opportunities. Derivative instruments that are currently used as part of LNC’s interest rate risk management strategy include interest rate swaps and interest rate caps. Derivative instruments that are used as part of LNC’s foreign currency risk management strategy include foreign currency swaps. Call options on LNC stock, total return swaps, and financial futures are used as part of LNC’s equity market risk management strategy. LNC also uses credit default swaps as part of its credit risk management strategy.
By using derivative instruments, LNC is exposed to credit and market risk. If the counterparty fails to perform, credit risk is equal to the extent of the fair value gain in the derivative. When the fair value of a derivative contract is positive, this generally indicates that the counterparty owes LNC and, therefore, creates a payment risk for LNC. When the fair value of a derivative contract is negative, LNC owes the counterparty and therefore LNC has no payment risk. LNC minimizes the credit (or payment) risk in derivative instruments by entering into transactions with high quality counterparties that are reviewed periodically by LNC. LNC also maintains a policy of requiring that all derivative contracts be governed by an International Swaps and Derivatives Association (“ISDA”) Master Agreement.
LNC and LNL are required to maintain minimum ratings as a matter of routine practice in negotiating ISDA agreements. Under the majority of ISDA agreements and as a matter of policy, LNL has agreed to maintain financial strength or claims-paying ratings above S&P BBB and Moody’s Baa2. LNC is required to maintain long-term senior debt ratings above S&P BBB and Moody’s Baa2. A downgrade below these levels would result in termination of the derivatives contract at which time any amounts payable by LNC would be dependent on the market value of the underlying derivative contract. In certain transactions, LNC and the counterparty have entered into a collateral support agreement requiring LNC to post collateral upon significant downgrade. LNC also requires for its own protection minimum rating standards for counterparty credit protection. LNL is required to maintain financial strength or claims-paying ratings above S&P A- and Moody’s A3 under certain ISDA agreements, which collectively do not represent material notional exposure. LNC does not believe the inclusion of termination or collateralization events pose any material threat to its liquidity position.
Market risk is the adverse effect that a change in interest rates, currency rates, implied volatility rates, or a change in certain equity indexes or instruments has on the value of a financial instrument. LNC manages the market risk by establishing and monitoring limits as to the types and degree of risk that may be undertaken.
LNC’s derivative instruments are monitored by its risk management committee as part of that committee’s oversight of LNC’s derivative activities. LNC’s derivative instruments committee is responsible for implementing various hedging strategies that are developed through its analysis of financial simulation models and other internal and industry sources. The resulting hedging strategies are then incorporated into LNC’s overall risk management strategies.
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7. Segment Disclosures
LNC has four business segments: Lincoln Retirement, Life Insurance, Investment Management and Lincoln UK.
The following tables show financial data by segment:
Six Months
Ended June 30
Three Months
Investment Management(1)
Other operations
Consolidating adjustments
Income (Loss) before Federal Income Taxes (Tax Benefits) and Cumulative Effect of Accounting Change:
(Tax Benefits):
Federal Income Taxes (Tax Benefits):
Cumulative Effect of Accounting Change (Net of Tax):
Net Income (Loss):
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June 30
December 31
Assets:
8. Earnings Per Share
Per share amounts for net income are shown on the income statement using 1) an earnings per common share basic calculation and 2) an earnings per common share-assuming dilution calculation. Reconciliation of the factors used in the two calculations is as follows:
Numerator: [in millions]
Net income, as used in basic calculation
Dividends on convertible preferred stock and adjustments for minority interests
Net income, as used in diluted calculation
* Less than $100,000.
Denominator: [number of shares]
Weighted-average shares, as used in basic calculation
Shares to cover conversion of preferred stock
Shares to cover non-vested stock
Average stock options outstanding during the period
Assumed acquisition of shares with assumed proceeds and benefits from exercising stock options (at average market price during the period)
Shares repurchaseable from measured but unrecognized stock option expense
Average deferred compensation shares
Weighted-average shares, as used in diluted calculation
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. Participants in LNC’s deferred compensation plans, who select LNC stock for measuring the investment return attributable to their deferral amounts, will be paid out in LNC stock. The obligation to satisfy these deferred compensation plan liabilities is dilutive and is shown in the table above.
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9. Employee Benefit Plans
Components of Net Periodic Pension Cost – U.S. Plans
The components of net defined benefit pension plan and post-retirement benefit plan expense are as follows:
Post-retirementBenefits
For the six months ended June 30 (in millions)
Service cost
Interest cost
Expected return on plan assets
Amortization of prior service cost
Recognized net actuarial losses
Net periodic benefit expense
For the three months ended June 30 (in millions)
As discussed in Note 2 to the unaudited financial statements, the amounts above for other post-retirement benefits do not reflect the Medicare Act.
Deferred Compensation Plans
As discussed in Note 6 to the audited financial statements in LNC’s annual report on Form 10-K for the year ended December 31, 2003, LNC sponsors unfunded contributory deferred compensation plans for certain U.S. employees and agents. Commencing in October 2001 and continuing through June 2002 LNC made a series of investments in a variable annuity contract with investment options similar to the investment options within the deferred compensation plans. The purpose of this investment was to partially mitigate the earnings effects created by changes in the value of LNC’s deferred compensation plan liability that result from changes in value of the underlying investment options. In June 2004, LNC withdrew its variable annuity contract, which had a value of $65.4 million, and entered into a total return swap agreement with a notional amount of $82.5 million and paid no initial premium. The expense associated with the mark-to-market on the deferred compensation liability for the six months ended June 30, 2004 was $4.4 million.
Stock and Incentive Compensation
Refer to Note 6 to the audited financial statements in LNC’s annual report on Form 10-K for the year ended December 31, 2003, for a detailed discussion of Stock and Incentive Compensation.
Performance Vesting Awards
Effective January 1, 2003, LNC’s long-term incentive plan provides for awards that may be paid out in a combination of LNC stock options, performance shares of LNC stock and cash. The performance measures that must be met for the grants under the plan are established at the beginning of each three-year performance period. Certain participants in the plan select from various combinations of stock options, performance shares and cash in determining the form of their award. Other participants will have their award paid in performance shares.
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Awards granted under the plan in 2003 are currently outstanding. In the first three months of 2004, LNC granted a combination of performance vesting stock options, performance share units and performance vesting cash awards under the new plan. These awards consisted of 414,798 10-year LNC stock options, 552,906 performance share units that could result in the issuance of LNC shares, and cash awards. As of June 30, 2004, 615,810 stock options and 1,248,521 performance share units were outstanding. The ultimate amount of stock to be issued for either the stock option or performance share awards, or cash to be paid for the cash awards will be determined by the level of achievement on LNC’s three performance measures over the three-year performance measurement periods. Information with respect to the expenses recorded for awards under these programs is as follows:
Stock Options
Performance Shares
Cash Awards
All expense calculations for performance vesting stock options, performance shares, and performance vesting cash awards that were granted in 2004 and 2003 have been based upon an estimate of performance achievement over the three-year performance measurement periods. As the three-year performance periods progress, LNC will continue to refine its estimate of the expense associated with these awards so that by the end of the three-year performance period, LNC’s cumulative expense will reflect the actual level of awards that vest.
LNC Stock Options
Information with respect to the LNC incentive plans involving stock options is as follows:
Weighted-
AverageExercise Price
Balance at December 31, 2003
Granted-original
Granted-reloads
Exercised (includes shares tendered)
Forfeited
Balance at June 30, 2004
Total compensation expense for LNC incentive plans involving stock options for the six months ended June 30, 2004 and 2003 was $11.4 million after-tax ($17.5 million pre-tax) and $12.8 million after-tax ($18.0 million pre-tax), respectively. Total compensation expense for LNC incentive plans involving stock options for the three months ended June 30, 2004 and 2003 was $5.0 million after-tax ($7.7 million pre-tax) and $6.9 million after-tax ($9.8 million pre-tax), respectively. Included in the above compensation is the acceleration of expense resulting from the 2004 and 2003 realignment activities.
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Delaware Investment U.S. Inc. (“DIUS”) and DIAL Holding Company, Inc. (“DIAL”) Plans
At June 30, 2004, DIUS had 10,000,000 shares of common stock outstanding. Information with respect to the DIUS incentive plan involving stock options is as follows:
At June 30, 2004, DIAL had 10,000,000 shares of common stock outstanding. Information with respect to the DIAL incentive plan involving stock options is as follows:
As discussed in Note 11, LNC has entered into a management buyout agreement for DIAL, which is expected to close in the third quarter of 2004. During the second quarter of 2004, a moratorium was placed on the exercise of options under the DIAL plan until immediately following the closing. Upon closing, the DIAL plan will become the plan of the acquirer.
Compensation expense for the DIUS and DIAL incentive plans involving stock options for the six months ended June 30, 2004 and 2003 totaled $4.8 million after-tax ($7.4 million pre-tax) and $4.6 million after-tax ($6.4 million pre-tax), respectively. Compensation expense for the DIUS and DIAL incentive plans involving stock options for the three months ended June 30, 2004 and 2003 totaled $2.5 million after-tax ($3.9 million pre-tax) and $2.6 million after-tax ($3.7 million pre-tax), respectively.
Stock Appreciation Rights (“SARs”)
Information with respect to the LNC incentive plan involving SARs is as follows:
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Total compensation expense for the LNC incentive plan involving SARs for the six months ended June 30, 2004 and 2003 was $3.2 million after-tax ($4.9 million pre-tax) and $1.1 million after-tax ($1.7 million pre-tax), respectively. Total compensation expense (income) for the LNC incentive plan involving SARs for the three months ended June 30, 2004 and 2003 was $0.5 million after-tax ($0.8 million pre-tax) and $1.6 million after-tax ($2.5 million pre-tax), respectively. As discussed in Note 6 to the audited consolidated financial statements in LNC’s annual report on Form 10K, LNC hedges volatility in net income from the accounting treatment for the SARs program by purchasing call options on LNC stock. The mark-to-market (gain) loss on the call options reported as a component of compensation expense was ($1.8) million after-tax (($2.7) million pre-tax) and $0.8 million after-tax ($1.2 million pre-tax) for the six months ended June 30, 2004 and 2003, respectively. The mark-to-market (gain) loss on the call options reported as a component of compensation expense was $0.1 million after-tax ($0.2 million pre-tax) and ($0.5) million after-tax (($0.7) million pre-tax) for the three months ended June 30, 2004 and 2003, respectively. The SAR liability at June 30, 2004 and December 31, 2003 was $9.6 million and $9.8 million, respectively.
