UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C.D.C. 20549
FORM 10-Q
(Mark One)
x | Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 |
For the quarterly period ended JuneSeptember 30, 2008.
¨ | Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 |
For the transition period from to .
Commission File Number 1-6028
LINCOLN NATIONAL CORPORATION
(Exact name of registrant as specified in its charter)
Indiana | 35-1140070 | |
(State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) | |
150 N. Radnor Chester Road, Radnor, Pennsylvania | 19087 | |
(Address of principal executive offices) | (Zip Code) |
(484) 583-1400
(Registrant’s telephone number, including area codecode)
Not Applicable
(Former name, former address and former fiscal year, if changed since last reportreport)
Indicate by check mark whether the 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 such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non- accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
(Check one): Large accelerated filer x Accelerated filer ¨ Non- acceleratedNon-accelerated filer ¨ Smaller reporting company ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
As of August 1,November 3, 2008, there were 256,827,934255,881,396 shares of the registrant’s common stock outstanding.
PART I – FINANCIAL INFORMATION
Item 1. | Financial Statements |
LINCOLN NATIONAL CORPORATION
CONSOLIDATED BALANCE SHEETS
(in millions, except share data)
As of June 30, 2008 | As of December 31, 2007 | As of September 30, 2008 | As of December 31, 2007 | |||||||||||
(Unaudited) | (Unaudited) | |||||||||||||
ASSETS | ||||||||||||||
Investments: | ||||||||||||||
Available-for-sale securities, at fair value: | ||||||||||||||
Fixed maturity (amortized cost: 2008 - $56,553; 2007 - $56,069) | $ | 54,518 | $ | 56,276 | ||||||||||
Equity (cost: 2008 - $617; 2007 - $548) | 464 | 518 | ||||||||||||
Fixed maturity (amortized cost: 2008 – $56,211; 2007 – $56,069) | $ | 51,931 | $ | 56,276 | ||||||||||
Equity (cost: 2008 – $612; 2007 – $548) | 493 | 518 | ||||||||||||
Trading securities | 2,550 | 2,730 | 2,393 | 2,730 | ||||||||||
Mortgage loans on real estate | 7,678 | 7,423 | 7,688 | 7,423 | ||||||||||
Real estate | 136 | 258 | 127 | 258 | ||||||||||
Policy loans | 2,802 | 2,835 | 2,870 | 2,885 | ||||||||||
Derivative investments | 890 | 807 | 1,262 | 807 | ||||||||||
Other investments | 1,163 | 1,075 | 1,193 | 1,075 | ||||||||||
Total investments | 70,201 | 71,922 | 67,957 | 71,972 | ||||||||||
Cash and invested cash | 1,921 | 1,665 | 2,160 | 1,665 | ||||||||||
Deferred acquisition costs and value of business acquired | 10,608 | 9,580 | 11,652 | 9,580 | ||||||||||
Premiums and fees receivable | 399 | 401 | 463 | 401 | ||||||||||
Accrued investment income | 876 | 843 | 921 | 843 | ||||||||||
Reinsurance recoverables | 8,220 | 8,237 | 8,222 | 8,187 | ||||||||||
Goodwill | 4,045 | 4,144 | 4,041 | 4,144 | ||||||||||
Other assets | 2,716 | 3,530 | 2,884 | 3,530 | ||||||||||
Separate account assets | 85,295 | 91,113 | 74,971 | 91,113 | ||||||||||
Total assets | $ | 184,281 | $ | 191,435 | $ | 173,271 | $ | 191,435 | ||||||
LIABILITIES AND STOCKHOLDERS’ EQUITY | ||||||||||||||
Liabilities | ||||||||||||||
Future contract benefits | $ | 16,218 | $ | 16,007 | $ | 16,281 | $ | 16,007 | ||||||
Other contract holder funds | 60,363 | 59,640 | 60,678 | 59,640 | ||||||||||
Short-term debt | 900 | 550 | 635 | 550 | ||||||||||
Long-term debt | 4,102 | 4,618 | 4,569 | 4,618 | ||||||||||
Reinsurance related derivative liability | 112 | 220 | (9 | ) | 220 | |||||||||
Funds withheld reinsurance liabilities | 2,069 | 2,117 | 2,062 | 2,117 | ||||||||||
Deferred gain on indemnity reinsurance | 658 | 696 | 639 | 696 | ||||||||||
Payables for collateral under securities loaned and derivatives | 1,490 | 1,135 | 1,668 | 1,135 | ||||||||||
Other liabilities | 2,576 | 3,621 | 2,277 | 3,621 | ||||||||||
Separate account liabilities | 85,295 | 91,113 | 74,971 | 91,113 | ||||||||||
Total liabilities | 173,783 | 179,717 | 163,771 | 179,717 | ||||||||||
Contingencies and Commitments (See Note 9) | ||||||||||||||
Contingencies and Commitments (See Note 10) | ||||||||||||||
Stockholders’ Equity | ||||||||||||||
Series A preferred stock - 10,000,000 shares authorized | — | — | ||||||||||||
Common stock - 800,000,000 shares authorized; 256,801,622 and 264,233,303 shares issued and outstanding as of June 30, 2008, and December 31, 2007, respectively | 7,023 | 7,200 | ||||||||||||
Series A preferred stock – 10,000,000 shares authorized | — | — | ||||||||||||
Common stock – 800,000,000 shares authorized; 255,841,633 and 264,233,303 shares issued and outstanding as of September 30, 2008, and December 31, 2007, respectively | 7,006 | 7,200 | ||||||||||||
Retained earnings | 4,283 | 4,293 | 4,304 | 4,293 | ||||||||||
Accumulated other comprehensive income (loss) | (808 | ) | 225 | (1,810 | ) | 225 | ||||||||
Total stockholders’ equity | 10,498 | 11,718 | 9,500 | 11,718 | ||||||||||
Total liabilities and stockholders’ equity | $ | 184,281 | $ | 191,435 | $ | 173,271 | $ | 191,435 | ||||||
See accompanying Notes to Consolidated Financial Statements
1
LINCOLN NATIONAL CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
(in millions, except per share data)
For the Three Months Ended June 30, | For the Six Months Ended June 30, | For the Three Months Ended September 30, | For the Nine Months Ended September 30, | |||||||||||||||||||||||||||
2008 | 2007 | 2008 | 2007 | 2008 | 2007 | 2008 | 2007 | |||||||||||||||||||||||
(Unaudited) | (Unaudited) | |||||||||||||||||||||||||||||
Revenues | ||||||||||||||||||||||||||||||
Insurance premiums | $ | 530 | $ | 489 | $ | 1,039 | $ | 948 | $ | 533 | $ | 491 | $ | 1,572 | $ | 1,439 | ||||||||||||||
Insurance fees | 842 | 742 | 1,654 | 1,506 | 791 | 836 | 2,446 | 2,342 | ||||||||||||||||||||||
Investment advisory fees | 76 | 93 | 152 | 183 | 68 | 89 | 220 | 272 | ||||||||||||||||||||||
Net investment income | 1,077 | 1,133 | 2,142 | 2,223 | 1,089 | 1,062 | 3,231 | 3,285 | ||||||||||||||||||||||
Realized gain (loss) | (108 | ) | 7 | (143 | ) | 41 | ||||||||||||||||||||||||
Realized loss | (204 | ) | (65 | ) | (347 | ) | (24 | ) | ||||||||||||||||||||||
Amortization of deferred gain on business sold through reinsurance | 19 | 26 | 38 | 45 | 19 | 19 | 57 | 65 | ||||||||||||||||||||||
Other revenues and fees | 146 | 181 | 292 | 346 | 140 | 169 | 431 | 514 | ||||||||||||||||||||||
Total revenues | 2,582 | 2,671 | 5,174 | 5,292 | 2,436 | 2,601 | 7,610 | 7,893 | ||||||||||||||||||||||
Benefits and Expenses | ||||||||||||||||||||||||||||||
Interest credited | 613 | 606 | 1,225 | 1,206 | 625 | 611 | 1,849 | 1,817 | ||||||||||||||||||||||
Benefits | 684 | 651 | 1,362 | 1,244 | 836 | 623 | 2,199 | 1,866 | ||||||||||||||||||||||
Underwriting, acquisition, insurance and other expenses | 847 | 816 | 1,656 | 1,625 | 754 | 850 | 2,408 | 2,475 | ||||||||||||||||||||||
Interest and debt expense | 65 | 73 | 140 | 135 | 69 | 69 | 209 | 204 | ||||||||||||||||||||||
Impairment of intangibles | 173 | — | 173 | — | — | — | 175 | — | ||||||||||||||||||||||
Total benefits and expenses | 2,382 | 2,146 | 4,556 | 4,210 | 2,284 | 2,153 | 6,840 | 6,362 | ||||||||||||||||||||||
Income from continuing operations before taxes | 200 | 525 | 618 | 1,082 | 152 | 448 | 770 | 1,531 | ||||||||||||||||||||||
Federal income taxes | 75 | 155 | 200 | 324 | 3 | 125 | 203 | 450 | ||||||||||||||||||||||
Income from continuing operations | 125 | 370 | 418 | 758 | 149 | 323 | 567 | 1,081 | ||||||||||||||||||||||
Income (loss) from discontinued operations, net of federal incomes taxes | — | 6 | (4 | ) | 14 | (1 | ) | 7 | (5 | ) | 21 | |||||||||||||||||||
Net income | $ | 125 | $ | 376 | $ | 414 | $ | 772 | $ | 148 | $ | 330 | $ | 562 | $ | 1,102 | ||||||||||||||
Earnings Per Common Share – Basic | ||||||||||||||||||||||||||||||
Income from continuing operations | $ | 0.48 | $ | 1.37 | $ | 1.61 | $ | 2.78 | $ | 0.58 | $ | 1.20 | $ | 2.20 | $ | 3.98 | ||||||||||||||
Income (loss) from discontinued operations | — | 0.02 | (0.02 | ) | 0.05 | — | 0.02 | (0.02 | ) | 0.08 | ||||||||||||||||||||
Net income | $ | 0.48 | $ | 1.39 | $ | 1.59 | $ | 2.83 | $ | 0.58 | $ | 1.22 | $ | 2.18 | $ | 4.06 | ||||||||||||||
Earnings Per Common Share – Diluted | ||||||||||||||||||||||||||||||
Income from continuing operations | $ | 0.48 | $ | 1.35 | $ | 1.60 | $ | 2.74 | $ | 0.58 | $ | 1.19 | $ | 2.18 | $ | 3.93 | ||||||||||||||
Income (loss) from discontinued operations | — | 0.02 | (0.02 | ) | 0.05 | — | 0.02 | (0.02 | ) | 0.07 | ||||||||||||||||||||
Net income | $ | 0.48 | $ | 1.37 | $ | 1.58 | $ | 2.79 | $ | 0.58 | $ | 1.21 | $ | 2.16 | $ | 4.00 | ||||||||||||||
See accompanying Notes to Consolidated Financial Statements
2
LINCOLN NATIONAL CORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(in millions, except per share data)
For the Six Months Ended June 30, | For the Nine Months Ended September 30, | |||||||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||||||
(Unaudited) | (Unaudited) | |||||||||||||||
Series A Preferred Stock | ||||||||||||||||
Balance at beginning-of-year | $ | — | $ | 1 | $ | — | $ | 1 | ||||||||
Balance at end-of-period | — | 1 | — | 1 | ||||||||||||
Common Stock | ||||||||||||||||
Balance at beginning-of-year | 7,200 | 7,449 | 7,200 | 7,449 | ||||||||||||
Issued for acquisition | — | 20 | — | 20 | ||||||||||||
Stock compensation | 41 | 85 | 51 | 113 | ||||||||||||
Deferred compensation payable in stock | 3 | 4 | 4 | 5 | ||||||||||||
Retirement of common stock/cancellation of shares | (221 | ) | (195 | ) | (249 | ) | (278 | ) | ||||||||
Balance at end-of-period | 7,023 | 7,363 | 7,006 | 7,309 | ||||||||||||
Retained Earnings | ||||||||||||||||
Balance at beginning-of-year | 4,293 | 4,138 | 4,293 | 4,138 | ||||||||||||
Cumulative effect of adoption of SOP 05-1 | — | (41 | ) | — | (41 | ) | ||||||||||
Cumulative effect of adoption of FIN 48 | — | (15 | ) | — | (15 | ) | ||||||||||
Cumulative effect of adoption of EITF 06-10 | (4 | ) | — | (4 | ) | — | ||||||||||
Comprehensive income (loss) | (619 | ) | 308 | (1,473 | ) | 686 | ||||||||||
Less other comprehensive loss, net of tax | (1,033 | ) | (464 | ) | (2,035 | ) | (416 | ) | ||||||||
Net income | 414 | 772 | 562 | 1,102 | ||||||||||||
Retirement of common stock | (205 | ) | (317 | ) | (227 | ) | (408 | ) | ||||||||
Dividends declared: Common (2008 - $.83; 2007 - $ .79) | (215 | ) | (214 | ) | ||||||||||||
Dividends declared: Common (2008 – $1.245; 2007 – $1.185) | (320 | ) | (320 | ) | ||||||||||||
Balance at end-of-period | 4,283 | 4,323 | 4,304 | 4,456 | ||||||||||||
Net Unrealized Gain on Available-for-Sale Securities | ||||||||||||||||
Balance at beginning-of-year | 86 | 493 | 86 | 493 | ||||||||||||
Change during the period | (1,025 | ) | (476 | ) | (1,990 | ) | (437 | ) | ||||||||
Balance at end-of-period | (939 | ) | 17 | (1,904 | ) | 56 | ||||||||||
Net Unrealized Gain on Derivative Instruments | ||||||||||||||||
Balance at beginning-of-year | 53 | 39 | 53 | 39 | ||||||||||||
Change during the period | (12 | ) | (4 | ) | 1 | (7 | ) | |||||||||
Balance at end-of-period | 41 | 35 | 54 | 32 | ||||||||||||
Foreign Currency Translation Adjustment | ||||||||||||||||
Balance at beginning-of-year | 175 | 165 | 175 | 165 | ||||||||||||
Change during the period | 2 | 16 | (54 | ) | 29 | |||||||||||
Balance at end-of-period | 177 | 181 | 121 | 194 | ||||||||||||
Funded Status of Employee Benefit Plans | ||||||||||||||||
Balance at beginning-of-year | (89 | ) | (84 | ) | (89 | ) | (84 | ) | ||||||||
Change during the period | 2 | — | 8 | (1 | ) | |||||||||||
Balance at end-of-period | (87 | ) | (84 | ) | (81 | ) | (85 | ) | ||||||||
Total stockholders’ equity at end-of-period | $ | 10,498 | $ | 11,836 | $ | 9,500 | $ | 11,963 | ||||||||
See accompanying Notes to Consolidated Financial Statements
3
LINCOLN NATIONAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in millions)
For the Six Months Ended June 30, | For the Nine Months Ended September 30, | |||||||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||||||
(Unaudited) | (Unaudited) | |||||||||||||||
Cash Flows from Operating Activities | ||||||||||||||||
Net income | $ | 414 | $ | 772 | $ | 562 | $ | 1,102 | ||||||||
Adjustments to reconcile net income to net cash provided by operating activities: | ||||||||||||||||
Deferred acquisition costs and value of business acquired deferrals and interest, net of amortization | (357 | ) | (484 | ) | ||||||||||||
Deferred acquisition costs, value of business acquired, deferred sales inducements and deferred front end loads deferrals and interest, net of amortization | (838 | ) | (907 | ) | ||||||||||||
Trading securities purchases, sales and maturities, net | 96 | 218 | 141 | 319 | ||||||||||||
Change in derivative investments | (7 | ) | (8 | ) | ||||||||||||
Change in premiums and fees receivable | 2 | (76 | ) | 47 | 1 | |||||||||||
Change in accrued investment income | (33 | ) | 5 | (78 | ) | (50 | ) | |||||||||
Change in reinsurance recoverables | 17 | (120 | ) | |||||||||||||
Change in future contract benefits | 223 | 196 | 159 | 113 | ||||||||||||
Change in other contract holder funds | 183 | 895 | 548 | 1,033 | ||||||||||||
Change in funds withheld reinsurance liability | (48 | ) | 61 | |||||||||||||
Change in funds withheld reinsurance liability and reinsurance recoverables | (57 | ) | (125 | ) | ||||||||||||
Change in federal income tax accruals | (230 | ) | 295 | (228 | ) | 358 | ||||||||||
Change in net periodic benefit accruals | — | (4 | ) | |||||||||||||
Realized (gain) loss | 143 | (41 | ) | |||||||||||||
Realized loss | 347 | 24 | ||||||||||||||
Loss on disposal of discontinued operations | 12 | — | 13 | — | ||||||||||||
Impairment of intangibles | 173 | — | 175 | — | ||||||||||||
Amortization of deferred gain on business sold through reinsurance | (38 | ) | (45 | ) | (57 | ) | (65 | ) | ||||||||
Stock-based compensation expense | 19 | 29 | 23 | 39 | ||||||||||||
Depreciation, amortization and accretion, net | 24 | 15 | ||||||||||||||
Other | (142 | ) | (319 | ) | 54 | 288 | ||||||||||
Net adjustments | 37 | 617 | 249 | 1,028 | ||||||||||||
Net cash provided by operating activities | 451 | 1,389 | 811 | 2,130 | ||||||||||||
Cash Flows from Investing Activities | ||||||||||||||||
Purchases of available-for-sale securities | (3,615 | ) | (7,995 | ) | (5,578 | ) | (10,740 | ) | ||||||||
Sales of available-for-sale securities | 1,014 | 5,206 | 1,803 | 6,456 | ||||||||||||
Maturities of available-for-sale securities | 1,924 | 2,125 | 2,978 | 3,162 | ||||||||||||
Purchases of other investments | (1,213 | ) | (1,251 | ) | (1,848 | ) | (1,849 | ) | ||||||||
Sales or maturities of other investments | 914 | 1,157 | 1,383 | 1,617 | ||||||||||||
Increase (decrease) in payables for collateral under securities loaned and derivatives | 355 | (132 | ) | 533 | (184 | ) | ||||||||||
Proceeds from sale of subsidiaries/businesses and disposal of discontinued operations | 644 | — | 645 | — | ||||||||||||
Other | (53 | ) | 10 | (90 | ) | (75 | ) | |||||||||
Net cash used in investing activities | (30 | ) | (880 | ) | (174 | ) | (1,613 | ) | ||||||||
Cash Flows from Financing Activities | ||||||||||||||||
Payment of long-term debt, including current maturities | (100 | ) | (553 | ) | (285 | ) | (653 | ) | ||||||||
Issuance of long-term debt | — | 750 | 450 | 1,050 | ||||||||||||
Issuance (decrease) in commercial paper | (65 | ) | 30 | (145 | ) | 226 | ||||||||||
Deposits of fixed account values, including the fixed portion of variable | 4,913 | 4,500 | 7,366 | 7,030 | ||||||||||||
Withdrawals of fixed account values, including the fixed portion of variable | (2,787 | ) | (4,071 | ) | (4,373 | ) | (5,805 | ) | ||||||||
Transfers to and from separate accounts, net | (1,233 | ) | (1,131 | ) | (1,838 | ) | (1,732 | ) | ||||||||
Maturities of funding agreements | (300 | ) | — | |||||||||||||
Payment of funding agreements | (550 | ) | — | |||||||||||||
Common stock issued for benefit plans and excess tax benefits | 25 | 62 | 32 | 81 | ||||||||||||
Repurchase of common stock | (401 | ) | (512 | ) | (476 | ) | (686 | ) | ||||||||
Dividends paid to stockholders | (217 | ) | (216 | ) | (323 | ) | (323 | ) | ||||||||
Net cash used in financing activities | (165 | ) | (1,141 | ) | (142 | ) | (812 | ) | ||||||||
Net increase (decrease) in cash and invested cash | 256 | (632 | ) | 495 | (295 | ) | ||||||||||
Cash and invested cash at beginning-of-year | 1,665 | 1,621 | 1,665 | 1,621 | ||||||||||||
Cash and invested cash at end-of-period | $ | 1,921 | $ | 989 | $ | 2,160 | $ | 1,326 | ||||||||
See accompanying Notes to Consolidated Financial Statements
4
LINCOLN NATIONAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. Nature of Operations and Basis of Presentation
Nature of Operations
Lincoln National Corporation and its majority-owned subsidiaries (“LNC” or the “Company,” which also may be referred to as “we,” “our” or “us”) operate multiple insurance and investment management businesses through six business segments, see Note 16.17. The collective group of businesses uses “Lincoln Financial Group” as its marketing identity. Through our business segments, we sell a wide range of wealth protection, accumulation and retirement income products and solutions.products. These products include institutional and/or retail fixed and indexed annuities, variable annuities, universal life insurance, term life insurance, mutual funds and managed accounts.
Basis of Presentation
The accompanying unaudited consolidated financial statements are prepared in accordance with United States of America generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions for the Securities and Exchange Commission (“SEC”) Quarterly Report on Form 10-Q, including Article 10 of Regulation S-X. Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements. Therefore, the information contained in the Notes to Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007 (“2007 Form 10-K”), should be read in connection with the reading of these interim unaudited consolidated financial statements.
In the opinion of management, these statements include all normal recurring adjustments necessary for a fair presentation of the Company’s results. Operating results for the three and sixnine month periods ended JuneSeptember 30, 2008, are not necessarily indicative of the results that may be expected for the full year ending December 31, 2008. All material intercompany accounts and transactions have been eliminated in consolidation.
Certain amounts reported in prior periods’ consolidated financial statements have been reclassified to conform to the presentation adopted in the current year. These reclassifications have no effect on net income or stockholders’ equity of the prior periods.
We have reclassified the results of certain derivatives and embedded derivatives to realized gain (loss),loss, which were previously reported within insurance fees, net investment income, interest credited or benefits. The associated amortization expense of deferred acquisition costs (“DAC”) and value of business acquired (“VOBA”) (previously reported within underwriting, acquisition, insurance and other expenses), deferred sales inducements (“DSI”) (previously reported within interest credited), deferred front-end loads (“DFEL”) (previously reported within insurance fees) and changes in future contract holder fundsbenefits (previously reported within benefits) have also been reclassified to realized gain (loss).loss.
The detail of the reclassifications from what was previously reported in prior period financial statements (in millions) was as follows:
For the Three Months Ended | For the Six Months Ended June 30, 2007 | For the Three Months Ended September 30, 2007 | For the Nine Months Ended September 30, 2007 | |||||||||||||||||
March 31, 2008 | June 30, 2007 | |||||||||||||||||||
Realized gain (loss), as previously reported | $ | (38 | ) | $ | (5 | ) | $ | 22 | ||||||||||||
Realized loss, as previously reported | $ | (37 | ) | $ | (15 | ) | ||||||||||||||
Effect of reclassifications to: | ||||||||||||||||||||
Insurance fees | 32 | 16 | 31 | 16 | 47 | |||||||||||||||
Net investment income | (97 | ) | 37 | 36 | 5 | 41 | ||||||||||||||
Interest credited | 102 | (25 | ) | (30 | ) | (15 | ) | (44 | ) | |||||||||||
Benefits | (13 | ) | (5 | ) | (1 | ) | (55 | ) | (57 | ) | ||||||||||
Underwriting, acquisition, insurance and other expenses | (21 | ) | (11 | ) | (17 | ) | 21 | 4 | ||||||||||||
Realized gain (loss), as adjusted | $ | (35 | ) | $ | 7 | $ | 41 | |||||||||||||
Realized loss, as adjusted | $ | (65 | ) | $ | (24 | ) | ||||||||||||||
5
2. New Accounting Standards
Adoption of New Accounting Standards
Statement of Financial Accounting Standards No. 157 – Fair Value Measurements
In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements” (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value under current accounting pronouncements that require or permit fair value measurement and enhances disclosures about fair value instruments. SFAS 157 retains the exchange price notion, but clarifies that exchange price is the price in an orderly transaction between market participants to sell the asset or transfer the liability (exit price) in the principal market, or the most advantageous market in the absence of a principal market, for that asset or liability, as opposed to the price that would be paid to acquire the asset or receive a liability (entry price). Fair value measurement is based on assumptions used by market participants in pricing the asset or liability, which may include inherent risk, restrictions on the sale or use of an asset or non-performance risk, which would include the reporting entity’s own credit risk. SFAS 157 establishes a three-level fair value hierarchy, which prioritizes the inputs to valuation techniques used to measure fair value. The three-level hierarchy for fair value measurement is defined as follows:
Level 1 – inputs to the valuation methodology are quoted prices available in active markets for identical investments as of the reporting date. “Blockage discounts” for large holdings of unrestricted financial instruments where quoted prices are readily and regularly available for an identical asset or liability in an active market are prohibited;
Level 2 – inputs to the valuation methodology are other than quoted prices in active markets, which are either directly or indirectly observable as of the reporting date, and fair value can be determined through the use of models or other valuation methodologies; and
Level 3 – inputs to the valuation methodology are unobservable inputs in situations where there is little or no market activity for the asset or liability and the reporting entity makes estimates and assumptions related to the pricing of the asset or liability, including assumptions regarding risk.
In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, an investment’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. Our assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the investment.
We have certain guaranteed benefit features within our annuity products that, prior to January 1, 2008, were recorded using fair value pricing. These benefits will continue to be measured on a fair value basis with the adoption of SFAS 157, utilizing Level 3 inputs and some Level 2 inputs, which are reflective of the hypothetical market participant perspective for fair value measurement, including liquidity assumptions and assumptions regarding the Company’s own credit or non-performance risk. In addition, SFAS 157 expands the disclosure requirements for annual and interim reporting to focus on the inputs used to measure fair value, including those measurements using significant unobservable inputs and the effects of the measurements on earnings. See Note 1516 for additional information.
6
We adopted SFAS 157 effective January 1, 2008, by recording increases (decreases) to the following categories (in millions) on our consolidated financial statements:
Assets | ||||||||
DAC | $ | 13 | $ | 13 | ||||
VOBA | (8 | ) | (8 | ) | ||||
Other assets – DSI | 2 | 2 | ||||||
Total assets | $ | 7 | $ | 7 | ||||
Liabilities | ||||||||
Other contract holder funds: | ||||||||
Future Contract Benefits: | ||||||||
Remaining guaranteed interest and similar contracts | $ | (20 | ) | $ | (20 | ) | ||
Embedded derivative instruments – living benefits liabilities | 48 | 48 | ||||||
DFEL | 3 | 3 | ||||||
Other liabilities – income tax liabilities | (8 | ) | (8 | ) | ||||
Total liabilities | $ | 23 | $ | 23 | ||||
Revenues | ||||||||
Realized loss | $ | (24 | ) | $ | (24 | ) | ||
Federal income tax benefit | (8 | ) | (8 | ) | ||||
Loss from continuing operations | $ | (16 | ) | $ | (16 | ) | ||
The impact for the first quarter adoption of SFAS 157 to basic and diluted per share amounts was a decrease of $0.06.
FASB Staff Position No. FAS 157-2– Effective Date of FASB Statement No. 157
In February 2008, the FASB issued FASB Staff Position (“FSP”) No. FAS 157-2, “Effective Date of FASB Statement No. 157” (“FSP 157-2”). FSP 157-2 delays the effective date of SFAS 157 for nonfinancial assets and nonfinancial liabilities to fiscal years beginning after November 15, 2008, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). Accordingly, we did not apply the provisions of SFAS 157 to nonfinancial assets and nonfinancial liabilities within the scope of FSP 157-2. Examples of items to which the deferral is applicable include, but are not limited to:
Nonfinancial assets and nonfinancial liabilities initially measured at fair value in a business combination or other new basis event, but not measured at fair value in subsequent periods;
Reporting units measured at fair value in the goodwill impairment test under SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”), and indefinite-lived intangible assets measured at fair value for impairment assessment under SFAS 142;
Nonfinancial long-lived assets measured at fair value for an impairment assessment under SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”;
Asset retirement obligations initially measured at fair value under SFAS No. 143, “Accounting for Asset Retirement Obligations”; and
Nonfinancial liabilities for exit or disposal activities initially measured at fair value under SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.”
FASB Staff Position No. FAS 157-3 – Determining the Fair Value of a Financial Asset When the Market for That Asset is Not Active
In October 2008, the FASB issued FSP FAS 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset is Not Active” (“FSP 157-3”). FSP 157-3 clarifies the application of SFAS 157 in a market that is not active and provides an illustrative example of key considerations to analyze in determining fair value of a financial asset when the market for the asset is not active. During times when there is little market activity for a financial asset, the objective of fair value measurement remains the same, that is, to value the asset at the price that would be received by the holder of the financial asset in an orderly transaction (exit price) that is not a forced liquidation or distressed sale at the measurement date. Determining fair value of a financial asset during a period of market inactivity may require the use of significant judgment and an evaluation of the facts and circumstances to determine if transactions for a financial asset represent a forced liquidation or distressed sale. An entity’s own assumptions regarding future cash flows and risk-adjusted discount rates for financial assets are acceptable when relevant observable inputs are not available. FSP 157-3 was effective on October 10, 2008, and for all prior periods for which financial statements have not been issued. Any changes in valuation techniques resulting from the adoption of FSP 157-3 shall be accounted for as a change in accounting estimated in accordance with SFAS No. 154, “Accounting Changes and Error Corrections.” We adopted the guidance
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in FSP 157-3 in our financial statements for the reporting period ending September 30, 2008. The adoption did not have a material impact on our consolidated financial condition or results of operations.
SFAS No. 159 – The Fair Value Option for Financial Assets and Financial Liabilities
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”), which allows an entity to make an irrevocable election, on specific election dates, to measure eligible items at fair value. The election to measure an item at fair value may be determined on an instrument by instrument basis, with certain exceptions. If the fair value option is elected, unrealized gains and losses will be recognized in earnings at each subsequent reporting date, and any upfront costs and fees related to the item will be recognized in earnings as incurred. In addition, the presentation and disclosure requirements of SFAS 159 are designed to assist in the comparison between entities that select different measurement attributes for similar types of assets and liabilities. SFAS 159 applies to fiscal years beginning after November 15, 2007, with early adoption permitted for an entity that has also elected to apply the provisions of SFAS 157. At the effective date, the fair value option may be elected for eligible items that exist on that date. Effective January 1, 2008, we elected not to adopt the fair value option for any financial assets or liabilities that existed as of January 1, 2008.that date.
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Emerging Issues Task Force Issue No. 06-10 – Accounting for Collateral Assignment Split-Dollar Life Insurance Arrangements
In March 2007, the FASB Board ratified the consensus reached by the Emerging Issues Task Force (“EITF”) in EITF Issue No. 06-10, “Accounting for Collateral Assignment Split-Dollar Life Insurance Arrangements” (“EITF 06-10”). EITF 06-10 requires an employer to recognize a liability related to a collateral assignment split-dollar life insurance arrangement in accordance with SFAS No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions,” if the employer has agreed to maintain a life insurance policy during the employee’s retirement. In addition, based on the split-dollar arrangement, an asset should be recognized by the employer for the estimated future cash flows to which the employer is entitled. The adoption of EITF 06-10 can be recognized either as a change in accounting principle through a cumulative-effect adjustment to retained earnings or through retrospective application to all prior periods. The consensus is effective for fiscal years beginning after December 15, 2007, including interim periods within those fiscal years.
We maintain collateral assignment split-dollar life insurance arrangements related to frozen policies that are within the scope of EITF 06-10. Effective January 1, 2008, we adopted EITF 06-10 by recording a $4 million cumulative effect adjustment to the opening balance of retained earnings, offset by an increase to our liability for postretirement benefits. We also recorded notes receivable for the amounts due to us from participants under the split-dollar arrangements. The recording of the notes receivable did not have a material effect on our consolidated financial condition or results of operations.
Derivative Implementation Group Statement 133 Implementation Issue No. E23 – Issues Involving the Application of the Shortcut Method Under Paragraph 68
In December 2007, the FASB issued Derivative Implementation Group (“DIG”) Statement 133 Implementation Issue No. E23, “Issues Involving the Application of the Shortcut Method under Paragraph 68” (“DIG E23”), which gives clarification to the application of the shortcut method of accounting for qualifying fair value hedging relationships involving an interest-bearing financial instrument and/or an interest rate swap, originally outlined in paragraph 68 in SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”). We adopted DIG E23 effective January 1, 2008, for hedging relationships designated on or after that date. The adoption did not have a material impact on our consolidated financial condition or results of operations.
Future Adoption of New Accounting Standards
SFAS No. 141(R) – Business Combinations
In December 2007, the FASB issued SFAS No. 141(revised 2007), “Business Combinations” (“SFAS 141(R)”), which is a revision of SFAS No. 141 “Business Combinations” (“SFAS 141”). SFAS 141(R) retains the fundamental requirements of SFAS 141, but establishes principles and requirements for the acquirer in a business combination to recognize and measure the identifiable assets acquired, liabilities assumed and any noncontrolling interests in the acquiree and the goodwill acquired or the gain from a bargain purchase. The revised statement requires, among other things, that assets acquired, liabilities assumed and any noncontrolling interest in the acquiree shall be measured at their acquisition-date fair values. For business combinations completed upon adoption of SFAS 141(R), goodwill will be measured as the excess of the consideration transferred, plus the fair value of any noncontrolling interest in the acquiree, in excess of the fair values of the identifiable net assets acquired. Any contingent consideration shall be recognized at the acquisition-date fair value, which improves the accuracy of the goodwill measurement. Under SFAS 141(R), contractual pre-acquisition contingencies will be recognized at their acquisition-date fair values and non-contractual pre-acquisition contingencies will be recognized at their acquisition date fair values if it is more likely than not that the contingency gives rise to an asset or liability. Deferred recognition of pre-acquisition contingencies will no longer be permitted. Acquisition costs will be expensed in the period the costs are incurred, rather than included in the cost of the acquiree, and disclosure requirements will be
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enhanced to provide users with information to evaluate the nature and financial effects of the business combination. SFAS 141(R) applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period on or after December 15, 2008, with earlier adoption prohibited. We will adopt SFAS 141(R) for acquisitions occurring after January 1, 2009.