10. Restructuring Charges
Included in the discussion below are restructuring plans that were implemented during the years 1999 through 2003 that were not yet completed as of December 31, 2003. Any restructuring plans that were implemented during the years 1999 through 2001 that were completed as of December 31, 2003 are not included in the discussion below. For discussion of these completed plans, see Note 12 to the audited consolidated financial statements in LNC’s annual report on Form 10-K for the year ended December 31, 2003. The aggregate charges associated with the restructuring plans were included in Underwriting, Acquisition, Insurance and Other Expenses on the Consolidated Statements of Income in the period incurred.
1999 and 2000 Restructuring Plan
During 1999 and 2000, LNC implemented restructuring plans relating to the Lincoln UK’s operations. In addition to various other activities, these plans involved vacating leased facilities. All other plan activities have been completed and the remaining reserves relate to future lease payments on exited properties, which expire through 2016. The following summarizes the remaining reserves and expenditures during the periods for these plans.
($ in millions)
Restructuring reserve at December 31, 2003
Amounts expended in the first six months of 2004
Amounts reversed in the first six months of 2004
Restructuring reserve at June 30, 2004
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2001 Restructuring Plan
During 2001, LNC implemented restructuring plans relating to 1) the elimination of duplicative functions in the Schaumburg, Illinois operations of First Penn-Pacific (FPP), and the absorption of these functions into the Lincoln Retirement and Life Insurance segment operations in Fort Wayne, Indiana and Hartford, Connecticut, respectively; 2) the planned consolidation of the Boston, Massachusetts investment and marketing office with the Philadelphia, Pennsylvania investment and marketing operations in order to eliminate redundant facilities and functions within the Investment Management segment; and 3) the consolidation of operations and space in LNC’s Fort Wayne, Indiana operations, recorded in “Other Operations”. The following table provides information about these restructuring plans.
($ in millions pre-tax)
Employee severance and termination benefits
Write-off of impaired assets
Other Costs:
Termination of equipment leases
Rent on abandoned office space
Total 2001 Restructuring Charges
Amounts expended and written-off through Dec. 31, 2003
Amounts reversed through December 31, 2003
Positions to be eliminated under original plan
Actual positions eliminated through June 30, 2004
Expected completion date
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2003 Restructuring Plan
In January 2003, the Life Insurance segment announced that it was realigning its operations in Hartford, Connecticut and Schaumburg, Illinois to enhance productivity, efficiency and scalability while positioning the segment for future growth. In February 2003, Lincoln Retirement announced plans to consolidate its fixed annuity operations in Schaumburg, Illinois into Fort Wayne, Indiana. In June 2003, LNC announced that it was combining its retirement and life insurance businesses into a single operating unit focused on providing wealth accumulation and protection, income distribution and wealth transfer products. The realigned organization is expected to significantly reduce operating expenses while positioning LNC for future growth and to take advantage of the recent market recovery. In August 2003, LNC announced additional realignment activities. The following table provides information about the 2003 restructuring plans.
Total expected charges
Total 2003 Restructuring Charges
Amounts expended or written-off through December 31, 2003
Additional amounts expended in 2003 that do not qualify as restructuring charges
Restructuring charges in the first six months of 2004:
Total restructuring charges in the first six months of 2004
Amounts expended or written-off in the first six months of 2004
Additional amounts expended in the first six months of 2004 that do not qualify as restructuring charges
2004 annualized expense savings realized through June 30, 2004
Total expected annual expense savings
Restructuring charges for the six-month period ended June 30, 2004 were reported as follows: Life Insurance Realignment — Life Insurance, Fixed Annuity Consolidation — Retirement, Realignment June/August — Retirement ($3.5 million), Life Insurance ($0.6 million), Investment Management ($1.5 million), and Other Operations ($8.5 million).
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11. Sale of International Investment Unit
On May 5, 2004, LNC announced that it entered into a management buyout agreement to sell its London-based international investment unit. Upon closing, LNC will receive $172 million in cash and will receive relief of certain obligations. LNC expects to recognize an after-tax gain of approximately $46 million from the transaction. LNC expects to use the sales proceeds for general corporate purposes. At June 30, 2004, LNC’s carrying value of the net assets related to the international investment unit, including goodwill, was approximately $90 million. The Investment Management’s results for the first six months and second quarter of 2004 included approximately $7.6 million and $4.1 million, respectively, of net income from the international investment unit. The Investment Management’s assets under management at June 30, 2004 included approximately $28 billion of assets managed by the international investment unit, of which it is expected that approximately $8 billion will be sub-advised on LNC’s behalf by the acquirer, subject to Fund board and shareholder approval where necessary.
Forward-Looking Statements – Cautionary Language
This report, among other things, reviews the results of operations of LNC Consolidated, LNC’s four business segments and Other Operations; LNC’s consolidated investments; and consolidated financial condition including liquidity, cash flows and capital resources. Historical financial information is presented and analyzed. This report and other written or oral statements made by LNC or on LNC’s behalf may contain forward-looking statements. Where appropriate, factors that may affect future financial performance are identified and discussed. Certain statements made in this report are “forward-looking statements” within the meaning of the Securities Litigation Reform Act of 1995 (“SLRA”). A forward-looking statement is any statement that is not a historical fact and, without limitation, includes any statement that may predict, forecast, indicate or imply future results, performance or achievements, and may contain words like: “believe”, “anticipate”, “expect”, “estimate”, “project”, “will”, “shall” and other words or phrases with similar meaning. LNC claims the protection afforded by the safe harbor for forward-looking statements provided by the SLRA.
Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from the results contained in the forward-looking statements. These risks and uncertainties include, among others, subsequent significant changes in:
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Other risks and uncertainties include:
The risks included here are not exhaustive. Other sections of this report, and LNC’s annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and other documents filed with the Securities and Exchange Commission include additional factors that could impact LNC’s business and financial performance. Moreover, LNC operates in a rapidly changing and competitive environment. New risk factors emerge from time to time and it is not possible for management to predict all such risk factors.
Further, it is not possible to assess the impact of all risk factors on LNC’s business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements. Given these risks and uncertainties, investors should not place undo reliance on forward-looking statements as a prediction of actual results. In addition, LNC disclaims any obligation to update any forward-looking statements to reflect events or circumstances that occur after the date of this report.
Introduction
LNC has the following business segments: 1) Lincoln Retirement, 2) Life Insurance, 3) Investment Management and 4) Lincoln UK. LNC reports operations not directly related to a single business segment and unallocated corporate items (i.e., corporate investment income, interest expense on corporate debt, unallocated overhead expenses, and the operations of Lincoln Financial Advisors (“LFA”) and Lincoln Financial Distributors (“LFD”) and the amortization of the deferred gain on the sale of Lincoln Re, etc.) in Other Operations.
Critical Accounting Policies
Refer to Management’s Discussion and Analysis of LNC’s annual report on Form 10-K for the year ended December 31, 2003, for a detailed discussion of LNC’s critical accounting policies. Refer to the various sections captioned Critical Accounting Policy within the discussion that follows for updates to the information provided in the Form 10-K.
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All amounts stated in this “Management’s Discussion and Analysis” are on an after-tax basis except where specifically noted as pre-tax.
Overview: Results of Consolidated Operations
Summary Financial Information
Three Months Ended
Realized loss on investments and derivative instruments
Interest and debt expenses
Income before cumulative effect of accounting changes
Cumulative effect of accounting change, net of tax
Items Included in Net Income (after-tax):
Reserve development on business sold through indemnity reinsurance and related amortization of deferred gain
Net gain on reinsurance embedded derivative/trading securities
SUMMARY
Net income for the three-month and six-month periods ended June 30, 2004 increased significantly from the same periods in 2003. A key driver of 2004 results was the favorable performance of the equity markets in the last half of 2003, resulting in higher account values and assets under management. The S&P index increased 17% from June 30, 2003 to June 30, 2004. The S&P 500 index increased 1% and 3% in the 2004 periods, compared with increases of 15% and 11% for the same periods of 2003. The increase in the equity markets positively affected net income through increased fee revenue. The impact of the equity markets is discussed in more detail within the discussion of results of operations by business segment. Growth in deposits and net flows during the last twelve months also contributed to the increases in assets under management and increased fee revenue.
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Realized losses on investments and derivatives, net of DAC, in the second quarter of 2004 increased compared to the same period last year. The increase in realized losses is attributable to an increase in the amount of DAC amortized against realized losses in 2004 resulting from actual credit defaults being lower than the credit default assumption used in the computation of amortization included in underwriting, acquisition, insurance and other expenses. The improvement in realized losses on investments and derivatives for the first six months of 2004 was reflective of the improvements in the credit markets as LNC did not experience in 2004 the levels of write-downs of fixed maturity securities available-for-sale experienced in the first half of 2003. Additional details on LNC’s investment performance are provided in the Consolidated Investments section.
As more fully discussed in the following section on new accounting pronouncements, net income for the six month period ended June 30, 2004 includes the effects of the implementation of Accounting Standards Executive Committee of the American Institute of Certified Public Accountants Statement of Position 03-1, “Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts” (“the SOP”). This standard affected the level of reserve requirements for products with guaranteed minimum death benefits (“GMDB”), the accounting for certain deferred sales inducements, and reserves for certain universal life insurance policy riders. Also included in net income in 2004 are the effects of Financial Accounting Standards Board (“FASB”) Derivative Implementation Group Statement No. 133 Implementation Issue No. B36 (“DIG B36”), implemented at the beginning of the fourth quarter of 2003. This required LNC to recognize an embedded derivative resulting from the structure of several significant reinsurance arrangements. Coincident with the recording of the embedded derivative, LNC reclassified a substantial portion of the investment securities supporting these reinsurance arrangements from available-for-sale to trading.
Revenues
The increase in consolidated revenues largely reflects the effects of favorable equity market performance on average account values and assets under management. The average level of the equity markets was higher for the first six months and second quarter of 2004, compared to the same periods in 2003, resulting in higher fee income for the Lincoln Retirement and Lincoln UK segments. Growth in the Investment Management segment’s retail and institutional assets under management resulting from favorable net flows also contributed to this improvement. Net investment income for the three-month and six-month periods ended June 30, 2004 increased $28.6 million and $35.1 million pre-tax, respectively, from commercial mortgage loan prepayment and bond makewhole premiums, from the same 2003 periods. In addition, net investment income for the first six months of 2004 includes the receipt of approximately $21.9 million pre-tax of contingent interest on mortgage loans on real estate previously owned by LNC. Excluding these items, the favorable effect of asset growth from net flows was offset by declining portfolio yields.
Benefits and Expenses
Consolidated expenses (exclusive of restructuring charges and federal income taxes) for the second quarter and first six months of 2004, increased from the same periods in 2003. Growth in LNC’s business, combined with a reduction in the level of GMDB reserves and benefits and DAC adjustments from the movements in the equity markets, compared with the second quarter of 2003, were the primary reasons for the increases. Spread management through lower crediting rates on interest-sensitive and contractholder deposit funds partially offset the increase. Restructuring charges in 2004 and 2003 were the result of expense initiatives undertaken by LNC during 2003 to improve operational efficiencies. Additional details on this activity are provided in the restructuring charge section.
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CONSOLIDATED DEPOSITS, NET FLOWS, AND ASSETS UNDER MANAGEMENT
Key measures of LNC’s success are its deposits, net flows and assets under management as presented in the table below. Deposits are the result of sales of LNC’s products and represent the money put into LNC’s products each period. Net flows represent the deposits net of withdrawals, payments on death and surrenders. Assets under management include LNC’s investment securities as well as those assets belonging to third parties but managed by LNC’s businesses.
(in billions)
Deposits (1):
Lincoln Retirement Segment
Life Insurance Segment
Investment Management Segment (including both retail and institutional deposits) (2)
Consolidating Adjustments (3)
Total Deposits
Net Flows (1):
Investment Management Segment (including both retail and institutional net flows) (2)
Total Net Flows
As of
Assets Under Management by Advisor
Investment Management Segment (2):
External Assets
Insurance Assets
Within Business Units (Policy Loans)
By Non-LNC Entities
Total Assets Under Management
NEW ACCOUNTING PRONOUNCEMENTS
In July 2003, the Accounting Standards Executive Committee (“AcSEC”) of the American Institute of Certified Public Accountants issued Statement of Position 03-1, “Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts” (“the SOP”). LNC implemented the
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provisions of the SOP as of January 1, 2004. Adjustments arising from implementation, as discussed below, have been recorded in net income as a cumulative effect of accounting change.
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In June 2004, the staff of the Financial Accounting Standards Board (“FASB”) issued Financial Staff Position No. FAS 97-1 (“FSP 97-1”), which is effective for the third quarter 2004. FSP 97-1 clarifies that the SOP did not restrict the recording of a liability for unearned revenue as defined in accordance with paragraphs 17(b) and 20 of Statement of Accounting Standards No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments” to only those situations where profits are followed by expected losses. LNC will be reviewing the applicability of FSP 97-1 to its life insurance business. LNC does not expect that the adoption of FSP 97-1 should have a material effect on LNC’s financial statements.
In December 2003, the Medicare Prescription Drug Improvement and Modernization Act of 2003 (“the Medicare Act”) became law. Beginning in 2006, the Medicare Act provides various alternatives that could result in an offset to some portion of the costs of prescription drug benefits provided to retirees. In January 2004, the staff of the FASB issued Financial Staff Position No. FAS 106-1 (“FSP 106-1”), which permitted a sponsor of a post-retirement health care plan that provides retiree prescription drug benefits to make a one-time election to defer accounting for the effects of the Medicare Act. In May 2004, the staff of the FASB issued Financial Staff Position No. FAS 106-2 (“FSP 106-2”), which requires sponsors of a post-retirement health care plan that provide retiree prescription drug benefits to reflect the provisions of the Medicare Act in determining post-retirement benefit cost for the first annual or interim period starting after June 15, 2004.
Due to these uncertainties about how participants in LNC’s post-retirement plan will elect to participate in the Medicare Act’s benefits, and the various uncertainties created by the current lack of guidelines for applying the Medicare Act’s provisions, LNC elected to defer accounting for the effects of the Medicare Act under the initial guidance provided by FSP 106-1. LNC has not completed its assessment of either the actuarial equivalence of its
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post-retirement prescription drug benefits with the provisions of the Medicare Act, or the effects of the other provisions of the Medicare Act on the future estimated post-retirement benefit obligation. LNC expects to complete these assessments and implement the provisions of FSP 106-2 during the third quarter of 2004.
RESTRUCTURING CHARGES
For an update on the status of restructuring plans implemented from 1999 through 2003, refer to Note 10 to the June 30, 2004 unaudited consolidated financial statements.
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Results of Operations by Segment
LINCOLN RETIREMENT
Results of Operations: Lincoln Retirement’s financial results and account values were as follows:
Increase
(Decrease)
Net gain on reinsurance derivative/trading securities
Cumulative effect of accounting change (1)
June 30 (in millions)
Account Values
Variable Annuities
Fixed Annuities
Reinsurance Ceded
Total Fixed Annuities
Total Account Values
Average Daily Variable Account Values
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Net Income Variances – Increase (Decrease) in the Period
From Prior Year Period
(in millions, after-tax)
Net Income Increase
Significant Changes in Net Income:
Realized loss on investments and derivatives
Reinsurance embedded derivatives/trading securities
Effects of equity markets*
Fee income
DAC/PVIF/DFEL
GMDB
Net flows
Contingent interest (after DAC)
Commercial mortgage loan prepayment and bond makewhole premiums
Mortality
The SOP sales inducements
Net income increased significantly for the first six months of 2004, reflecting improving equity markets and realized gains on investments and derivative instruments. The significant realized losses on investments and derivative instruments in 2003 were the result of the decline in value and sales and write-downs of fixed maturity securities. Net income for the first six months of 2004 also includes the effects of the implementation of the SOP, which resulted in adjustments to reserves for GMDB products and related unlocking effects on DAC, PVIF and DFEL. The improvement for the second quarter of 2004 reflects the favorable effects of improving equity markets partially offset by increased realized losses on investments and derivative instruments.
Restructuring Charges
The restructuring charges for 2004 were incurred in connection with the 2003 realignment initiatives including the combining of the Lincoln Retirement and Life Insurance operations. For further details on these restructuring charges, refer to note 10 to the unaudited consolidated financial statements.
Effects of Equity Markets
Fee Income: Average daily variable annuity account values, a key driver of fee income for the segment, were above last year, reflecting the improvement of equity markets during the last nine months of 2003, and resulted in increased fee income for the three-month and six-month periods ended June 30, 2004 relative to the same periods of 2003. Deposits and shifts from the fixed portion of variable annuity products into the variable portion of variable annuity products for the second quarter and first six months of 2004 also contributed to the increase in variable account values.
DAC, PVIF, DFEL and GMDB: Equity market performance in the second quarter and first six months of 2004 was approximately 1% and 2% below the expected market performance used in LNC’s DAC assumptions, and significantly below the equity market performance experienced in the same periods last year. This resulted in unfavorable retrospective unlocking and net changes in amortization for DAC and PVIF compared with the same periods of 2003. As discussed in Note 2, Accounting Changes to the unaudited financial statements, under the
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SOP GMDB reserves are not subject to the same period-to-period volatility from changes in the equity markets as was the case under LNC’s previous reserving methodology.
Net Flows
As discussed in the Net Flows section, the Lincoln Retirement segment experienced a significant improvement in net flows in the first half of 2004 compared to the same period last year. The cumulative net flows since the second quarter of 2003 totaled $2.2 billion and contributed to the increase in net income.
Investment Margins
Net investment income for the Lincoln Retirement segment for the first six months and second quarter of 2004 included $23.1 million pre-tax and $19.7 million pre-tax, respectively, from commercial mortgage loan prepayment and bond makewhole premiums, and for the first six months, $13.0 million pre-tax of contingent interest income. Excluding these items, interest rate margin on fixed annuity products for the periods ending June 30, 2004 declined from the same periods last year. Annuity product investment rate margins represent the excess of the yield on earning assets over the average crediting rate. The yield on earning assets is calculated as net investment income on fixed product investment portfolios divided by average earning assets. The average crediting rate is calculated using interest credited on annuity products less bonus credits and excess dollar cost averaging interest, divided by the average fixed account values net of coinsured account values. Fixed account values reinsured under modified coinsurance agreements are included in account values for this calculation. The table below summarizes the changes in the interest rate margin. Although the net investment income yield declined year over year, LNC was able to reduce crediting rates to substantially offset this decrease. (See discussion on investment margins and the interest rate risk due to falling interest rates in Item 3, Quantitative and Qualitative Disclosures About Market Risk.)
Net investment income yield
Interest rate credited to policyholders
Interest rate margin
Effect on Yield and Interest Rate Margin
Contingent interest
Interest rate margin adjusted for above items
Average fixed account values (in billions)
Effect on Net Income (After-tax, After DAC) (in millions)
Effect on Net Income
The income improvement from the increase in average fixed annuity account values resulted from net flows in 2003 and the first six months of 2004.
CRITICAL ACCOUNTING POLICIES
Deferred Acquisition Cost
Refer to Management’s Discussion and Analysis of LNC’s annual report on Form 10-K for the year ended December 31, 2003, for a detailed discussion of this critical accounting policy. At June 30, 2004, Lincoln Retirement’s reversion to the mean gross growth rate assumption for the equity markets was 4.3%, which compares to the assumption of 4.2% at December 31, 2003. The increase in the growth rate was due to the lower than anticipated performance of separate accounts since December 31, 2003.