SFAS No. 160 – Noncontrolling Interests in Consolidated Financial Statements – an Amendment of Accounting Research Bulletin No. 51
In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements – an amendment of Accounting Research Bulletin No. 51” (“SFAS 160”), which aims to improve the relevance, comparability and transparency of the financial information that a reporting entity provides in its consolidated financial statements by establishing accounting and reporting standards surrounding noncontrolling interests, or minority interests, which are the portions of equity in a subsidiary not attributable, directly or indirectly, to a parent. The ownership interests in subsidiaries held by parties other than the parent shall be clearly identified, labeled and presented in the consolidated statement of financial position within equity, but separate from the parent’s equity. The amount of consolidated net income attributable to the parent and to the noncontrolling
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interest must be clearly identified and presented on the face of the Consolidated Statements of Income. Changes in a parent’s ownership interest while the parent retains its controlling financial interest in its subsidiary must be accounted for consistently as equity transactions. A parent’s ownership interest in a subsidiary changes if the parent purchases additional ownership interests in its subsidiary, sells some of its ownership interests in its subsidiary, the subsidiary reacquires some of its ownership interests or the subsidiary issues additional ownership interests. When a subsidiary is deconsolidated, any retained noncontrolling equity investment in the former subsidiary must be initially measured at fair value. The gain or loss on the deconsolidation of the subsidiary is measured using the fair value of any noncontrolling equity investment rather than the carrying amount of that retained investment. Entities must provide sufficient disclosures that clearly identify and distinguish between the interests of the parent and the interests of the noncontrolling owners. SFAS 160 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. We will adopt SFAS 160 effective January 1, 2009, and do not expect the adoption will have a material impact on our consolidated financial condition and results of operations.
FSP FAS No. 140-3 – Accounting for Transfers of Financial Assets and Repurchase Financing Transactions
In February 2008, the FASB issued FSP FAS No. 140-3, “Accounting for Transfers of Financial Assets and Repurchase Financing Transactions” (“FSP 140-3”), regarding the criteria for a repurchase financing to be considered a linked transaction under SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities.” A repurchase financing is a transaction where the buyer (“transferee”) of a financial asset obtains financing from the seller (“transferor”) and transfers the financial asset back to the seller as collateral until the financing is repaid. Under FSP 140-3, the transferor and the transferee shall not separately account for the transfer of a financial asset and a related repurchase financing unless the two transactions have a valid and distinct business or economic purpose for being entered into separately and the repurchase financing does not result in the initial transferor regaining control over the financial asset. In addition, an initial transfer of a financial asset and a repurchase financing entered into contemporaneously with, or in contemplation of, one another, must meet the criteria identified in FSP 140-3 in order to receive separate accounting treatment. FSP 140-3 is effective for financial statements issued for fiscal years beginning after November 15, 2008, and interim periods within those fiscal years. FSP 140-3 will be applied prospectively to initial transfers and repurchase financings executed on or after the beginning of the fiscal year in which FSP 140-3 is initially applied. Early application is not permitted. We will adopt FSP 140-3 effective January 1, 2009, and do not expect the adoption will have a material impact on our consolidated financial condition and results of operations.
SFAS No. 161 – Disclosures about Derivative Instruments and Hedging Activities – an Amendment of FASB Statement No. 133
In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities – an amendment of FASB Statement No. 133” (“SFAS 161”), which amends and expands current qualitative and quantitative disclosure requirements for derivative instruments and hedging activities. Enhanced disclosures will include: how and why we use derivative instruments; how derivative instruments and related hedged items are accounted for under SFAS 133; and how derivative instruments and related hedged items affect our financial position, financial performance and cash flows. Quantitative disclosures will be enhanced by requiring a tabular format by primary underlying risk and accounting designation for the fair value amount and location of derivative instruments in the financial statements and the amount and location of gains and losses in the financial statements for derivative instruments and related hedged items. The tabular disclosures should improve transparency of derivative positions existing at the end of the reporting period and the effect of using derivatives during the reporting period. SFAS 161 also requires the disclosure of credit-risk-related contingent features in derivative instruments and cross-referencing within the notes to the consolidated financial statements to assist users in locating information about derivative instruments. The amended and expanded disclosure requirements apply to all derivative instruments within the scope of SFAS 133, non-derivative hedging instruments and all hedged items designated and qualifying as hedges under SFAS 133. SFAS 161 is effective prospectively for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. We will adopt SFAS 161 effective January 1, 2009, at which time we will include these required enhanced disclosures related to derivative instruments and hedging activities in our financial statements.
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FSP FAS No. 142-3 – Determination of the Useful Life of Intangible Assets
In April 2008, the FASB issued FSP FAS No. 142-3, “Determination of the Useful Life of Intangible Assets” (“FSP 142-3”), which applies to recognized intangible assets accounted for under the guidance in SFAS 142. When developing renewal or extension assumptions in determining the useful life of recognized intangible assets, FSP 142-3 requires an entity to consider its own historical experience in renewing or extending similar arrangements. Absent the historical experience, an entity should use the assumptions a market participant would make when renewing and extending the intangible asset consistent with the highest and best use of the asset by market participants. In addition, FSP 142-3 requires financial statement disclosure regarding the extent to which expected future cash flows associated with the asset are affected by an entity’s intent and/or ability to renew or extend an arrangement. FSP 142-3 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2008, with early adoption prohibited. FSP 142-3 should be applied prospectively to determine the useful life of a recognized intangible asset acquired after the effective date. In addition, FSP 142-3 requires prospective application of the disclosure
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requirements to all intangible assets recognized as of, and subsequent to, the effective date. We will adopt FSP 142-3 on January 1, 2009, and do not expect the adoption will have a material impact on our consolidated financial condition and results of operations.
SFAS No. 163 – Accounting for Financial Guarantee Insurance Contracts – an Interpretation of FASB Statement No. 60
In May 2008, the FASB issued SFAS No. 163, “Accounting for Financial Guarantee Insurance Contracts – an interpretation of FASB Statement No. 60” (“SFAS 163”), which applies to financial guarantee insurance and reinsurance contracts not accounted for as derivative instruments, and issued by entities within the scope of SFAS No. 60, “Accounting and Reporting by Insurance Enterprises.” SFAS 163 changes current accounting practice related to the recognition and measurement of premium revenue and claim liabilities such that premium revenue recognition is linked to the amount of insurance protection and the period in which it is provided, and a claim liability is recognized when it is expected that a claim loss will exceed the unearned premium revenue. In addition, SFAS 163 expands disclosure requirements to include information related to the premium revenue and claim liabilities, as well as information related to the risk-management activities used to evaluate credit deterioration in insured financial obligations. SFAS 163 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and all interim periods within those fiscal years; early application is not permitted. However, the disclosure requirements related to risk-management activities are effective in the first period (including interim periods) beginning after May 2008. We will adopt SFAS 163 effective January 1, 2009, except for the disclosure requirements which, if applicable, will be provided in the third quarter of 2008. Since we do not hold a significant amount of financial guarantee insurance and reinsurance contracts, no additional disclosures have been made and we expect the adoption of SFAS 163 will not be material to our consolidated financial condition or results of operations.
EITF No. 07-5 – Determining Whether an Instrument (or Embedded Feature) is Indexed to an Entity’s Own Stock
In June 2008, the FASB issued EITF No. 07-5, “Determining Whether an Instrument (or Embedded Feature) is Indexed to an Entity’s Own Stock” (“EITF 07-5”). EITF 07-5 provides guidance to determine whether an instrument (or an embedded feature) is indexed to an entity’s own stock when evaluating the instrument as a derivative under SFAS 133. An instrument that is both indexed to an entity’s own stock and classified in stockholders’ equity in the entity’s statement of financial position is not considered a derivative for the purposes of applying the guidance in SFAS 133. EITF 07-5 provides a two-step process to determine whether an equity-linked instrument (or embedded feature) is indexed to its own stock first by evaluating the instrument’s contingent exercise provisions, if any, and second, by evaluating the instrument’s settlement provisions. EITF 07-5 is applicable to outstanding instruments as of the beginning of the fiscal year in which the issue is adopted and is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. We will adopt EITF 07-5 on January 1, 2009, and do not expect the adoption will be material to our consolidated financial condition and results of operations.
FSP FAS No. 133-1 and FIN 45-4 – Disclosures about Credit Derivatives and Certain Guarantees: An Amendment of FASB Statement No. 133 and FASB Interpretation No. 45; and Clarification of the Effective Date of FASB Statement No. 161
In September 2008, the FASB issued FSP FAS No. 133-1 and FIN 45-4, “Disclosures about Credit Derivatives and Certain Guarantees: An Amendment of FASB Statement No. 133 and FASB Interpretation No. 45; and Clarification of the Effective Date of FASB Statement No. 161” (“FSP 133-1”). FSP 133-1 amends the disclosure requirements of SFAS 133 to require the seller of credit derivatives, including hybrid financial instruments with embedded credit derivatives, to disclose additional information regarding, among other things, the nature of the credit derivative, information regarding the facts and circumstances that may require performance or payment under the credit derivative, and the nature of any recourse provisions the seller can use for recovery of payments made under the credit derivative. In addition, FSP 133-1 amends the disclosure requirements in FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”) to require additional disclosure about the payment/performance risk of a guarantee. Finally, FSP 133-1 clarifies the intent of the FASB regarding the effective date of SFAS 161. The provisions of FSP 133-1 related to SFAS 133 and FIN 45 are effective for annual and interim reporting periods ending after November 15, 2008, with comparative disclosures required only for those periods ending subsequent to initial adoption. The clarification of the effective date of SFAS 161 was effective upon the issuance of FSP 133-1, and will not impact the effective date of SFAS 161 in our financial statements.
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We will adopt FSP 133-1 on December 31, 2008, at which time we will include these required enhanced disclosures related to credit derivatives and guarantees in the notes to the consolidated financial statements.
3. Dispositions
Discontinued Media Operations
During the fourth quarter of 2007, we entered into a definitive agreementagreements to sell our television broadcasting, Charlotte radio and sports programming businesses. These businesses were acquired as part of the Jefferson-Pilot merger on April 3, 2006. The sports programming sale closed on November 30, 2007, the Charlotte radio broadcasting sale closed on January 31, 2008, and the television broadcasting sale closed on March 31, 2008. Accordingly, in the periods prior to the closings, the assets and liabilities of these businesses were reclassified as held-for-sale and were reported within other assets and other liabilities on our Consolidated Balance Sheets. The major classes of assets and liabilities held-for-sale (in millions) were as follows:
As of June 30, 2008 | As of December 31, 2007 | As of September 30, 2008 | As of December 31, 2007 | |||||||||
Goodwill | $ | — | $ | 340 | $ | — | $ | 340 | ||||
Specifically identifiable intangible assets | — | 266 | — | 266 | ||||||||
Other | — | 146 | — | 146 | ||||||||
Total assets held-for-sale | $ | — | $ | 752 | $ | — | $ | 752 | ||||
Liabilities held-for-sale | $ | — | $ | 354 | $ | — | $ | 354 | ||||
The results of operations of these businesses were reclassified into income (loss) from discontinued operations on our Consolidated Statements of Income, and the amounts (in millions) were as follows:
For the Three Months Ended June 30, | For the Six Months Ended June 30, | For the Three Months Ended September 30, | For the Nine Months Ended September 30, | ||||||||||||||||||||||||
2008 | 2007 | 2008 | 2007 | 2008 | 2007 | 2008 | 2007 | ||||||||||||||||||||
Discontinued Operations Before Disposal | |||||||||||||||||||||||||||
Media revenues, net of agency commissions | $ | — | $ | 29 | $ | 22 | $ | 71 | $ | — | $ | 33 | $ | 22 | $ | 104 | |||||||||||
Income from discontinued operations before disposal, before federal income taxes | $ | — | $ | 10 | $ | 8 | $ | 22 | $ | — | $ | 10 | $ | 8 | $ | 32 | |||||||||||
Federal income taxes | — | 4 | 3 | 8 | — | 3 | 3 | 11 | |||||||||||||||||||
Income from discontinued operations before disposal | — | 6 | 5 | 14 | — | 7 | 5 | 21 | |||||||||||||||||||
Disposal | |||||||||||||||||||||||||||
Loss on disposal, before federal income taxes | — | — | (12 | ) | — | — | — | (13 | ) | — | |||||||||||||||||
Federal income tax benefit | — | — | (3 | ) | — | ||||||||||||||||||||||
Federal income tax expense (benefit) | 1 | — | (3 | ) | — | ||||||||||||||||||||||
Loss on disposal | — | — | (9 | ) | — | (1 | ) | — | (10 | ) | — | ||||||||||||||||
Income (loss) from discontinued operations | $ | — | $ | 6 | $ | (4 | ) | $ | 14 | $ | (1 | ) | $ | 7 | $ | (5 | ) | $ | 21 | ||||||||
Fixed Income Investment Management Business
During the fourth quarter of 2007, we sold certain institutional taxable fixed income business to an unaffiliated investment management company. Investment Management transferred $12.3 billion of assets under management as part of this transaction. Based upon the assets transferred as of October 31, 2007, the purchase price is expected to be no more than $49 million. We expect this transaction to decrease income from operations, compared to the corresponding periods in 2007, by approximately $3 million, after-tax, per quarter in 2008.
During the fourth quarter of 2007, we received $25 million of the purchase price, with additional scheduled payments over the next three years. During 2007, we recorded an after-tax loss of $2 million on our Consolidated Statements of Income as a result of the goodwill we attributed to this business. Any adjustment to the purchase price, if necessary, will be determined at October 31, 2008. During the three and sixnine months ended JuneSeptember 30, 2008, we recorded an after-tax gain of $1 million and $3$4 million, respectively, on our Consolidated Statements of Income in realized loss related to this transaction.
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4. Investments
Available-for-Sale Securities
The amortized cost, gross unrealized gains and losses and fair value of available-for-sale securities (in millions) were as follows:
As of June 30, 2008 | ||||||||||||
Amortized Cost | Gross Unrealized | Fair Value | ||||||||||
Gains | Losses | |||||||||||
Corporate bonds | $ | 44,160 | $ | 675 | $ | 2,216 | $ | 42,619 | ||||
U.S. Government bonds | 191 | 13 | 1 | 203 | ||||||||
Foreign government bonds | 887 | 43 | 23 | 907 | ||||||||
Asset and mortgage-backed securities: | ||||||||||||
Mortgage pass-through securities | 1,712 | 17 | 24 | 1,705 | ||||||||
Collateralized mortgage obligations | 6,730 | 64 | 418 | 6,376 | ||||||||
Commercial mortgage-backed securities | 2,628 | 21 | 182 | 2,467 | ||||||||
State and municipal bonds | 142 | 1 | 2 | 141 | ||||||||
Redeemable preferred stocks | 103 | 2 | 5 | 100 | ||||||||
Total fixed maturity securities | 56,553 | 836 | 2,871 | 54,518 | ||||||||
Equity securities | 617 | 39 | 192 | 464 | ||||||||
Total available-for-sale securities | $ | 57,170 | $ | 875 | $ | 3,063 | $ | 54,982 | ||||
As of December 31, 2007 | ||||||||||||
Amortized Cost | Gross Unrealized | Fair Value | ||||||||||
Gains | Losses | |||||||||||
Corporate bonds | $ | 43,973 | $ | 1,120 | $ | 945 | $ | 44,148 | ||||
U.S. Government bonds | 205 | 17 | — | 222 | ||||||||
Foreign government bonds | 979 | 67 | 9 | 1,037 | ||||||||
Asset and mortgage-backed securities: | ||||||||||||
Mortgage pass-through securities | 1,226 | 24 | 4 | 1,246 | ||||||||
Collateralized mortgage obligations | 6,721 | 78 | 130 | 6,669 | ||||||||
Commercial mortgage-backed securities | 2,711 | 49 | 70 | 2,690 | ||||||||
State and municipal bonds | 151 | 2 | — | 153 | ||||||||
Redeemable preferred stocks | 103 | 9 | 1 | 111 | ||||||||
Total fixed maturity securities | 56,069 | 1,366 | 1,159 | 56,276 | ||||||||
Equity securities | 548 | 13 | 43 | 518 | ||||||||
Total available-for-sale securities | $ | 56,617 | $ | 1,379 | $ | 1,202 | $ | 56,794 | ||||
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As of September 30, 2008 | ||||||||||||
Amortized Cost | Gross Unrealized | Fair Value | ||||||||||
Gains | Losses | |||||||||||
Corporate bonds | $ | 43,461 | $ | 425 | $ | 3,866 | $ | 40,020 | ||||
U.S. Government bonds | 200 | 17 | — | 217 | ||||||||
Foreign government bonds | 784 | 30 | 28 | 786 | ||||||||
Mortgage-backed securities: | ||||||||||||
Mortgage pass-through securities | 2,021 | 25 | 27 | 2,019 | ||||||||
Collateralized mortgage obligations | 6,896 | 46 | 618 | 6,324 | ||||||||
Commercial mortgage-backed securities | 2,588 | 10 | 279 | 2,319 | ||||||||
State and municipal bonds | 130 | 2 | 2 | 130 | ||||||||
Redeemable preferred stocks | 131 | 1 | 16 | 116 | ||||||||
Total fixed maturity securities | 56,211 | 556 | 4,836 | 51,931 | ||||||||
Equity securities | 612 | 9 | 128 | 493 | ||||||||
Total available-for-sale securities | $ | 56,823 | $ | 565 | $ | 4,964 | $ | 52,424 | ||||
As of December 31, 2007 | ||||||||||||
Amortized Cost | Gross Unrealized | Fair Value | ||||||||||
Gains | Losses | |||||||||||
Corporate bonds | $ | 43,973 | $ | 1,120 | $ | 945 | $ | 44,148 | ||||
U.S. Government bonds | 205 | 17 | — | 222 | ||||||||
Foreign government bonds | 979 | 67 | 9 | 1,037 | ||||||||
Mortgage-backed securities: | ||||||||||||
Mortgage pass-through securities | 1,226 | 24 | 4 | 1,246 | ||||||||
Collateralized mortgage obligations | 6,721 | 78 | 130 | 6,669 | ||||||||
Commercial mortgage-backed securities | 2,711 | 49 | 70 | 2,690 | ||||||||
State and municipal bonds | 151 | 2 | — | 153 | ||||||||
Redeemable preferred stocks | 103 | 9 | 1 | 111 | ||||||||
Total fixed maturity securities | 56,069 | 1,366 | 1,159 | 56,276 | ||||||||
Equity securities | 548 | 13 | 43 | 518 | ||||||||
Total available-for-sale securities | $ | 56,617 | $ | 1,379 | $ | 1,202 | $ | 56,794 | ||||
The amortized cost and fair value of fixed maturity available-for-sale securities by contractual maturities (in millions) were as follows:
As of June 30, 2008 | As of September 30, 2008 | |||||||||||
Amortized Cost | Fair Value | Amortized Cost | Fair Value | |||||||||
Due in one year or less | $ | 1,893 | $ | 1,901 | $ | 1,992 | $ | 1,984 | ||||
Due after one year through five years | 12,993 | 13,049 | 12,940 | 12,632 | ||||||||
Due after five years through ten years | 15,715 | 14,916 | 15,018 | 13,593 | ||||||||
Due after ten years | 14,882 | 14,104 | 14,756 | 13,060 | ||||||||
Subtotal | 45,483 | 43,970 | 44,706 | 41,269 | ||||||||
Asset and mortgage-backed securities | 11,070 | 10,548 | ||||||||||
Mortgage-backed securities | 11,505 | 10,662 | ||||||||||
Total fixed maturity available-for-sale securities | $ | 56,553 | $ | 54,518 | $ | 56,211 | $ | 51,931 | ||||
Actual maturities may differ from contractual maturities because issuers may have the right to call or pre-pay obligations.
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The fair value and gross unrealized losses of available-for-sale securities (in millions), aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, were as follows:
As of June 30, 2008 | As of September 30, 2008 | |||||||||||||||||||||||||||||||||||
Less Than Or Equal to Twelve Months | Greater Than Twelve Months | Total | Less Than Or Equal to Twelve Months | Greater Than Twelve Months | Total | |||||||||||||||||||||||||||||||
Fair Value | Gross Unrealized Losses | Fair Value | Gross Unrealized Losses | Fair Value | Gross Unrealized Losses | Fair Value | Gross Unrealized Losses | Fair Value | Gross Unrealized Losses | Fair Value | Gross Unrealized Losses | |||||||||||||||||||||||||
Corporate bonds | $ | 17,482 | $ | 945 | $ | 6,742 | $ | 1,271 | $ | 24,224 | $ | 2,216 | $ | 22,046 | $ | 1,943 | $ | 6,384 | $ | 1,923 | $ | 28,430 | $ | 3,866 | ||||||||||||
U.S. Government bonds | 37 | 1 | — | — | 37 | 1 | 12 | — | — | — | 12 | — | ||||||||||||||||||||||||
Foreign government bonds | 274 | 8 | 98 | 15 | 372 | 23 | 236 | 11 | 95 | 17 | 331 | 28 | ||||||||||||||||||||||||
Asset and mortgage-backed securities: | ||||||||||||||||||||||||||||||||||||
Mortgage-backed securities: | ||||||||||||||||||||||||||||||||||||
Mortgage pass-through securities | 664 | 16 | 67 | 8 | 731 | 24 | 521 | 16 | 62 | 11 | 583 | 27 | ||||||||||||||||||||||||
Collateralized mortgage obligations | 2,024 | 159 | 896 | 259 | 2,920 | 418 | 2,425 | 231 | 930 | 387 | 3,355 | 618 | ||||||||||||||||||||||||
Commercial mortgage-backed securities | 1,082 | 51 | 647 | 131 | 1,729 | 182 | 1,222 | 81 | 652 | 198 | 1,874 | 279 | ||||||||||||||||||||||||
State and municipal bonds | 55 | 2 | 5 | — | 60 | 2 | 43 | 2 | 4 | — | 47 | 2 | ||||||||||||||||||||||||
Redeemable preferred stocks | 60 | 5 | 1 | — | 61 | 5 | 78 | 16 | — | — | 78 | 16 | ||||||||||||||||||||||||
Total fixed maturity securities | 21,678 | 1,187 | 8,456 | 1,684 | 30,134 | 2,871 | 26,583 | 2,300 | 8,127 | 2,536 | 34,710 | 4,836 | ||||||||||||||||||||||||
Equity securities | 350 | 190 | 15 | 2 | 365 | 192 | 420 | 126 | 12 | 2 | 432 | 128 | ||||||||||||||||||||||||
Total available-for-sale securities | $ | 22,028 | $ | 1,377 | $ | 8,471 | $ | 1,686 | $ | 30,499 | $ | 3,063 | $ | 27,003 | $ | 2,426 | $ | 8,139 | $ | 2,538 | $ | 35,142 | $ | 4,964 | ||||||||||||
Total number of securities in an unrealized loss position | 3,320 | Total number of securities in an unrealized loss position | 3,911 | |||||||||||||||||||||||||||||||||
As of December 31, 2007 | ||||||||||||||||||||||||||||||||||||
Less Than Or Equal to Twelve Months | Greater Than Twelve Months | Total | ||||||||||||||||||||||||||||||||||
Fair Value | Gross Unrealized Losses | Fair Value | Gross Unrealized Losses | Fair Value | Gross Unrealized Losses | |||||||||||||||||||||||||||||||
Corporate bonds | $ | 11,540 | $ | 679 | $ | 4,467 | $ | 266 | $ | 16,007 | $ | 945 | ||||||||||||||||||||||||
U.S. Government bonds | — | — | 3 | — | 3 | — | ||||||||||||||||||||||||||||||
Foreign government bonds | 95 | 4 | 51 | 4 | 146 | 8 | ||||||||||||||||||||||||||||||
Mortgage-backed securities: | ||||||||||||||||||||||||||||||||||||
Mortgage pass-through securities | 32 | 1 | 193 | 4 | 225 | 5 | ||||||||||||||||||||||||||||||
Collateralized mortgage obligations | 1,742 | 101 | 1,116 | 29 | 2,858 | 130 | ||||||||||||||||||||||||||||||
Commercial mortgage-backed securities | 520 | 47 | 562 | 23 | 1,082 | 70 | ||||||||||||||||||||||||||||||
State and municipal bonds | 29 | — | 17 | — | 46 | — | ||||||||||||||||||||||||||||||
Redeemable preferred stocks | 13 | 1 | — | — | 13 | 1 | ||||||||||||||||||||||||||||||
Total fixed maturity securities | 13,971 | 833 | 6,409 | 326 | 20,380 | 1,159 | ||||||||||||||||||||||||||||||
Equity securities | 402 | 42 | 8 | 1 | 410 | 43 | ||||||||||||||||||||||||||||||
Total available-for-sale securities | $ | 14,373 | $ | 875 | $ | 6,417 | $ | 327 | $ | 20,790 | $ | 1,202 | ||||||||||||||||||||||||
Total number of securities in an unrealized loss position | Total number of securities in an unrealized loss position | 2,441 | ||||||||||||||||||||||||||||||||||
We had perpetual preferred securities in unrealized loss positions as of September 30, 2008, and December 31, 2007, which are included in the corporate bonds and redeemable preferred stock line items above. As of September 30, 2008, and December 31, 2007, our amortized cost of perpetual preferred securities reported in corporate bonds was $1.3 billion and $1.4 billion, respectively, and the fair value was $1.1 billion and $1.3 billion, respectively.
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As of December 31, 2007 | ||||||||||||||||||
Less Than Or Equal to Twelve Months | Greater Than Twelve Months | Total | ||||||||||||||||
Fair Value | Gross Unrealized Losses | Fair Value | Gross Unrealized Losses | Fair Value | Gross Unrealized Losses | |||||||||||||
Corporate bonds | $ | 11,540 | $ | 679 | $ | 4,467 | $ | 266 | $ | 16,007 | $ | 945 | ||||||
U.S. Government bonds | — | — | 3 | — | 3 | — | ||||||||||||
Foreign government bonds | 95 | 4 | 51 | 4 | 146 | 8 | ||||||||||||
Asset and mortgage-backed securities: | ||||||||||||||||||
Mortgage pass-through securities | 32 | 1 | 193 | 4 | 225 | 5 | ||||||||||||
Collateralized mortgage obligations | 1,742 | 101 | 1,116 | 29 | 2,858 | 130 | ||||||||||||
Commercial mortgage-backed securities | 520 | 47 | 562 | 23 | 1,082 | 70 | ||||||||||||
State and municipal bonds | 29 | — | 17 | — | 46 | — | ||||||||||||
Redeemable preferred stocks | 13 | 1 | — | — | 13 | 1 | ||||||||||||
Total fixed maturity securities | 13,971 | 833 | 6,409 | 326 | 20,380 | 1,159 | ||||||||||||
Equity securities | 402 | 42 | 8 | 1 | 410 | 43 | ||||||||||||
Total available-for-sale securities | $ | 14,373 | $ | 875 | $ | 6,417 | $ | 327 | $ | 20,790 | $ | 1,202 | ||||||
Total number of securities in an unrealized loss position | 2,441 | |||||||||||||||||
The fair value, gross unrealized losses (in millions) and number of available-for-sale securities where the fair value had declined below amortized cost by greater than 20%, were as follows:
As of June 30, 2008 | ||||||||
Fair Value | Gross Unrealized Losses | Number of Securities | ||||||
Less than six months | $ | 198 | $ | 102 | 59 | |||
Six months or greater, but less than nine months | 354 | 255 | 27 | |||||
Nine months or greater, but less than twelve months | 225 | 128 | 38 | |||||
Twelve months or greater | 1,512 | 981 | 255 | |||||
Total available-for-sale securities | $ | 2,289 | $ | 1,466 | 379 | |||
As of December 31, 2007 | As of September 30, 2008 | |||||||||||||||
Fair Value | Gross Unrealized Losses | Number of Securities | Fair Value | Gross Unrealized Losses | Number of Securities | |||||||||||
Less than six months | $ | 136 | $ | 49 | 22 | $ | 640 | $ | 302 | 131 | ||||||
Six months or greater, but less than nine months | 427 | 138 | 32 | 711 | 299 | 108 | ||||||||||
Nine months or greater, but less than twelve months | 364 | 110 | 17 | 667 | 300 | 73 | ||||||||||
Twelve months or greater | 183 | 81 | 60 | 2,733 | 1,827 | 490 | ||||||||||
Total available-for-sale securities | $ | 1,110 | $ | 378 | 131 | $ | 4,751 | $ | 2,728 | 802 | ||||||
As of December 31, 2007 | ||||||||||||||||
Fair Value | Gross Unrealized Losses | Number of Securities | ||||||||||||||
Less than six months | $ | 136 | $ | 49 | 22 | |||||||||||
Six months or greater, but less than nine months | 427 | 138 | 32 | |||||||||||||
Nine months or greater, but less than twelve months | 364 | 110 | 17 | |||||||||||||
Twelve months or greater | 183 | 81 | 60 | |||||||||||||
Total available-for-sale securities | $ | 1,110 | $ | 378 | 131 | |||||||||||
As described more fully in Note 1 of our 2007 Form 10-K, we regularly review our investment holdings for other-than-temporary impairments. Based upon this review, the cause of the $1.9$3.8 billion increase in our gross available-for-sale securities unrealized losses for the sixnine months ended JuneSeptember 30, 2008, was attributable primarily to the combination of reduced liquidity in severalall market segments and deterioration in credit fundamentals and an increase in treasury rates.fundamentals. We believe that the securities in an unrealized loss position as of JuneSeptember 30, 2008, were not other-than-temporarily impaired due to our ability and intent to hold for a period of time sufficient for recovery.
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Trading Securities
Trading securities at fair value retained in connection with modified coinsurance and coinsurance with funds withheld reinsurance arrangements (in millions) consisted of the following:
As of June 30, 2008 | As of December 31, 2007 | As of September 30, 2008 | As of December 31, 2007 | |||||||||
Corporate bonds | $ | 1,850 | $ | 1,999 | $ | 1,690 | $ | 1,999 | ||||
U.S. Government bonds | 376 | 367 | 383 | 367 | ||||||||
Foreign government bonds | 39 | 46 | 39 | 46 | ||||||||
Asset and mortgage-backed securities: | ||||||||||||
Mortgage-backed securities: | ||||||||||||
Mortgage pass-through securities | 21 | 22 | 32 | 22 | ||||||||
Collateralized mortgage obligations | 137 | 160 | 129 | 160 | ||||||||
Commercial mortgage-backed securities | 99 | 107 | 92 | 107 | ||||||||
State and municipal bonds | 17 | 19 | 17 | 19 | ||||||||
Redeemable preferred stocks | 9 | 8 | 9 | 8 | ||||||||
Total fixed maturity securities | 2,548 | 2,728 | 2,391 | 2,728 | ||||||||
Equity securities | 2 | 2 | 2 | 2 | ||||||||
Total trading securities | $ | 2,550 | $ | 2,730 | $ | 2,393 | $ | 2,730 | ||||
The portion of trading losses that relate to trading securities still held as of JuneSeptember 30, 2008, was $91$187 million for the secondthird quarter of 2008.
Mortgage Loans on Real Estate
Mortgage loans on real estate principally involve commercial real estate. The commercial loans are geographically diversified throughout the United States with the largest concentrations in California and Texas, which accounted for approximately 29% of mortgage loans as of JuneSeptember 30, 2008.