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Guaranteed Minimum Benefit Reserves
Refer to Management’s Discussion and Analysis of LNC’s annual report on Form 10-K for the year ended December 31, 2003, and the previous section on New Accounting Pronouncements for detailed discussions of this critical accounting policy. At June 30, 2004, Lincoln Retirement’s net amount at risk (“NAR”) was $1.3 billion and the GAAP reserve was $41.9 million. The reserve for statutory accounting was $55.2 million. The comparable amounts at December 31, 2003 were a NAR of $1.5 billion, GAAP reserves of $46.4 million and statutory reserves of $58.9 million. See the table below for additional statistics related to GMDB as of June 30, 2004:
Variable Annuity Account Value (billions)
% of Total Annuity Account Value
Average Account Value
Average NAR
NAR (billions)
Average Age of Contract Holder
% of Contract Holders > 70 Years of Age
As described in LNC’s annual report on Form 10-K for the year ended December 31, 2003, LNC has variable annuity contracts containing GMDB’s which have a dollar for dollar withdrawal feature. As of June 30, 2004, there were 625 contracts for which the death benefit to account value ratio was greater than ten to one. The NAR on these contracts was $44.1 million. Effective May of 2003, the GMDB feature offered on new sales was a pro-rata GMDB feature whereby each dollar of withdrawal will reduce the GMDB benefit in proportion to the current GMDB to account value ratio.
Hedge Program for Guaranteed Minimum Benefits
As described in LNC’s annual report on Form 10-K for the year ended December 31, 2003, the Lincoln Retirement segment has begun implementing a hedging strategy designed to mitigate the income statement volatility caused by falling equity markets associated with the Lincoln Principal Security sm Guaranteed Minimum Withdrawal Benefit (“GMWB”) and LNC’s various GMDB features. The design of the hedging strategy is such that changes in actual hedge contracts move in the opposite direction of changes in the value of and reserves for the embedded guarantee of the GMWB or changes in the reserve for GMDB contracts subject to the hedging strategy. As of June 30, 2004, there were no hedges in place for GMWB, as there was no required reserve for this feature due to the favorable performance of the equity market since the feature was introduced.
With the adoption of the SOP, the reserves related to the GMDB embedded guarantee are now based on the application of a benefit ratio to fees charged for the embedded guarantee. The level and direction of the change in reserve will vary over time based on the emergence of the benefit ratio (which is based on both historical and projected future level of benefits) and the level of fees (both historical and projected) charged for the embedded guarantee. Because the GMDB reserves computed under the SOP are based upon projected long-term equity market return assumptions, and since the value of the hedging contracts will reflect current equity market conditions, the quarterly changes in values for the GMDB reserves and the hedging contracts may not move in an offsetting manner. Despite these short-term fluctuations in values, LNC intends to continue to hedge its long-term GMDB exposure in order to mitigate the risk associated with falling equity markets. At June 30, 2004 account balances covered in this hedging program combined with account balances for which there is no death benefit represent approximately 53% of total variable annuity account balances. LNC expects to continue expanding the coverage of its GMDB hedging program on an opportunistic basis, as the underlying account values increase due to equity market appreciation. This hedging program reflects the benefit designs of the segment’s products and has been effective to date. LNC continues to evaluate various hedging tools and opportunities as it considers additional benefits, product features, and alternative hedging strategies.
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Lincoln Retirement’s product deposits, withdrawals and net flows were as follows:
Variable Portion of Annuity Deposits
Variable Portion of Annuity Withdrawals (1)
Variable Portion of Annuity Net Flows
Fixed Portion of Variable Annuity Deposits
Fixed Portion of Variable Annuity Withdrawals
Fixed Portion of Variable Annuity Net Flows
Total Variable Annuity Deposits
Total Variable Annuity Withdrawals
Total Variable Annuity Net Flows
Fixed Annuity Deposits
Fixed Annuity Withdrawals
Fixed Annuity Net Flows
Total Annuity Deposits
Total Annuity Withdrawals
Total Annuity Net Flows
Incremental Deposits (2)
LNC has been following a two-pronged approach to improving net flows over the last few years. Attracting new deposits and retaining existing accounts are key drivers of the Retirement segment’s ability to achieve profitable future earnings growth. Variable product sales were up 85% and 94% in first six months and second quarter of 2004, respectively, over the same periods in 2003, while fixed product sales were down slightly from the prior year. Through the first quarter of 2004, the Retirement segment has experienced 12 consecutive quarters of positive net flows.
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New Deposits
(in Millions)
Individual Annuities
Variable
Fixed
Total Individual
Employer-Sponsored Annuities
Total Employer-Sponsored
Total Annuities
New deposits are an important component of LNC’s effort to grow the annuity business. In the past several years, this effort has concentrated on both product and distribution breadth. Annuity deposits improved significantly in the first six months and second quarter of 2004 compared to the same periods in 2003, with deposit growth in both the individual variable annuity business and the employer-sponsored business.
LNC’s growth in 2004 in the individual variable annuity deposits was primarily a result of increased sales from the introduction of the Lincoln Principal Securitysm benefit in June of 2003. Lincoln ChoicePlussm and American Legacy variable annuity gross deposits were up nearly 163% for the first six months of 2004 compared to the same period of 2003 as a result of the GMWB feature of the Lincoln Principal Securitysm benefit. As of June 30, 2004, less than 10% of deposits that elected this feature have elected automatic withdrawal benefits at the 7% level and a total of 21%, based on account values, are taking withdrawals at some level.
In addition to the introduction of the Lincoln Principal Securitysm feature, Lincoln Financial Distributors (“LFD”) began adding wholesalers in the latter part of 2003, and is continuing this expansion in 2004. The increase in wholesalers contributed to the growth in deposits and is expected to continue to increase sales.
Individual fixed product sales experienced a decline for the first six months and second quarter of 2004 compared to the same periods of 2003. With the decline in interest rates over the last few years, it has been difficult to offer rates that are competitive in the marketplace and still allow LNC to achieve targeted spreads on fixed annuity products. LNC has approached the fixed annuity marketplace on an opportunistic basis throughout 2003 and into 2004, generally offering rates that are consistent with LNC’s required spreads.
LNC’s Alliance program continued to experience strong deposit growth in the employer-sponsored business. The Alliance program enables the Retirement segment to sell a multi-manager mutual fund based product within the employer-sponsored marketplace. Variable product deposits of the Alliance program were $438 million and $187 million in the first six months and second quarter of 2004, respectively, increases of 7% and 23%, respectively, from the same periods last year.
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LIFE INSURANCE
Results of Operations: The Life Insurance segment’s financial results were as follows:
Net loss on reinsurance derivative/trading securities
Periods Ended
June 30, 2004
Six
Months
Significant Changes In Net Income:
Effects of equity markets(2) -
DAC
Prospective DAC/PVIF/DFEL unlocking in first quarter 2003 and related DAC amortization
Interest rate margins (including earnings on investment partnerships)
There were a number of factors contributing to the increase in the Life Insurance segment’s net income in the first six months and second quarter of 2004 compared to the same periods of 2003. In the first six months of 2003, the segment’s net income was negatively impacted by prospective DAC unlocking for face amount reductions. There was no similar unlocking in the comparable period of 2004. As discussed below, the segment benefited from favorable investment income and investment margins in both the first and second quarters of 2004. Favorable equity market performance in the latter half of 2003 and in the first half of 2004 resulted in higher account values generating higher fees. The segment benefited from the improvements in the credit markets as the net realized losses on investments and derivative instruments were lower in the first half of 2004. Net income for the six months of 2004 includes the effects of the implementation of the SOP. For further discussion on this issue, refer to the previous discussion in Note 2 to the unaudited consolidated financial statements.
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As presented in the table below, interest rate margins for the Life Insurance segment improved in the three and six month periods ended June 30, 2004, compared to the same periods last year. Net investment income for the Life Insurance segment for the first six months and second quarter of 2004 includes $11.0 million and $9.1 million pre-tax, respectively, from commercial mortgage loan prepayment and bond makewhole premiums, and for the first six months, $8.9 million pre-tax ($6.5 million in the interest sensitive lines and $2.5 million for traditional non-par lines) of contingent interest income. The table below provides information on the effects on interest rate margin and net income from commercial mortgage loan prepayment and bond makewhole premiums for the periods ended June 30, 2004 and 2003. Refer to the discussion of interest rate margins in LNC’s Annual Report on Form 10-K for the year ended December 31, 2003 for additional information. At June 30, 2004, interest-sensitive products represented 89% of total interest sensitive and traditional non-par earning assets, compared to 88% at June 30, 2003. At June 30, 2004, 30% of the interest sensitive account values have crediting rates at contract guarantee levels and 20% have crediting rates within 50 basis points of contractual guarantees. Additional information on interest rate margins and the interest rate risk due to falling interest rates is provided within Item 3, Quantitative and Qualitative Disclosures About Market Risk.
Periods Ended June 30, 2004
Change
in Rate-basispoints
Interest Sensitive Products
Interest rate margin after the above items
Effect on Net Income (After-tax, After DAC)
Traditional Products
Effect on Yield
Net investment income yield after the above items
Effect on Net Income (After-tax)
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Critical Accounting Policy – DAC, PVIF and DFEL
Refer to Management’s Discussion and Analysis of LNC’s annual report on Form 10-K for the year ended December 31, 2003, for a detailed discussion of this critical accounting policy. For the first six months and second quarter of 2004, the Life Insurance segment experienced positive DAC unlocking of $1.6 million and $0.5 million, respectively, compared to negative DAC unlocking of $8.9 million and $1.0 million, respectively for the same periods last year. The negative unlocking in the first six months of 2003 resulted primarily from revised assumptions regarding face amount reductions. This change in assumption resulted in lower future estimated gross profits, resulting in increased DAC amortization for the first six months and second quarter of 2004.
Sales, Net Flow, Account Values and In-force
Periods Ended June 30,
First Year Premiums - by Product (in millions)
Universal Life
Excluding MoneyGuard
MoneyGuard
Total Universal Life
Variable Universal Life
Whole Life
Term
Total Retail
Corporate Owned Life Insurance (“COLI”)
Total First Year Premiums
Net Flows (in millions)
Deposits
Withdrawals & Deaths
Policyholder Assessments
June 30 (in billions)
Interest-Sensitive Whole Life
Total Life Insurance Account Values
In Force - Face Amount
Universal Life and Other
Term Insurance
Total In-Force
Total sales for the periods ended June 30, 2004 as measured by first year premiums increased from the same periods last year. The sales growth for UL was driven by sales of MoneyGuard, a UL product with a long-term care rider, and strong growth in other fixed UL products.
Sales of retail life insurance products through both LNC distribution organizations were strong as sales through LNC’s financial planning organization, Lincoln Financial Advisors (“LFA”) were up 12% and 3% for the first six months and second quarter of 2004, respectively, relative to the same periods in 2003. Sales through LFD were up 17% and 19% for the first six months and second quarter of 2004, compared with the same periods of 2003.
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Refer to the discussion of the Life Insurance segment beginning on page 41 of LNC’s annual report on Form 10-K for the year ended December 31, 2003, for additional information on this segment, including discussion of the impact of the levels of mortality risk that have been transferred to reinsurers, the mix of product sales, and the unusual levels of reductions in face amount of policyholder coverages on the Life Insurance segment’s revenues and net income.
Results of Operations: The Investment Management segment’s financial results were as follows:
Periods Ended June 30 (in millions)
Total Investment Advisory Fees (Included in Total Revenue)
Realized gain (loss) on investments
Three
Effects of financial markets/net flows, variable expenses and other
Other financial markets related variances
Seed capital
Deferred compensation liability
NM – Not Meaningful
Net income for the three and six months periods ended June 30, 2004 improved relative to the prior year periods due to increased investment advisory fees generated by higher assets under management. The higher retail and institutional assets under management were a result of rising equity markets and positive flows.
The segment’s net income for the second quarter and first six months of 2004 included a decrease from the change in value of seed capital relative to the same periods of 2003. The level of seed capital was lower at June 30, 2004 than in 2003 as certain funds reached established thresholds resulting in a return of seed capital to LNC. These declines were partially offset by changes to the deferred compensation liability due to movements in the equity markets. For a more detailed discussion of seed capital and the deferred compensation liability, refer to the Equity Markets discussion in the Investment Management section of Management’s Discussion and Analysis of LNC’s annual report on Form 10-K for the year ended December 31, 2003 and to Footnote 9 in the notes to financial statements to the June 30, 2004 unaudited financial statements.
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Assets Under Management and Client Net Flows
Assets Under Management
Retail-Equity
Retail-Fixed
Institutional-Equity
Institutional-Fixed
Total Institutional
Retail:
Equity Sales
Equity Redemptions and Transfers
Fixed Sales
Fixed Redemptions and Transfers
Redemptions and Transfers
Institutional:
Equity Inflows
Equity Withdrawals and Transfers
Fixed Inflows
Fixed Withdrawals and Transfers
Inflows
Withdrawals and Transfers
Combined Retail and Institutional:
Sales and Inflows
Redemptions, Withdrawals and Transfers
Total Retail and Institutional Net Flows
The increase in assets under management reflects market value gains and positive net flows. Market value gains in the twelve-month period ending June 30, 2004 were $3.7 billion in retail and $5.3 billion in institutional. Positive
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net flows across equity and fixed income products account for the growth in both institutional and retail assets under management. Retail net flows reflect higher sales partially offset by higher withdrawals. The combined net flows, as well as retail and institutional sales were the highest since LNC acquired Delaware in 1995. Net flows for the segment have been positive for ten consecutive quarters.
Institutional amounts in the above table include amounts from LNC’s London-based international investment unit. The sale of this unit is anticipated to close in the third quarter of 2004. The following table presents institutional assets under management, sales and inflows and net flows excluding the international institutional amounts attributable to this unit.
Institutional Sales and Inflows
Institutional Net Flows
As of June 30
Institutional Assets Under Management
Sales of Delaware’s mutual funds by LFA increased approximately 117% and 76% in the first six months and second quarter of 2004, respectively, compared to the same periods in 2003, and improved during the first six months of 2004 to approximately 10% of LFA’s total mutual fund sales compared to 6% in the same period of 2003. Sales of mutual funds, managed accounts and 401(k) products distributed by LFD increased 96% and 76% in the first six months and second quarter of 2004, respectively, compared to the same periods in 2003, reflecting the addition of wholesalers and market recognition of Delaware’s favorable investment performance.
In April 2004, the Investment Management segment entered into an agreement to outsource its mutual fund based 401(k) record keeping business. This arrangement is not expected to have a material effect on the segment.
Investment Performance
Investment performance is a key driver of Delaware’s ability to attract new sales, retain existing assets and improve net flows. On the institutional side, for the 12 months ended June 30, 2004, 3 of the 8 largest product composites met or outperformed their respective indices, compared to 6 out of 8 for the 12 months ended June 30, 2003.
Delaware closely monitors the relative performance of individual funds. Fund performance is compared to a benchmark group of peer funds having similar investment characteristics and objectives. In addition, performance in various key categories as reported to Lipper, the leading provider of mutual fund research, is also used by Delaware in measuring its funds’ performance. The following table summarizes the June 2004 and 2003 performance for the largest 25 mutual funds in the Delaware Investments Family of Funds. The Delaware Investments Family of Funds does not include mutual funds managed by Delaware for certain LNC affiliates or other third parties.
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Twelve Months Ended June 30
25 Largest Funds performing in the top half of their respective Lipper universes:
Number of Funds
Percentage of total assets
Total retail funds in Lipper Leader Category:
Consistent Return
Capital Preservation
Total Return
Expense
Tax Efficiency
Number labeled Lipper Leader in at least one category
Number labeled Lipper Leader in multiple categories
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Result of Operations: Lincoln UK’s financial results, account values, in-force and exchange rates were as follows:
Realized loss on investments
Gain on exercise of put option
Unit-Linked Assets
Individual Life Insurance In-Force
Exchange Rate Ratio - U.S. Dollars to Pounds Sterling
Average for the period
End of period
Periods Ended June 30, 2004 (in millions, after-tax)
Effects of Equity Markets*
Fee income from equity-linked assets
Operating expenses
Net income for the three and six month periods ended June 30, 2004 includes a gain on exercise of a put option arising from the 2002 transfer of Lincoln UK’s back office operations to Capita Life and Pension Services Limited, the outsourcing firm for Lincoln UK’s customer and policy administration functions (Refer to Note 7 in the Notes to Consolidated Financial Statement in the Annual Report on Form 10-K for the Year Ended December 31, 2003). Excluding this item, net income for the three and six month periods of 2004 declined from the same periods of 2003 due to less favorable equity market experience, which drove a net decline in earnings from the combined effects on DAC/PVIF/DFEL amortization. Higher expenses driven by efforts to maintain the existing customer base through enhanced service and alternative product offerings also contributed to the declines. Partially offsetting these declines was increased fee revenue earned by the segment from higher average equity-linked account values resulting from the increase in the FTSE 100 index during 2003.
The performance of the equity markets for the Lincoln UK segment is measured by the FTSE 100 index and this index increased 11% for the twelve months ended June 30, 2004, and increased 2% and 12% in the second quarter of 2004 and 2003, respectively.
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Lincoln UK continues to maintain reserves established in 1997 and 1999 for mis-selling activities. During the second quarter of 2004, Lincoln UK increased its reserves as a result of its ongoing assessment of redress payment patterns and complaint activity. In 2004, there has been increased publicity surrounding mortgage endowments following the Treasury Select Committee’s report on various issues associated with mortgage endowment contracts and the revised rules regarding time limits for making a complaint for mortgage endowments introduced by the Financial Services Authority in May 2004. Also in the second quarter of 2004, Lincoln UK reached a favorable settlement with a liability carrier for reimbursement of certain costs incurred in connection with certain United Kingdom selling practices. The combined effect of the increase to mis-selling reserves and the favorable settlement resulted in minimal impact to net income. Future changes in complaint levels could affect Lincoln UK’s ultimate exposure to this issue, although LNC believes that any future change would not materially affect the consolidated financial position of LNC.
Other Operations
Results of Operations: Other Operations’ financial results were as follows:
Periods Ended (in millions)
Net Income (Loss) by Source:
LFA
LFD
LNC Financing
Other Corporate
Net Loss
Items Included in Net Loss (after-tax):
Realized gain on investments and derivative instruments
Gain on sale of subsidiary/business
Market adjustment for reinsurance embedded derivative/trading securities
The net loss for the three and six month periods ended June 30, 2004 includes a gain from the sale of LFA’s employee benefits marketing business. Revenues and earnings of this business were not significant. Excluding this item, net losses for the first six months of 2004 increased modestly from the same period last year as lower losses in LNC’s distribution operations were offset by realignment charges. Net losses for the second quarter of 2004 were lower compared with the same period last year, as lower distribution losses more than offset realignment charges. Refer to note 10 to the unaudited financial statements for additional information on realignment activities.
Net losses for LNC Financing increased as a result of the $200 million 4.75% Notes due 2014 issued in February 2004, partially offset by lower interest rates and other changes made to LNC’s outstanding debt during 2004 and 2003 as described in the liquidity and cash flow section.
Within Other Corporate in 2004, there were costs associated with LNC’s realignment activities. These costs totaled $2.6 million and $0.8 million for the six and three month periods ended June 30, 2004, including $1.1 million and $0.1 million, respectively, reported as restructuring charges.
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As discussed above, LFA’s results for the first six months and second quarter of 2004 include $9.0 million from the second quarter sale of the employee benefits marketing business. LFA’s results also include realignment costs of $5.3 million and $2.1 million for the six and three month periods ended June 30, 2004, of which $4.3 million and $1.7 million, respectively, were reported as restructuring charges. Excluding these items, results improved for the first six months and second quarter of 2004 compared to the same periods last year due to strong sales and revenue growth combined with expense management resulting from realignment activities initiated in 2003. Sales growth across all lines of business was extremely strong, with increases for the six months for individual annuity deposits of 111%, life first year premiums of 12%, and Broker-Dealer of 37%.