Net Investment Income
The major categories of net investment income (in millions) were as follows:
For the Three Months Ended June 30, | For the Six Months Ended June 30, | For the Three Months Ended September 30, | For the Nine Months Ended September 30, | |||||||||||||||||||||||||||||
2008 | 2007 | 2008 | 2007 | 2008 | 2007 | 2008 | 2007 | |||||||||||||||||||||||||
Fixed maturity available-for-sale securities | $ | 855 | $ | 845 | $ | 1,713 | $ | 1,689 | $ | 856 | $ | 856 | $ | 2,569 | $ | 2,543 | ||||||||||||||||
Equity available-for-sale securities | 8 | 12 | 17 | 20 | 7 | 10 | 24 | 31 | ||||||||||||||||||||||||
Trading securities | 42 | 44 | 85 | 90 | 41 | 44 | 126 | 134 | ||||||||||||||||||||||||
Mortgage loans on real estate | 129 | 132 | 250 | 262 | 121 | 123 | 371 | 385 | ||||||||||||||||||||||||
Real estate | 6 | 13 | 14 | 28 | 6 | 16 | 20 | 43 | ||||||||||||||||||||||||
Policy loans | 43 | 44 | 88 | 87 | 46 | 43 | 134 | 130 | ||||||||||||||||||||||||
Invested cash | 15 | 17 | 34 | 36 | 12 | 14 | 46 | 52 | ||||||||||||||||||||||||
Alternative investments | 13 | 70 | 8 | 90 | 27 | — | 36 | 90 | ||||||||||||||||||||||||
Other investments | (3 | ) | 3 | (2 | ) | 12 | 2 | 5 | (1 | ) | 17 | |||||||||||||||||||||
Investment income | 1,108 | 1,180 | 2,207 | 2,314 | 1,118 | 1,111 | 3,325 | 3,425 | ||||||||||||||||||||||||
Investment expense | (31 | ) | (47 | ) | (65 | ) | (91 | ) | (29 | ) | (49 | ) | (94 | ) | (140 | ) | ||||||||||||||||
Net investment income | $ | 1,077 | $ | 1,133 | $ | 2,142 | $ | 2,223 | $ | 1,089 | $ | 1,062 | $ | 3,231 | $ | 3,285 | ||||||||||||||||
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Realized Gain (Loss)Loss Related to Investments
The detail of the realized gain (loss)loss related to investments (in millions) was as follows:
For the Three Months Ended June 30, | For the Six Months Ended June 30, | For the Three Months Ended September 30, | For the Nine Months Ended September 30, | |||||||||||||||||||||||||||||
2008 | 2007 | 2008 | 2007 | 2008 | 2007 | 2008 | 2007 | |||||||||||||||||||||||||
Fixed maturity available-for-sale securities: | ||||||||||||||||||||||||||||||||
Gross gains | $ | 22 | $ | 26 | $ | 31 | $ | 82 | $ | 27 | $ | 26 | $ | 58 | $ | 108 | ||||||||||||||||
Gross losses | (138 | ) | (46 | ) | (238 | ) | (53 | ) | (380 | ) | (44 | ) | (618 | ) | (97 | ) | ||||||||||||||||
Equity available-for-sale securities: | ||||||||||||||||||||||||||||||||
Gross gains | — | 4 | 3 | 6 | 1 | 1 | 4 | 7 | ||||||||||||||||||||||||
Gross losses | (7 | ) | — | (7 | ) | — | (26 | ) | — | (33 | ) | — | ||||||||||||||||||||
Gain on other investments | 3 | 5 | 28 | 1 | ||||||||||||||||||||||||||||
Gain (loss) on other investments | (1 | ) | 6 | 27 | 7 | |||||||||||||||||||||||||||
Associated amortization expense of DAC, VOBA, DSI and DFEL and changes in other contract holder funds and funds withheld reinsurance liabilities | 95 | (14 | ) | 144 | (36 | ) | ||||||||||||||||||||||||||
Total realized loss on investments, excluding trading securities | (284 | ) | (25 | ) | (418 | ) | (11 | ) | ||||||||||||||||||||||||
Loss on certain derivative instruments | (30 | ) | (11 | ) | (62 | ) | (7 | ) | ||||||||||||||||||||||||
Associated amortization expense of DAC, VOBA, DSI and DFEL and changes in other contract holder funds | 24 | (2 | ) | 49 | (22 | ) | — | 1 | — | — | ||||||||||||||||||||||
Total realized gain (loss) on investments, excluding trading securities | (96 | ) | (13 | ) | (134 | ) | 14 | |||||||||||||||||||||||||
Gain (loss) on certain derivative instruments | (29 | ) | 4 | (32 | ) | 4 | ||||||||||||||||||||||||||
Total realized gain (loss) on investments and certain derivative instruments, excluding trading securities | $ | (125 | ) | $ | (9 | ) | $ | (166 | ) | $ | 18 | |||||||||||||||||||||
Total realized loss on investments and certain derivative instruments, excluding trading securities | $ | (314 | ) | $ | (35 | ) | $ | (480 | ) | $ | (18 | ) | ||||||||||||||||||||
Write-downs for other-than-temporary impairments included in realized loss on available-for-sale securities above | $ | (120 | ) | $ | (30 | ) | $ | (211 | ) | $ | (34 | ) | $ | (312 | ) | $ | (34 | ) | $ | (523 | ) | $ | (68 | ) | ||||||||
See Note 1112 for a comprehensive listing of realized gain (loss).loss.
Securities Lending
The carrying values of securities pledged under securities lending agreements were $602$463 million and $655 million as of JuneSeptember 30, 2008, and December 31, 2007, respectively. The fair values of these securities were $578$435 million and $634 million as of JuneSeptember 30, 2008, and December 31, 2007, respectively.
Reverse Repurchase Agreements
The carrying values of securities pledged under reverse repurchase agreements were $280 million and $480 million as of JuneSeptember 30, 2008, and December 31, 2007.2007, respectively. The fair values of these securities were $508$293 million and $502 million as of JuneSeptember 30, 2008, and December 31, 2007, respectively.
Investment Commitments
As of JuneSeptember 30, 2008, our investment commitments for fixed maturity securities (primarily private placements), limited partnerships, real estate and mortgage loans on real estate were $1.2$1.1 billion, which includes $337$314 million of standby commitments to purchase real estate upon completion and leasing.
Concentrations of Financial Instruments
As of JuneSeptember 30, 2008, and December 31, 2007, we did not have a significant concentration of financial instruments in a single investee, industry or geographic region of the U.S.
16
Credit-Linked Notes
As of JuneSeptember 30, 2008, and December 31, 2007, other contract holder funds on our Consolidated Balance Sheets included $850$600 million and $1.2 billion outstanding in funding agreements of the Lincoln National Life Insurance Company (“LNL”), respectively. LNL invested the proceeds of $850 million received for issuing three funding agreements in 2006 and 2007 into three separate credit-linked notes originated by third party companies. TheseOne of the credit linked notes totaling $250 million was paid off at par in September and as a result, the related structure, including the $250 million funding agreement, was terminated. The two remaining credit-linked notes are asset-backed securities, classified as asset-backed securitiescorporate bonds in the tables above and are
16
included in our reported as fixed maturity securities on our Consolidated Balance Sheets. An additional $300 million funding agreement was assumed as a result of the merger of Jefferson-Pilot, but was not invested into credit-linked notes. This $300 million funding agreement matured on June 2, 2008.
We earn a spread between the coupon received on the credit-linked notes and the interest credited on the funding agreement. Our credit-linked notes were created using a trust that combines highly rated assets with credit default swaps to produce a multi-class structured security. Our affiliate, Delaware Investments, actively manages the credit default swaps in the underlying portfolios. The high quality asset in two of these transactions is a AAA-rated asset-backed security secured by a pool of credit card receivables. The high quality asset in the third transaction is a guaranteed investment contract issued by MBIA, which is further secured by a pool of high quality assets.
Consistent with other debt market instruments, we are exposed to credit losses within the structure of the credit-linked notes, which could result in principal losses to our investments. However, we have attempted to protect our investments from credit losses through the multi-tiered class structure of the credit-linked note, which requires the subordinated classes of the investment pool to absorb all of the initial credit losses. LNL owns the mezzanine tranche of these investments, which currently carries a mid- or low-AA rating.investments. To date, there havehas been no defaultsone default in any of the underlying collateral pools.pool of the $400 million credit-linked note and two defaults in the underlying collateral pool of the $200 million credit-linked note. There has been no event of default on the credit-linked notes themselves, and we feel the remaining subordination is sufficient to absorb future initial credit losses. Similar to other debt market instruments, our maximum principal loss is limited to our original investment of $850$600 million as of JuneSeptember 30, 2008.
As in the general markets, spreads on these transactions have widened, causing unrealized losses. We had unrealized losses of $390$421 million on the $600 million in credit-linked notes as of September 30, 2008 and $190 million on the $850 million in credit-linked notes as of June 30, 2008, and December 31, 2007, respectively.2007. As described more fully in Note 1 of our 2007 Form 10-K, we regularly review our investment holdings for other-than-temporary impairments. Based upon this review, we believe that these securities were not other-than-temporarily impaired as of JuneSeptember 30, 2008, and December 31, 2007.
The following summarizes information regarding our investments in these securities (dollars in millions):
Amount and Date of Issuance | |||||||||
$400 December 2006 | $200 April 2007 | $250 April 2007 | |||||||
Amount of subordination(1) | $ | 2,184 | $ | 410 | $ | 1,167 | |||
Maturity | 12/20/16 | 3/20/17 | 6/20/17 | ||||||
Current rating of tranche (1) | AA- | Aa2 | A- | ||||||
Number of entities(1) | 125 | 100 | 102 | ||||||
Number of countries(1) | 20 | 21 | 14 |
Amount and Date of Issuance | ||||||
$400 December 2006 | $200 April 2007 | |||||
Amount of subordination (1) | $ | 1,944 | $ | 296 | ||
Maturity | 12/20/16 | 3/20/17 | ||||
Current rating of tranche (1) | A+ | Baa2 | ||||
Number of entities (1) | 124 | 98 | ||||
Number of countries (1) | 20 | 21 |
(1) | As of |
17
5. DAC, VOBA, DSI and DFEL
On a quarterly basis, we may record an adjustment to the amounts included within our Consolidated Balance Sheets for DAC, VOBA, DSI and DFEL with an offsetting benefit or charge to revenue or expense for the impact of the difference between the estimates of future gross profits used in the prior quarter and the emergence of actual and updated estimates of future gross profits in the current quarter (“retrospective unlocking”). In addition, in the third quarter of each year, we conduct our annual comprehensive review of the assumptions and the projection models used for our estimates of future gross profits underlying the amortization of DAC, VOBA, DSI and DFEL and the calculations of the embedded derivatives and reserves for annuity and life insurance products with living benefit and death benefit guarantees. These assumptions include investment margins, mortality, retention and rider utilization. Based on our review, the cumulative balances of DAC, VOBA, DSI and DFEL, included on our Consolidated Balance Sheets, are adjusted with an offsetting benefit or charge to revenue or amortization expense to reflect such change (“prospective unlocking – assumption changes”). We may also identify and implement actuarial modeling refinements (“prospective unlocking – model refinements”) that result in increases or decreases to the carrying values of DAC, VOBA, DSI, DFEL, embedded derivatives and reserves for annuity and life insurance products with living benefit and death benefit guarantees. The primary distinction between retrospective and prospective unlocking is that retrospective unlocking is driven by the emerging experience period-over-period, while prospective unlocking is driven by changes in assumptions or projection models related to estimated future gross profits.
Changes in DAC (in millions) were as follows:
For the Six Months Ended June 30, | For the Nine Months Ended September 30, | |||||||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||||||
Balance at beginning-of-year | $ | 6,510 | $ | 5,116 | $ | 6,510 | $ | 5,116 | ||||||||
Cumulative effect of adoption of Statement of Position (“SOP”) 05-1 (“SOP 05-1”) | — | (31 | ) | — | (31 | ) | ||||||||||
Deferrals | 896 | 968 | 1,354 | 1,469 | ||||||||||||
Amortization, net of interest: | ||||||||||||||||
Unlocking | (10 | ) | 31 | |||||||||||||
Other amortization | (403 | ) | (385 | ) | ||||||||||||
DAC and VOBA amortization, net of interest: | ||||||||||||||||
Prospective unlocking – assumption changes | 24 | 35 | ||||||||||||||
Prospective unlocking – model refinements | 44 | (56 | ) | |||||||||||||
Retrospective unlocking | (69 | ) | 46 | |||||||||||||
Other amortization, net of interest | (585 | ) | (600 | ) | ||||||||||||
Adjustment related to realized gains on available-for-sale securities and derivatives | (10 | ) | (27 | ) | (16 | ) | (10 | ) | ||||||||
Adjustment related to unrealized losses on available-for-sale securities and derivatives | 332 | 188 | 715 | 184 | ||||||||||||
Foreign currency translation adjustment | 1 | 13 | (51 | ) | 23 | |||||||||||
Balance at end-of-period | $ | 7,316 | $ | 5,873 | $ | 7,926 | $ | 6,176 | ||||||||
18
Changes in VOBA (in millions) were as follows:
For the Six Months Ended June 30, | ||||||||
2008 | 2007 | |||||||
Balance at beginning-of-year | $ | 3,070 | $ | 3,304 | ||||
Cumulative effect of adoption of SOP 05-1 | — | (35 | ) | |||||
Business acquired | — | 14 | ||||||
Deferrals | 26 | 24 | ||||||
Amortization: | ||||||||
Unlocking | (20 | ) | 9 | |||||
Other amortization | (199 | ) | (233 | ) | ||||
Accretion of interest | 67 | 70 | ||||||
Adjustment related to realized (gains) losses on available-for-sale securities and derivatives | 13 | (11 | ) | |||||
Adjustment related to unrealized losses on available-for-sale securities and derivatives | 334 | 78 | ||||||
Foreign currency translation adjustment | 1 | 8 | ||||||
Balance at end-of-period | $ | 3,292 | $ | 3,228 | ||||
18
For the Nine Months Ended September 30, | ||||||||
2008 | 2007 | |||||||
Balance at beginning-of-year | $ | 3,070 | $ | 3,304 | ||||
Cumulative effect of adoption of SOP 05-1 | — | (35 | ) | |||||
Business acquired | — | 14 | ||||||
Deferrals | 32 | 35 | ||||||
DAC and VOBA amortization, net of interest: | ||||||||
Prospective unlocking – assumption changes | 26 | 14 | ||||||
Prospective unlocking – model refinements | (15 | ) | (7 | ) | ||||
Retrospective unlocking | (21 | ) | 16 | |||||
Other amortization, net of interest | (288 | ) | (348 | ) | ||||
Accretion of interest | 100 | 108 | ||||||
Adjustment related to realized (gains) losses on available-for-sale securities and derivatives | 53 | (6 | ) | |||||
Adjustment related to unrealized losses on available-for-sale securities and derivatives | 796 | 53 | ||||||
Foreign currency translation adjustment | (27 | ) | 13 | |||||
Balance at end-of-period | $ | 3,726 | $ | 3,161 | ||||
Changes in DSI (in millions) were as follows:
For the Six Months Ended June 30, | For the Nine Months Ended September 30, | |||||||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||||||
Balance at beginning-of-year | $ | 279 | $ | 194 | $ | 279 | $ | 194 | ||||||||
Cumulative effect of adoption of SOP 05-1 | — | (3 | ) | — | (3 | ) | ||||||||||
Deferrals | 52 | 51 | 77 | 81 | ||||||||||||
Amortization, net of interest: | ||||||||||||||||
Unlocking | 1 | 2 | ||||||||||||||
Other amortization | (15 | ) | (16 | ) | ||||||||||||
DAC and VOBA amortization, net of interest: | ||||||||||||||||
Prospective unlocking – assumption changes | — | 2 | ||||||||||||||
Prospective unlocking – model refinements | — | (1 | ) | |||||||||||||
Retrospective unlocking | (2 | ) | 2 | |||||||||||||
Other amortization, net of interest | (21 | ) | (25 | ) | ||||||||||||
Adjustment related to realized gains on available-for-sale securities and derivatives | (3 | ) | (3 | ) | (5 | ) | (1 | ) | ||||||||
Balance at end-of-period | $ | 314 | $ | 225 | $ | 328 | $ | 249 | ||||||||
19
Changes in DFEL (in millions) were as follows:
For the Six Months Ended June 30, | ||||||||
2008 | 2007 | |||||||
Balance at beginning-of-year | $ | 1,183 | $ | 977 | ||||
Cumulative effect of adoption of SOP 05-1 | — | (2 | ) | |||||
Deferrals | 206 | 203 | ||||||
Amortization, net of interest: | ||||||||
Unlocking | (14 | ) | 9 | |||||
Other amortization | (95 | ) | (90 | ) | ||||
Adjustment related to realized (gains) losses on available-for-sale securities and derivatives | 1 | (1 | ) | |||||
Foreign currency translation adjustment | 1 | 10 | ||||||
Balance at end-of-period | $ | 1,282 | $ | 1,106 | ||||
19
For the Nine Months Ended September 30, | ||||||||
2008 | 2007 | |||||||
Balance at beginning-of-year | $ | 1,183 | $ | 977 | ||||
Cumulative effect of adoption of SOP 05-1 | — | (2 | ) | |||||
Deferrals | 316 | 300 | ||||||
DAC and VOBA amortization, net of interest: | ||||||||
Prospective unlocking – assumption changes | 5 | 4 | ||||||
Prospective unlocking – model refinements | 25 | (34 | ) | |||||
Retrospective unlocking | (29 | ) | 10 | |||||
Other amortization, net of interest | (135 | ) | (144 | ) | ||||
Adjustment related to realized (gains) losses on available-for-sale securities and derivatives | (2 | ) | — | |||||
Foreign currency translation adjustment | (38 | ) | 17 | |||||
Balance at end-of-period | $ | 1,325 | $ | 1,128 | ||||
6. Goodwill and Specifically Identifiable Intangibles
The changes in the carrying amount of goodwill (in millions) by reportable segment were as follows:
For the Six Months Ended June 30, 2008 | For the Nine Months Ended September 30, 2008 | ||||||||||||||||||||||||||||||||||
Balance At Beginning- of-Year | Purchase Accounting Adjustments | Impairment | Foreign Currency Translation Adjustment | Balance At End- of-Period | Balance At Beginning- of-Year | Purchase Accounting Adjustments | Impairment | Foreign Currency Translation Adjustment | Balance At End- of-Period | ||||||||||||||||||||||||||
Individual Markets: | |||||||||||||||||||||||||||||||||||
Retirement Solutions: | |||||||||||||||||||||||||||||||||||
Annuities | $ | 1,046 | $ | (6 | ) | $ | — | $ | — | $ | 1,040 | ||||||||||||||||||||||||
Defined Contribution | 20 | — | — | — | 20 | ||||||||||||||||||||||||||||||
Insurance Solutions: | |||||||||||||||||||||||||||||||||||
Life Insurance | $ | 2,201 | $ | (9 | ) | $ | — | $ | — | $ | 2,192 | 2,201 | (11 | ) | — | — | 2,190 | ||||||||||||||||||
Annuities | 1,046 | (6 | ) | — | — | 1,040 | |||||||||||||||||||||||||||||
Employer Markets: | |||||||||||||||||||||||||||||||||||
Retirement Products | 20 | — | — | — | 20 | ||||||||||||||||||||||||||||||
Group Protection | 274 | — | — | — | 274 | 274 | — | — | — | 274 | |||||||||||||||||||||||||
Investment Management | 247 | 1 | — | — | 248 | 247 | 1 | — | — | 248 | |||||||||||||||||||||||||
Lincoln UK | 17 | — | — | — | 17 | 17 | — | — | (2 | ) | 15 | ||||||||||||||||||||||||
Other Operations | 339 | (2 | ) | (83 | ) | — | 254 | 339 | (2 | ) | (83 | ) | — | 254 | |||||||||||||||||||||
Total goodwill | $ | 4,144 | $ | (16 | ) | $ | (83 | ) | $ | — | $ | 4,045 | $ | 4,144 | $ | (18 | ) | $ | (83 | ) | $ | (2 | ) | $ | 4,041 | ||||||||||
The purchase accounting adjustments above relate to income tax deductions recognized when stock options attributable to mergers were exercised.exercised or the release of unrecognized tax benefits acquired through mergers.
As a result of declines in current and forecasted advertising revenue for the entire radio market, we updated our intangible impairment review in the second quarter of 2008, which was outside of our annual process normally completed as of October 1 each year. This impairment test showed the implied fair value of our remaining radio properties were lower than their carrying amounts, therefore we recorded non-cash impairments of goodwill (set forth above) and specifically identifiable intangible (set forth below), based upon the guidance of SFAS 142. The impairment of goodwill did not have any offsetting tax benefit; therefore, our effective tax rate for the three and sixnine months ended JuneSeptember 30, 2008, was elevated over the corresponding periodsperiod in 2007.
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The gross carrying amounts and accumulated amortization (in millions) for each major specifically identifiable intangible asset class by reportable segment were as follows:
As of June 30, 2008 | As of December 31, 2007 | As of September 30, 2008 | As of December 31, 2007 | |||||||||||||||||||||
Gross Carrying Amount | Accumulated Amortiza- tion | Gross Carrying Amount | Accumulated Amortiza- tion | Gross Carrying Amount | Accumulated Amortization | Gross Carrying Amount | Accumulated Amortization | |||||||||||||||||
Individual Markets – Life Insurance: | ||||||||||||||||||||||||
Insurance Solutions – Life Insurance: | ||||||||||||||||||||||||
Sales force | $ | 100 | $ | 9 | $ | 100 | $ | 7 | $ | 100 | $ | 10 | $ | 100 | $ | 7 | ||||||||
Employer Markets – Retirement Products: | ||||||||||||||||||||||||
Retirement Solutions – Defined Contribution: | ||||||||||||||||||||||||
Mutual fund contract rights(1) | 3 | — | 3 | — | 3 | — | 3 | — | ||||||||||||||||
Investment Management: | ||||||||||||||||||||||||
Client lists | 92 | 91 | 92 | 90 | 92 | 92 | 92 | 90 | ||||||||||||||||
Other(1) | 4 | — | 3 | — | 5 | — | 3 | — | ||||||||||||||||
Other Operations: | ||||||||||||||||||||||||
FCC licenses(1) (2) | 294 | — | 384 | — | 292 | — | 384 | — | ||||||||||||||||
Other | 4 | 3 | 4 | 3 | 4 | 3 | 4 | 3 | ||||||||||||||||
Total | $ | 497 | $ | 103 | $ | 586 | $ | 100 | $ | 496 | $ | 105 | $ | 586 | $ | 100 | ||||||||
(1) | No amortization recorded as the intangible asset has indefinite life. |
(2) | We recorded FCC licenses impairment of $90 million during the second quarter of 2008, as discussed above. |
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See Note 3 for goodwill and specifically identifiable intangibles included within discontinued operations.
7. Guaranteed Benefit Features
We issue variable annuity contracts through our separate accounts for which investment income and investment gains and losses accrue directly to, and investment risk is borne by, the contract holder (traditional variable annuities). We also issue variable annuity and life contracts through separate accounts that include various types of guaranteed death benefit (“GDB”), guaranteed withdrawal benefit (“GWB”) and guaranteed income benefit (“GIB”) features. The GDB features include those where we contractually guarantee to the contract holder either: return of no less than total deposits made to the contract less any partial withdrawals (“return of net deposits”); total deposits made to the contract less any partial withdrawals plus a minimum return (“minimum return”); or the highest contract value on any contract anniversary date through age 80 minus any payments or withdrawals following the contract anniversary (“anniversary contract value”).
These guarantees are considered embedded derivatives and are recorded in future contract benefits on our Consolidated Balance Sheets at fair value under SFAS 133 and SFAS 157. Effective January 1, 2008, we adopted SFAS 157, which affected the valuation of our embedded derivatives. See Note 2 of this report for details on the adoption of SFAS 157. We use derivative instruments to hedge our exposure to the risks and earnings volatility that result from the embedded derivatives for living benefits in certain of our variable annuity products. The change in fair value of these instruments tends to move in the opposite direction of the change in fair value of the embedded derivatives. The net impact of these changes is reported as guaranteed living benefit (“GLB”), which is a component of realized loss discussed in Note 12.
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Information on the GDB features outstanding (dollars in millions) was as follows (our variable contracts with guarantees may offer more than one type of guarantee in each contract; therefore, the amounts listed are not mutually exclusive):
As of September 30, 2008 | As of December 31, 2007 | |||||||
Return of Net Deposits | ||||||||
Variable annuity account value | $ | 39,646 | $ | 44,833 | ||||
Net amount at risk(1) | 2,503 | 93 | ||||||
Average attained age of contract holders | 56 years | 55 years | ||||||
Minimum Return | ||||||||
Variable annuity account value | $ | 256 | $ | 355 | ||||
Net amount at risk(1) | 72 | 25 | ||||||
Average attained age of contract holders | 68 years | 68 years | ||||||
Guaranteed minimum return | 5 | % | 5 | % | ||||
Anniversary Contract Value | ||||||||
Variable annuity account value | $ | 20,794 | $ | 25,537 | ||||
Net amount at risk(1) | 4,821 | 359 | ||||||
Average attained age of contract holders | 65 years | 64 years |
(1) | Represents the amount of death benefit in excess of the current account balance at the end-of-period. The increase in net amount of risk when comparing September 30, 2008, to December 31, 2007, was attributed primarily to the decline in equity markets and associated reduction in the account values. |
The determination of GDB liabilities is based on models that involve a range of scenarios and assumptions, including those regarding expected market rates of return and volatility, contract surrender rates and mortality experience. The following summarizes the balances of and changes in the liabilities for GDB (in millions), which were recorded in future contract benefits on our Consolidated Balance Sheets:
For the Nine Months Ended September 30, | ||||||||
2008 | 2007 | |||||||
Balance at beginning-of-year | $ | 38 | $ | 23 | ||||
Cumulative effect of adoption of SOP 05-1 | — | (4 | ) | |||||
Changes in reserves | 87 | 17 | ||||||
Benefits paid | (22 | ) | (4 | ) | ||||
Balance at end-of-period | $ | 103 | $ | 32 | ||||
The changes to the benefit reserves amounts above are reflected in benefits on our Consolidated Statements of Income.
Account balances of variable annuity contracts with guarantees (in millions) were invested in separate account investment options as follows:
As of September 30, 2008 | As of December 31, 2007 | |||||||
Asset Type | ||||||||
Domestic equity | $ | 32,578 | $ | 44,982 | ||||
International equity | 9,974 | 8,076 | ||||||
Bonds | 9,559 | 8,034 | ||||||
Money market | 4,849 | 6,545 | ||||||
Total | $ | 56,960 | $ | 67,637 | ||||
Percent of total variable annuity separate account values | 98 | % | 97 | % |
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8. Other Contract Holder Funds
Details of other contract holder funds (in millions) were as follows:
As of June 30, 2008 | As of December 31, 2007 | As of September 30, 2008 | As of December 31, 2007 | |||||||||
Account values and other contract holder funds | $ | 58,337 | $ | 57,698 | $ | 58,632 | $ | 57,698 | ||||
Deferred front-end loads | 1,282 | 1,183 | 1,325 | 1,183 | ||||||||
Contract holder dividends payable | 519 | 524 | 499 | 524 | ||||||||
Premium deposit funds | 133 | 140 | 129 | 140 | ||||||||
Undistributed earnings on participating business | 92 | 95 | 93 | 95 | ||||||||
Total other contract holder funds | $ | 60,363 | $ | 59,640 | $ | 60,678 | $ | 59,640 | ||||
8.9. Federal Income Taxes
The effective tax rate was 38%2% and 30%28% for the three months ended JuneSeptember 30, 2008 and 2007, respectively. The effective tax rate for the sixnine months ended JuneSeptember 30, 2008 and 2007 was 32%26% and 30%29%, respectively. Differences in the effective rates and the U.S. statutory rate of 35% in 2008 were the result of certain tax preferred investment income, separate account dividends-received deduction (“DRD”), foreign tax credits and other tax preference itemsitems. For information about the unfavorable impact to our effective tax rate for the nine months ended September 30, 2008, due from impairment of goodwill, see Note 6.
Federal income tax expense for the third quarter and the impactfirst nine months of the goodwill impairment2008 included a reduction of $34 million related to media operations, which did not havefavorable adjustments from the 2007 tax return, filed in the third quarter of 2008, primarily relating to the separate account DRD, foreign tax credits and other tax preference items. Federal income tax expense for the third quarter and first nine months of 2007 included a correspondingreduction of $13 million related to favorable adjustments from the 2006 tax effect. See Note 6 for additional information.return, filed in the third quarter of 2007, relating to the separate account DRD, foreign tax credits and other tax preference items.
Changes to the Internal Revenue Code, administrative rulings or court decisions could increase our effective tax rate. In this regard, on August 16, 2007, the Internal Revenue Service (“IRS”) issued a revenue ruling that purports, among other things, to modify the calculation of the separate account DRD received by life insurance companies. Subsequently, the IRS issued another revenue ruling that suspended the August 16, 2007, ruling and announced a new regulation project on the issue. The current separate account DRD lowered the effective tax rate by approximately 12%15% and 4%5% for the three months ended JuneSeptember 30, 2008 and 2007, respectively, and 7%9% and 4% for the sixnine months ended JuneSeptember 30, 2008 and 2007, respectively. The separate account deduction for dividends was relatively flat compared to prior quarters; however, its impact to the effective tax rate was the result of lower pre-tax income for the three months ended JuneSeptember 30, 2008.
We are required to establish a valuation allowance for any gross deferred tax assets that are unlikely to reduce taxes payable in future years’ tax returns. As of JuneSeptember 30, 2008, we believed that it was more likely than not that all gross deferred tax assets will reduce taxes payable in future years.
As of JuneSeptember 30, 2008, there have been no material changes to the balance of unrecognized tax benefits reported at December 31, 2007. We anticipate a change to our unrecognized tax benefits within the next 12 months in the range of none to $12 million.
We recognize interest and penalties, if any, accrued related to unrecognized tax benefits as a component of tax expense.
In the normal course of business, we are subject to examination by taxing authorities throughout the U.S. and the U.K. At any given time, we may be under examination by state, local or non-U.S. income tax authorities. During the third quarter of 2008, the IRS completed its examination for the tax years 2003 and 2004 resulting in a proposed assessment. We believe a portion of the assessment is inconsistent with existing law and are protesting it through the established IRS appeals process. We do not anticipate that any adjustments that might result from such appeals would be material to our consolidated results of operations or financial condition.
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9.10. Contingencies and Commitments
See “Contingencies and Commitments” in Note 13 to the consolidated financial statements in our 2007 Form 10-K for a discussion of commitments and contingencies, which information is incorporated herein by reference.
Regulatory and Litigation Matters
Federal and state regulators continue to focus on issues relating to fixed and variable insurance products, including, but not limited to, suitability, replacements and sales to seniors. Like others in the industry, we have received inquiries including requests for information regarding sales to seniors from the Financial Industry Regulatory Authority, and we have responded to these inquiries. We continue to cooperate fully with such authority.
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In the ordinary course of its business, 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, after consideration of any reserves and rights to indemnification, ultimately will be resolved without materially affecting the consolidated financial position of LNC. However, given the large and indeterminate amounts sought in certain of these proceedings and the inherent difficulty in predicting the outcome of such legal proceedings, including the proceeding described below, it is possible that an adverse outcome in certain matters could be material to our operating results for any particular reporting period.
Transamerica Investment Management, LLC and Transamerica Investments Services, Inc. v. Delaware Management Holdings, Inc. (dba Delaware Investments), Delaware Investment Advisers and certain individuals, was filed in the San Francisco County Superior Court on April 28, 2005. The plaintiffs are seeking substantial compensatory and punitive damages. The complaint alleges breach of fiduciary duty, breach of duty of loyalty, breach of contract, breach of the implied covenant of good faith and fair dealing, unfair competition, interference with prospective economic advantage, conversion, unjust enrichment and conspiracy, in connection with Delaware Investment Advisers’ hiring of a portfolio management team from the plaintiffs. We and the individual defendants dispute the allegations and are vigorously defending these actions.
10.11. Stockholders’ Equity and Shares
Stockholders’ Equity
The changes in our preferred and common stock (number of shares) were as follows:
For the Three Months Ended June 30, | For the Six Months Ended June 30, | For the Three Months Ended September 30, | For the Nine Months Ended September 30, | |||||||||||||||||||||
2008 | 2007 | 2008 | 2007 | 2008 | 2007 | 2008 | 2007 | |||||||||||||||||
Series A Preferred Stock | ||||||||||||||||||||||||
Balance at beginning-of-period | 11,662 | 12,526 | 11,960 | 12,706 | 11,662 | 12,361 | 11,960 | 12,706 | ||||||||||||||||
Conversion into common stock | — | (165 | ) | (298 | ) | (345 | ) | (100 | ) | (155 | ) | (398 | ) | (500 | ) | |||||||||
Balance at end-of-period | 11,662 | 12,361 | 11,662 | 12,361 | 11,562 | 12,206 | 11,562 | 12,206 | ||||||||||||||||
Common Stock | ||||||||||||||||||||||||
Balance at beginning-of-period | 259,206,033 | 270,685,522 | 264,233,303 | 275,752,668 | 256,801,622 | 271,441,613 | 264,233,303 | 275,752,668 | ||||||||||||||||
Conversion of Series A preferred stock | — | 2,640 | 4,768 | 5,520 | 1,600 | 2,480 | 6,368 | 8,000 | ||||||||||||||||
Stock compensation(1) | 300,262 | 734,675 | 691,644 | 2,838,673 | 96,454 | 774,931 | 775,676 | 3,610,276 | ||||||||||||||||
Deferred compensation payable in stock | 17,725 | 25,929 | 67,079 | 69,161 | 18,465 | 35,149 | 85,544 | 104,310 | ||||||||||||||||
Retirement of common stock by repurchase/cancellation of shares | (2,722,398 | ) | (7,153 | ) | (8,195,172 | ) | (7,224,409 | ) | (1,076,508 | ) | (3,096,069 | ) | (9,259,258 | ) | (10,317,150 | ) | ||||||||
Balance at end-of-period | 256,801,622 | 271,441,613 | 256,801,622 | 271,441,613 | 255,841,633 | 269,158,104 | 255,841,633 | 269,158,104 | ||||||||||||||||
Common stock at end-of-period: | ||||||||||||||||||||||||
Assuming conversion of preferred stock | 256,988,214 | 271,639,389 | 256,988,214 | 271,639,389 | 256,026,625 | 269,353,400 | 256,026,625 | 269,353,400 | ||||||||||||||||
Diluted basis | 257,825,399 | 274,489,187 | 257,825,399 | 274,489,187 | 256,908,832 | 271,722,491 | 256,908,832 | 271,722,491 |
(1) | Amount includes non stock option awards issued, including issuances for benefit plans and stock options exercised. |
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Earnings Per Share
The income used in the calculation of our diluted earnings per share (“EPS”) is our income from continuing operations and net income, reduced by minority interest adjustments related to outstanding stock options under the Delaware Investments U.S., Inc. (“DIUS”) stock option incentive plan of $1 million for the nine months ended September 30, 2008 and 2007 and less than $1 million for all periods presented,the three months ended September 30, 2008 and preferred dividends declared and payable.2007. A reconciliation of the denominator (number of shares) in the calculations of basic and diluted net income and income from discontinued operations per share was as follows:
For the Three Months Ended June 30, | For the Six Months Ended June 30, | For the Three Months Ended September 30, | For the Nine Months Ended September 30, | |||||||||||||||||||||
2008 | 2007 | 2008 | 2007 | 2008 | 2007 | 2008 | 2007 | |||||||||||||||||
Weighted-average shares, as used in basic calculation | 257,785,473 | 270,566,521 | 259,368,519 | 272,716,140 | 255,865,067 | 269,395,799 | 258,192,178 | 271,597,197 | ||||||||||||||||
Shares to cover conversion of preferred stock | 186,592 | 199,012 | 187,824 | 199,980 | 185,672 | 196,509 | 187,101 | 198,811 | ||||||||||||||||
Shares to cover non-vested stock | 273,307 | 354,054 | 256,615 | 751,427 | 315,939 | 361,084 | 276,132 | 621,802 | ||||||||||||||||
Average stock options outstanding during the period | 9,199,383 | 13,307,765 | 9,596,842 | 13,815,359 | 6,241,386 | 12,182,185 | 8,478,357 | 13,270,967 | ||||||||||||||||
Assumed acquisition of shares with assumed proceeds and benefits from exercising stock options (at average market price for the year) | (8,998,441 | ) | (11,111,321 | ) | (9,411,397 | ) | (11,613,259 | ) | (6,240,810 | ) | (10,811,052 | ) | (8,392,562 | ) | (11,352,163 | ) | ||||||||
Shares repurchasable from measured but unrecognized stock option expense | (100,707 | ) | (257,704 | ) | (85,157 | ) | (256,675 | ) | (2,279 | ) | (168,157 | ) | (57,531 | ) | (227,169 | ) | ||||||||
Average deferred compensation shares | 1,271,413 | 1,345,246 | 1,277,542 | 1,326,853 | 1,280,279 | 1,331,319 | 1,278,454 | 1,328,341 | ||||||||||||||||
Weighted-average shares, as used in diluted calculation | 259,617,020 | 274,403,573 | 261,190,788 | 276,939,825 | 257,645,254 | 272,487,687 | 259,962,129 | 275,437,786 | ||||||||||||||||
In the event the average market price of LNC common stock exceeds the issue price of stock options, such options would be dilutive to our EPS and will be shown in the table above. Participants in our deferred compensation plans that 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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11.12. Realized Gain (Loss)Loss
Details underlying realized gain (loss)loss (in millions) were as follows:
For the Three Months Ended June 30, | For the Six Months Ended June 30, | For the Three Months Ended September 30, | For the Nine Months Ended September 30, | |||||||||||||||||||||||||||||
2008 | 2007 | 2008 | 2007 | 2008 | 2007 | 2008 | 2007 | |||||||||||||||||||||||||
Total realized gain (loss) on investments and certain derivative instruments, excluding trading securities(1) | $ | (125 | ) | $ | (9 | ) | $ | (166 | ) | $ | 18 | |||||||||||||||||||||
Total realized loss on investments and certain derivative instruments, excluding trading securities(1) | $ | (314 | ) | $ | (35 | ) | $ | (480 | ) | $ | (18 | ) | ||||||||||||||||||||
Gain (loss) on certain reinsurance derivative/trading securities(2) | 1 | 4 | 2 | 4 | (2 | ) | (1 | ) | — | 3 | ||||||||||||||||||||||
Indexed annuity net derivative results(3): | ||||||||||||||||||||||||||||||||
Gross | 3 | 13 | 11 | 11 | 8 | (13 | ) | 19 | (2 | ) | ||||||||||||||||||||||
Associated amortization expense of DAC, VOBA, DSI and DFEL | (1 | ) | (6 | ) | (6 | ) | (6 | ) | (5 | ) | 7 | (10 | ) | 1 | ||||||||||||||||||
Guaranteed living benefits(4): | ||||||||||||||||||||||||||||||||
Gross | 20 | 12 | 38 | 30 | 159 | (37 | ) | 196 | (6 | ) | ||||||||||||||||||||||
Associated amortization expense of DAC, VOBA, DSI and DFEL | (8 | ) | (6 | ) | (27 | ) | (15 | ) | (59 | ) | 15 | (85 | ) | — | ||||||||||||||||||
Guaranteed death benefits(5): | ||||||||||||||||||||||||||||||||
Gross | — | (2 | ) | 2 | (2 | ) | 8 | (2 | ) | 10 | (3 | ) | ||||||||||||||||||||
Associated amortization expense of DAC, VOBA, DSI and DFEL | — | 1 | (1 | ) | 1 | (1 | ) | 1 | (3 | ) | 1 | |||||||||||||||||||||
Gain on sale of subsidiaries/businesses | 2 | — | 4 | — | 2 | — | 6 | — | ||||||||||||||||||||||||
Total realized gain (loss) | $ | (108 | ) | $ | 7 | $ | (143 | ) | $ | 41 | ||||||||||||||||||||||
Total realized loss | $ | (204 | ) | $ | (65 | ) | $ | (347 | ) | $ | (24 | ) | ||||||||||||||||||||
(1) | See Note 4 “Realized |
(2) | Represents changes in the fair value of total return swaps (embedded derivatives) related to various modified coinsurance and coinsurance with funds withheld reinsurance arrangements that have contractual returns related to various assets and liabilities associated with these arrangements. Changes in the fair value of these derivatives are offset by the change in fair value of trading securities in the portfolios that support these arrangements. |
(3) | Represents the net difference between the change in the fair value of the Standard & Poor’s (“S&P”) 500 |
(4) | Represents the net difference in the change in fair value of the embedded derivative liabilities of our |
(5) | Represents the change in the fair value of the derivatives used to hedge our |
Guaranteed Benefit Features
We issue variable annuity contracts through our separate accounts for which investment income and investment gains and losses accrue directly to, and investment risk is borne by, the contract holder (traditional variable annuities). We also issue variable annuity and life contracts through separate accounts that include various types of GDB, guaranteed withdrawal benefit (“GWB”) and guaranteed income benefit (“GIB”) features. The GDB features include those where we contractually guarantee to the contract holder either: return of no less than total deposits made to the contract less any partial withdrawals (“return of net deposits”); total deposits made to the contract less any partial withdrawals plus a minimum return (“minimum return”); or the highest contract value on any contract anniversary date through age 80 minus any payments or withdrawals following the contract anniversary (“anniversary contract value”).
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These guarantees are considered embedded derivatives and are recorded in future contract benefits on our Consolidated Balance Sheets at fair value under SFAS 133 and SFAS 157. Effective January 1, 2008, we adopted SFAS 157, which affected the valuation of our embedded derivatives. See Note 2 of this report for details on the adoption of SFAS 157. We use derivative instruments to hedge our exposure to the risks and earnings volatility that result from the embedded derivatives for living benefits in certain of our variable annuity products. The change in fair value of these instruments tends to move in the opposite direction of the change in fair value of the embedded derivatives. The net impact of these changes is reported as GLB, which is a component of realized gain (loss) discussed above.
Information in the event of death on the GDB features outstanding (dollars in millions) was as follows (our variable contracts with guarantees may offer more than one type of guarantee in each contract; therefore, the amounts listed are not mutually exclusive):
As of June 30, 2008 | As of December 31, 2007 | |||||||
Return of Net Deposits | ||||||||
Variable annuity account value | $ | 43,337 | $ | 44,833 | ||||
Net amount at risk(1) | 701 | 93 | ||||||
Average attained age of contract holders | 56 years | 55 years | ||||||
Minimum Return | ||||||||
Variable annuity account value | $ | 297 | $ | 355 | ||||
Net amount at risk(1) | 46 | 25 | ||||||
Average attained age of contract holders | 68 years | 68 years | ||||||
Guaranteed minimum return | 5 | % | 5 | % | ||||
Anniversary Contract Value | ||||||||
Variable annuity account value | $ | 23,625 | $ | 25,537 | ||||
Net amount at risk(1) | 2,104 | 359 | ||||||
Average attained age of contract holders | 64 years | 64 years |
|
|
The determination of GDB liabilities is based on models that involve a range of scenarios and assumptions, including those regarding expected market rates of return and volatility, contract surrender rates and mortality experience. The following summarizes the balances of and changes in the liabilities for GDB (in millions), which were recorded in future contract benefits on our Consolidated Balance Sheets:
For the Six Months Ended June 30, | ||||||||
2008 | 2007 | |||||||
Balance at beginning-of-year | $ | 38 | $ | 23 | ||||
Cumulative effect of adoption of SOP 05-1 | — | (4 | ) | |||||
Changes in reserves | 25 | 10 | ||||||
Benefits paid | (11 | ) | (3 | ) | ||||
Balance at end-of-period | $ | 52 | $ | 26 | ||||
The changes to the benefit reserves amounts above are reflected in benefits on our Consolidated Statements of Income.
The results of the hedging program are included in realized gain (loss), which included gains of less than $1 million and $2 million for GDB for the three months and six months ended June 30, 2008, respectively, and losses of $1 million and $2 million for the three and six months ended June 30, 2007, respectively.
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Account balances of variable annuity contracts with guarantees (in millions) were invested in separate account investment options as follows:
As of June 30, 2008 | As of December 31, 2007 | |||||||
Asset Type | ||||||||
Domestic equity | $ | 37,447 | $ | 44,982 | ||||
International equity | 11,899 | 8,076 | ||||||
Bonds | 9,740 | 8,034 | ||||||
Money market | 4,831 | 6,545 | ||||||
Total | $ | 63,917 | $ | 67,637 | ||||
Percent of total variable annuity separate account values | 98 | % | 97 | % |
12.13. Underwriting, Acquisition, Insurance and Other Expenses
Details underlying underwriting, acquisition, insurance and other expenses (in millions) were as follows:
For the Three Months Ended June 30, | For the Six Months Ended June 30, | For the Three Months Ended September 30, | For the Nine Months Ended September 30, | |||||||||||||||||||||||||||||
2008 | 2007 | 2008 | 2007 | 2008 | 2007 | 2008 | 2007 | |||||||||||||||||||||||||
Commissions | $ | 499 | $ | 536 | $ | 992 | $ | 1,050 | $ | 495 | $ | 542 | $ | 1,486 | $ | 1,592 | ||||||||||||||||
General and administrative expenses | 422 | 452 | 844 | 863 | 416 | 438 | 1,260 | 1,300 | ||||||||||||||||||||||||
DAC and VOBA deferrals and interest, net of amortization | (156 | ) | (272 | ) | (357 | ) | (484 | ) | (245 | ) | (228 | ) | (602 | ) | (712 | ) | ||||||||||||||||
Other intangibles amortization | 2 | 3 | 3 | 5 | 1 | 3 | 5 | 8 | ||||||||||||||||||||||||
Media expenses | 15 | 15 | 31 | 30 | 14 | 13 | 45 | 43 | ||||||||||||||||||||||||
Taxes, licenses and fees | 49 | 52 | 112 | 117 | 60 | 52 | 170 | 169 | ||||||||||||||||||||||||
Merger-related expenses | 16 | 30 | 31 | 44 | 13 | 30 | 44 | 75 | ||||||||||||||||||||||||
Total | $ | 847 | $ | 816 | $ | 1,656 | $ | 1,625 | $ | 754 | $ | 850 | $ | 2,408 | $ | 2,475 | ||||||||||||||||
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13.14. Employee Benefit Plans
Pension and Other Postretirement Benefit Plans
The components of net defined benefit pension plan and postretirement benefit plan expense (in millions) were as follows:
For the Three Months Ended June 30, | ||||||||||||||||
Pension Benefits | Other Postretirement Benefits | |||||||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||||||
U.S. Plans | ||||||||||||||||
Service cost | $ | — | $ | 7 | $ | 1 | $ | 1 | ||||||||
Interest cost | 15 | 14 | 2 | 2 | ||||||||||||
Expected return on plan assets | (20 | ) | (20 | ) | — | — | ||||||||||
Amortization of prior service cost | — | (1 | ) | — | — | |||||||||||
Recognized net actuarial gain | — | — | (1 | ) | (1 | ) | ||||||||||
Net periodic benefit expense (recovery) | $ | (5 | ) | $ | — | $ | 2 | $ | 2 | |||||||
Non-U.S. Plans | ||||||||||||||||
Service cost | $ | 1 | $ | — | ||||||||||||
Interest cost | 5 | 5 | ||||||||||||||
Expected return on plan assets | (5 | ) | (5 | ) | ||||||||||||
Recognized net actuarial loss | 1 | 1 | ||||||||||||||
Net periodic benefit expense | $ | 2 | $ | 1 | ||||||||||||
For the Six Months Ended June 30, | For the Three Months Ended September 30, | |||||||||||||||||||||||||||||||
Pension Benefits | Other Postretirement Benefits | Pension Benefits | Other Postretirement Benefits | |||||||||||||||||||||||||||||
2008 | 2007 | 2008 | 2007 | 2008 | 2007 | 2008 | 2007 | |||||||||||||||||||||||||
U.S. Plans | ||||||||||||||||||||||||||||||||
Service cost | $ | — | $ | 16 | $ | 1 | $ | 2 | $ | — | $ | 9 | $ | 1 | $ | — | ||||||||||||||||
Interest cost | 30 | 30 | 4 | 4 | 15 | 14 | 2 | 2 | ||||||||||||||||||||||||
Expected return on plan assets | (39 | ) | (40 | ) | (1 | ) | (1 | ) | (19 | ) | (19 | ) | — | (1 | ) | |||||||||||||||||
Amortization of prior service cost | — | (1 | ) | — | — | — | 1 | — | — | |||||||||||||||||||||||
Recognized net actuarial gain | 1 | — | (1 | ) | (1 | ) | 1 | — | — | — | ||||||||||||||||||||||
Net periodic benefit expense (recovery) | $ | (8 | ) | $ | 5 | $ | 3 | $ | 4 | $ | (3 | ) | $ | 5 | $ | 3 | $ | 1 | ||||||||||||||
Non-U.S. Plans | ||||||||||||||||||||||||||||||||
Service cost | $ | 1 | $ | 1 | $ | — | $ | — | ||||||||||||||||||||||||
Interest cost | 10 | 9 | 5 | 5 | ||||||||||||||||||||||||||||
Expected return on plan assets | (11 | ) | (10 | ) | (5 | ) | (5 | ) | ||||||||||||||||||||||||
Recognized net actuarial loss | 2 | 2 | 1 | 1 | ||||||||||||||||||||||||||||
Net periodic benefit expense | $ | 2 | $ | 2 | $ | 1 | $ | 1 | ||||||||||||||||||||||||
For the Nine Months Ended September 30, | ||||||||||||||||||||||||||||||||
Pension Benefits | Other Postretirement Benefits | |||||||||||||||||||||||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||||||||||||||||||||||
U.S. Plans | ||||||||||||||||||||||||||||||||
Service cost | $ | 1 | $ | 25 | $ | 2 | $ | 2 | ||||||||||||||||||||||||
Interest cost | 46 | 44 | 6 | 6 | ||||||||||||||||||||||||||||
Expected return on plan assets | (58 | ) | (59 | ) | (1 | ) | (2 | ) | ||||||||||||||||||||||||
Amortization of prior service cost | — | — | — | — | ||||||||||||||||||||||||||||
Recognized net actuarial gain | 3 | — | (1 | ) | (1 | ) | ||||||||||||||||||||||||||
Net periodic benefit expense (recovery) | $ | (8 | ) | $ | 10 | $ | 6 | $ | 5 | |||||||||||||||||||||||
Non-U.S. Plans | ||||||||||||||||||||||||||||||||
Service cost | $ | 2 | $ | 1 | ||||||||||||||||||||||||||||
Interest cost | 15 | 14 | ||||||||||||||||||||||||||||||
Expected return on plan assets | (16 | ) | (15 | ) | ||||||||||||||||||||||||||||
Recognized net actuarial loss | 2 | 3 | ||||||||||||||||||||||||||||||
Net periodic benefit expense | $ | 3 | $ | 3 | ||||||||||||||||||||||||||||
On May 1, 2007, simultaneous with our announcement of the freeze of our primary defined benefit pension plans, we announced a number of enhancements to our employees’ 401(k) plan effective January 1, 2008. Consequently, we are no longer accruing service costs in our U.S. pension plans.
For any additional disclosures and other general information regarding our benefit plans, see Note 16 in our 2007 Form 10-K.
2728
14.15. Stock-Based Incentive Compensation Plans
We sponsor various incentive plans for our employees, agents and directors and our subsidiaries that provide for the issuance of stock options, stock incentive awards, stock appreciation rights, restricted stock awards, restricted stock units (“performance shares”), and deferred stock units. DIUSDelaware Investments U.S., Inc. (“DIUS”) has a separate stock-based incentive compensation plan, which has DIUS stock underlying the awards.
In the first quarter of 2008, a performance period from 2008-2010 was approved for our executive officers by the Compensation Committee. Executive officers participating in this performance period received one-half of their award in 10-year LNC or DIUS restricted stock units, with the remainder of the award in a combination of either: 100% performance shares or 75% performance shares and 25% cash. LNC stock options granted for this performance period vest ratably over the three-year period, based solely on a service condition. DIUS restricted stock units granted for this performance period vest ratably over a four-year period, based solely on a service condition and were granted only to employees of DIUS. Depending on the performance, the actual amount of performance shares could range from zero to 200% of the granted amount. Under the 2008-2010 plan, a total of 1,564,800 LNC stock options were granted; 2,726 DIUS restricted stock units were granted; and 218,308 LNC performance shares were granted during the sixnine months ended JuneSeptember 30, 2008.
In addition to the stock-based grants noted above, various other LNC stock-based awards were granted in the three and sixnine months ended JuneSeptember 30, 2008, which are summarized in the table below:and were as follows:
For the Three Months Ended June 30, 2008 | For the Six Months Ended June 30, 2008 | For the Three Months Ended September 30, 2008 | For the Nine Months Ended September 30, 2008 | |||||
Awards | ||||||||
10-year LNC stock options | 10,772 | 14,326 | — | 14,326 | ||||
Non-employee director stock options | — | 60,489 | — | 60,489 | ||||
Non-employee agent stock options | 20,982 | 197,113 | 210 | 197,323 | ||||
Restricted stock | 18,776 | 163,397 | 1,732 | 165,129 | ||||
Stock appreciation rights | — | 234,800 | — | 234,800 |
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15.16. Financial Instruments Carried at Fair Value
See “Fair Value of Financial Instruments” in Note 19 to the consolidated financial statements in our 2007 Form 10-K andSFAS No. 157 – Fair Value Measurements in Note 2 above for discussions of the methodologies and assumptions used to determine the fair value of our financial instruments.
The following table summarizes our financial instruments carried at fair value (in millions) on a recurring basis by the SFAS 157 fair value hierarchy levels described in Note 2. We did not have any assets or liabilities measured at fair value on a non-recurring basis during the secondthird quarter of 2008 or as of JuneSeptember 30, 2008.
As of June 30, 2008 | As of September 30, 2008 | ||||||||||||||||||||||||||||
Quoted Prices in Active Markets for Identical Assets (Level 1) | Significant Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) | Total Fair Value | Quoted Prices in Active Markets for Identical Assets (Level 1) | Significant Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) | Total Fair Value | ||||||||||||||||||||||
Assets | |||||||||||||||||||||||||||||
Investments: | |||||||||||||||||||||||||||||
Available-for-sale securities: | |||||||||||||||||||||||||||||
Fixed maturities | $ | 234 | $ | 50,053 | $ | 4,231 | $ | 54,518 | $ | 238 | $ | 47,877 | $ | 3,816 | $ | 51,931 | |||||||||||||
Equity | 66 | 252 | 146 | 464 | 52 | 337 | 104 | 493 | |||||||||||||||||||||
Trading securities | 5 | 2,444 | 101 | 2,550 | 3 | 2,293 | 97 | 2,393 | |||||||||||||||||||||
Derivative instruments | — | 24 | 866 | 890 | — | 161 | 1,101 | 1,262 | |||||||||||||||||||||
Cash and invested cash | — | 1,921 | — | 1,921 | — | 2,160 | — | 2,160 | |||||||||||||||||||||
Separate account assets | — | 85,295 | — | 85,295 | — | 74,971 | — | 74,971 | |||||||||||||||||||||
Total assets | $ | 305 | $ | 139,989 | $ | 5,344 | $ | 145,638 | $ | 293 | $ | 127,799 | $ | 5,118 | $ | 133,210 | |||||||||||||
Liabilities | |||||||||||||||||||||||||||||
Other contract holder funds: | |||||||||||||||||||||||||||||
Future Contract Benefits: | |||||||||||||||||||||||||||||
Remaining guaranteed interest and similar contracts | $ | — | $ | — | $ | (298 | ) | $ | (298 | ) | $ | — | $ | — | $ | (265 | ) | $ | (265 | ) | |||||||||
Embedded derivative instruments – living benefits liabilities | — | — | (335 | ) | (335 | ) | — | — | (564 | ) | (564 | ) | |||||||||||||||||
Reinsurance related derivative liability | — | (112 | ) | — | (112 | ) | — | 9 | — | 9 | |||||||||||||||||||
Total liabilities | $ | — | $ | (112 | ) | $ | (633 | ) | $ | (745 | ) | $ | — | $ | 9 | $ | (829 | ) | $ | (820 | ) | ||||||||
Our investment securities are valued using market inputs, including benchmark yields, reported trades, broker-dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers and reference data. In addition, market indicators, industry and economic events are monitored and further market data is acquired if certain triggers are met. For certain security types, additional inputs may be used, or some of the inputs described above may not be applicable. For broker-quoted only securities, quotes from market makers or broker-dealers are obtained from sources recognized to be market participants. In order to validate the pricing information and broker-dealer quotes, we employ, where possible, procedures that include comparisons with similar observable positions, comparisons with subsequent sales, discussions with senior business leaders and brokers as well as observations of general market movements for those asset classes.
30
The following tables summarize changes to our financial instruments carried at fair value (in millions) and classified within level 3 of the fair value hierarchy. This summary excludes any impact of amortization on DAC, VOBA, DSI and DFEL. When a determination is made to classify an asset or liability within level 3 of the fair value hierarchy, the determination is based upon the significance of the unobservable inputs to the overall fair value measurement. Certain securities trade in less liquid or illiquid markets with limited or no pricing information, and the determination of fair value for these securities is inherently more difficult. However, level 3 fair value investments may include, in addition to the unobservable or level 3 inputs, observable components (that is, components that are actively quoted or can be validated to market-based sources). The gains and losses in the table below may include changes in fair value due in part to observable inputs that are a component of the valuation methodology.
29
For the Three Months Ended June 30, 2008 | ||||||||||||||||||||||||
Beginning Fair Value | Items Included in Earnings, Net | Gains (Losses) in OCI | Sales, Issuances, Maturities, Settlements, Calls, Net | Transfers In or Out of Level 3, Net (1) | Ending Fair Value | |||||||||||||||||||
Investments: | ||||||||||||||||||||||||
Available-for-sale securities: | ||||||||||||||||||||||||
Fixed maturities | $ | 4,223 | $ | (13 | ) | $ | (22 | ) | $ | 133 | $ | (90 | ) | $ | 4,231 | |||||||||
Equity | 35 | (6 | ) | 50 | 67 | — | 146 | |||||||||||||||||
Trading securities | 108 | (6 | ) | — | (1 | ) | — | 101 | ||||||||||||||||
Derivative instruments | 969 | (118 | ) | (5 | ) | 20 | — | 866 | ||||||||||||||||
Other contract holder funds: | ||||||||||||||||||||||||
Remaining guaranteed interest and similar contracts | (321 | ) | 21 | — | 2 | — | (298 | ) | ||||||||||||||||
Embedded derivative instruments – living benefits liabilities | (535 | ) | 2 | 234 | (36 | ) | — | (335 | ) | |||||||||||||||
�� | ||||||||||||||||||||||||
Total, net | $ | 4,479 | $ | (120 | ) | $ | 257 | $ | 185 | $ | (90 | ) | $ | 4,711 | ||||||||||
For the Six Months Ended June 30, 2008 | For the Three Months Ended September 30, 2008 | ||||||||||||||||||||||||||||||||||||||||||||||
Beginning Fair Value | Items Included in Earnings, Net | Gains (Losses) in OCI | Sales, Issuances, Maturities, Settlements, Calls, Net | Transfers In or Out of Level 3, Net (1) | Ending Fair Value | Beginning Fair Value | Items Included in Net Income | Gains (Losses) in OCI | Sales, Issuances, Maturities, Settlements, Calls, Net | Transfers In or Out of Level 3, Net(1) | Ending Fair Value | ||||||||||||||||||||||||||||||||||||
Investments: | |||||||||||||||||||||||||||||||||||||||||||||||
Available-for-sale securities: | |||||||||||||||||||||||||||||||||||||||||||||||
Fixed maturities | $ | 4,420 | $ | (15 | ) | $ | (428 | ) | $ | 62 | $ | 192 | $ | 4,231 | $ | 4,231 | $ | (25 | ) | $ | (206 | ) | $ | (90 | ) | $ | (94 | ) | $ | 3,816 | |||||||||||||||||
Equity | 54 | (6 | ) | 31 | 67 | — | 146 | 146 | (23 | ) | (38 | ) | 19 | — | 104 | ||||||||||||||||||||||||||||||||
Trading securities | 112 | (8 | ) | — | (8 | ) | 5 | 101 | 101 | (2 | ) | — | (5 | ) | 3 | 97 | |||||||||||||||||||||||||||||||
Derivative instruments | 767 | (8 | ) | 5 | 102 | — | 866 | 866 | 127 | 6 | 102 | — | 1,101 | ||||||||||||||||||||||||||||||||||
Other contract holder funds: | |||||||||||||||||||||||||||||||||||||||||||||||
Future Contract Benefits: | |||||||||||||||||||||||||||||||||||||||||||||||
Remaining guaranteed interest and similar contracts | (389 | ) | 47 | — | 44 | — | (298 | ) | (298 | ) | 23 | — | 10 | — | (265 | ) | |||||||||||||||||||||||||||||||
Embedded derivative instruments – living benefits liabilities | (279 | ) | 4 | 9 | (69 | ) | — | (335 | ) | (335 | ) | (190 | ) | — | (39 | ) | — | (564 | ) | ||||||||||||||||||||||||||||
Total, net | $ | 4,685 | $ | 14 | $ | (383 | ) | $ | 198 | $ | 197 | $ | 4,711 | $ | 4,711 | $ | (90 | ) | $ | (238 | ) | $ | (3 | ) | $ | (91 | ) | $ | 4,289 | ||||||||||||||||||
For the Nine Months Ended September 30, 2008 | |||||||||||||||||||||||||||||||||||||||||||||||
Beginning Fair Value | Items Included in Net Income | Gains (Losses) in OCI | Sales, Issuances, Maturities, Settlements, Calls, Net | Transfers In or Out of Level 3, Net(1) | Ending Fair Value | ||||||||||||||||||||||||||||||||||||||||||
Investments: | |||||||||||||||||||||||||||||||||||||||||||||||
Available-for-sale securities: | |||||||||||||||||||||||||||||||||||||||||||||||
Fixed maturities | $ | 4,420 | $ | (44 | ) | $ | (646 | ) | $ | (55 | ) | $ | 141 | $ | 3,816 | ||||||||||||||||||||||||||||||||
Equity | 54 | (30 | ) | (6 | ) | 86 | — | 104 | |||||||||||||||||||||||||||||||||||||||
Trading securities | 112 | (11 | ) | (12 | ) | 8 | 97 | ||||||||||||||||||||||||||||||||||||||||
Derivative instruments | 767 | 118 | 13 | 203 | — | 1,101 | |||||||||||||||||||||||||||||||||||||||||
Future Contract Benefits: | |||||||||||||||||||||||||||||||||||||||||||||||
Remaining guaranteed interest and similar contracts | (389 | ) | 34 | — | 90 | — | (265 | ) | |||||||||||||||||||||||||||||||||||||||
Embedded derivative instruments – living benefits liabilities | (279 | ) | (177 | ) | — | (108 | ) | — | (564 | ) | |||||||||||||||||||||||||||||||||||||
Total, net | $ | 4,685 | $ | (110 | ) | $ | (639 | ) | $ | 204 | $ | 149 | $ | 4,289 | |||||||||||||||||||||||||||||||||
(1) | Transfers in or out of level 3 for available-for-sale and trading securities are displayed at amortized cost at the beginning of the period. For available-for-sale and trading securities, the difference between beginning of period amortized cost and beginning of period fair value was included in other comprehensive income (“OCI”) and earnings, respectively, in prior periods. |
3031
The following tables provide the components of the items included in earnings, net income, excluding any impact of amortization on DAC, VOBA, DSI and DFEL and changes in otherfuture contract holder funds,benefits, (in millions) as reported in the table above:
For the Three Months Ended June 30, 2008 | ||||||||||||||||||
(Amortization) Accretion, Net | Other- Than- Temporary Impairment | Gains (Losses) from Sales, Maturities, Settlements, Calls | Unrealized Holding Gains (Losses) | Total | ||||||||||||||
Investments: | ||||||||||||||||||
Available-for-sale securities: | ||||||||||||||||||
Fixed maturities (1) | $ | 1 | $ | (14 | ) | $ | — | $ | — | $ | (13 | ) | ||||||
Equity | — | (6 | ) | — | — | (6 | ) | |||||||||||
Trading securities(1) | 1 | (7 | ) | — | — | (6 | ) | |||||||||||
Derivative instruments(2) | — | — | 4 | (122 | ) | (118 | ) | |||||||||||
Other contract holder funds: | ||||||||||||||||||
Remaining guaranteed interest and similar contracts (2) | — | — | 6 | 15 | 21 | |||||||||||||
Embedded derivative instruments – living benefits liabilities(2) | — | — | — | 2 | 2 | |||||||||||||
Total, net | $ | 2 | $ | (27 | ) | $ | 10 | $ | (105 | ) | $ | (120 | ) | |||||
For the Six Months Ended June 30, 2008 | For the Three Months Ended September 30, 2008 | |||||||||||||||||||||||||||||||||||||
(Amortization) Accretion, Net | Other- Than- Temporary Impairment | Gains (Losses) from Sales, Maturities, Settlements, Calls | Unrealized Holding Gains (Losses) | Total | (Amortization) Accretion, Net | Other- Than- Temporary Impairment | Gains (Losses) from Sales, Maturities, Settlements, Calls | Unrealized Holding Gains (Losses)(3) | Total | |||||||||||||||||||||||||||||
Investments: | ||||||||||||||||||||||||||||||||||||||
Available-for-sale securities: | ||||||||||||||||||||||||||||||||||||||
Fixed maturities(1) | $ | 1 | $ | (16 | ) | $ | — | $ | — | $ | (15 | ) | $ | 1 | $ | (29 | ) | $ | 3 | $ | — | $ | (25 | ) | ||||||||||||||
Equity | — | (6 | ) | — | — | (6 | ) | — | (24 | ) | 1 | — | (23 | ) | ||||||||||||||||||||||||
Trading securities(1) | 1 | (7 | ) | — | (2 | ) | (8 | ) | 1 | (2 | ) | — | (1 | ) | (2 | ) | ||||||||||||||||||||||
Derivative instruments(2) | — | — | (23 | ) | 15 | (8 | ) | — | — | (15 | ) | 142 | 127 | |||||||||||||||||||||||||
Other contract holder funds: | ||||||||||||||||||||||||||||||||||||||
Future Contract Benefits: | ||||||||||||||||||||||||||||||||||||||
Remaining guaranteed interest and similar contracts(2) | — | — | 10 | 37 | 47 | — | — | 5 | 18 | 23 | ||||||||||||||||||||||||||||
Embedded derivative instruments – living benefits liabilities(2) | — | — | — | 4 | 4 | — | — | 1 | (191 | ) | (190 | ) | ||||||||||||||||||||||||||
Total, net | $ | 2 | $ | (29 | ) | $ | (13 | ) | $ | 54 | $ | 14 | $ | 2 | $ | (55 | ) | $ | (5 | ) | $ | (32 | ) | $ | (90 | ) | ||||||||||||
For the Nine Months Ended September 30, 2008 | ||||||||||||||||||||||||||||||||||||||
(Amortization) Accretion, Net | Other- Than- Temporary Impairment | Gains (Losses) from Sales, Maturities, Settlements, Calls | Unrealized Holding Gains (Losses)(3) | Total | ||||||||||||||||||||||||||||||||||
Investments: | ||||||||||||||||||||||||||||||||||||||
Available-for-sale securities: | ||||||||||||||||||||||||||||||||||||||
Fixed maturities(1) | $ | 2 | $ | (52 | ) | $ | 6 | $ | — | $ | (44 | ) | ||||||||||||||||||||||||||
Equity | — | (31 | ) | 1 | — | (30 | ) | |||||||||||||||||||||||||||||||
Trading securities(1) | 2 | (8 | ) | — | (5 | ) | (11 | ) | ||||||||||||||||||||||||||||||
Derivative instruments(2) | — | — | (61 | ) | 179 | 118 | ||||||||||||||||||||||||||||||||
Future Contract Benefits: | ||||||||||||||||||||||||||||||||||||||
Remaining guaranteed interest and similar contracts (2) | — | — | 14 | 20 | 34 | |||||||||||||||||||||||||||||||||
Embedded derivative instruments – living benefits liabilities(2) | — | — | 5 | (182 | ) | (177 | ) | |||||||||||||||||||||||||||||||
Total, net | $ | 4 | $ | (91 | ) | $ | (35 | ) | $ | 12 | $ | (110 | ) | |||||||||||||||||||||||||
(1) | Amortization and accretion, net and unrealized holding losses are included in net investment income on our Consolidated Statements of Income. All other amounts are included in realized |
(2) | All amounts are included in realized |
(3) | This change in unrealized gains or losses relates to assets and liabilities that we still held as of September 30, 2008. |
3132
The fair value of available-for-sale fixed maturity securities (in millions) classified within level 3 of the fair value hierarchy was as follows:
As of June 30, 2008 | ||||||
Fair Value | % of Total Fair Value | |||||
Corporate bonds | $ | 2,327 | 55.0 | % | ||
Asset-backed securities | 807 | 19.1 | % | |||
Commercial mortgage-backed securities | 360 | 8.5 | % | |||
Collateralized mortgage obligations | 223 | 5.3 | % | |||
Mortgage pass-through securities | 105 | 2.5 | % | |||
Municipals | 129 | 3.0 | % | |||
Government and government agencies | 249 | 5.9 | % | |||
Redeemable preferred stock | 31 | 0.7 | % | |||
Total available-for-sale fixed maturity securities | $ | 4,231 | 100.0 | % | ||
As of December 31, 2007 | ||||||
Fair Value | % of Total Fair Value | |||||
Corporate bonds | $ | 2,143 | 48.5 | % | ||
Asset-backed securities | 1,113 | 25.2 | % | |||
Commercial mortgage-backed securities | 395 | 8.9 | % | |||
Collateralized mortgage obligations | 296 | 6.7 | % | |||
Mortgage pass-through securities | 31 | 0.7 | % | |||
Municipals | 139 | 3.1 | % | |||
Government and government agencies | 272 | 6.2 | % | |||
Redeemable preferred stock | 31 | 0.7 | % | |||
Total available-for-sale fixed maturity securities | $ | 4,420 | 100.0 | % | ||
32
As of September 30, 2008 | ||||||
Fair Value | % of Total Fair Value | |||||
Corporate bonds | $ | 2,330 | 61.1 | % | ||
Asset-backed securities | 483 | 12.7 | % | |||
Commercial mortgage-backed securities | 356 | 9.3 | % | |||
Collateralized mortgage obligations | 182 | 4.8 | % | |||
Mortgage pass-through securities | 25 | 0.7 | % | |||
Municipals | 118 | 3.1 | % | |||
Government and government agencies | 272 | 7.1 | % | |||
Redeemable preferred stock | 50 | 1.3 | % | |||
Total available-for-sale fixed maturity securities | $ | 3,816 | 100.0 | % | ||
As of December 31, 2007 | ||||||
Fair Value | % of Total Fair Value | |||||
Corporate bonds | $ | 2,143 | 48.5 | % | ||
Asset-backed securities | 1,113 | 25.2 | % | |||
Commercial mortgage-backed securities | 395 | 8.9 | % | |||
Collateralized mortgage obligations | 296 | 6.7 | % | |||
Mortgage pass-through securities | 31 | 0.7 | % | |||
Municipals | 139 | 3.1 | % | |||
Government and government agencies | 272 | 6.2 | % | |||
Redeemable preferred stock | 31 | 0.7 | % | |||
Total available-for-sale fixed maturity securities | $ | 4,420 | 100.0 | % | ||
16.17. Segment Information
As of June 30, 2008, we provided products and services in four operating businesses: Individual Markets, Employer Markets, Investment Management and Lincoln UK, and report results through six business segments. We also have Other Operations, which includes the financial data for operations that are not directly related to the business segments. Other Operations also includes the Institutional Pension business, which was previously reported in Employer Markets – Retirement Products.