Net losses for LFD for the first six months and second quarter of 2004 declined $7.7 million and $4.3 million, respectively, from the same periods last year. These improvements resulted from significant sales growth from the first half of 2003. Overall sales growth was 92% for the first half of 2004, reflecting increased sales in investment products (103% increase), variable annuities (141% increase) and retail life insurance (16% increase). Sales of both the Choice Plus and the American Legacy Variable Annuity product were key contributors to the variable annuity sales growth in 2004. Higher expenses, primarily associated with the continuing expansion of the wholesaling force, partially offset the favorable results from improved sales.
As discussed in LNC’s annual report on Form 10-K for the year ended December 31, 2003, LFD completed the transition of the wholesaling arrangement from American Funds Distributors during 2003.
CONSOLIDATED INVESTMENTS
The following table presents consolidated invested assets, net investment income and investment yield.
Total Consolidated Investments (at Fair Value)
Average Invested Assets (at Amortized Cost)
Six months ended
Adjusted Net Investment Income (1)
Investment Yield (ratio of net investment income to average invested assets)
Items included in Net Investment Income:
Limited partnership investment income (loss)
The decrease in LNC’s investment portfolio for the second quarter of 2004 resulted from declines in fair value of securities available-for-sale partially offset by purchases of investments from cash flow generated by the business segments.
LNC’s insurance assets are invested primarily in high quality fixed maturity securities that are expected to generate cash flows that will enable LNC to meet the liability funding requirements of LNC’s life insurance and annuity businesses. The dominant investments held are fixed maturity securities available-for-sale, which represent approximately 77.4% of the investment portfolio. Trading securities, which are primarily fixed maturity securities, represent approximately 7.3% of the investment portfolio.
LNC has the ability to maintain its investment holdings throughout credit cycles because of its capital position, the long-term nature of its liabilities and matching of LNC’s portfolios of investment assets with the liabilities of LNC’s various products.
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The quality of LNC’s available-for-sale fixed maturity securities portfolio, as measured at fair value and by the percentage of fixed maturity securities invested in various ratings categories relative to the entire available-for-sale fixed maturity security portfolio, as of June 30, 2004 was as follows:
AAA and Agencies
AA
A
The ratings data listed above have been determined by using the lowest of all publicly available ratings assigned to a particular fixed maturity security. If no public ratings exist, a rating is assigned based upon LNC’s analysis of the inherent risks of the individual security.
As of June 30, 2004 and December 31, 2003, $2.3 billion or 7.1% and $2.3 billion or 7.0%, respectively, of all fixed maturity securities available-for-sale were invested in below investment grade securities (less than BBB). This represents 5.5% and 5.4% of the total investment portfolio at June 30, 2004 and December 31, 2003, respectively. When viewed on a cost basis, below investment grade securities held at both June 30, 2004 and December 31, 2003 represented 7.3% of fixed maturity securities.
Fixed Maturity and Equity Securities Portfolios: Fixed maturity securities and equity securities consist of portfolios classified as available-for-sale and trading. Included in both portfolios are mortgage-backed and private securities.
Available-for-Sale: Securities that are classified as “available-for-sale” make up 91% of LNC’s fixed maturity and equity securities portfolio. These securities are carried at fair value on LNC’s balance sheet. Changes in fair value net of related deferred acquisition costs, amounts required to satisfy policyholder commitments and taxes are charged or credited directly to shareholder’s equity. Changes in fair value that are other than temporary are recorded as realized losses in the income statement.
Trading Securities: Securities that are classified as “trading” make up the remaining 9% of LNC’s fixed maturity and equity securities portfolio. Investment results for these portfolios, including gains and losses from sales, are passed directly to the reinsurers through the contractual terms of the reinsurance arrangements. Trading securities are carried at fair value and changes in fair value are recorded in net income as they occur. Offsetting these amounts are corresponding changes in the fair value of the embedded derivative liability associated with the underlying reinsurance arrangement.
Mortgage-Backed Securities: LNC’s fixed maturity securities include residential and commercial mortgage-backed securities. The mortgage-backed securities included in LNC’s investment portfolio are subject to risks associated with variable prepayments. This may result in these securities having a different actual cash flow and maturity than expected at the time of purchase. LNC limits the extent of its risk on mortgage-backed securities by prudently limiting exposure to the asset class, by generally avoiding the purchase of securities with a cost that significantly exceeds par, by purchasing securities backed by stable collateral, and by concentrating on securities with enhanced priority in their trust structure. Such securities with reduced risk typically have a lower yield (but higher liquidity) than higher-risk mortgage-backed securities. At selected times, higher-risk securities may be purchased if they do not compromise the safety of the general portfolio. LNC’s investments in residential mortgage-backed securities at June 30, 2004 and December 31, 2003 totaled $3.2 billion and $3.1 billion, respectively. At June 30, 2004 and December 31, 2003, LNC’s investments in commercial mortgage-backed securities totaled $2.3 billion and $2.1 billion, respectively.
Private Securities Investments: The fair value for all private securities was $ 4,675.7 million and $4,875.8 million at June 30, 2004 and December 31, 2003, respectively, representing about 11.0% and 11.4% of total invested assets, respectively. This excludes section 144 registered securities, which have fair values that are readily available for these publicly-traded securities.
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Mortgage Loans on Real Estate and Real Estate: As of June 30, 2004, investments in real estate represented 0.2% of LNC’s total investment portfolio. The following summarizes key information on mortgage loans:
Total Portfolio (net of reserves)
Percentage of total investment portfolio
Percentage of investment by property type
Commercial office buildings
Retail stores
Industrial buildings
Apartments
Hotels/motels
Impaired mortgage loans
Impaired mortgage loans as a percentage of total mortgage loans
Mortgage loans two or more payments
delinquent (including in process of foreclosure)
Restructured loans in good standing
Reserve for mortgage loans
In addition to the dispersion by property type, the mortgage loan portfolio is geographically diversified throughout the United States.
All mortgage loans that are impaired have an established allowance for credit loss. Changing economic conditions impact LNC’s valuation of mortgage loans. Increasing vacancies and declining rents are incorporated into the discounted cash flow analysis that LNC performs for monitored loans and may contribute to the establishment of (or an increase in) an allowance for credit losses. In addition, LNC continues to monitor the entire commercial mortgage loan portfolio to identify risk. Areas of current emphasis are the hotel mortgage loan portfolio and retail, office and industrial properties that have deteriorating credits or have experienced debt coverage reduction. Where warranted, LNC has established or increased loss reserves based upon this analysis. Impaired mortgage loans as a percentage of total mortgage loans have deteriorated over the last two years as a result of increased credit losses in the sectors noted above. This percentage was 3.5%, 2.9%, 1.7% and 0.6% as of June 30, 2004, and December 31, 2003, 2002 and 2001, respectively.
Limited Partnership Investments: As of June 30, 2004 and December 31, 2003, there were $261.6 million and $259.8 million, respectively, of limited partnership investments included in consolidated investments. These include investments in approximately 53 different partnerships that allow LNC to gain exposure to a broadly diversified portfolio of asset classes such as venture capital, hedge funds, and oil and gas. Limited partnership investments are accounted for using the equity method of accounting and the majority of these investments are included in “Other Investments” in the consolidated balance sheets.
Net Investment Income: Net investment income increased 3.5% in the first six months of 2004 when compared with the first six months of 2003. Excluding contingent interest and commercial mortgage loan prepayment and bond makewhole premiums, the favorable effect of asset growth from net flows was offset by a declining portfolio yield. The decline was due to lower interest rates on new securities purchased as assets matured and net product sales flowed into the portfolio.
Fixed maturity securities available-for-sale, mortgage loans on real estate and real estate that were non-income producing for the three months ended June 30, 2004 were not significant. As of June 30, 2004 and December 31, 2003, the carrying value of non-income producing securities was $128.6 million and $133.0 million, respectively.
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The following discussion addresses LNC’s invested assets excluding trading account securities. As discussed above, investment results attributable to the trading securities are passed directly to the reinsurers under the terms of the reinsurance arrangements. For additional information regarding LNC’s investments see the discussion in LNC’s 2003 annual report on Form 10-K under “Consolidated Investments.”
Critical Accounting Policy - Realized Gain (Loss) on Investments and Derivative Instruments: LNC had net pre-tax realized losses on investments and derivatives of $36.5 million and $94.1 million for the six months ended June 30, 2004 and 2003, respectively, and $20.6 million and $2.7 million for the three months ended June 30, 2004 and 2003, respectively.
Prior to the amortization of acquisition costs, provision for policyholder commitments and investment expenses, net pre-tax realized losses were $8.6 million and $168.5 million for the six months ended June 30, 2004 and 2003, respectively,and net pre-tax realized losses were $15.1 million and $14.4 million for the three months ended June 30, 2004 and 2003, respectively.
Gross realized gains on fixed maturity and equity securities were $66.1 million and $28.5 million, and gross realized losses on fixed maturity and equity securities were $63.3 million and $40.6 million for the six and three months ended June 30, 2004, respectively. Included within losses are write-downs for impairments of $28.1 million and $18.6 million in the six and three months ended June 30, 2004, respectively.
For additional information regarding LNC’s process for determining whether declines in fair value of securities available-for-sale are other than temporary, see the discussion in LNC’s 2003 annual report on Form 10-K under “Critical Accounting Policy—Write-Downs and Allowances for Losses.”
Unrealized Gains and Losses – Available-for-Sale Securities: When considering unrealized gain and loss information, it is important to realize that the information relates to the status of securities at a particular point in time, and may not be indicative of the status of LNC’s investment portfolios subsequent to the balance sheet date. Further, since the timing of the recognition of realized investment gains and losses through the selection of which securities are sold is largely at management’s discretion, it is important to consider the information provided below within the context of the overall unrealized gain or loss position of LNC’s investment portfolios. These are important considerations that should be included in any evaluation of the potential impact of unrealized loss securities upon LNC’s future earnings. LNC had an overall net unrealized gain (after the amortization of acquisition costs, provision for policyholder commitments, investment expenses and taxes) on securities available-for-sale under FAS 115 of $412.0 million and $793.1 million at June 30, 2004 and December 31, 2003, respectively.