On July 21, 2008, we announced the realignment of our segments under our former Employer Markets and Individual Markets operating businesses into two new operating businesses – Retirement Solutions and Insurance Solutions. We believe the new structure more closely aligns with consumer needs and should lead to more coordinated product development and greater effectiveness across the enterprise. The only change to our current segment reporting will be to report the results of the Executive Benefits business, which as of June 30, 2008, was part of the Retirement Products segment, in the Life Insurance segment. Accordingly, for the third quarter of 2008, we will provide products and services in four operating business and report results through six segments as follows:
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These changes to the Retirement Products and the Life Insurance segments are in accordance with the provisions of SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” and reflect the manner in which we are organized for purposes of making operating decisions and assessing performance. Our segment results will be reported under this new structure beginning in the third quarter of 2008, andAccordingly, we will restatehave restated results from prior periods in a consistent manner.manner with our realigned segments.
Under our newly realigned segments, we will report the results of the Executive Benefits business, which as of June 30, 2008, was part of the Retirement Products segment, in the Life Insurance segment. We do not view thethese changes to the existingour segment reporting as material to our consolidated financial statements.
We provide products and services in four operating businesses and report results through six segments as immaterial.follows:
Business | Corresponding Segments | |||
Retirement Solutions | Annuities | |||
Defined Contribution (formerly Retirement Products) | ||||
Insurance Solutions | Life Insurance (including Executive Benefits business) | |||
Group Protection | ||||
Investment Management | Investment Management | |||
Lincoln UK | Lincoln UK |
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We also have Other Operations, which includes the financial data for operations that are not directly related to the business segments. Other Operations also includes our run-off Institutional Pension business, which was previously reported in Employer Markets – Retirement Products and the results of our remaining media businesses.
Beginning with the quarter ended June 30, 2008, we changed our definitions of segment operating revenues and income from operations to better reflect: the underlying economics of our variable and indexed annuities that employ derivative instruments to hedge policy benefits and the manner in which management evaluates that business. Our change in the definition of income from operations is primarily the result of our adoption of SFAS 157 during the first quarter of 2008. See Note 2. Under SFAS 157’s fair value calculation,157, we are required to measure the fair value of these annuities from an “exit value” perspective, (i.e., what a market participant or willing buyer would charge to assume the liability). We, therefore, must include margins that a market participant buyer would require as well as a factor for non-performance risk related to our credit quality.risk. We do not believe that these factors relate to the economics of the underlying business and do not reflect the manner in which management evaluates the business. The items that are now excluded from our operating results that were previously included are as follows: GLB net derivatives results; indexed annuity forward-starting option; and GDB derivatives results. See Note 1112 for more information about these items.
We continue to exclude the effects of any realized gain (loss) on investments from segment operating revenues and income from operations as we believe that such items are not necessarily indicative of current operating fundamentals or future performance of the business segments, and, in many instances, decisions regarding these items do not necessarily relate to the operations of the individual segments.
We believe that our new definitions of operating revenues and income (loss) from operations will provide investors with a more valuable measure of our performance because it better reveals trends in our business.
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Segment operating revenues and income (loss) from operations are internal measures used by our management and Board of Directors to evaluate and assess the results of our segments. Income (loss) from operations is GAAP net income excluding the after-tax effects of the following items, as applicable:
Realized gains and losses associated with the following (“excluded realized gain (loss)”):
Sale or disposal of securities;
Impairments of securities;
Change in the fair value of embedded derivatives within certain reinsurance arrangements and the change in the fair value of related trading securities;
Change in the fair value of the embedded derivatives of our GLBs within our variable annuities net of the change in the fair value of the derivatives we own to hedge the changes in the embedded derivative;
Net difference between the benefit ratio unlocking of SOP No. 03-1, “Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts” reserves on our GDB riders within our variable annuities and the change in the fair value of the derivatives excluding our expected cost of purchasing the hedging instruments; and
Changes in the fair value of the embedded derivative liabilities related to index call options we may purchase in the future to hedge contract holder index allocations applicable to future reset periods for our indexed annuity products as required under SFAS 133 and 157.
Income (loss) from the initial adoption of changes in accounting principles;
Income (loss) from reserve changes (net of related amortization) on business sold through reinsurance;
Losses on early retirement of debt, including subordinated debt;
Losses from the impairment of intangible assets; and
Income (loss) from discontinued operations.
Operating revenues represent GAAP revenues excluding the pre-tax effects of the following items, as applicable:
Excluded realized gain (loss);
Amortization of deferred gains arising from the reserve changes on business sold through reinsurance; and
Revenue adjustments from the initial impact of the adoption of changes in accounting principles.
Operating revenues and income (loss) from operations do not replace revenues and net income as the GAAP measures of our consolidated results of operations.
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Segment information (in millions) was as follows:
For the Three Months Ended June 30, | For the Six Months Ended June 30, | For the Three Months Ended September 30, | For the Nine Months Ended September 30, | |||||||||||||||||||||||||||
2008 | 2007 | 2008 | 2007 | 2008 | 2007 | 2008 | 2007 | |||||||||||||||||||||||
Revenues | ||||||||||||||||||||||||||||||
Operating revenues: | ||||||||||||||||||||||||||||||
Individual Markets: | ||||||||||||||||||||||||||||||
Retirement Solutions: | ||||||||||||||||||||||||||||||
Annuities | $ | 618 | $ | 624 | $ | 1,241 | $ | 1,214 | $ | 675 | $ | 647 | $ | 1,916 | $ | 1,861 | ||||||||||||||
Defined Contribution | 241 | 243 | 718 | 742 | ||||||||||||||||||||||||||
Total Retirement Solutions | 916 | 890 | 2,634 | 2,603 | ||||||||||||||||||||||||||
Insurance Solutions: | ||||||||||||||||||||||||||||||
Life Insurance | 1,021 | 957 | 2,008 | 1,929 | 1,072 | 1,056 | 3,210 | 3,121 | ||||||||||||||||||||||
Total Individual Markets | 1,639 | 1,581 | 3,249 | 3,143 | ||||||||||||||||||||||||||
Employer Markets: | ||||||||||||||||||||||||||||||
Retirement Products | 304 | 318 | 608 | 634 | ||||||||||||||||||||||||||
Group Protection | 425 | 391 | 824 | 751 | 403 | 368 | 1,227 | 1,119 | ||||||||||||||||||||||
Total Employer Markets | 729 | 709 | 1,432 | 1,385 | ||||||||||||||||||||||||||
Total Insurance Solutions | 1,475 | 1,424 | 4,437 | 4,240 | ||||||||||||||||||||||||||
Investment Management(1) | 125 | 151 | 245 | 301 | 110 | 150 | 354 | 451 | ||||||||||||||||||||||
Lincoln UK(2) | 98 | 93 | 183 | 183 | 80 | 89 | 263 | 272 | ||||||||||||||||||||||
Other Operations | 110 | 123 | 229 | 233 | 111 | 113 | 341 | 345 | ||||||||||||||||||||||
Excluded realized gain (loss), pre-tax | (120 | ) | 6 | (166 | ) | 39 | ||||||||||||||||||||||||
Excluded realized loss, pre-tax | (256 | ) | (66 | ) | (421 | ) | (27 | ) | ||||||||||||||||||||||
Amortization of deferred gain arising from reserve changes on business sold through reinsurance, pre-tax | 1 | 8 | 2 | 8 | — | 1 | 2 | 9 | ||||||||||||||||||||||
Total revenues | $ | 2,582 | $ | 2,671 | $ | 5,174 | $ | 5,292 | $ | 2,436 | $ | 2,601 | $ | 7,610 | $ | 7,893 | ||||||||||||||
(1) | Revenues for the Investment Management segment included inter-segment revenues for asset management services provided to our other segments. These inter-segment revenues totaled $21 million and |
(2) | Revenues from our Lincoln UK segment represent our revenues from a foreign country. |
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For the Three Months Ended June 30, | For the Six Months Ended June 30, | For the Three Months Ended September 30, | For the Nine Months Ended September 30, | |||||||||||||||||||||||||||||
2008 | 2007 | 2008 | 2007 | 2008 | 2007 | 2008 | 2007 | |||||||||||||||||||||||||
Net Income | ||||||||||||||||||||||||||||||||
Income (loss) from operations: | ||||||||||||||||||||||||||||||||
Individual Markets: | ||||||||||||||||||||||||||||||||
Retirement Solutions: | ||||||||||||||||||||||||||||||||
Annuities | $ | 116 | $ | 123 | $ | 234 | $ | 240 | $ | 131 | $ | 126 | $ | 365 | $ | 366 | ||||||||||||||||
Defined Contribution | 42 | 41 | 124 | 138 | ||||||||||||||||||||||||||||
Total Retirement Solutions | 173 | 167 | 489 | 504 | ||||||||||||||||||||||||||||
Insurance Solutions: | ||||||||||||||||||||||||||||||||
Life Insurance | 153 | 176 | 298 | 343 | 137 | 182 | 458 | 548 | ||||||||||||||||||||||||
Total Individual Markets | 269 | 299 | 532 | 583 | ||||||||||||||||||||||||||||
Employer Markets: | ||||||||||||||||||||||||||||||||
Retirement Products | 52 | 58 | 104 | 120 | ||||||||||||||||||||||||||||
Group Protection | 32 | 29 | 58 | 52 | 27 | 33 | 86 | 85 | ||||||||||||||||||||||||
Total Employer Markets | 84 | 87 | 162 | 172 | ||||||||||||||||||||||||||||
Total Insurance Solutions | 164 | 215 | 544 | 633 | ||||||||||||||||||||||||||||
Investment Management | 15 | 11 | 27 | 28 | 5 | 22 | 32 | 49 | ||||||||||||||||||||||||
Lincoln UK | 18 | 12 | 29 | 23 | 12 | 10 | 41 | 33 | ||||||||||||||||||||||||
Other Operations | (44 | ) | (35 | ) | (86 | ) | (65 | ) | (39 | ) | (49 | ) | (127 | ) | (115 | ) | ||||||||||||||||
Excluded realized gain (loss), after-tax | (78 | ) | 4 | (108 | ) | 25 | ||||||||||||||||||||||||||
Excluded realized loss, after-tax | (166 | ) | (42 | ) | (274 | ) | (16 | ) | ||||||||||||||||||||||||
Income (loss) from reserve changes (net of related amortization) on business sold through reinsurance, after-tax | — | (8 | ) | 1 | (8 | ) | — | — | 1 | (7 | ) | |||||||||||||||||||||
Impairment of intangibles, after-tax | (139 | ) | — | (139 | ) | — | — | — | (139 | ) | — | |||||||||||||||||||||
Income from continuing operations, after-tax | 125 | 370 | 418 | 758 | 149 | 323 | 567 | 1,081 | ||||||||||||||||||||||||
Income (loss) from discontinued operations, after-tax | — | 6 | (4 | ) | 14 | (1 | ) | 7 | (5 | ) | 21 | |||||||||||||||||||||
Net income | $ | 125 | $ | 376 | $ | 414 | $ | 772 | $ | 148 | $ | 330 | $ | 562 | $ | 1,102 | ||||||||||||||||
17.18. Supplemental Disclosures of Cash Flow and Fair Value of Financial Instruments Information
The following summarizes our supplemental cash flow data (in millions):
For the Six Months Ended June 30, | For the Nine Months Ended September 30, | |||||||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||||||
Significant non-cash investing and financing transactions: | ||||||||||||||||
Business combinations: | ||||||||||||||||
Fair value of assets acquired (includes cash and invested cash) | $ | — | $ | 86 | $ | — | $ | 86 | ||||||||
Fair value of common stock issued and stock options recognized | — | (20 | ) | — | (20 | ) | ||||||||||
Cash paid for common shares | — | (1 | ) | — | (1 | ) | ||||||||||
Liabilities assumed | — | 65 | — | 65 | ||||||||||||
Business dispositions: | ||||||||||||||||
Assets disposed (includes cash and invested cash) | (732 | ) | — | (732 | ) | — | ||||||||||
Liabilities disposed | 127 | — | 126 | — | ||||||||||||
Cash received | 647 | — | 647 | — | ||||||||||||
Realized gain on disposal | 42 | — | 41 | — | ||||||||||||
Estimated gain on net assets held-for-sale in prior periods | (54 | ) | (54 | ) | ||||||||||||
Loss on discontinued operations in current period | $ | (12 | ) | $ | — | $ | (13 | ) | $ | — | ||||||
Sale of subsidiaries/businesses: | ||||||||||||||||
Proceeds from sale of subsidiaries/businesses, reported as gain on sale of subsidiaries/businesses | $ | 5 | $ | — | $ | 6 | $ | — | ||||||||
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The carrying values and estimated fair values of our debt financial instruments (in millions) were as follows:
As of June 30, 2008 | As of December 31, 2007 | |||||||||||||||
Carrying Value | Fair Value | Carrying Value | Fair Value | |||||||||||||
Short-term debt | $ | (900 | ) | $ | (896 | ) | $ | (550 | ) | $ | (550 | ) | ||||
Long-term debt | (4,102 | ) | (3,817 | ) | (4,618 | ) | (4,511 | ) |
18. Subsequent Event
During July 2008, we borrowed $200 million under a new $200 million borrowing facility. The facility expires, and all outstanding loans under the facility mature, on July 18, 2013. Proceeds from this borrowing were used for general corporate purposes and to repay maturing debt.
On July 21, 2008, we announced the realignment of our Employer Markets and Individual Markets businesses into two new businesses – Retirement Solutions and Insurance Solutions. Our other businesses, including Investment Management, Lincoln UK and Other Operations, remain unchanged. The new structure is more closely aligned with consumer needs and will lead to more coordinated product development and greater effectiveness across the enterprise. Our segment results will be reported under this new structure beginning in the third quarter of 2008, and we will restate results from prior periods in a consistent manner. For more information regarding the realignment, see Note 16.
As of September 30, 2008 | As of December 31, 2007 | |||||||||||||||
Carrying Value | Fair Value | Carrying Value | Fair Value | |||||||||||||
Short-term debt | $ | (635 | ) | $ | (600 | ) | $ | (550 | ) | $ | (550 | ) | ||||
Long-term debt | (4,569 | ) | (3,930 | ) | (4,618 | ) | (4,511 | ) |
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Item 2. | Management’s Discussion and Analysis of Financial Condition and Results of Operations |
The following Management’s Discussion and Analysis (“MD&A”) is intended to help the reader understand the financial condition of Lincoln National Corporation and its consolidated subsidiaries (“LNC,” “Lincoln” or the “Company,” which also may be referred to as “we,” “our” or “us”) as of JuneSeptember 30, 2008, compared with December 31, 2007, and the results of operations of LNC for the three and sixnine months ended JuneSeptember 30, 2008, as compared with the corresponding periods in 2007. The MD&A is provided as a supplement to and should be read in conjunction with our consolidated financial statements and the accompanying notes to the consolidated financial statements (“Notes”) presented in “Item 1. Financial Statements” and our Form 10-K for the year ended December 31, 2007 (“2007 Form 10-K”), including the sections entitled “Part I – Item 1A. Risk Factors,” “Part II – Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Part II – Item 8. Financial Statements and Supplementary Data.”Data”, as well as “Part II – Item 1A. Risk Factors” below.
In this report, in addition to providing consolidated revenues and net income (loss), we also provide segment operating revenues and income (loss) from operations because we believe they are meaningful measures of revenues and the profitability of our operating segments. Income (loss) from operations is net income recorded in accordance with United States of America generally accepted accounting principles (“GAAP”) excluding the after-tax effects of the following items, as applicable:
Realized gains and losses associated with the following (“excluded realized gain (loss)”):
Sale or disposal of securities;
Impairments of securities;
Change in the fair value of embedded derivatives within certain reinsurance arrangements and the change in the fair value of related trading securities;
Change in the fair value of the embedded derivatives of our guaranteed living benefits (“GLB”) within our variable annuities net of the change in the fair value of the derivatives we own to hedge the changes in the embedded derivative;
Net difference between the benefit ratio unlocking of Statement of Position (“SOP”) No. 03-1, “Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts” (“SOP 03-1”) reserves on our guaranteed death benefit (“GDB”) riders within our variable annuities and the change in the fair value of the derivatives excluding our expected cost of purchasing the hedging instruments; and
Changes in the fair value of the embedded derivative liabilities related to index call options we may purchase in the future to hedge contract holder index allocations applicable to future reset periods for our indexed annuity products as required under Statements of Financial Accounting Standards (“SFAS”) No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”) and SFAS No. 157, “Fair Value Measurements” (“SFAS 157”).
Income (loss) from the initial adoption of changes in accounting principles;
Income (loss) from reserve changes (net of related amortization) on business sold through reinsurance;
Losses on early retirement of debt, including subordinated debt;
Losses from the impairment of intangible assets; and
Income (loss) from discontinued operations.
Operating revenues represent GAAP revenues excluding the pre-tax effects of the following items, as applicable:
Excluded realized gain (loss);
Amortization of deferred gains arising from the reserve changes on business sold through reinsurance; and
Revenue adjustments from the initial impact of the adoption of changes in accounting principles.
Operating revenues and income (loss) from operations are the financial performance measures we use to evaluate and assess the results of our segments. Accordingly, we report operating revenues and income (loss) from operations by segment in Note 16.17. Our management and Board of Directors believe that operating revenues and income (loss) from operations explain the results of our ongoing businesses in a manner that allows for a better understanding of the underlying trends in our current businesses because the excluded items are unpredictable and not necessarily indicative of current operating fundamentals or future performance of the business segments, and, in many instances, decisions regarding these items do not necessarily relate to the operations of the individual segments. Operating revenues and income (loss) from operations do not replace revenues and net income as the GAAP measures of our consolidated results of operations.
Beginning with the quarter ended June 30, 2008, we changed our definitions of segment operating revenues and income from operations to better reflect: the underlying economics of our variable and indexed annuities that employ derivative instruments to hedge policy benefits; and the manner in which management evaluates that business. Our change in the definition of income from operations is primarily the result of our adoption of SFAS 157 during the first quarter of 2008. See Note 2. Under SFAS 157’s fair value calculation, we are required to fair value these annuities from an “exit value” perspective, (i.e., what a market participant or
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willing buyer would charge to assume the liability). We, therefore, must include margins that a market participant buyer would require as well as a factor for non-performance risk related to our credit quality. We do not believe that these factors relate to the
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economics of the underlying business and do not reflect the manner in which management evaluates the business. The items that are now excluded from our operating results that were previously included are as follows: GLB net derivatives results; indexed annuity forward-starting option; and GDB derivatives results. For more information regarding this change, see our current report on Form 8-K dated July 16, 2008.
We continue to exclude the effects of any realized gain (loss) on investments from segment operating revenues and income from operations as we believe that such items are not necessarily indicative of current operating fundamentals or future performance of the business segments, and, in many instances, decisions regarding these items do not necessarily relate to the operations of the individual segments.
We believe that our new definitions of operating revenues and income (loss) from operations will provide investors with a more valuable measure of our performance because it better reveals trends in our business. See “Realized Gain (Loss)”Loss” below for more information about these items.
Certain reclassifications have been made to prior periods’ financial information. Included in these reclassifications is the change in our definition of segment operating revenues and income (loss) from operations as discussed above. In addition, we have reclassified the results of certain derivatives and embedded derivatives to realized gain (loss), which were previously reported within insurance fees, net investment income, interest credited or benefits. The associated amortization expense of deferred acquisition costs (“DAC”) and value of business acquired (“VOBA”) (previously reported within underwriting, acquisition, insurance and other expenses), deferred sales inducements (“DSI”) (previously reported within interest credited), deferred front-end loads (“DFEL”) (previously reported within insurance fees) and changes in contract holder funds (previously reported within benefits) have also been reclassified to realized gain (loss). See Note 1 for additional information.
FORWARD-LOOKING STATEMENTS–CAUTIONARY LANGUAGE
Certain statements made in this report and in other written or oral statements made by LNC or on LNC’s behalf are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 (“PSLRA”). A forward-looking statement is a 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 in connection with a discussion of future operating or financial performance. In particular, these include statements relating to future actions, trends in our businesses, prospective services or products, future performance or financial results and the outcome of contingencies, such as legal proceedings. LNC claims the protection afforded by the safe harbor for forward-looking statements provided by the PSLRA.
Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from the results contained in the forward-looking statements. Risks and uncertainties that may cause actual results to vary materially, some of which are described within the forward-looking statements, include, among others:
Continued deterioration in general economic and business conditions, both domestic and foreign, that may affect foreign exchange rates, premium levels, claims experience, the level of pension benefit costs and funding and investment results;
Continued economic declines and credit market illiquidity could cause us to realize additional impairments on investments and certain intangible assets including a valuation allowance against deferred tax assets, which may reduce future earnings and/or affect our financial condition and ability to raise additional capital or refinance existing debt as it matures;
Uncertainty about the effectiveness of the U.S. government’s plan to purchase large amounts of illiquid, mortgage-backed and other securities from financial institutions;
Legislative, regulatory or tax changes, both domestic and foreign, that affect the cost of, or demand for, LNC’s products, the required amount of reserves and/or surplus, or otherwise affect our ability to conduct business, including changes to statutory reserves and/or risk-based capital (“RBC”) requirements related to secondary guarantees under universal life and variable annuity products such as Actuarial Guideline VACARVM (“VACARVM”); restrictions on revenue sharing and 12b-1 payments; and the potential for U.S. Federal tax reform;
The initiation of legal or regulatory proceedings against LNC or its subsidiaries, and the outcome of any legal or regulatory proceedings, such as: adverse actions related to present or past business practices common in businesses in which LNC and its subsidiaries compete; adverse decisions in significant actions including, but not limited to, actions brought by federal and state authorities and extra-contractual and class action damage cases; new decisions that result in changes in law; and unexpected trial court rulings;
Changes in interest rates causing a reduction of investment income, the margins of LNC’s fixed annuity and life insurance businesses and demand for LNC’s products;
A decline in the equity markets causing a reduction in the sales of LNC’s products, a reduction of asset-based fees that LNC charges on various investment and insurance products, an acceleration of amortization of DAC, VOBA, DSI and DFEL and an increase in liabilities related to guaranteed benefit features of LNC’s variable annuity products;
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Ineffectiveness of LNC’s various hedging strategies used to offset the impact of changes in the value of liabilities due to changes in the level and volatility of the equity markets and interest rates;
A deviation in actual experience regarding future persistency, mortality, morbidity, interest rates or equity market returns from LNC’s assumptions used in pricing its products, in establishing related insurance reserves and in the amortization of intangibles that may result in an increase in reserves and a decrease in net income, including as a result of stranger-originated life insurance business;
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Changes in GAAP that may result in unanticipated changes to LNC’s net income, including the impact of SFAS 157 and SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities”;
Lowering of one or more of LNC’s debt ratings issued by nationally recognized statistical rating organizations and the adverse impact such action may have on LNC’s ability to raise capital and on its liquidity and financial condition;
Lowering of one or more of the insurer financial strength ratings of LNC’s insurance subsidiaries and the adverse impact such action may have on the premium writings, policy retention and profitability of its insurance subsidiaries;
Significant credit, accounting, fraud or corporate governance issues that may adversely affect the value of certain investments in the portfolios of LNC’s companies requiring that LNC realize losses on such investments;
The impact of acquisitions and divestitures, restructurings, product withdrawals and other unusual items, including LNC’s ability to integrate acquisitions and to obtain the anticipated results and synergies from acquisitions, including LNC’s ability to successfully integrate Jefferson-Pilot Corporation (“Jefferson-Pilot”) businesses acquired on April 3, 2006, to achieve the expected synergies from the merger or to achieve such synergies within our expected timeframe;
The adequacy and collectibility of reinsurance that LNC has purchased;
Acts of terrorism, war or other man-made and natural catastrophes that may adversely affect LNC’s businesses and the cost and availability of reinsurance;
Competitive conditions, including pricing pressures, new product offerings and the emergence of new competitors, that may affect the level of premiums and fees that LNC can charge for its products;
The unknown impact on LNC’s business resulting from changes in the demographics of LNC’s client base, as aging baby-boomers move from the asset-accumulation stage to the asset-distribution stage of life; and
Loss of key management, portfolio managers in the Investment Management segment, financial planners or wholesalers;
Changes in general economic or business conditions, both domestic and foreign, that may be less favorable than expected and may affect foreign exchange rates, premium levels, claims experience, the level of pension benefit costs and funding and investment results; and
Continued economic declines and credit market volatility that could cause us to realize additional impairments on investments and certain intangible assets and dampen future earnings.wholesalers.
The risks included here are not exhaustive. Other sections of this report, our 2007 Form 10-K, current reports on Form 8-K and other documents filed with the Securities and Exchange Commission (“SEC”) include additional factors that could impact LNC’s business and financial performance, including “Item 3. Quantitative and Qualitative Disclosures About Market Risk” and the risk discussions included in this section under “Critical Accounting Policies and Estimates,” “Consolidated Investments” and “Reinsurance,” which are incorporated herein by reference. 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 undue 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
Executive Summary
We are a holding company that operates multiple insurance and investment management businesses through subsidiary companies. Through our business segments, we sell a wide range of wealth protection, accumulation and retirement income products and solutions. These products include institutional and/or retail fixed and indexed annuities, variable annuities, universal life insurance (“UL”), variable universal life insurance (“VUL”), linked-benefit UL, term life insurance, mutual funds and managed accounts.
As of June 30, 2008, we provided products and services in four operating businesses: Individual Markets, Employer Markets, Investment Management and Lincoln UK, and reported results through six business segments: Individual Markets – Annuities; Individual Markets – Life Insurance; Employer Markets – Retirement Products; Employer Markets – Group Protection; Investment Management; and Lincoln UK. These operating businesses and their segments are described in “Part I – Item 1. Business” of our 2007 Form 10-K. We also have Other Operations, which includes the financial data for operations that are not directly related to the business segments. Other Operations also includes the Institutional Pension business, which was previously reported in Employer Markets – Retirement Products.
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On July 21, 2008, we announced the realignment of our segments under our former Employer Markets and Individual Markets operating businesses into two new operating businesses – Retirement Solutions and Insurance Solutions. We believe the new structure more closely aligns with consumer needs and should lead to more coordinated product development and greater effectiveness across the enterprise. The only change to our current segment reporting will be to reportis reporting the results of the Executive Benefits business, which as of June 30, 2008, was part of the Retirement Products segment, in the Life Insurance segment. Accordingly, forbeginning in the third quarter of 2008, we will provide products and services in four operating business and report results through six segments as follows:
Business | Corresponding Segments | |||||
Retirement Solutions | Annuities | |||||
| ||||||
Defined Contribution (formerly Retirement Products) | ||||||
Insurance Solutions | Life Insurance (including Executive Benefits business) | |||||
Group Protection | ||||||
Investment Management | Investment Management | |||||
Lincoln UK | Lincoln UK |
These changes to the Retirement Products and the Life Insurance segments are in accordance with the provisions of SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” and reflect the manner in which we are organized for purposes of making operating decisions and assessing performance. Our segment results will beare reported under this new structure beginning in the third quarter of 2008, and we will restatehave restated results from prior periods in a consistent manner. We view the changes to the existing segments as immaterial.
We also have Other Operations, which includes the financial data for operations that are not directly related to the business segments. Other Operations also includes our run-off Institutional Pension business, which was previously reported in Employer Markets – Retirement Products and the results of our remaining media businesses.
Current Market Conditions
During the first halfnine months of the year, the capital markets continued to experience high volatility that affected both equity market returns and interest rates. In addition, we also saw the widening of credit spreads widened across asset classes and reduced liquidity in the credit markets. Earnings infor the second halfremainder of 2008 will continue to be unfavorably impacted by the significant decline in the Standard & Poor’s (“S&P”) 500 Index®equity markets during June. While the average S&P 500 Index® for second quarter was higher than first quarter, the S&P 500 Index® ended June at a lower level than the average because favorable equity market performance in April and May was largely offset by unfavorable performance in June.nine months of 2008. Due to these challenges, the capital markets had a significant effect on our segment operating income and consolidated net income for the three and sixnine months ended JuneSeptember 30, 2008. Furthermore, although the fourth quarter is normally the strongest in terms of sales for our Life Insurance segment, we expect that those results will be muted in the fourth quarter. The markets impact primarily the following areas:
Earnings from Assets Under Management
Our asset-gathering segments: Individual MarketsRetirement Solutions – Annuities; Employer MarketsRetirement Solutions – Retirement Products;Defined Contribution; and Investment Management; are sensitive to the equity markets. We discuss the earnings impact of the equity markets on account values, assets under management and the related asset-based fees below in “Item 3. Quantitative and Qualitative Disclosures About Market Risk – Equity Market Risk – Impact of Equity Market Sensitivity.” From the end of 2007 to JuneSeptember 30, 2008, the daily average value of the Standard & Poor’s (“S&P&P”) 500 Index®Index® decreased 7%10%. Solely as a result of the equity markets, our assets under management as of JuneSeptember 30, 2008, were down $14.1$30.1 billion from the end of the prior year. Strong deposits over the last year have only helped to more thanpartially offset this impact for the three and sixnine months ended JuneSeptember 30, 2008, compared to the same periods in 2007.
We have continued to experience unfavorable equity markets as the October 2008 daily average of the S&P 500 Index® declined 17% from its value as of September 30, 2008, resulting in an approximate $18 billion decline in our assets under management. We expect our income from operations to be negatively impacted in our asset-gathering businesses from lower asset-based earnings and expect our net flows in these businesses to continue to be pressured from these unfavorable equity market conditions.
Investment Income on Alternative Investments
We believe that overall market conditions in both the equity and credit markets caused our alternative investments portfolio, which consists mostly of hedge funds and various limited partnership investments, to under-performperform in line relative to our long-term expectations, andbut we expect these assets to under-perform, going forward, in the prior periods.short term. This impact was primarily in our Individual MarketsInsurance Solutions – Life Insurance, Employer MarketsRetirement Solutions – Annuities and Retirement Products and Individual MarketsSolutions – AnnuitiesDefined Contribution segments. See “Consolidated Investments – Alternative Investments” for additional information on our investment portfolio.