At June 30, 2004 and December 31, 2003, gross unrealized gains on securities available-for-sale were $1,459.3 million and $2,054.4 million, respectively, and gross unrealized losses on securities available-for-sale were $430.5 million and $218.8 million, respectively. At June 30, 2004, gross unrealized gains and losses on fixed maturity securities available-for-sale were $1,435.6 million and $429.4 million, respectively, and gross unrealized gains and losses on equity securities available-for-sale were $23.7million and $1.1 million, respectively. At December 31, 2003, gross unrealized gains and losses on fixed maturity securities available-for-sale were $2,027.1 million and $217.1 million, respectively, and gross unrealized gains and losses on equity securities available-for-sale were $27.3 million and $1.7 million, respectively.
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Unrealized Losses on Available-for-Sale Securities: For total publicly traded and private available-for-sale securities held by LNC at June 30, 2004 that were in unrealized loss status, the fair value, amortized cost, unrealized loss and total time period that the security has been in an unrealized loss position are presented in the table below.
Fair
Value
%
FairValue
£ 90 days
> 90 days but £ 180 days
> 180 days but £ 270 days
> 270 days but £ 1 year
> 1 year
The composition by industry categories of all securities available-for-sale in unrealized loss status, held by LNC at June 30, 2004 is presented in the table below.
Sovereigns
Airlines
Banking
Collateralized Mortgage Obligations
Electric
Collateralized Mortgage Backed Securities
Asset-Backed Securities
Automotive
Food and Beverage
Retailers
Entertainment
Wirelines
Chemicals
Metals and Mining
Technology
Pipelines
Government
Consumer Products
Property & Casualty
Wireless
Paper
Federal Home Loan Mortgage Corporation
Media Cable
Municipal
Federal Natl Mtg Assn
Foreign Local Governments
Distributors
Brokerage
Non-Captive Consumer
Transportation Services
Captive
Financial Other
Independent
Media-Noncable
Consumer Cyclical
Diversified Manufacturing
Tennessee Valley Auth
Building Materials
Gaming
Oil Field Services
FNMA Convntl 30yr
Non-Captive Diversified
Supranationals
Integrated
Industries With U/R Losses < $1mm
Grand Total
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As of June 30, 2004, gross unrealized losses of $430.5 million compared to gross unrealized losses of $161.0 million at March 31, 2004. Credit spreads in the market remained relatively stable over the quarter with a majority of the increase in gross unrealized losses due to the overall increase in treasury rates. The 10-year Treasury yield increased to 4.58% as of June 30, 2004, compared to 3.84% at the end of March 2004. As Treasury rates increase, the market value of securities decline, increasing gross unrealized loss as of June 30, 2004. As of June 30, 2004, only one sector, Sovereigns, had unrealized losses that represent more than 10% of the total LNC gross unrealized losses. LNC’s view of risk factors at June 30, 2004 with respect to these industries is substantially unchanged from its view as discussed in the Consolidated Investments section in LNC’s 2003 annual report on Form 10-K for the year ended December 31, 2003.
Unrealized losses on available-for-sale securities subject to enhanced analysis were $37.3 million at June 30, 2004, compared with $34.7 million at December 31, 2003.
Unrealized Loss on All Below-Investment-Grade Available-for-Sale Fixed Maturity Securities: Gross unrealized losses on all available-for-sale below-investment-grade securities were $122.0 million at June 30, 2004, representing 28.3% of total gross unrealized losses on all available-for-sale securities. Generally, below-investment-grade fixed maturity securities are more likely than investment-grade securities to develop credit concerns. The remaining $308.5 million or 71.7% of the gross unrealized losses relates to investment grade available-for-sale securities. The ratios of fair value to amortized cost reflected in the table below are not necessarily indicative of the fair value to amortized cost relationships for the securities throughout the entire time that the securities have been in an unrealized loss position nor are they necessarily indicative of these ratios subsequent to June 30, 2004.
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For fixed maturity securities available-for-sale held by LNC at June 30, 2004 that are below investment grade and in an unrealized loss position, the fair value, amortized cost, unrealized loss and the ratios of market value to amortized cost are presented in the table below.
Aging Category (in millions)
Bk Mkt Ratio
<=90 days
70% to 100%
40% to 70%
Below 40%
<=90 days Total
>90 days but <=180 days
>90 days but <=180 days Total
>180 days but <=270 days
>180 days but <=270 days Total
>270 days but <=1 year
>270 days but <=1 year Total
>1 year
>1 year Total
Total Below-Investment-Grade
At June 30, 2004 and December 31, 2003, 90.6% and 84.4%, respectively, of total publicly traded and private securities in unrealized loss status were rated as investment grade. At June 30, 2004, the range of maturity dates for total publicly traded and private securities available-for-sale in unrealized loss status varies, with about 28.6% maturing between 5 and 10 years, 57.5% maturing after 10 years and the remaining securities maturing in less than 5 years. At December 31, 2003, the range of maturity dates for total publicly traded and private securities in unrealized loss status varies, with about 26.0% maturing between 5 and 10 years, 56.3% maturing after 10 years and the remaining securities maturing in less than 5 years.
Unrealized Loss on Fixed Maturity Securities Available-for-Sale in Excess of $10 million:
For fixed maturity securities available-for-sale with gross unrealized losses in excess of $10 million held by LNC at June 30, 2004, the fair value, amortized cost, unrealized loss and length of time in a loss position are presented in the table below. There were no investment grade available-for-sale fixed maturity securities with unrealized losses in excess of $10 million at June 30, 2004.
Length of Time
in Loss Position
Non-Investment-Grade
US Based International Airline Company
Sovereign Debt Issued by South American Country
Total Non-Investment Grade
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The information presented above is subject to rapidly changing conditions. As such, LNC expects that the level of securities with overall unrealized gains and losses will fluctuate, as will the level of unrealized loss securities that are subject to enhanced analysis and monitoring.
REVIEW OF CONSOLIDATED FINANCIAL CONDITION
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. The consolidated statements of cash flows in the unaudited consolidated financial statements indicate that operating activities provided cash of $428.5 million during the first six months of 2004. This statement also classifies the other sources and uses of cash by investing activities and financing activities and discloses the amount of cash available at the end of the period to meet LNC’s obligations.
When considering LNC’s liquidity and cash flow it is important to distinguish between the needs of LNC’s principal insurance subsidiary, The Lincoln National Life Insurance Company (“LNL”) and its insurance subsidiaries, and the needs of the holding company, LNC. Refer to the discussion of Liquidity and Cash Flows in LNC’s annual report on Form 10-K for a detailed discussion of LNC’s liquidity and cash flow considerations.
Insurance Company Liquidity and Cash Flow
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. In general, dividends are not subject to prior approval from the Indiana Insurance Commissioner (“Commissioner”) provided LNL’s statutory earned surplus is positive and such dividends do not exceed the standard limitation of the greater of 10% of total statutory earned surplus or the amount of statutory earnings in the prior calendar year. Generally, these restrictions pose no short-term liquidity concerns for the holding company. However, as discussed in detail within Note 6 to the unaudited consolidated financial statements, as a result of the payment of dividends plus earnings in 2002, LNL’s statutory earned surplus was negative as of December 31, 2002. Due to the negative statutory earned surplus as of December 31, 2002, dividends paid by LNL in 2003 were subject to prior approval from the Commissioner. Statutory earned surplus was positive at December 31, 2003, and LNL’s quarterly 2004 dividends of $50 million each did not require prior approval. Based upon anticipated on-going positive statutory earnings and favorable credit markets, LNL expects to be able to continue to pay dividends in 2004 without prior approval from the Commissioner.
2003 LNL Dividends: During 2003, LNL received prior approval from the Commissioner and paid dividends of $200 million. As occurred in 2001, the dividends approved and paid while statutory earned surplus was negative were classified as a reduction to paid-in-capital. Statutory earnings for 2003 together with a reduced dividend payment, resulted in a positive earned surplus position at December 31, 2003.
2004 LNL Dividends: During the three and six months ended June 30, 2004, LNL paid dividends of $50 million and $100 million, respectively. Statutory earned surplus remains positive at June 30, 2004. Due to statutory earnings and favorable credit markets, LNL expects to be able to continue to pay dividends in 2004 without prior approval.
LNL is recognized as an accredited reinsurer in the state of New York, which effectively enables it to conduct reinsurance business with unrelated insurance companies that are domiciled within the state of New York. As a result, in addition to regulatory restrictions imposed by the state of Indiana, LNL is also subject to the regulatory requirements that the State of New York imposes upon accredited reinsurers. These include risk based capital requirements, which differ from the State of Indiana.
Lincoln UK’s operations consist primarily of unit-linked life and pension products, which are similar to US produced variable life and annuity products. Lincoln UK’s insurance subsidiaries are regulated by the UK Financial Services Authority (FSA) and are subject to capital requirements as defined by the UK Required Minimum Solvency Margin (RMSM). Lincoln UK maintains approximately 1.5 to 2 times the required capital as prescribed by the regulatory margin. As is the case with regulated insurance companies in the US, changes to
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regulatory capital requirements can impact the dividend capacity of the UK insurance subsidiaries and cash flow to LNC.
Holding Company Liquidity and Cash Flow
LNC’s liquidity and cash flow position is driven principally by dividends and interest payments from subsidiaries augmented by holding company short-term investments, bank lines of credit, a commercial paper program, and the ongoing availability of long-term financing under a SEC shelf registration. These sources of liquidity and cash flow support the general corporate needs of the holding company including its common stock dividends, interest and debt service, funding of callable securities, securities repurchases, and acquisitions.
LNC Debt Financing and Related Activity
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, and the retirement of LNC’s debt and equity. LNC has $600 million of remaining authorization under a shelf registration to issue various securities, including debt securities, preferred stock, common stock, warrants, stock purchase contracts and stock purchase units of LNC and trust preferred securities of four subsidiary trusts. The net proceeds from the sale of the securities offered by this shelf registration are expected to be used by LNC for general corporate purposes, including repurchases of outstanding common stock, repayment or redemption of outstanding debt or preferred stock, the possible acquisition of financial services businesses or assets thereof, and working capital needs. Cash funds are also available from LNC’s revolving credit agreements and through LNC’s commercial paper program.