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Variable Annuity Living Benefit Hedge Program Results
We offer variable annuity products with living benefit guarantees. These guarantees are considered embedded derivatives and are recorded on our Consolidated Balance Sheets at fair value under SFAS 133 and SFAS 157. Effective January 1, 2008, we adopted SFAS 157, which affected the valuation of our embedded derivatives. See Note 2 of this report for details on the adoption of SFAS 157. As described below in “Critical Accounting Policies and Estimates – Derivatives – Guaranteed Living Benefits,” we use
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derivative instruments to hedge our exposure to the risks and earnings volatility that result from the embedded derivatives for living benefits in certain of our variable annuity products. The change in fair value of these instruments tends to move in the opposite direction of the change in fair value of the embedded derivatives. For the three and sixnine months ended JuneSeptember 30, 2008, the market conditions noted above negatively affected the net result of the change in the fair value of the living benefit embedded derivative, excluding the effect of a change in our non-performance risk factor, and the change in fair value of the hedging derivatives. The change in our non-performance risk factor used in the calculation of the embedded derivative liability had a favorable effect resulting in an overall positive outcome. These results are excluded from operating revenues and income (loss) from operations.
Credit Losses, Impairments and Unrealized Losses
Related to the our investments in fixed income and equity securities, we experienced net realized losses of $125$314 million and $166$480 million for the three and sixnine months ended JuneSeptember 30, 2008, which included gross write-downs of securities for other-than-temporary impairments of $120$312 million and $211$523 million, respectively. Widening spreads was the primary cause of an increase in gross unrealized losses of $1.7$3.7 billion on investments in our general account for the sixnine months ended JuneSeptember 30, 2008, for our available-for-sale fixed maturity securities. These unrealized losses were concentrated in the investment grade category of investments and demonstrate how reduced liquidity in the credit markets have resulted in a decline in asset values as investors shift their investments to safer government securities, such as U.S. Treasuries.
We recorded $139 million, after-tax, of impairment of goodwill and our Federal Communications Commission (“FCC”) license intangible assets on our remaining radio clusters attributable primarily to declines in advertising revenues for the entire radio market.
The effect of the negative equity markets on our assets under management in the first sixnine months of 2008 will continue to dampen our earnings throughout 2008 even if, for the remainder of the year, the equity market returns are consistent with our long-term assumptions. Accordingly, we may continue to report lower asset-based fees relative to expectations or prior periods. The volatility and uncertainty in the capital markets will also likely result in lower than expected returns in the short term on alternative investments. In addition, a continued weakness in the economic environment could lead to increased credit defaults.defaults, resulting in additional write-downs of securities for other-than-temporary impairments.
In the face of these capital market challenges, we continue to focus on building our businesses through these difficult markets and beyond by developing and introducing high quality products, expanding distribution in new and existing key accounts and channels and targeting market segments that have high growth potential while maintaining a disciplined approach to managing our expenses.
Capital Preservation
On October 10, 2008, the Board of Directors approved a decrease in the quarterly dividend to stockholders from $0.415 per share to $0.21 per share effective in 2009, which is expected to add approximately $50 million to capital each quarter. Additionally, we have suspended further stock repurchase activity. Both of these changes will favorably impact our capital position prospectively.
Emergency Economic Stabilization Act of 2008
In reaction to the credit market illiquidity and global financial crisis experienced during September and October of 2008, Congress enacted the Emergency Economic Stabilization Act of 2008 (“EESA”) on October 3, 2008, in an effort to restore liquidity to the U.S. credit markets. The EESA defines financial institutions to include insurance companies. The EESA contains the Troubled Assets Relief Program (“TARP”). The TARP authorized the U.S. Treasury to purchase “troubled assets” (as defined in the TARP) from financial institutions, including insurance companies. Pursuant to the authority granted under the TARP, the U.S. Treasury also adopted the Capital Purchase Program. Under the Capital Purchase Program, as currently adopted, bank and thrift holding companies may apply to the U.S. Treasury for the direct sale of preferred stock and warrants to the U.S. Treasury. It remains unclear at this point, if and when the EESA will restore sustained liquidity and confidence in the markets and its affect on the fair value of our invested assets.
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Strategic and Operational Review
Continual productProduct development and strong distribution expansion are important to our ability to meet the challenges of the competitive marketplace. In the third quarter of 2008, our Insurance Solutions – Life Insurance segment launchedLincoln AssetEdgeSM VUL, a variable life insurance product offering clients the ability to align their portfolio to match investment goals, while retaining the flexibility to change allocations as needs change. In February 2008, our Individual MarketsRetirement Solutions – Annuities segment launched a new guaranteed withdrawal benefit (“GWB”),Lincoln Lifetime IncomeSMAdvantage, which includes features such as: a reduced minimum age for lifetime income eligibility; a 5% benefit enhancement in each year an owner does not take a withdrawal; a health care benefit; and a guaranteed minimum accumulation benefit. In our Individual Markets – Life Insurance segment, we intend to launch a variable life insurance product in the third quarter of 2008 after receiving appropriate regulatory approvals. Within the mid-sized market of our Employer MarketsRetirement Solutions – Retirement ProductsDefined Contribution segment, in the first quarter we launched ourLincoln SmartFutureSM retirement program to fill the gap between our Alliance program and our group variable annuities.
In the third quarter we launched our new LINCOLN DIRECTORSM product that offers more than 80 investment options and will be positioned as our primary product in the micro-to small 401(k) plan marketplace. This product includes fiduciary support for plan sponsors, accumulation strategies and tools for plan participants and will also offer our patented distribution option,i4LIFE® Advantage.
In terms of increasing our distribution breadth, we launched variable annuity products into three large banks during the first halfnine months of 2008. In support of these and other activities, Lincoln Financial Distributors (“LFD”) increased the number of wholesalers by 9%13% since the end of 2007 with additional increases expected in the remainder of the year.2007.
Challenges and Outlook
For the remainder of 2008, we expect major challenges to include:
Continuation of volatility in the equity markets and hedge breakage, as the October 2008 daily average of the S&P 500 Index® declined 17% from its value as of September 30, 2008, causing continued variable account value erosion;
Continuation of illiquid credit markets;markets and impact on spreads and on other-than-temporary impairments;
Continuation of the low interest rate environment, which creates a challenge for our products that generate investment margin profits, such as fixed annuities and UL;
Continuation of challenges in the economy, orincluding the potential for a recession;
Achieving success in our portfolio of products, and marketplace acceptance of new variable annuity features and maintaining management and wholesalers that will help maintain our competitive position;
Continuation of the successful expansion of our wholesale distribution businesses;
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Ability to improve financial and sales results and increase scale in our Employer Markets – Defined Contribution and Investment Management businesses;
Continuation of focus by the government on tax reform including potential changes in company dividends-received deduction (“DRD”) calculations, which may impact our products and overall earnings;
Continuation of competitive pressures in the life insurance and annuity marketplace; and
Regulatory scrutiny of the life and annuity industry, which may lead to higher product costs and negative perceptions about the industry.earnings.
In the face of these challenges, we expect to focus on the following throughout the remainder of 2008:
Continue to significantly invest in expanding our distribution in each of our core Retirement Solutions, Insurance Solutions and Investment Management businesses;
Continue near term product development in our manufacturing units and future product development initiatives in our Retirement Income Security Venture unit related to the evolving retirement income security marketplace;
Explore strategies to increase scaleEngage in our Employer Markets – Defined Contributioncost reduction initiatives and Investment Management businesses;
Furtherfurther embed financial and execution discipline throughout our operations by using technology and making other investments to improve operating effectiveness and lower unit costs; and
Substantially complete the remaining platform and system consolidations necessary to achieve the final portion of integration cost saves as well as prepare us for more effective customer interaction in the future.
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Critical Accounting Policies and Estimates
The MD&A included in our 2007 Form 10-K contains a detailed discussion of our critical accounting policies and estimates. The following information updates the critical accounting policies and estimates provided in our 2007 Form 10-K and, accordingly, should be read in conjunction with the critical accounting policies and estimates discussed in our 2007 Form 10-K.
Adoption of SFAS No. 157 – Fair Value Measurements
We adopted SFAS 157 for all our financial instruments effective January 1, 2008. For detailed discussions of the methodologies and assumptions used to determine the fair value of our financial instruments and a summary of our financial instruments carried at fair value as of JuneSeptember 30, 2008, see Notes 2 and 1516 of this report and Notes 1 and 19 to the consolidated financial statements in our 2007 Form 10-K.
The adoption of SFAS 157 decreased income from continuing operations by $16 million. The impact to revenue is reported in realized gain (loss) and such amount along with the associated federal income taxes is excluded from income from operations of our segments. For a detailed description of the impact of adoption on our consolidated financial statements, see Note 2.
We did not make any material changes to valuation techniques or models used to determine the fair value of our assets and liabilities carried at fair value during the three and sixnine months ended JuneSeptember 30, 2008, subsequent to the adoption of SFAS 157. As part of our on-going valuation process, we assess the reasonableness of all our valuation techniques or models and make adjustments as necessary.
Our investment securities are valued using market inputs, including benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers and reference data. In addition, market indicators and industry and economic events are monitored, and further market data is acquired if certain triggers are met. Credit risk is also incorporated and considered in the valuation of our investment securities as we incorporate the issuer’s credit rating and a risk premium, if warranted, due to the issuer’s industry and the security’s time to maturity. The credit rating is based upon internal and external analysis of the issuer’s financial strength. For certain security types, additional inputs may be used, or some of the inputs described above may not be applicable. For broker-quoted only securities, quotes from market makers or broker-dealers are obtained from sources recognized to be market participants. In order to validate the pricing information and broker/dealer quotes, we employ, where possible, procedures that include comparisons with similar observable positions, comparisons with subsequent sales, discussions with senior business leaders and brokers as well as observations of general market movements for those asset classes. The broker/dealer quotes are non-binding. Our broker-quoted only securities are generally classified as Level 3 in the SFAS 157 hierarchy.
It is possible that different valuation techniques and models, other than those described above, could produce materially different estimates of fair values.
The following summarizes our financial instruments carried at fair value by pricing source and SFAS 157 hierarchy level (in millions):
As of September 30, 2008 | ||||||||||||||||
Level 1 | Level 2 | Level 3 | Total | |||||||||||||
Priced by third party pricing services | $ | 293 | $ | 43,861 | $ | — | $ | 44,154 | ||||||||
Priced by independent broker quotations | — | — | 2,528 | 2,528 | ||||||||||||
Priced by matrices | — | 6,807 | — | 6,807 | ||||||||||||
Priced by other methods (1) | — | — | 2,590 | 2,590 | ||||||||||||
Cash and invested cash(2) | — | 2,160 | — | 2,160 | ||||||||||||
Total | $ | 293 | $ | 52,828 | $ | 5,118 | $ | 58,239 | ||||||||
Percent of total | 1 | % | 90 | % | 9 | % | 100 | % |
(1) | Represents primarily securities for which pricing models were used to compute the fair values. |
(2) | Valued primarily at amortized cost, which approximates fair value. |
Our insurance liabilities that contain embedded derivatives are valued based on a stochastic projection of scenarios of the embedded derivative fees, benefits and expenses. The scenario assumptions, at each valuation date, are those we view to be appropriate for a hypothetical market participant and include assumptions for capital markets, actuarial lapse, benefit utilization, mortality, risk margin, administrative expenses and a margin for profit. In addition, a non-performance risk component is determined each valuation date that reflects our risk of not fulfilling the obligations of the underlying liability. The spread for the non-performance risk is added to the discount rates used in determining the fair value from the net cash flows. We believe these
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assumptions are consistent with those that would be used by a market participant; however, as the related markets develop we will continue to reassess our assumptions. It is possible that different valuation techniques and assumptions could produce a materially different estimate of fair value.
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The adoption of SFAS 157 increased our exposure to earnings volatility from period to period due primarily to the inclusion of the non-performance risk into the calculation of the GLB embedded derivative liability. For additional information, see our discussion in “Realized Gain (Loss)Loss” below and “Item 3. Quantitative and Qualitative Disclosures About Market Risk.” below.
The following summarizes the percentages of our financial instruments carried at fair value on a recurring basis by the SFAS 157 hierarchy levels:
As of June 30, 2008 | As of September 30, 2008 | |||||||||||||||||||||||
Level 1 | Level 2 | Level 3 | Total Fair Value | Level 1 | Level 2 | Level 3 | Total Fair Value | |||||||||||||||||
Assets | 1 | % | 90 | % | 9 | % | 100 | % | 1 | % | 90 | % | 9 | % | 100 | % | ||||||||
Liabilities | 0 | % | 15 | % | 85 | % | 100 | % | 0 | % | 0 | % | 100 | % | 100 | % |
Note: The percentages above are calculated excluding separate account assets.
Changes of our financial instruments carried at fair value and classified within level 3 of the fair value hierarchy result from changes in market conditions, as well as changes in our portfolio mix and increases and decreases in fair values as a result of those classifications. During the three and sixnine months ended JuneSeptember 30, 2008, there were no material changes in financial instruments classified as level 3 of the fair value hierarchy. For further detail, see Note 15.16.
See “Consolidated Investments” below for a summary of our investments in available-for-sale securities backed by pools of residential mortgages.
DAC, VOBA, DSI and DFEL
On a quarterly basis, we may record an adjustment to the amounts included within our Consolidated Balance Sheets for DAC, VOBA, DSI and DFEL with an offsetting benefit or charge to revenue or expense for the impact of the difference between the estimates of future gross profits used in the prior quarter and the emergence of actual and updated estimates of future gross profits in the current quarter (“retrospective unlocking”). In addition, in the third quarter of each year, we conduct our annual comprehensive review of the assumptions and the projection models used for our estimates of future gross profits underlying the amortization of DAC, VOBA, DSI and DFEL and the calculations of the embedded derivatives and reserves for annuity and life insurance products with living benefit and death benefit guarantees. These assumptions include investment margins, mortality, retention and rider utilization. Based on our review, the cumulative balances of DAC, VOBA, DSI and DFEL, included on our Consolidated Balance Sheets, are adjusted with an offsetting benefit or charge to revenue or amortization expense to reflect such change (“prospective unlocking – assumption changes”). We may also identify and implement actuarial modeling refinements (“prospective unlocking – model refinements”) that result in increases or decreases to the carrying values of DAC, VOBA, DSI, DFEL, embedded derivatives and reserves for annuity and life insurance products with living benefit and death benefit guarantees. The primary distinction between retrospective and prospective unlocking is that retrospective unlocking is driven by the emerging experience period-over-period, while prospective unlocking is driven by changes in assumptions or projection models related to estimated future gross profits.
In discussing our results of operations below in this MD&A, we refer to favorable and unfavorable unlocking. With respect to DAC, VOBA and DSI, favorable unlocking refers to a decrease in the amortization expense in the period, whereas unfavorable unlocking refers to an increase in the amortization expense in the period. With respect to DFEL, favorable unlocking refers to an increase in the amortization expense in the period, whereas unfavorable unlocking refers to a decrease in the amortization expense in the period. With respect to the calculations of the embedded derivatives and reserves for annuity and life insurance products with living benefit and death benefit guarantees, favorable unlocking refers to a decrease in the change in reserves in the period, whereas unfavorable unlocking refers to an increase in the change in reserves in the period.
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Details underlying the increase to income from continuing operations from our prospective unlocking (in millions) were as follows:
For the Three Months Ended September 30, | ||||||||
2008 | 2007 | |||||||
Insurance fees: | ||||||||
Retirement Solutions – Annuities | $ | (1 | ) | $ | (1 | ) | ||
Insurance Solutions – Life Insurance | (28 | ) | 26 | |||||
Lincoln UK | (1 | ) | 5 | |||||
Total insurance fees | (30 | ) | 30 | |||||
Realized gain (loss): | ||||||||
Indexed annuity forward-starting option | — | 1 | ||||||
GLB | 48 | 2 | ||||||
Total realized gain (loss) | 48 | 3 | ||||||
Total revenues | 18 | 33 | ||||||
Interest credited: | ||||||||
Retirement Solutions – Annuities | — | (1 | ) | |||||
Total interest credited | — | (1 | ) | |||||
Benefits: | ||||||||
Retirement Solutions – Annuities | — | 2 | ||||||
Insurance Solutions – Life Insurance | 85 | — | ||||||
Total benefits | 85 | 2 | ||||||
Underwriting, acquisition, insurance and other expenses: | ||||||||
Retirement Solutions – Annuities | (2 | ) | (12 | ) | ||||
Retirement Solutions – Defined Contribution | — | 3 | ||||||
Insurance Solutions – Life Insurance | (81 | ) | 21 | |||||
Lincoln UK | 4 | 2 | ||||||
Total underwriting, acquisition, insurance and other expenses | (79 | ) | 14 | |||||
Total benefits and expenses | 6 | 15 | ||||||
Income from continuing operations before taxes | 12 | 18 | ||||||
Federal income taxes | 4 | 6 | ||||||
Income from continuing operations | $ | 8 | $ | 12 | ||||
As equity markets do not move in a systematic manner, we use a “reversion to the mean” (“RTM”) process to compute our best estimate long-term gross growth rate assumption. Under our current RTM process, on each valuation date, future estimated gross profits (“EGPs”) are projected using stochastic modeling of a large number of future equity market scenarios in conjunction with best estimates of lapse rates, interest rate spreads and mortality to develop a statistical distribution of the present value of future EGPs for our variable annuity, annuity-based 401(k) and unit-linked product blocks of business. This process is not applied to our life insurance and fixed annuity businesses, as equity market performance does not have as significant of an impact on these products. Because future equity market returns are unpredictable, the underlying premise of this process is that best estimate projections of future EGPs, as required by SFAS No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments” (“SFAS 97”), need not be affected by random short-term and insignificant deviations from expectations in equity market returns. However, long-term or significant deviations from expected equity market returns require a change to best estimate projections of EGPs and prospective unlocking of DAC, VOBA, DSI and DFEL. The statistical distribution is designed to identify when the equity market return deviations from expected returns have become significant enough to warrant a change of the future equity return EGP assumption.
The stochastic modeling performed for our variable annuity blocks of business as described above is used to develop a range of reasonably possible future EGPs. We compare the range of the present value of the future EGPs from the stochastic modeling to that used in our amortization model. A set of intervals around the mean of these scenarios is utilized to calculate two separate statistical ranges of reasonably possible EGPs. These intervals are then compared again to the present value of the EGPs used in the amortization model. If the present value of EGP assumptions utilized for amortization were to exceed the margin of the
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reasonable range of statistically calculated EGPs, a revision of the EGPs used to calculate amortization would occur. If a revision is deemed necessary, future EGPs would be re-projected using the current account values at the end of the period during which the revision occurred along with a revised long-term annual equity market gross return assumption such that the reprojected EGPs would be our best estimate of EGPs.
Notwithstanding these intervals, if a severe decline or advance in equity markets were to occur or should other circumstances, including contract holder behavior, suggest that the present value of future EGPs no longer represents our best estimate, we could determine that a revision of the EGPs is necessary.
Our practice is not necessarily to unlock immediately after exceeding the first of the two statistical ranges, but, rather, if we stay between the first and second statistical range for several quarters, we would likely unlock. Additionally, if we exceed the ranges as a result of a short-term market reaction, we would not necessarily unlock. However, if the second statistical range is exceeded for more than one quarter, it is likely that we would unlock. While this approach reduces adjustments to DAC, VOBA, DSI and DFEL due to short-term equity market fluctuations, significant changes in the equity markets that extend beyond one or two quarters could result in a significant favorable or unfavorable unlocking.
The October 2008 daily average of the S&P 500 Index® declined 17% from its value as of September 30, 2008, negatively impacting our variable account values. If equity markets do not materially improve over the remainder of the fourth quarter, we may unlock our model assumption for equity market returns for DAC, VOBA, DSI and DFEL and the calculations of the embedded derivatives and reserves for annuity products with living and death benefit guarantees, resulting in a significant unfavorable impact to net income. We estimate that if the variable account values were to decline approximately 20% at December 31, 2008 from the levels at September 30, 2008, an unlocking during the fourth quarter could reduce net income by approximately $250 million, after-tax.
Goodwill and Other Intangible Assets
Under SFAS No. 142, “Goodwill and Other Intangible Assets,” goodwill and intangible assets with indefinite lives are not amortized, but are subject to impairment tests conducted at least annually. Intangibles that do not have indefinite lives are amortized over their estimated useful lives. We use October 1 as the annual review date for goodwill and other intangible assets impairment testing.
The valuation techniques we use to estimate the fair value of the group of assets comprising the different reporting units varies based on the characteristics of each reporting unit’s business and operations. A market-based valuation technique that focuses on price-to-earnings multiplier and the segment-level operating income is used for the Retirement Solutions and Insurance Solutions segments and the remaining media business that is now reported in Other Operations. For the Lincoln UK segment, a discounted cash flow model is utilized to determine the fair value. A valuation technique combining multiples of revenues, earnings before interest, taxes, depreciation and amortization and assets under management is used to assess the goodwill in our Investment Management segment.
Derivatives
To protect us from a variety of equity market and interest rate risks that are inherent in many of our life insurance and annuity products, we use various derivative instruments. Assessing the effectiveness of these hedging programs and evaluating the carrying values of the related derivatives often involve a variety of assumptions and estimates. We use derivatives to hedge equity market risks, interest rate risk and foreign currency exposures that are embedded in our annuity and life insurance product liabilities or investment portfolios. Derivatives held as of JuneSeptember 30, 2008, contain industry standard terms and are entered into with financial institutions with long-standing, superior performance records. Our accounting policies for derivatives and the potential impact on interest spreads in a falling rate environment are discussed in “Item 3. Quantitative and Qualitative Disclosures About Market Risk” of this report and “Part II – Item 7A. Quantitative and Qualitative Disclosures About Market Risk” and Note 5 to the consolidated financial statements in our 2007 Form 10-K.
Guaranteed Living Benefits
We have a dynamic hedging strategy designed to mitigate theselected risk and income statement volatility caused by changes in the equity markets, interest rates and market implied volatilities associated with theLincoln SmartSecurity® Advantage GWB feature and ouri4LIFE® Advantage guaranteed income benefit (“GIB”) feature that is available in our variable annuity products. In the second quarter of 2007, we also began hedging our 4LATER®4LATER® Advantage GIB feature available in our variable annuity products. These living benefit features are collectively referred to as GLBs. During 2007, we made adjustments to our hedging program to purchase longer dated volatility protection and increased our hedges related to volatility to better match liability sensitivities under SFAS 157. In addition, in early January 2008, we added the variable annuity business in our New York insurance subsidiary, with total account values of approximately $1.2$1.1 billion as of JuneSeptember 30, 2008, to our hedge program. In February 2008, we also added our new GWBLincoln Lifetime IncomeSMAdvantage to our hedging program. In addition to mitigating selected risk and
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income statement volatility, the hedge program is also focused on long-term performance of the hedge program recognizing that any material potential claims under the GLBs are approximately a decade in the future.
The hedging strategy is designed such that changes in the value of the hedge contracts move in the opposite direction of changes in the value of the embedded derivative of the GWB and GIB features. This dynamic hedging strategy utilizes options on U.S.-based equity indices, futures on U.S.-based and international equity indices and variance swaps on U.S.-based equity indices, as well as interest rate futures and swaps. The notional amounts of the underlying hedge instruments are such that the magnitude of the change in the value of the hedge instruments due to changes in equity markets, interest rates and implied volatilities is designed to offset the magnitude of the change in the fair value of the GWB and GIB guarantees caused by those same factors. As of JuneSeptember 30, 2008, the embedded derivatives for GWB, thei4LIFE® Advantage GIB and the 4LATER®4LATER® Advantage GIB were liabilities valued at $220$249 million, $74$200 million and $41$115 million, net of the non-performance risk factor (“NPR”) required by SFAS 157, respectively.
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For additional information on our hedging results, see our discussion in “Realized Gain (Loss)”Loss” below.
Acquisitions and Dispositions
Dispositions
Media Business
On June 7, 2007, we announced plans to explore strategic options for our former business segment, Lincoln Financial Media. During the fourth quarter of 2007, we decided to divest our television and Charlotte radio broadcasting and sports programming businesses, and, on November 12, 2007, we signed agreements to sell them. The divestiture of the sports programming business closed on November 30, 2007, the Charlotte radio broadcasting business closed on January 31, 2008, and the television broadcasting business closed on March 31, 2008. Accordingly, we have reported the results of these businesses as discontinued operations on our Consolidated Statements of Income and the assets and liabilities as held for sale on our Consolidated Balance Sheets for all periods presented. We continue to actively manage our investment in our remaining radio clusters, which are now being reported within Other Operations, to maximize station performance and future valuation. For additional information, see Note 3.
The proceeds from the sales of the above media properties were used for repurchase of shares, repayment of debt and other strategic initiatives.
The results of operations of these businesses have been reclassified into income from discontinued operations for all periods presented on the Consolidated Statements of Income. The amounts (in millions) related to operations of these businesses, included in income from discontinued operations, were as follows:
For the Three Months Ended June 30, | Change | For the Six Months Ended June 30, | Change | For the Three Months Ended September 30, | For the Nine Months Ended September 30, | ||||||||||||||||||||||||||||||||||
2008 | 2007 | 2008 | 2007 | 2008 | 2007 | Change | 2008 | 2007 | Change | ||||||||||||||||||||||||||||||
Discontinued Operations Before Disposal | |||||||||||||||||||||||||||||||||||||||
Media revenues, net of agency commissions | $ | — | $ | 29 | -100 | % | $ | 22 | $ | 71 | -69 | % | $ | — | $ | 33 | -100 | % | $ | 22 | $ | 104 | -79 | % | |||||||||||||||
Income from discontinued operations before disposal, before federal income taxes | $ | — | $ | 10 | -100 | % | $ | 8 | $ | 22 | -64 | % | $ | — | $ | 10 | -100 | % | $ | 8 | $ | 32 | -75 | % | |||||||||||||||
Federal income taxes | — | 4 | -100 | % | 3 | 8 | -63 | % | — | 3 | -100 | % | 3 | 11 | -73 | % | |||||||||||||||||||||||
Income from discontinued operations before disposal | — | 6 | -100 | % | 5 | 14 | -64 | % | — | 7 | -100 | % | 5 | 21 | -76 | % | |||||||||||||||||||||||
Disposal | |||||||||||||||||||||||||||||||||||||||
Loss on disposal, before federal income taxes | — | — | NM | (12 | ) | — | NM | — | — | NM | (13 | ) | — | NM | |||||||||||||||||||||||||
Federal income tax benefit | — | — | NM | (3 | ) | — | NM | 1 | — | NM | (3 | ) | — | NM | |||||||||||||||||||||||||
Loss on disposal | — | — | NM | (9 | ) | — | NM | (1 | ) | — | NM | (10 | ) | — | NM | ||||||||||||||||||||||||
Income (loss) from discontinued operations | $ | — | $ | 6 | -100 | % | $ | (4 | ) | $ | 14 | NM | $ | (1 | ) | $ | 7 | NM | $ | (5 | ) | $ | 21 | NM | |||||||||||||||
During the first quarter of 2008, we adjusted our loss on disposal of discontinued media properties due primarily to changes in the net assets disposed of for the television broadcasting business.
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Fixed Income Investment Management Business
During the fourth quarter of 2007, we sold certain institutional taxable fixed income business to an unaffiliated investment management company. Investment Management transferred $12.3 billion of assets under management as part of this transaction. Based upon the assets transferred as of October 31, 2007, the purchase price is expected to be no more than $49 million. We expectThe impact of this transaction to decrease income from operations, compared to the corresponding periodsis discussed further below in 2007, by approximately $3 million, after-tax, per quarter in 2008.results of Investment Management.
During the fourth quarter of 2007, we received $25 million of the purchase price, with additional scheduled payments over the next three years. During 2007, we recorded an after-tax realized loss of $2 million on our Consolidated Statements of Income as a result
45
of goodwill we attributed to this business. There were certain other pipeline accounts in process at the time of the transaction closing, and any adjustment to the purchase price, if necessary, will be determined at October 31, 2008. During the three and sixnine months ended JuneSeptember 30, 2008, we recorded an after-tax gain of $1 million and $3$4 million, respectively, on our Consolidated Statements of Income related to this transaction.
For additional information about acquisitions and dispositions, Seesee “Part II – Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Introduction – Acquisition and Dispositions” in our 2007 Form 10-K.
RESULTS OF CONSOLIDATED OPERATIONS
Net Income
Details underlying the consolidated results and assets under management (in millions) were as follows:
For the Three Months Ended June 30, | Change | For the Six Months Ended June 30, | Change | For the Three Months Ended September 30, | For the Nine Months Ended September 30, | |||||||||||||||||||||||||||||||||||||
2008 | 2007 | 2008 | 2007 | �� | 2008 | 2007 | Change | 2008 | 2007 | Change | ||||||||||||||||||||||||||||||||
Revenues | ||||||||||||||||||||||||||||||||||||||||||
Insurance premiums | $ | 530 | $ | 489 | 8 | % | $ | 1,039 | $ | 948 | 10 | % | $ | 533 | $ | 491 | 9 | % | $ | 1,572 | $ | 1,439 | 9 | % | ||||||||||||||||||
Insurance fees | 842 | 742 | 13 | % | 1,654 | 1,506 | 10 | % | 791 | 836 | -5 | % | 2,446 | 2,342 | 4 | % | ||||||||||||||||||||||||||
Investment advisory fees | 76 | 93 | -18 | % | 152 | 183 | -17 | % | 68 | 89 | -24 | % | 220 | 272 | -19 | % | ||||||||||||||||||||||||||
Net investment income | 1,077 | 1,133 | -5 | % | 2,142 | 2,223 | -4 | % | 1,089 | 1,062 | 3 | % | 3,231 | 3,285 | -2 | % | ||||||||||||||||||||||||||
Realized gain (loss) | (108 | ) | 7 | NM | (143 | ) | 41 | NM | ||||||||||||||||||||||||||||||||||
Realized loss | (204 | ) | (65 | ) | NM | (347 | ) | (24 | ) | NM | ||||||||||||||||||||||||||||||||
Amortization of deferred gain on business sold through reinsurance | 19 | 26 | -27 | % | 38 | 45 | -16 | % | 19 | 19 | 0 | % | 57 | 65 | -12 | % | ||||||||||||||||||||||||||
Other revenues and fees | 146 | 181 | -19 | % | 292 | 346 | -16 | % | 140 | 169 | -17 | % | 431 | 514 | -16 | % | ||||||||||||||||||||||||||
Total revenues | 2,582 | 2,671 | -3 | % | 5,174 | 5,292 | -2 | % | 2,436 | 2,601 | -6 | % | 7,610 | 7,893 | -4 | % | ||||||||||||||||||||||||||
Benefits and Expenses | ||||||||||||||||||||||||||||||||||||||||||
Interest credited | 613 | 606 | 1 | % | 1,225 | 1,206 | 2 | % | 625 | 611 | 2 | % | 1,849 | 1,817 | 2 | % | ||||||||||||||||||||||||||
Benefits | 684 | 651 | 5 | % | 1,362 | 1,244 | 9 | % | 836 | 623 | 34 | % | 2,199 | 1,866 | 18 | % | ||||||||||||||||||||||||||
Underwriting, acquisition, insurance and other expenses | 847 | 816 | 4 | % | 1,656 | 1,625 | 2 | % | 754 | 850 | -11 | % | 2,408 | 2,475 | -3 | % | ||||||||||||||||||||||||||
Interest and debt expense | 65 | 73 | -11 | % | 140 | 135 | 4 | % | 69 | 69 | 0 | % | 209 | 204 | 2 | % | ||||||||||||||||||||||||||
Impairment of intangibles | 173 | — | NM | 173 | — | NM | — | — | NM | 175 | — | NM | ||||||||||||||||||||||||||||||
Total benefits and expenses | 2,382 | 2,146 | 11 | % | 4,556 | 4,210 | 8 | % | 2,284 | 2,153 | 6 | % | 6,840 | 6,362 | 8 | % | ||||||||||||||||||||||||||
Income from continuing operations before taxes | 200 | 525 | -62 | % | 618 | 1,082 | -43 | % | 152 | 448 | -66 | % | 770 | 1,531 | -50 | % | ||||||||||||||||||||||||||
Federal income taxes | 75 | 155 | -52 | % | 200 | 324 | -38 | % | 3 | 125 | -98 | % | 203 | 450 | -55 | % | ||||||||||||||||||||||||||
Income from continuing operations | 125 | 370 | -66 | % | 418 | 758 | -45 | % | 149 | 323 | -54 | % | 567 | 1,081 | -48 | % | ||||||||||||||||||||||||||
Income (loss) from discontinued operations, net of federal incomes taxes | — | 6 | -100 | % | (4 | ) | 14 | NM | (1 | ) | 7 | NM | (5 | ) | 21 | NM | ||||||||||||||||||||||||||
Net income | $ | 125 | $ | 376 | -67 | % | $ | 414 | $ | 772 | -46 | % | $ | 148 | $ | 330 | -55 | % | $ | 562 | $ | 1,102 | -49 | % | ||||||||||||||||||
4649
For the Three Months Ended June 30, | Change | For the Six Months Ended June 30, | Change | |||||||||||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||||||||||||
Revenues | ||||||||||||||||||||||
Operating revenues: | ||||||||||||||||||||||
Individual Markets: | ||||||||||||||||||||||
Annuities | $ | 618 | $ | 624 | -1 | % | $ | 1,241 | $ | 1,214 | 2 | % | ||||||||||
Life Insurance | 1,021 | 957 | 7 | % | 2,008 | 1,929 | 4 | % | ||||||||||||||
Total Individual Markets | 1,639 | 1,581 | 4 | % | 3,249 | 3,143 | 3 | % | ||||||||||||||
Employer Markets: | ||||||||||||||||||||||
Retirement Products | 304 | 318 | -4 | % | 608 | 634 | -4 | % | ||||||||||||||
Group Protection | 425 | 391 | 9 | % | 824 | 751 | 10 | % | ||||||||||||||
Total Employer Markets | 729 | 709 | 3 | % | 1,432 | 1,385 | 3 | % | ||||||||||||||
Investment Management | 125 | 151 | -17 | % | 245 | 301 | -19 | % | ||||||||||||||
Lincoln UK | 98 | 93 | 5 | % | 183 | 183 | 0 | % | ||||||||||||||
Other Operations | 110 | 123 | -11 | % | 229 | 233 | -2 | % | ||||||||||||||
Excluded realized gain (loss), pre-tax | (120 | ) | 6 | NM | (166 | ) | 39 | NM | ||||||||||||||
Amortization of deferred gain arising from reserve changes on business sold through reinsurance, pre-tax | 1 | 8 | -88 | % | 2 | 8 | -75 | % | ||||||||||||||
Total revenues | $ | 2,582 | $ | 2,671 | -3 | % | $ | 5,174 | $ | 5,292 | -2 | % | ||||||||||
For the Three Months Ended June 30, | Change | For the Six Months Ended June 30, | Change | |||||||||||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||||||||||||
Net Income | ||||||||||||||||||||||
Income (loss) from operations: | ||||||||||||||||||||||
Individual Markets: | ||||||||||||||||||||||
Annuities | $ | 116 | $ | 123 | -6 | % | $ | 234 | $ | 240 | -3 | % | ||||||||||
Life Insurance | 153 | 176 | -13 | % | 298 | 343 | -13 | % | ||||||||||||||
Total Individual Markets | 269 | 299 | -10 | % | 532 | 583 | -9 | % | ||||||||||||||
Employer Markets: | ||||||||||||||||||||||
Retirement Products | 52 | 58 | -10 | % | 104 | 120 | -13 | % | ||||||||||||||
Group Protection | 32 | 29 | 10 | % | 58 | 52 | 12 | % | ||||||||||||||
Total Employer Markets | 84 | 87 | -3 | % | 162 | 172 | -6 | % | ||||||||||||||
Investment Management | 15 | 11 | 36 | % | 27 | 28 | -4 | % | ||||||||||||||
Lincoln UK | 18 | 12 | 50 | % | 29 | 23 | 26 | % | ||||||||||||||
Other Operations | (44 | ) | (35 | ) | -26 | % | (86 | ) | (65 | ) | -32 | % | ||||||||||
Excluded realized gain (loss), after-tax | (78 | ) | 4 | NM | (108 | ) | 25 | NM | ||||||||||||||
Income (loss) from reserve changes (net of related amortization) on business sold through reinsurance, after-tax | — | (8 | ) | 100 | % | 1 | (8 | ) | 113 | % | ||||||||||||
Impairment of intangibles, after-tax | (139 | ) | — | NM | (139 | ) | — | NM | ||||||||||||||
Income from continuing operations | 125 | 370 | -66 | % | 418 | 758 | -45 | % | ||||||||||||||
Income (loss) from discontinued operations | — | 6 | -100 | % | (4 | ) | 14 | NM | ||||||||||||||
Net income | $ | 125 | $ | 376 | -67 | % | $ | 414 | $ | 772 | -46 | % | ||||||||||
For the Three Months Ended September 30, | For the Nine Months Ended September 30, | |||||||||||||||||||||
2008 | 2007 | Change | 2008 | 2007 | Change | |||||||||||||||||
Revenues | ||||||||||||||||||||||
Operating revenues: | ||||||||||||||||||||||
Retirement Solutions: | ||||||||||||||||||||||
Annuities | $ | 675 | $ | 647 | 4 | % | $ | 1,916 | $ | 1,861 | 3 | % | ||||||||||
Defined Contribution | 241 | 243 | -1 | % | 718 | 742 | -3 | % | ||||||||||||||
Total Retirement Solutions | 916 | 890 | 3 | % | 2,634 | 2,603 | 1 | % | ||||||||||||||
Insurance Solutions: | ||||||||||||||||||||||
Life Insurance | 1,072 | 1,056 | 2 | % | 3,210 | 3,121 | 3 | % | ||||||||||||||
Group Protection | 403 | 368 | 10 | % | 1,227 | 1,119 | 10 | % | ||||||||||||||
Total Insurance Solutions | 1,475 | 1,424 | 4 | % | 4,437 | 4,240 | 5 | % | ||||||||||||||
Investment Management | 110 | 150 | -27 | % | 354 | 451 | -22 | % | ||||||||||||||
Lincoln UK | 80 | 89 | -10 | % | 263 | 272 | -3 | % | ||||||||||||||
Other Operations | 111 | 113 | -2 | % | 341 | 345 | -1 | % | ||||||||||||||
Excluded realized loss, pre-tax | (256 | ) | (66 | ) | NM | (421 | ) | (27 | ) | NM | ||||||||||||
Amortization of deferred gain arising from reserve changes on business sold through reinsurance, pre-tax | — | 1 | -100 | % | 2 | 9 | -78 | % | ||||||||||||||
Total revenues | $ | 2,436 | $ | 2,601 | -6 | % | $ | 7,610 | $ | 7,893 | -4 | % | ||||||||||
For the Three Months Ended September 30, | For the Nine Months Ended September 30, | |||||||||||||||||||||
2008 | 2007 | Change | 2008 | 2007 | Change | |||||||||||||||||
Net Income | ||||||||||||||||||||||
Income (loss) from operations: | ||||||||||||||||||||||
Retirement Solutions: | ||||||||||||||||||||||
Annuities | $ | 131 | $ | 126 | 4 | % | $ | 365 | $ | 366 | 0 | % | ||||||||||
Defined Contribution | 42 | 41 | 2 | % | 124 | 138 | -10 | % | ||||||||||||||
Total Retirement Solutions | 173 | 167 | 4 | % | 489 | 504 | -3 | % | ||||||||||||||
Insurance Solutions: | ||||||||||||||||||||||
Life Insurance | 137 | 182 | -25 | % | 458 | 548 | -16 | % | ||||||||||||||
Group Protection | 27 | 33 | -18 | % | 86 | 85 | 1 | % | ||||||||||||||
Total Insurance Solutions | 164 | 215 | -24 | % | 544 | 633 | -14 | % | ||||||||||||||
Investment Management | 5 | 22 | -77 | % | 32 | 49 | -35 | % | ||||||||||||||
Lincoln UK | 12 | 10 | 20 | % | 41 | 33 | 24 | % | ||||||||||||||
Other Operations | (39 | ) | (49 | ) | 20 | % | (127 | ) | (115 | ) | -10 | % | ||||||||||
Excluded realized loss, after-tax | (166 | ) | (42 | ) | NM | (274 | ) | (16 | ) | NM | ||||||||||||
Income (loss) from reserve changes (net of related amortization) on business sold through reinsurance, after-tax | — | — | NM | 1 | (7 | ) | 114 | % | ||||||||||||||
Impairment of intangibles, after-tax | — | — | NM | (139 | ) | — | NM | |||||||||||||||
Income from continuing operations | 149 | 323 | -54 | % | 567 | 1,081 | -48 | % | ||||||||||||||
Income (loss) from discontinued operations | (1 | ) | 7 | NM | (5 | ) | 21 | NM | ||||||||||||||
Net income | $ | 148 | $ | 330 | -55 | % | $ | 562 | $ | 1,102 | -49 | % | ||||||||||
4750
For the Three Months Ended June 30, | Change | For the Six Months Ended June 30, | Change | For the Three Months Ended September 30, | For the Nine Months Ended September 30, | |||||||||||||||||||||||||||||||||||||||
2008 | 2007 | 2008 | 2007 | 2008 | 2007 | Change | 2008 | 2007 | Change | |||||||||||||||||||||||||||||||||||
Deposits | ||||||||||||||||||||||||||||||||||||||||||||
Individual Markets: | ||||||||||||||||||||||||||||||||||||||||||||
Retirement Solutions: | ||||||||||||||||||||||||||||||||||||||||||||
Annuities | $ | 3,436 | $ | 3,277 | 5 | % | $ | 6,462 | $ | 6,098 | 6 | % | $ | 2,948 | $ | 3,478 | -15 | % | $ | 9,410 | $ | 9,577 | -2 | % | ||||||||||||||||||||
Life Insurance | 952 | 1,005 | -5 | % | 1,919 | 2,044 | -6 | % | ||||||||||||||||||||||||||||||||||||
Employer Markets: | ||||||||||||||||||||||||||||||||||||||||||||
Retirement Products – Defined Contribution | 1,421 | 1,273 | 12 | % | 2,972 | 2,760 | 8 | % | ||||||||||||||||||||||||||||||||||||
Retirement Products – Executive Benefits | 110 | 79 | 39 | % | 275 | 144 | 91 | % | ||||||||||||||||||||||||||||||||||||
Defined Contribution | 1,334 | 1,525 | -13 | % | 4,306 | 4,285 | 0 | % | ||||||||||||||||||||||||||||||||||||
Insurance Solutions – Life Insurance | 1,082 | 1,032 | 5 | % | 3,276 | 3,219 | 2 | % | ||||||||||||||||||||||||||||||||||||
Investment Management | 3,507 | 6,150 | -43 | % | 8,229 | 12,185 | -32 | % | 3,988 | 5,745 | -31 | % | 12,217 | 17,929 | -32 | % | ||||||||||||||||||||||||||||
Consolidating adjustments (1) | (811 | ) | (1,077 | ) | 25 | % | (2,394 | ) | (1,989 | ) | -20 | % | (1,118 | ) | (907 | ) | -23 | % | (3,514 | ) | (2,896 | ) | -21 | % | ||||||||||||||||||||
Total deposits | $ | 8,615 | $ | 10,707 | -20 | % | $ | 17,463 | $ | 21,242 | -18 | % | $ | 8,234 | $ | 10,873 | -24 | % | $ | 25,695 | $ | 32,114 | -20 | % | ||||||||||||||||||||
Net Flows | ||||||||||||||||||||||||||||||||||||||||||||
Individual Markets: | ||||||||||||||||||||||||||||||||||||||||||||
Retirement Solutions: | ||||||||||||||||||||||||||||||||||||||||||||
Annuities | $ | 1,589 | $ | 1,137 | 40 | % | $ | 2,770 | $ | 1,892 | 46 | % | $ | 944 | $ | 1,291 | -27 | % | $ | 3,714 | $ | 3,185 | 17 | % | ||||||||||||||||||||
Life Insurance | 627 | 586 | 7 | % | 1,207 | 1,283 | -6 | % | ||||||||||||||||||||||||||||||||||||
Employer Markets: | ||||||||||||||||||||||||||||||||||||||||||||
Retirement Products – Defined Contribution | 237 | 73 | 225 | % | 517 | 294 | 76 | % | ||||||||||||||||||||||||||||||||||||
Retirement Products – Executive Benefits | 50 | 26 | 92 | % | 121 | (49 | ) | NM | ||||||||||||||||||||||||||||||||||||
Defined Contribution | 93 | 133 | -30 | % | 610 | 428 | 43 | % | ||||||||||||||||||||||||||||||||||||
Insurance Solutions – Life Insurance | 690 | 629 | 10 | % | 2,018 | 1,863 | 8 | % | ||||||||||||||||||||||||||||||||||||
Investment Management | (1,471 | ) | (424 | ) | NM | (2,638 | ) | (512 | ) | NM | (3,332 | ) | 90 | NM | (5,970 | ) | (423 | ) | NM | |||||||||||||||||||||||||
Consolidating adjustments (1) | (24 | ) | 304 | NM | (90 | ) | 348 | NM | 169 | 200 | -16 | % | 79 | 547 | -86 | % | ||||||||||||||||||||||||||||
Total net flows | $ | 1,008 | $ | 1,702 | -41 | % | $ | 1,887 | $ | 3,256 | -42 | % | $ | (1,436 | ) | $ | 2,343 | NM | $ | 451 | $ | 5,600 | -92 | % | ||||||||||||||||||||
(1) | Consolidating adjustments represents the elimination of deposits and net flows on products affecting more than one segment. |
As of June 30, | Change | As of September 30, | ||||||||||||||||
2008 | 2007 | 2008 | 2007 | Change | ||||||||||||||
Assets Under Management by Advisor | ||||||||||||||||||
Investment Management: | ||||||||||||||||||
External assets | $ | 75,691 | $ | 97,725 | -23 | % | $ | 57,662 | $ | 89,540 | -36 | % | ||||||
Inter-segment assets | 65,997 | 66,423 | -1 | % | 72,468 | 77,500 | -6 | % | ||||||||||
Lincoln UK | 7,833 | 9,168 | -15 | % | 6,585 | 9,192 | -28 | % | ||||||||||
Policy loans | 2,802 | 2,787 | 1 | % | 2,870 | 2,841 | 1 | % | ||||||||||
Assets administered through unaffiliated third parties | 68,292 | 68,925 | -1 | % | 59,922 | 72,406 | -17 | % | ||||||||||
Total assets under management | $ | 220,615 | $ | 245,028 | -10 | % | $ | 199,507 | $ | 251,479 | -21 | % | ||||||
Comparison of the Three and Six Months Ended JuneSeptember 30, 2008 to 2007
Net income decreased due primarily to the following:
Impairment of goodwill and our FCC license intangible assets on our remaining radio clusters attributable primarily to declines in advertising revenues for the entire radio market; however, these non-cash impairments will not impact our future liquidity;
Higher write-downs for other-than-temporary impairments on our available-for-sale securities attributable primarily to unfavorable changes in credit quality and increases in credit spreads;
Lower net investment income driven by less favorable results from our alternative investmentsA $72 million unfavorable retrospective unlocking of DAC, VOBA, DSI, DFEL and prepaymentthe reserves for annuity and bond makewhole premiums as well as certain capital transactions providing relief from Actuarial Guideline 38 (“AG38”) reserve requirementslife insurance products with living benefit and death benefit guarantees in the fourththird quarter of 2008 compared to a $9 million favorable retrospective unlocking in the third quarter of 2007;
Higher benefits due to growth in business in force and higher death claims;
48
NetUnfavorable GDB derivative results driven by lower account values from unfavorable retrospective unlocking of DAC, VOBA, DSIequity markets; and DFEL compared to net favorable retrospective unlocking for the same periods in 2007;
Lower earnings from our variable annuity and mutual fund products as a result of declines in assets under management caused by decreases in the level of the equity markets; and
The results for the second quarter of 2007 included a $6 million one-time curtailment gain related to a change in our employee pension plan.markets.
The causes of decreases in net income were partially offset by:
Favorable GLB net derivatives results as gains attributable to the SFAS 157 non-performance risk adjustment attributable primarily to widening credit spreads more than offset the GLB hedge program ineffectiveness and unfavorable GDB results, both excluding the impact of unlocking, due to extreme market conditions;
51
Lower DAC and VOBA amortization, net of interest and excluding unlocking, due primarily to declines in variable account values from unfavorable equity markets during 2008;
A reduction in income tax expense related to favorable tax return true-ups and other items driven primarily by the separate account DRD in 2008, compared to unfavorable tax return true-ups and other items in 2007;
Higher net investment income driven by more favorable results from our surplus and alternative investments; and
Lower broker-dealer expenses driven by lower sales and lower merger-related expenses.
Comparison of the Nine Months Ended September 30, 2008 to 2007
In addition to the items discussed above, excluding the unfavorable retrospective unlocking, lower earnings on variable annuity and mutual fund products and higher net investment income items, net income for the nine months ended September 30, 2008, compared to the same period in 2007 was also affected by:
Impairment of goodwill and our FCC license intangible assets on our remaining radio clusters during the second quarter of 2008 attributable primarily to declines in advertising revenues for the entire radio market; however, these non-cash impairments will not impact our future liquidity;
A $73 million unfavorable retrospective unlocking of DAC, VOBA, DSI, DFEL and the reserves for annuity and life insurance products with living benefit and death benefit guarantees in 2008 compared to a $34 million favorable retrospective unlocking in 2007;
Growth in insurance fees driven by increases in life insurance in force as a result of new sales since JuneSeptember 30, 2007, and favorable persistency along with increases in variable account values from positive net flows and transfers from fixed account values, including the fixed portion of variable, partially offset by unfavorable equity markets and adjustments during the second quarter of 2007 resulting from adjusting account values for certain of our life insurance policies and modifying the accounting for certain of our life insurance policies;
Lower litigationnet investment income driven by less favorable results from our alternative investments and merger-related expenses;prepayment and bond makewhole premiums;
Lower incentive compensation accruals as a result of lower earnings and production performance relative to planned goals;
The results in the secondfirst quarter of 2007 included an $8 million expense for an increase in reserves (net2008 adjustment to our loss on disposition of related deferred gain amortization) on the personal accident business that was sold to Swiss Re through an indemnity reinsurance transaction in 2001;our discontinued operations;
Lower broker-dealer expenses driven by lower sales;A $16 million effect of the initial adoption of SFAS 157 on January 1, 2008; and
Favorable benefit reserve adjustments in the second quarter of 2008 for our Lincoln UK segment.
In addition to the items discussed above, net income for the six months ended June 30, 2008, compared to the same period in 2007 was affected by:
A $14 million reduction in benefits in the first quarter of 2007 related to a purchase accounting adjustment to the opening balance sheet of Jefferson-Pilot;
A $16 million effect of the initial adoption of SFAS 157 on January 1, 2008;
Higher interest and debt expenses from increased debt; and
The first quarter of 2008 adjustment to our loss on disposition of our discontinued operations.Jefferson-Pilot.
The foregoing items are discussed in further detail in results of operations by segment discussions and “Realized Gain (Loss)”Loss” below. In addition, for a discussion of the earnings impact of the equity markets, see “Item 3. Quantitative and Qualitative Disclosures About Market Risk – Equity Market Risk – Impact of Equity Market Sensitivity.”
4952
RESULTS OF INDIVIDUAL MARKETSRETIREMENT SOLUTIONS
The Individual MarketsRetirement Solutions business provides its products through two segments: Annuities and Life Insurance. Through itsDefined Contribution. The Retirement Solutions – Annuities segment Individual Markets provides tax-deferred investment growth and lifetime income opportunities for its clients by offering individual fixed annuities, including indexed annuities, and variable annuities. The Life InsuranceRetirement Solutions – Defined Contribution segment offers wealth protectionprovides employer-sponsored variable and transfer opportunities through term insurance, a linked-benefit product (whichfixed annuities and mutual-fund based programs in the 401(k), 403(b) and 457 marketplaces.
Details underlying the results for Retirement Solutions (in millions) were as follows:
For the Three Months Ended September 30, | For the Nine Months Ended September 30, | |||||||||||||||||
2008 | 2007 | Change | 2008 | 2007 | Change | |||||||||||||
Operating Revenues | ||||||||||||||||||
Insurance premiums | $ | 52 | $ | 43 | 21 | % | $ | 103 | $ | 72 | 43 | % | ||||||
Insurance fees | 302 | 324 | -7 | % | 927 | 916 | 1 | % | ||||||||||
Net investment income | 424 | 422 | 0 | % | 1,263 | 1,315 | -4 | % | ||||||||||
Operating realized gain | 52 | 1 | NM | 74 | 3 | NM | ||||||||||||
Other revenues and fees | 86 | 100 | -14 | % | 267 | 297 | -10 | % | ||||||||||
Total operating revenues | 916 | 890 | 3 | % | 2,634 | 2,603 | 1 | % | ||||||||||
Operating Expenses | ||||||||||||||||||
Interest credited | 277 | 269 | 3 | % | 816 | 806 | 1 | % | ||||||||||
Benefits | 112 | 56 | 100 | % | 199 | 108 | 84 | % | ||||||||||
Underwriting, acquisition, insurance and other expenses | 331 | 341 | -3 | % | 1,003 | 1,009 | -1 | % | ||||||||||
Total operating expenses | 720 | 666 | 8 | % | 2,018 | 1,923 | 5 | % | ||||||||||
Income from operations before taxes | 196 | 224 | -13 | % | 616 | 680 | -9 | % | ||||||||||
Federal income taxes | 23 | 57 | -60 | % | 127 | 176 | -28 | % | ||||||||||
Income from operations | $ | 173 | $ | 167 | 4 | % | $ | 489 | $ | 504 | -3 | % | ||||||
53
Details underlying account values for Retirement Solutions (in millions) were as follows:
As of September 30, | |||||||||||
2008 | 2007 | Change | |||||||||
Account Values | |||||||||||
Variable portion of variable annuities | $ | 63,462 | $ | 76,873 | -17 | % | |||||
Fixed portion of variable annuities | 9,661 | 9,418 | 3 | % | |||||||
Total variable annuities | 73,123 | 86,291 | -15 | % | |||||||
Fixed annuities, including indexed | 19,446 | 19,286 | 1 | % | |||||||
Fixed annuities ceded to reinsurers | (1,196 | ) | (1,430 | ) | 16 | % | |||||
Total fixed annuities | 18,250 | 17,856 | 2 | % | |||||||
Total annuities | 91,373 | 104,147 | -12 | % | |||||||
Mutual funds | 7,675 | 7,165 | 7 | % | |||||||
Total annuities and mutual funds | $ | 99,048 | $ | 111,312 | -11 | % | |||||
For the Three Months Ended September 30, | For the Nine Months Ended September 30, | |||||||||||||||||
2008 | 2007 | Change | 2008 | 2007 | Change | |||||||||||||
Average daily variable account values | $ | 70,299 | $ | 73,989 | -5 | % | $ | 72,298 | $ | 70,965 | 2 | % | ||||||
Average fixed account values, including the fixed portion of variable | 28,495 | 28,263 | 1 | % | 28,524 | 28,534 | 0 | % |
The discussion of Retirement Solutions is a UL policy linked with riders that provide for long-term care costs)provided in “Retirement Solutions – Annuities” and both single and survivorship versions of UL and VUL.“Retirement Solutions – Defined Contribution” below.
54
Individual MarketsRetirement Solutions – Annuities
Income from Operations
Details underlying the results for Individual MarketsRetirement Solutions – Annuities (in millions) were as follows:
For the Three Months Ended June 30, | Change | For the Six Months Ended June 30, | Change | For the Three Months Ended September 30, | Change | For the Nine Months Ended September 30, | Change | |||||||||||||||||||||||||||||
2008 | 2007 | 2008 | 2007 | 2008 | 2007 | 2008 | 2007 | |||||||||||||||||||||||||||||
Operating Revenues | ||||||||||||||||||||||||||||||||||||
Insurance premiums | $ | 19 | $ | 17 | 12 | % | $ | 51 | $ | 29 | 76 | % | $ | 52 | $ | 43 | 21 | % | $ | 103 | $ | 72 | 43 | % | ||||||||||||
Insurance fees | 257 | 244 | 5 | % | 503 | 465 | 8 | % | 246 | 259 | -5 | % | 749 | 724 | 3 | % | ||||||||||||||||||||
Net investment income | 245 | 265 | -8 | % | 493 | 531 | -7 | % | 243 | 249 | -2 | % | 736 | 780 | -6 | % | ||||||||||||||||||||
Operating realized gain | 12 | 1 | NM | 23 | 2 | NM | 52 | 1 | NM | 74 | 3 | NM | ||||||||||||||||||||||||
Other revenues and fees | 85 | 97 | -12 | % | 171 | 187 | -9 | % | 82 | 95 | -14 | % | 254 | 282 | -10 | % | ||||||||||||||||||||
Total operating revenues | 618 | 624 | -1 | % | 1,241 | 1,214 | 2 | % | 675 | 647 | 4 | % | 1,916 | 1,861 | 3 | % | ||||||||||||||||||||
Operating Expenses | ||||||||||||||||||||||||||||||||||||
Interest credited | 163 | 165 | -1 | % | 325 | 326 | 0 | % | 170 | 165 | 3 | % | 496 | 492 | 1 | % | ||||||||||||||||||||
Benefits | 35 | 27 | 30 | % | 87 | 52 | 67 | % | 112 | 56 | 100 | % | 199 | 108 | 84 | % | ||||||||||||||||||||
Underwriting, acquisition, insurance and other expenses | 268 | 267 | 0 | % | 520 | 517 | 1 | % | 254 | 256 | -1 | % | 774 | 772 | 0 | % | ||||||||||||||||||||
Total operating expenses | 466 | 459 | 2 | % | 932 | 895 | 4 | % | 536 | 477 | 12 | % | 1,469 | 1,372 | 7 | % | ||||||||||||||||||||
Income from operations before taxes | 152 | 165 | -8 | % | 309 | 319 | -3 | % | 139 | 170 | -18 | % | 447 | 489 | -9 | % | ||||||||||||||||||||
Federal income taxes | 36 | 42 | -14 | % | 75 | 79 | -5 | % | 8 | 44 | -82 | % | 82 | 123 | -33 | % | ||||||||||||||||||||
Income from operations | $ | 116 | $ | 123 | -6 | % | $ | 234 | $ | 240 | -3 | % | $ | 131 | $ | 126 | 4 | % | $ | 365 | $ | 366 | 0 | % | ||||||||||||
(1) | Other revenues and fees consists primarily of broker-dealer earnings that are subject to market volatility. |
Comparison of the Three and Six Months Ended JuneSeptember 30, 2008 to 2007
Income from operations for this segment increased due primarily to the following:
Lower DAC and VOBA amortization, net of interest and excluding unlocking, due primarily to declines in variable account values from unfavorable equity markets during 2008 and lower incentive compensation accruals as a result of production performance relative to planned goals; and
A reduction in income tax expense related to favorable tax return true-ups and other items driven primarily by the separate account DRD in 2008, compared to unfavorable tax return true-ups and other items in 2007.
The increase in income from operations was partially offset by the following:
A $9 million unfavorable retrospective unlocking of DAC, VOBA, DSI, DFEL and reserves for annuity products with living benefit and death benefit guarantees in 2008 compared to a $4 million favorable retrospective unlocking in 2007;
A $7 million favorable prospective unlocking of DAC, VOBA, DSI, DFEL and reserves for annuity products with living benefit and death benefit guarantees (an $18 million favorable unlocking from assumption changes net of a $11 million unfavorable unlocking from model refinements) in 2007;
Lower insurance fees driven by lower average daily variable account values due to unfavorable equity markets, partially offset by an increase in surrender charges; and
A decline in surplus investment income, which was attributable to a decision to hold more cash, thereby lowering earnings, and declines in investment income on alternative investments and commercial mortgage loan prepayment and bond makewhole premiums.
55
Comparison of the Nine Months Ended September 30, 2008 to 2007
Income from operations for this segment modestly decreased due primarily to a decrease inthe following:
Lower investment income from fixed maturity securities, mortgage loans on real estate and other net investment income fromprimarily attributable to the decline in the average fixed account values, including the fixed portion of variable, driven primarily by transfers to variable account values in excess of net flows;
A $6 million unfavorable retrospective unlocking of DAC, VOBA, DSI, DFEL and reserves for annuity products with living benefit and death benefit guarantees in 2008 compared to a $14 million favorable retrospective unlocking in 2007;
The impact of prospective unlocking discussed above; and
A less favorable net broker-dealer margin attributable to lower earnings on surplus investments and alternative investments due tofrom unfavorable equity markets.
The decrease in income from operations was partially offset by growththe following:
Lower DAC and VOBA amortization, net of interest and excluding unlocking, due primarily to a decline in the emergence of gross profits and lower incentive compensation accruals as a result of lower earnings and production performance relative to planned goals;
A reduction in income tax expense related to favorable tax return true-ups and other items driven primarily by the separate account DRD in 2008, compared to unfavorable tax return true-ups and other items in 2007; and
An increase in insurance fees attributable to increases indriven by higher average daily variable annuity account values fromattributable to positive net flows and transfers from fixed account values, including the fixed portion of variable, partially offset by the increase in attributed fees. The positive net flows served to mitigate the negative effect on fees from the decline in account values driven by the unfavorable performance of the equity markets.
The decrease in income from operations isforegoing items are discussed further below.below following “Impact of Current Market Conditions.” For detail on the operating realized gain, see “Realized Gain (Loss)”Loss” below.
Impact of Current Market Conditions
The October 2008 daily average of the S&P 500 Index® declined 17% from its value as of September 30, 2008, negatively impacting our variable account values. Consequently, we expect lower earnings in the fourth quarter as a result of October’s results, including the following:
Lower variable account values, which will reduce expense assessment revenue, partially offset by lower asset-based expenses;
Higher unfavorable retrospective unlocking due to lower equity market performance than our model projections assumed; and
If equity markets do not materially improve over the remainder of the fourth quarter, we may unlock our amortization model assumption for equity market returns for DAC, VOBA, DSI, DFEL and reserves for annuity products with living and death benefit guarantees, resulting in a significant decrease to income from operations in the period. For more information, see “Critical Accounting Policies and Estimates – DAC, VOBA, DSI and DFEL” above.
For factors that could cause actual results to differ materially from those set forth in this section, see “Part I – Item 1A. Risk Factors” in our 2007 Form 10-K as updated by “Part II – Item 1A. Risk Factors” and “Forward-Looking Statements – Cautionary Language” in this report.