Debt and financing activity during the six month period ended June 30, 2004 consisted of the February 2004 issuance of $200 million 4.75% Notes due 2014 with semi-annual interest payments in February and August. The notes were priced at 99.297% and net proceeds to the company were $197.3 million, which will be used for general corporate purposes. Until the funds are needed for such purposes, the net proceeds will be used to invest in short-term investment grade securities and to pay down short-term debt. LNC used a treasury lock to reduce exposure to interest rate changes prior to closing. The treasury lock was closed prior to the issuance of the Notes with a gain of approximately $1 million. This gain, along with the costs of issuance, will be amortized over the life of the Notes.
LNC Return of Capital to Shareholders
One of the principal liquidity and capital requirements for LNC is providing a return to its shareholders. Through dividends and stock repurchases, LNC has an established record of providing significant cash returns to its shareholders. The following table summarizes this activity for 2004 and 2003.
(in millions, except share repurchase information)
Dividends to shareholders
Repurchase of common stock
Total Cash Returned to Shareholders
Number of shares repurchased
Average Price Per Share
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LNC has established a 20-year track record of increasing its dividend. In determining its dividend payout, LNC balances the desire to increase dividends against capital needs, rating agency considerations, and requirements for financial flexibility.
Stock Repurchase Activity
LNC resumed its share repurchase activity in 2004. Through the first six months of 2004, LNC repurchased 4,595,745 shares for a total of $213.1 million. LNC has $462.2 million remaining under the Board share repurchase authorization. The amount and timing of future repurchase activity is dependent on trends in key capital ratios, rating agency expectations, the generation of free cash flow, and the relative attractiveness of alternative uses for the capital.
Holding Company Sources and Uses of Cash Flow
The following tables highlight significant sources and uses of cash flow at the holding company. The tables focus on significant and recurring cash flow items and exclude the effects of certain financing activities, namely the periodic issuance and retirement of debt and cash flows related to LNC’s intercompany cash management account. Taxes have been eliminated from the analysis as a tax sharing agreement is in place with LNC’s primary subsidiaries resulting in a modest impact on net cash flows at the holding company. Also excluded from this analysis is the modest amount of investment income on short-term investments of the holding company.
The following table summarizes the primary sources of LNC cash flow.
Ended
Dividends from LNC Subsidiaries
LNL
Delaware Investments
Subsidiary Loan Repayments & Interest
LNL Interest on Surplus Notes (1)
Commencing in October 2001, and continuing through June 2002, LNC made a series of investments in a variable annuity contract with investment options similar to the investment options within the unfunded contributory deferred compensation plan. The purpose of this investment was to partially mitigate the earnings effects created by changes in the value of LNC’s deferred compensation plan liability that result from changes in value of the underlying investment options. In June 2004, LNC withdrew its variable annuity contract, which had a value of $65.4 million, and entered into a total return swap agreement with a notional amount of 82.5 million and paid no initial premium.
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The following table summarizes the primary uses of LNC cash flow.
LNC Debt Service (Interest Paid)
LNC Common Dividends
Common Stock Repurchases
LNC Credit Ratings
As of March 31, 2004, LNC’s senior debt ratings were Moody’s at A3 (“Upper Medium Grade”), Standard and Poor’s at A- (“Strong”), Fitch at A (“Strong”) and A.M. Best at “a-” (“Strong”), and LNC’s commercial paper ratings included Moody’s at P-2 (“Strong”), Standard and Poor’s at A-2 (“Satisfactory”) and Fitch at F-1 (“Very Strong”).
LNC Bank Lines and Commercial Paper Program
At June 30, 2004, LNC maintained three revolving credit agreements with a group of domestic and foreign banks totaling $518 million. LNC’s commercial paper is supported by two facilities, a $200 million three-year revolving credit facility maturing in February 2007 and a $300 million revolving credit facility maturing in December 2005. The UK facility was renewed in January 2004 for $18 million maturing in January 2005. At December 31, 2003, LNC did not have any loans outstanding under any of the bank lines.
Bank Line Covenants, Ratings, and Liquidity
Under all three agreements, LNC must maintain senior unsecured long-term debt ratings of at least S&P A- or Moody’s A3 or be restricted by an adjusted debt to capitalization ratio. In addition, LNC must maintain a minimum level of capitalization. LNC completes a quarterly compliance certificate for its banks demonstrating compliance with each financial covenant. At June 30, 2004 LNC was in compliance with all such covenants.
If current debt ratings and claims paying ratings were downgraded in the future, certain covenants of various contractual obligations may be triggered which could negatively impact overall liquidity. In addition, contractual selling agreements with intermediaries could be negatively impacted which could have an adverse impact on overall sales of annuities, life insurance and investment products. At June 30, 2004, LNC maintains adequate current financial strength and senior debt ratings and does not anticipate any ratings-based impact to future liquidity.
Capital Resources
Total shareholders’ equity decreased $292.7 million during the six month period ended June 30, 2004. The table below provides a reconciliation of shareholders’ equity from December 31, 2003 to June 30, 2004 (in millions).
Changes to Accumulated Other Comprehensive Income
Unrealized loss on securities available-for-sale and derivative instruments
Minimum pension liability adjustments
Total Changes to Accumulated Other Comprehensive Income
Issuance of common stock related to stock compensation and benefit plans
Dividends declared to shareholders
Total Changes to Shareholders’ Equity
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As noted above, shareholders’ equity includes accumulated other comprehensive income. At June 30, 2004, the book value of $31.32 per share included $2.81 of accumulated other comprehensive income. At December 31, 2003, the book value of $32.56 per share included $4.87 of accumulated other comprehensive income.
Contingencies
See Note 6 to the June 30, 2004 unaudited consolidated financial statements for information regarding contingencies.
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LNC provided a discussion of its market risk in Item 7A of its 2003 Annual Report on Form 10-K for the year ended December 31, 2003. During the first six months of 2004, there was no substantive change to LNC’s market risk except for the items noted below:
Interest Rate Risk – Falling Rates
As discussed in the Quantitative and Qualitative Disclosures About Market Risk section of LNC’s annual report on Form 10-K for the year ended December 31, 2003, interest spreads would be at risk on LNC’s fixed annuity and interest-sensitive whole life, universal life and fixed portion of variable universal life insurance policies if interest rates continued to fall and remained lower for a period of time. The following table provides detail on the difference between interest crediting rates and minimum guaranteed rates as of June 30, 2004. For example, at June 30, 2004, there are $421 million of combined Retirement and Life Insurance account values where the excess of the crediting rate over contract minimums is between 1.01% and 1.50%. The analysis presented below ignores any non-guaranteed elements within the life insurance products such as cost of insurance or expense loads, which for many products may be redetermined in the event that interest margins deteriorate below the level that would cause the credited rate to equal the minimum guaranteed rate.
As of June 30, 2004 (in millions)
CD and On-Benefit type annuities
Discretionary rate setting products*
No difference
up to .1%
.11% to .20%
.21% to .30%
.31% to .40%
.41% to .50%
.51% to .60%
.61% to .70%
.71% to .80%
.81% to .90%
.91% to 1.0%
1.01% to 1.50%
1.51% to 2.00%
2.01% to 2.50%
2.51% to 3.00%
3.01% and above
Total Discretionary rate setting products
Total – Account Values
The following is a discussion of changes to LNC’s derivative positions.
Derivatives
As indicated in Note 7 to the consolidated financial statements for the year ended December 31, 2003, LNC has entered into derivative transactions to reduce its exposure to fluctuations in interest rates, the risk of changes in liabilities indexed to equity markets, credit risk and foreign exchange risk. 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
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initiated periodically upon review of the Company’s overall risk assessment. During the first six months of 2004, the more significant changes in LNC’s derivative positions are as follows:
LNC is exposed to credit loss in the event of non-performance by counterparties on various derivative contracts. 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.
LNC maintains disclosure controls and procedures, which are designed to ensure that information required to be disclosed in the reports it files or submits under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to the
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Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.
An evaluation of the effectiveness of LNC’s disclosure controls and procedures as of June 30, 2004 was conducted under the supervision and with the participation of LNC’s Chief Executive Officer and Chief Financial Officer. Based on that evaluation, LNC’s Chief Executive Officer and Chief Financial Officer have concluded that LNC’s disclosure controls and procedures were adequate and designed to ensure that material information relating to LNC and its consolidated subsidiaries would be made known to the Chief Executive Officer and Chief Financial Officer by others within those entities, particularly during the periods when periodic reports under the Exchange Act are being prepared.
Furthermore, there has been no change in LNC’s internal control over financial reporting, identified in connection with the evaluation of such control, that occurred during LNC’s last fiscal quarter that has materially affected, or is reasonably likely to materially affect, LNC’s internal control over financial reporting. Refer to the Certifications by the Company’s Chief Executive Officer and Chief Financial Officer filed as exhibits to this report.
PART II — OTHER INFORMATION AND EXHIBITS
Items 1, 2a-d, 3 and 5 of this Part II are either inapplicable or are answered in the negative and are omitted pursuant to the instructions to Part II.
ISSUER PURCHASES OF EQUITY SECURITIES
Period
1/1/04 – 1/31/04
2/1/04 – 2/29/04
3/1/04 – 3/31/04
4/1/04 – 4/30/04
5/1/04 – 5/31/04
6/1/04 – 6/30/04
a & b. Refer to LNC’s Annual Report on Form 10-K for the year ended December 31, 2003 for information on share repurchase plans. Total number of shares include those purchased as part of publicly announced plans or programs as well as shares received for the purchase price on the exercise of stock options and shares withheld for taxes on the vesting of restricted stock.
c. Both plans have no expiration date
d. No plans expired during 2nd quarter
e. No plans were terminated
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Election of Directors
Nominee
William J. Avery
Jon A. Boscia
Eric G. Johnson
Glenn F. Tilton
Proposals
Proposal
Broker
Non-Votes
Approval of Lincoln National
Deferred Compensation Plan for Non-Employee Directors including a related authorization of 700,000 shares of LNC’s common stock
(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.)
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(b) Reports on Form 8-K
During the three months ended June 30, 2004, the following Current Reports on Form 8-K were filed with or furnished to the SEC by LNC:
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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.
By
Date: August 6, 2004
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Exhibit Index for the Report on Form 10-Q
For the Quarter Ended June 30, 2004
Description
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