5056
Insurance Fees
Details underlying insurance fees, account values and net flows (in millions) were as follows:
For the Three Months Ended June 30, | Change | For the Six Months Ended June 30, | Change | For the Three Months Ended September 30, | Change | For the Nine Months Ended September 30, | Change | |||||||||||||||||||||||||||||||||||||
2008 | 2007 | 2008 | 2007 | 2008 | 2007 | 2008 | 2007 | |||||||||||||||||||||||||||||||||||||
Insurance Fees | ||||||||||||||||||||||||||||||||||||||||||||
Mortality, expense and other assessments | $ | 257 | $ | 242 | 6 | % | $ | 503 | $ | 460 | 9 | % | $ | 245 | $ | 258 | -5 | % | $ | 748 | $ | 717 | 4 | % | ||||||||||||||||||||
Surrender charges | 9 | 10 | -10 | % | 19 | 20 | -5 | % | 13 | 10 | 30 | % | 32 | 30 | 7 | % | ||||||||||||||||||||||||||||
DFEL: | ||||||||||||||||||||||||||||||||||||||||||||
Deferrals | (13 | ) | (12 | ) | -8 | % | (25 | ) | (22 | ) | -14 | % | (13 | ) | (12 | ) | -8 | % | (38 | ) | (33 | ) | -15 | % | ||||||||||||||||||||
Amortization, excluding unlocking | 4 | 4 | 0 | % | 7 | 7 | 0 | % | ||||||||||||||||||||||||||||||||||||
Amortization, net of interest: | ||||||||||||||||||||||||||||||||||||||||||||
Prospective unlocking – assumption changes | (1 | ) | (1 | ) | 0 | % | (1 | ) | (1 | ) | 0 | % | ||||||||||||||||||||||||||||||||
Retrospective unlocking | — | — | NM | (1 | ) | — | NM | 3 | — | NM | 3 | (1 | ) | NM | ||||||||||||||||||||||||||||||
Other amortization, net of interest | (1 | ) | 4 | NM | 5 | 12 | -58 | % | ||||||||||||||||||||||||||||||||||||
Total insurance fees | $ | 257 | $ | 244 | 5 | % | $ | 503 | $ | 465 | 8 | % | $ | 246 | $ | 259 | -5 | % | $ | 749 | $ | 724 | 3 | % | ||||||||||||||||||||
As of June 30, | Change | As of September 30, | Change | |||||||||||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||||||||||||
Account Values | ||||||||||||||||||||||
Variable portion of variable annuities | $ | 55,855 | $ | 55,171 | 1 | % | $ | 49,982 | $ | 58,293 | -14 | % | ||||||||||
Fixed portion of variable annuities | 3,478 | 3,458 | 1 | % | 3,547 | 3,470 | 2 | % | ||||||||||||||
Total variable annuities | 59,333 | 58,629 | 1 | % | 53,529 | 61,763 | -13 | % | ||||||||||||||
Fixed annuities, including indexed | 14,321 | 14,409 | -1 | % | 14,142 | 14,343 | -1 | % | ||||||||||||||
Fixed annuities ceded to reinsurers | (1,255 | ) | (1,598 | ) | 21 | % | (1,196 | ) | (1,430 | ) | 16 | % | ||||||||||
Total fixed annuities | 13,066 | 12,811 | 2 | % | 12,946 | 12,913 | 0 | % | ||||||||||||||
Total account values | $ | 72,399 | $ | 71,440 | 1 | % | $ | 66,475 | $ | 74,676 | -11 | % | ||||||||||
For the Three Months Ended June 30, | Change | For the Six Months Ended June 30, | Change | For the Three Months Ended September 30, | Change | For the Nine Months Ended September 30, | Change | |||||||||||||||||||||||||||||
2008 | 2007 | 2008 | 2007 | 2008 | 2007 | 2008 | 2007 | |||||||||||||||||||||||||||||
Averages | ||||||||||||||||||||||||||||||||||||
Daily variable account values | $ | 57,763 | $ | 53,465 | 8 | % | $ | 56,541 | $ | 51,327 | 10 | % | $ | 54,717 | $ | 55,827 | -2 | % | $ | 55,929 | $ | 52,922 | 6 | % | ||||||||||||
Daily S&P 500 Index® | 1,371.26 | 1,496.87 | -8 | % | 1,360.21 | 1,461.02 | -7 | % | 1,255.42 | 1,489.60 | -16 | % | 1,325.03 | 1,470.65 | -10 | % | ||||||||||||||||||||
5157
For the Three Months Ended June 30, | Change | For the Six Months Ended June 30, | Change | For the Three Months Ended September 30, | Change | For the Nine Months Ended September 30, | Change | |||||||||||||||||||||||||||||||||||||
2008 | 2007 | 2008 | 2007 | 2008 | 2007 | 2008 | 2007 | |||||||||||||||||||||||||||||||||||||
Net Flows | ||||||||||||||||||||||||||||||||||||||||||||
Variable portion of variable annuity deposits | $ | 2,065 | $ | 2,295 | -10 | % | $ | 3,931 | $ | 4,295 | -8 | % | $ | 1,672 | $ | 2,247 | -26 | % | $ | 5,602 | $ | 6,543 | -14 | % | ||||||||||||||||||||
Variable portion of variable annuity withdrawals | (1,229 | ) | (1,247 | ) | 1 | % | (2,488 | ) | (2,426 | ) | -3 | % | (1,216 | ) | (1,296 | ) | 6 | % | (3,704 | ) | (3,722 | ) | 0 | % | ||||||||||||||||||||
Variable portion of variable annuity net flows | 836 | 1,048 | -20 | % | 1,443 | 1,869 | -23 | % | 456 | 951 | -52 | % | 1,898 | 2,821 | -33 | % | ||||||||||||||||||||||||||||
Fixed portion of variable annuity deposits | 878 | 662 | 33 | % | 1,734 | 1,197 | 45 | % | 896 | 746 | 20 | % | 2,631 | 1,943 | 35 | % | ||||||||||||||||||||||||||||
Fixed portion of variable annuity withdrawals | (110 | ) | (155 | ) | 29 | % | (234 | ) | (306 | ) | 24 | % | (124 | ) | (181 | ) | 31 | % | (358 | ) | (486 | ) | 26 | % | ||||||||||||||||||||
Fixed portion of variable annuity net flows | 768 | 507 | 51 | % | 1,500 | 891 | 68 | % | 772 | 565 | 37 | % | 2,273 | 1,457 | 56 | % | ||||||||||||||||||||||||||||
Total variable annuity deposits | 2,943 | 2,957 | 0 | % | 5,665 | 5,492 | 3 | % | 2,568 | 2,993 | -14 | % | 8,233 | 8,486 | -3 | % | ||||||||||||||||||||||||||||
Total variable annuity withdrawals | (1,339 | ) | (1,402 | ) | 4 | % | (2,722 | ) | (2,732 | ) | 0 | % | (1,340 | ) | (1,477 | ) | 9 | % | (4,062 | ) | (4,208 | ) | 3 | % | ||||||||||||||||||||
Total variable annuity net flows | 1,604 | 1,555 | 3 | % | 2,943 | 2,760 | 7 | % | 1,228 | 1,516 | -19 | % | 4,171 | 4,278 | -3 | % | ||||||||||||||||||||||||||||
Fixed indexed annuity deposits | 356 | 191 | 86 | % | 574 | 351 | 64 | % | 215 | 199 | 8 | % | 789 | 550 | 43 | % | ||||||||||||||||||||||||||||
Fixed indexed annuity withdrawals | (102 | ) | (61 | ) | -67 | % | (186 | ) | (123 | ) | -51 | % | (114 | ) | (59 | ) | -93 | % | (299 | ) | (182 | ) | -64 | % | ||||||||||||||||||||
Fixed indexed annuity net flows | 254 | 130 | 95 | % | 388 | 228 | 70 | % | 101 | 140 | -28 | % | 490 | 368 | 33 | % | ||||||||||||||||||||||||||||
Other fixed annuity deposits | 137 | 129 | 6 | % | 223 | 255 | -13 | % | 165 | 286 | -42 | % | 388 | 541 | -28 | % | ||||||||||||||||||||||||||||
Other fixed annuity withdrawals | (406 | ) | (677 | ) | 40 | % | (784 | ) | (1,351 | ) | 42 | % | (550 | ) | (651 | ) | 16 | % | (1,335 | ) | (2,002 | ) | 33 | % | ||||||||||||||||||||
Other fixed annuity net flows | (269 | ) | (548 | ) | 51 | % | (561 | ) | (1,096 | ) | 49 | % | (385 | ) | (365 | ) | -5 | % | (947 | ) | (1,461 | ) | 35 | % | ||||||||||||||||||||
Total annuity deposits | 3,436 | 3,277 | 5 | % | 6,462 | 6,098 | 6 | % | 2,948 | 3,478 | -15 | % | 9,410 | 9,577 | -2 | % | ||||||||||||||||||||||||||||
Total annuity withdrawals | (1,847 | ) | (2,140 | ) | 14 | % | (3,692 | ) | (4,206 | ) | 12 | % | (2,004 | ) | (2,187 | ) | 8 | % | (5,696 | ) | (6,392 | ) | 11 | % | ||||||||||||||||||||
Total annuity net flows | $ | 1,589 | $ | 1,137 | 40 | % | $ | 2,770 | $ | 1,892 | 46 | % | $ | 944 | $ | 1,291 | -27 | % | $ | 3,714 | $ | 3,185 | 17 | % | ||||||||||||||||||||
We charge contract holders mortality and expense assessments on variable annuity accounts to cover insurance and administrative expenses. These assessments are a function of the rates priced into the product and the average daily variable account values. Average daily account values are driven by net flows and equity markets. In addition, for our fixed annuity contracts and for some variable contracts, we collect surrender charges when contract holders surrender their contracts during their surrender charge periods to protect us from premature withdrawals. Insurance fees include charges on both our variable and fixed annuity products, but exclude the attributed fees on our GLB products. The attributed fees are the portion of rider charges used in the calculation of the embedded derivative and represent net valuation premium plus a margin that a theoretical market participant would include for risk/profit, including a non-performance risk factor required by SFAS 157. Net valuation premium represents a level portion of rider fees required to fund potential claims for the living benefit. Operating realized gain is the attributed fees less the net valuation premium, net of the associated amortization expense of DAC, VOBA, DSI and DFEL.
New deposits are an important component of our effort to grow the annuity business. Although deposits do not significantly impact current period income from operations, they are an important indicator of future profitability.
The other component of net flows relates to the retention of the business. One of the key assumptions in pricing a product is the account persistency, which we refer to as the lapse rate. The lapse rate compares the amount of withdrawals to the average account values.
Comparison of the Three and Six Months Ended JuneSeptember 30, 2008 to 2007
The decrease in insurance fees was due primarily to lower expense assessments attributable to a decrease in average daily variable annuity account values partially offset by expense assessments based on guaranteed amounts, which, in some cases, are above actual account values. Additionally, an increase in surrender charges and continued growth in expense assessmentsrider elections partially offset the overall decline in insurance fees.
Overall lapse rates for the three months ended September 30, 2008, were 9% compared to 10% for the same period in 2007.
The decrease in DFEL amortization, net of interest and excluding unlocking, was attributable primarily to andeclines in variable account values from unfavorable equity markets during 2008.
The three months ended September 30, 2008, had favorable retrospective unlocking due primarily to actual gross profits being lower than EGPs driven by lower maintenance and expense charges and lower equity market performance than our model projections assumed.
58
Comparison of the Nine Months Ended September 30, 2008 to 2007
The increase in insurance fees was due primarily to growth in average daily variable annuity account values. The increase in account values reflects cumulative positive net flows, which offset the reduction in variable account values from unfavorable equity markets during the first nine months of 2008. Additionally, an increase in surrender charges, continued growth in rider elections and an increase in the three and six months ended June 30, 2008.
Inaverage expense assessment rates contributed to the past several years, we have concentrated our efforts on expanding both product and distribution breadth. Annuity deposits increased as a result of continued strong sales of products with GLB riders and the expansion of the wholesaling forceoverall increase in LFD.insurance fees.
Overall lapse rates for the three and sixnine months ended JuneSeptember 30, 2008, were 8% compared to 10% for the same periodsperiod in 2007.
The nine months ended September 30, 2008, had favorable retrospective unlocking due primarily to lower maintenance and expense charges and lower equity market performance than our model projections assumed. The nine months ended September 30, 2007, had unfavorable retrospective unlocking due primarily to lower lapses and higher equity market performance than our model projections assumed.
52
Net Investment Income and Interest Credited
Details underlying net investment income, interest credited (in millions) and our interest rate spread were as follows:
For the Three Months Ended June 30, | Change | For the Six Months Ended June 30, | Change | For the Three Months Ended September 30, | Change | For the Nine Months Ended September 30, | Change | |||||||||||||||||||||||||||||||||||||
2008 | 2007 | 2008 | 2007 | 2008 | 2007 | 2008 | 2007 | |||||||||||||||||||||||||||||||||||||
Net Investment Income | ||||||||||||||||||||||||||||||||||||||||||||
Fixed maturity securities, mortgage loans on real estate and other, net of investment expenses | $ | 224 | $ | 229 | -2 | % | $ | 453 | $ | 467 | -3 | % | $ | 222 | $ | 224 | -1 | % | $ | 675 | $ | 691 | -2 | % | ||||||||||||||||||||
Commercial mortgage loan prepayment and bond makewhole premiums (1) | — | 3 | -100 | % | 1 | 5 | -80 | % | 1 | 2 | -50 | % | 2 | 7 | -71 | % | ||||||||||||||||||||||||||||
Alternative investments(2) | — | 1 | -100 | % | (1 | ) | 2 | NM | — | (1 | ) | 100 | % | (1 | ) | 1 | NM | |||||||||||||||||||||||||||
Surplus investments(3) | 20 | 31 | -35 | % | 38 | 54 | -30 | % | 19 | 24 | -21 | % | 57 | 78 | -27 | % | ||||||||||||||||||||||||||||
Broker-dealer | 1 | 1 | 0 | % | 2 | 3 | -33 | % | 1 | — | NM | 3 | 3 | 0 | % | |||||||||||||||||||||||||||||
Total net investment income | $ | 245 | $ | 265 | -8 | % | $ | 493 | $ | 531 | -7 | % | $ | 243 | $ | 249 | -2 | % | $ | 736 | $ | 780 | -6 | % | ||||||||||||||||||||
Interest Credited | ||||||||||||||||||||||||||||||||||||||||||||
Amount provided to contract holders | $ | 180 | $ | 184 | -2 | % | $ | 363 | $ | 367 | -1 | % | $ | 187 | $ | 186 | 1 | % | $ | 550 | $ | 555 | -1 | % | ||||||||||||||||||||
Opening balance sheet adjustment(4) | — | — | NM | — | (4 | ) | 100 | % | — | — | NM | — | (4 | ) | 100 | % | ||||||||||||||||||||||||||||
DSI deferrals | (26 | ) | (27 | ) | 4 | % | (52 | ) | (51 | ) | -2 | % | (25 | ) | (30 | ) | 17 | % | (76 | ) | (81 | ) | 6 | % | ||||||||||||||||||||
Interest credited before DSI amortization | 154 | 157 | -2 | % | 311 | 312 | 0 | % | 162 | 156 | 4 | % | 474 | 470 | 1 | % | ||||||||||||||||||||||||||||
DSI amortization: | ||||||||||||||||||||||||||||||||||||||||||||
Excluding unlocking | 9 | 9 | 0 | % | 15 | 16 | -6 | % | ||||||||||||||||||||||||||||||||||||
Prospective unlocking – assumption changes | — | (2 | ) | 100 | % | — | (2 | ) | 100 | % | ||||||||||||||||||||||||||||||||||
Prospective unlocking – model refinements | — | 1 | -100 | % | — | 1 | -100 | % | ||||||||||||||||||||||||||||||||||||
Retrospective unlocking | — | (1 | ) | 100 | % | (1 | ) | (2 | ) | 50 | % | 3 | — | NM | 2 | (2 | ) | 200 | % | |||||||||||||||||||||||||
Other amortization | 5 | 10 | -50 | % | 20 | 25 | -20 | % | ||||||||||||||||||||||||||||||||||||
Total interest credited | $ | 163 | $ | 165 | -1 | % | $ | 325 | $ | 326 | 0 | % | $ | 170 | $ | 165 | 3 | % | $ | 496 | $ | 492 | 1 | % | ||||||||||||||||||||
(1) | See “Consolidated Investments – Commercial Mortgage Loan Prepayment and Bond Makewhole Premiums” below for additional information. |
(2) | See “Consolidated Investments – Alternative Investments” below for additional information. |
(3) | Represents net investment income on the required statutory surplus for this segment. |
(4) | Net adjustment to the opening balance sheet of Jefferson-Pilot finalized in 2007. |
For the Three Months Ended June 30, | Basis Point Change | For the Six Months Ended June 30, | Basis Point Change | |||||||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||||||||
Interest Rate Spread | ||||||||||||||||||
Fixed maturity securities, mortgage loans on real estate and other, net of investment expenses | 5.88 | % | 5.82 | % | 6 | 5.86 | % | 5.84 | % | 2 | ||||||||
Commercial mortgage loan prepayment and bond make whole premiums | 0.00 | % | 0.08 | % | (8 | ) | 0.02 | % | 0.06 | % | (4 | ) | ||||||
Alternative investments | -0.01 | % | 0.02 | % | (3 | ) | -0.01 | % | 0.02 | % | (3 | ) | ||||||
Net investment income yield on reserves | 5.87 | % | 5.92 | % | (5 | ) | 5.87 | % | 5.92 | % | (5 | ) | ||||||
Interest rate credited to contract holders | 3.73 | % | 3.73 | % | — | 3.77 | % | 3.68 | % | 9 | ||||||||
Interest rate spread | 2.14 | % | 2.19 | % | (5 | ) | 2.10 | % | 2.24 | % | (14 | ) | ||||||
59
For the Three Months Ended September 30, | Basis Point Change | For the Nine Months Ended September 30, | Basis Point Change | |||||||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||||||||
Interest Rate Spread | ||||||||||||||||||
Fixed maturity securities, mortgage loans on real estate and other, net of investment expenses | 5.82 | % | 5.82 | % | — | 5.85 | % | 5.83 | % | 2 | ||||||||
Commercial mortgage loan prepayment and bond make whole premiums | 0.02 | % | 0.05 | % | (3 | ) | 0.02 | % | 0.06 | % | (4 | ) | ||||||
Alternative investments | 0.00 | % | -0.03 | % | 3 | -0.01 | % | 0.01 | % | (2 | ) | |||||||
Net investment income yield on reserves | 5.84 | % | 5.84 | % | — | 5.86 | % | 5.90 | % | (4 | ) | |||||||
Interest rate credited to contract holders | 3.95 | % | 3.77 | % | 18 | 3.83 | % | 3.71 | % | 12 | ||||||||
Interest rate spread | 1.89 | % | 2.07 | % | (18 | ) | 2.03 | % | 2.19 | % | (16 | ) | ||||||
�� |
Note: The yields, rates and spreads above are calculated using whole dollars instead of dollars rounded to millions.
53
For the Three Months Ended June 30, | Change | For the Six Months Ended June 30, | Change | For the Three Months Ended September 30, | Change | For the Nine Months Ended September 30, | Change | |||||||||||||||||||||||||||||
2008 | 2007 | 2008 | 2007 | 2008 | 2007 | 2008 | 2007 | |||||||||||||||||||||||||||||
Average invested assets on reserves | $ | 15,743 | $ | 16,077 | -2 | % | $ | 15,729 | $ | 16,289 | -3 | % | $ | 15,615 | $ | 15,749 | -1 | % | $ | 15,691 | $ | 16,109 | -3 | % | ||||||||||||
Average fixed account values, including the fixed portion of variable | 17,373 | 17,548 | -1 | % | 17,343 | 17,697 | -2 | % | 17,174 | 17,358 | -1 | % | 17,291 | 17,590 | -2 | % | ||||||||||||||||||||
Net flows for fixed annuities, including the fixed portion of variable | 753 | 89 | NM | 1,327 | 23 | NM | 488 | 340 | 44 | % | 1,816 | 364 | NM |
A portion of our investment income earned is credited to the contract holders of our fixed annuity products, including the fixed portion of variable annuity contracts. We expect to earn a spread between what we earn on the underlying general account investments supporting the fixed annuity product line, including the fixed portion of variable annuity contracts, and what we credit to our fixed annuity contract holders’ accounts, including the fixed portion of variable annuity contracts. The interest rate spread for this segment represents the excess of the yield on invested assets on reserves over the average crediting rate. The yield on invested assets on reserves is calculated as net investment income, excluding the amounts attributable to our surplus investments, reverse repurchase agreement interest expense, inter-segment cash management account interest expense and interest on collateral divided by average invested assets on reserves. The average invested assets on reserves is calculated based upon total invested assets, excluding hedge derivatives and collateral. The average crediting rate is calculated as interest credited before DSI amortization, plus the immediate annuity reserve change (included within benefits) divided by the average fixed account values, including the fixed portion of variable, net of coinsured account values. Fixed account values reinsured under modified coinsurance agreements are included in account values for this calculation. Changes in commercial mortgage loan prepayments and bond makewhole premiums, investment income on alternative investments and surplus investment income can vary significantly from period to period due to a number of factors and, therefore, may contribute to investment income results that are not indicative of the underlying trends.
We expect to manage the effect of spreads for near-term income from operations through a combination of rate actions and portfolio management. Our expectation includes the assumption that there are no significant changes in net flows in or out of our fixed accounts or other changes that may cause interest rate spreads to differ from our expectation. For information on interest rate spreads and the interest rate risk due to falling interest rates, see “Item 3. Quantitative and Qualitative Disclosures About Market Risk.”
Comparison of the Three and Six Months Ended JuneSeptember 30, 2008 to 2007
The declinedecrease in net investment income related primarily to declines in surplus investment income, which was attributable to less favorablea decision to hold more cash, thereby lowering earnings, and declines in investment income on alternative investments.investments and commercial mortgage loan prepayment and bond makewhole premiums.
The declinethree months ended September 30, 2008, had unfavorable retrospective unlocking due primarily to lower maintenance and expense charges and lower equity market performance than our model projections assumed.
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Comparison of the Nine Months Ended September 30, 2008 to 2007
The decrease in investment income from fixed maturity securities, mortgage loans on real estate and other net investment income was due primarily attributable to a decreasethe decline in the average fixed account values, including the fixed portion of variable, which included a $300 million funding agreement that matured on June 2, 2008. Interest crediteddriven primarily by transfers to contract holders remained relatively flat as a decline in our fixedvariable account values including the fixed portionin excess of variable,net flows. The decrease in investment income on surplus and alternative investments was offset by an elevated rate.primarily attributable to less favorable results from our limited partnership investments.
The nine months ended September 30, 2008, had unfavorable retrospective unlocking due primarily to lower maintenance and expense charges and lower equity market performance than our model projections assumed. The nine months ended September 30, 2007, had favorable retrospective unlocking due primarily to lower lapses and higher equity market performance than our model projections assumed.
Our fixed annuity business includes products with crediting rates that are reset on an annual basis and are not subject to surrender charges. Account values for these products were $5.1$5.0 billion as of JuneSeptember 30, 2008, with 42%41% already at their minimum guaranteed rates. The average crediting rates for these products were approximately 4147 basis points in excess of average minimum guaranteed rates. Our ability to retain annual reset annuities will be subject to current competitive conditions at the time interest rates for these products reset. In addition to the separate items identified in the interest rate spread table above, the other component of the interest rate credited to contract holders decreased due primarily to a roll-off of multi-year guarantee and annual reset annuities with higher interest rates.
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Benefits
Benefits for this segment include changes in reserves on immediate annuity account values driven by premiums, death benefits paid and changes in reserves on guaranteed death benefits.
Comparison of the Three and SixNine Months Ended JuneSeptember 30, 2008 to 2007
The increase in benefits was attributable to an increase in reserves for single premium immediate annuities, which resulted in a corresponding increase in insurance premiums. Additionally, benefits increased due to an unfavorable variance in the SOP 03-1 benefit ratio unlocking, which was offset by changes in the value of the derivative included in operating realized gain, as well as an increasegain.
On August 15, 2007, we entered into a reinsurance arrangement with Swiss Re coveringLincoln SmartSecurity® Advantage, our GWB rider related to our variable annuity products. For additional information about this agreement, refer to “Reinsurance” in reserves for single premium immediate annuities, which had a corresponding increase in insurance premiums.this report.
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Underwriting, Acquisition, Insurance and Other Expenses
Details underlying underwriting, acquisition, insurance and other expenses (in millions) were as follows:
For the Three Months Ended June 30, | Change | For the Six Months Ended June 30, | Change | For the Three Months Ended September 30, | Change | For the Nine Months Ended September 30, | Change | |||||||||||||||||||||||||||||||||||||
2008 | 2007 | 2008 | 2007 | 2008 | 2007 | 2008 | 2007 | |||||||||||||||||||||||||||||||||||||
Underwriting, Acquisition, Insurance and Other Expenses | ||||||||||||||||||||||||||||||||||||||||||||
Commissions | $ | 186 | $ | 179 | 4 | % | $ | 352 | $ | 331 | 6 | % | $ | 161 | $ | 188 | -14 | % | $ | 513 | $ | 520 | -1 | % | ||||||||||||||||||||
General and administrative expenses | 80 | 82 | -2 | % | 160 | 152 | 5 | % | 83 | 82 | 1 | % | 243 | 231 | 5 | % | ||||||||||||||||||||||||||||
Taxes, licenses and fees | 8 | 6 | 33 | % | 18 | 15 | 20 | % | 5 | 5 | 0 | % | 21 | 17 | 24 | % | ||||||||||||||||||||||||||||
Total expenses incurred, excluding broker-dealer | 274 | 267 | 3 | % | 530 | 498 | 6 | % | 249 | 275 | -9 | % | 777 | 768 | 1 | % | ||||||||||||||||||||||||||||
DAC and VOBA deferrals | (192 | ) | (189 | ) | -2 | % | (364 | ) | (347 | ) | -5 | % | (170 | ) | (196 | ) | 13 | % | (534 | ) | (543 | ) | 2 | % | ||||||||||||||||||||
Total pre-broker-dealer expenses incurred, excluding amortization, net of interest | 82 | 78 | 5 | % | 166 | 151 | 10 | % | 79 | 79 | 0 | % | 243 | 225 | 8 | % | ||||||||||||||||||||||||||||
DAC and VOBA amortization, net of interest: | ||||||||||||||||||||||||||||||||||||||||||||
Prospective unlocking – assumption changes | (2 | ) | (28 | ) | 93 | % | (2 | ) | (28 | ) | 93 | % | ||||||||||||||||||||||||||||||||
Prospective unlocking – model refinements | — | 16 | -100 | % | — | 16 | -100 | % | ||||||||||||||||||||||||||||||||||||
Retrospective unlocking | — | (9 | ) | 100 | % | — | (15 | ) | 100 | % | 35 | (7 | ) | NM | 35 | (21 | ) | 267 | % | |||||||||||||||||||||||||
Other amortization | 101 | 105 | -4 | % | 180 | 201 | -10 | % | ||||||||||||||||||||||||||||||||||||
Other amortization, net of interest | 63 | 103 | -39 | % | 241 | 304 | -21 | % | ||||||||||||||||||||||||||||||||||||
Broker-dealer expenses incurred: | ||||||||||||||||||||||||||||||||||||||||||||
Commissions | 64 | 72 | -11 | % | 131 | 141 | -7 | % | 60 | 72 | -17 | % | 191 | 212 | -10 | % | ||||||||||||||||||||||||||||
General and administrative expenses | 21 | 20 | 5 | % | 43 | 39 | 10 | % | 18 | 20 | -10 | % | 62 | 60 | 3 | % | ||||||||||||||||||||||||||||
Taxes, licenses and fees | — | 1 | -100 | % | — | — | NM | 1 | 1 | 0 | % | 4 | 4 | 0 | % | |||||||||||||||||||||||||||||
Total underwriting, acquisition, insurance and other expenses | $ | 268 | $ | 267 | 0 | % | $ | 520 | $ | 517 | 1 | % | $ | 254 | $ | 256 | -1 | % | $ | 774 | $ | 772 | 0 | % | ||||||||||||||||||||
DAC and VOBA deferrals | ||||||||||||||||||||||||||||||||||||||||||||
As a percentage of sales/deposits | 5.6 | % | 5.8 | % | 5.6 | % | 5.7 | % | 5.8 | % | 5.6 | % | 5.7 | % | 5.7 | % |
Commissions and other costs that vary with and are related primarily to the production of new business are deferred to the extent recoverable and are amortized over the lives of the contracts in relation to estimated gross profits (“EGPs”).EGPs. We have certain trail commissions that are based upon account values that are expensed as incurred rather than being deferred and amortized.
Broker-dealer expenses that vary with and are related to sales are expensed as incurred and not deferred and amortized. These expenses are more than offset by increases to other income.
Comparison of the Three Months Ended JuneSeptember 30, 2008 to 2007
The decrease in expenses incurred, excluding broker-dealer, was attributable primarily to the decrease in commissions from lower sales and lower incentive compensation accruals as a result of production performance relative to planned goals.
The decrease in DAC and VOBA amortization, net of interest and excluding unlocking, was attributable primarily to lower emergence of gross profits.
The decrease in broker-dealer commissions was due to lower sales of non-proprietary products.
The third quarter of 2008 had favorable prospective unlocking – assumption changes related primarily to maintenance expenses and fee margins partially offset by lapses. The third quarter of 2007 had favorable prospective unlocking – assumption changes related primarily to favorable interest rates, maintenance expense and account retention assumptions partially offset by unfavorable asset-based commission assumptions.
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The third quarter of 2008 had unfavorable retrospective unlocking due primarily to lower maintenance and expense charges and lower equity market performance than our model projections assumed. The third quarter of 2007 had favorable retrospective unlocking due primarily to lower lapses and higher equity market performance than our model projections assumed.
Comparison of the Nine Months Ended September 30, 2008 to 2007
The increase in expenses incurred, excluding broker-dealer, was attributable primarily to growthincreased distribution expenses and Federal Insurance Contributions Act taxes associated with the expansion of the wholesaling force in LFD, partially offset by lower incentive compensation accruals as a result of lower earnings and production performance relative to planned goals.
The decrease in DAC and VOBA amortization, net of interest and excluding unlocking, was attributable primarily to declines in variable account values from sales, which increased commissions and general and administrative expenses.unfavorable equity markets during 2008.
The decrease in broker-dealer commissions was due to lower sales of non-proprietary products.
See the discussion above regarding prospective unlocking in 2008 and 2007.
The second quarterfirst nine months of 2008 had unfavorable retrospective unlocking due primarily to lower maintenance and expense charges and lower equity market performance than our model projections assumed. The first nine months of 2007 had favorable retrospective unlocking (decrease to DAC and VOBA amortization) due primarily to lower lapses and higher equity market returnsperformance than estimated in our model projections.projections assumed.
Federal Income Taxes
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Comparison of the SixThree and Nine Months Ended JuneSeptember 30, 2008 to 2007
The increaseeffective federal income tax rate decreased to 6% and 18% for the three and nine months ended September 30, 2008, from 26% and 25% for the same periods in expenses incurred, excluding broker-dealer, was attributable2007. Federal income tax expense for the three and nine months ended September 30, 2008, included a reduction of $21 million related to favorable tax return true-ups and other items driven primarily by the separate account DRD in 2008, compared to growtha $2 million unfavorable tax return true-up and other items for the same periods in account values from sales, which increased commissions and general and administrative expenses.2007. For additional information on our effective tax rates, see Note 4 to our consolidated financial statements.
The decrease in broker-dealer commissions was due to lower sales of non-proprietary products. The increase in broker-dealer general and administrative expenses was attributable primarily to increases in personnel costs.
The first six months of 2007 had favorable retrospective unlocking (decrease to DAC and VOBA amortization) due primarily to lower lapses and higher equity market returns than estimated in our model projections.63
Individual Markets Retirement Solutions– Life InsuranceDefined Contribution
Income from Operations
Details underlying the results for Individual MarketsRetirement Solutions – Life InsuranceDefined Contribution (in millions) were as follows:
For the Three Months Ended June 30, | For the Six Months Ended June 30, | For the Three Months Ended September 30, | Change | For the Nine Months Ended September 30, | Change | |||||||||||||||||||||||||||||||
2008 | 2007 | Change | 2008 | 2007 | Change | 2008 | 2007 | 2008 | 2007 | |||||||||||||||||||||||||||
Operating Revenues | ||||||||||||||||||||||||||||||||||||
Insurance premiums | $ | 89 | $ | 88 | 1 | % | $ | 176 | $ | 176 | 0 | % | ||||||||||||||||||||||||
Insurance fees | 460 | 368 | 25 | % | 905 | 787 | 15 | % | $ | 56 | $ | 65 | -14 | % | $ | 178 | $ | 192 | -7 | % | ||||||||||||||||
Net investment income | 467 | 493 | -5 | % | 914 | 947 | -3 | % | 181 | 173 | 5 | % | 527 | 535 | -1 | % | ||||||||||||||||||||
Other revenues and fees | 5 | 8 | -38 | % | 13 | 19 | -32 | % | 4 | 5 | -20 | % | 13 | 15 | -13 | % | ||||||||||||||||||||
Total operating revenues | 1,021 | 957 | 7 | % | 2,008 | 1,929 | 4 | % | 241 | 243 | -1 | % | 718 | 742 | -3 | % | ||||||||||||||||||||
Operating Expenses | ||||||||||||||||||||||||||||||||||||
Interest credited | 262 | 254 | 3 | % | 520 | 506 | 3 | % | 107 | 104 | 3 | % | 320 | 314 | 2 | % | ||||||||||||||||||||
Benefits | 300 | 263 | 14 | % | 597 | 509 | 17 | % | ||||||||||||||||||||||||||||
Underwriting, acquisition, insurance and other expenses | 228 | 171 | 33 | % | 440 | 392 | 12 | % | 77 | 85 | -9 | % | 229 | 237 | -3 | % | ||||||||||||||||||||
Total operating expenses | 790 | 688 | 15 | % | 1,557 | 1,407 | 11 | % | 184 | 189 | -3 | % | 549 | 551 | 0 | % | ||||||||||||||||||||
Income from operations before taxes | 231 | 269 | -14 | % | 451 | 522 | -14 | % | 57 | 54 | 6 | % | 169 | 191 | -12 | % | ||||||||||||||||||||
Federal income taxes | 78 | 93 | -16 | % | 153 | 179 | -15 | % | 15 | 13 | 15 | % | 45 | 53 | -15 | % | ||||||||||||||||||||
Income from operations | $ | 153 | $ | 176 | -13 | % | $ | 298 | $ | 343 | -13 | % | $ | 42 | $ | 41 | 2 | % | $ | 124 | $ | 138 | -10 | % | ||||||||||||
Comparison of the Three Months Ended JuneSeptember 30, 2008 to 2007
Income from operations for this segment modestly increased due primarily to the following:
Higher net investment income attributable primarily to the growth in the average fixed account values, including the fixed portion of variable, driven by transfers from variable to fixed, and more favorable results from commercial mortgage loan prepayments and bond makewhole premiums and investment income on alternative investments;
Lower underwriting, acquisition, insurance and other expenses due in part to the implementation of several expense management controls and practices that are focused on aggressively managing expenses and lower incentive compensation accruals as a result of production performance relative to planned goals; and
A $2 million unfavorable prospective unlocking from assumption changes of DAC and VOBA in 2007.
The increase in income from operations was partially offset by lower insurance fees driven by lower average daily account values due to unfavorable equity markets. In addition, the third quarters of 2008 and 2007 had $2 million unfavorable retrospective unlocking of DAC, VOBA and DSI.
Comparison of the Nine Months Ended September 30, 2008 to 2007
Income from operations for this segment decreased due primarily to the following:
Lower insurance fees driven by lower average daily account values due to unfavorable equity markets; and
Lower net investment income attributable to less favorable investment income on surplus and alternative investments.
The decrease in income from operations was partially offset by the following:
Lower underwriting, acquisition, insurance and other expenses due in part to the implementation of several expense management controls and practices that are focused on aggressively managing expenses and lower incentive compensation accruals as a result of lower earnings and production performance relative to planned goals; and
The impact of prospective unlocking discussed above.
In addition, the first nine months of 2008 and 2007 had $3 million unfavorable retrospective unlocking of DAC, VOBA and DSI.
The foregoing items are discussed further below following “Impact of Current Market Conditions.”
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Impact of Current Market Conditions
The October 2008 daily average of the S&P 500 Index® declined 17% from its value as of September 30, 2008, negatively impacting our variable account values. Consequently, we expect lower earnings in the fourth quarter as a result of October’s results, including the following:
Lower variable account values, which will reduce expense assessment revenue, partially offset by lower asset-based expenses;
Higher unfavorable retrospective unlocking due to lower equity market performance than our model projections assumed; and
If equity markets do not materially improve over the remainder of the fourth quarter, we may unlock our amortization model assumption for equity market returns for DAC, VOBA and DSI, resulting in a significant increase to amortization in the period. For more information, see “Critical Accounting Policies and Estimates – DAC, VOBA, DSI and DFEL” above.
Due to a change in business mix, a substantial increase in new deposit production in other products is necessary to maintain earnings at current levels.
For factors that could cause actual results to differ materially from those set forth in this section, see “Part I – Item 1A. Risk Factors” in our 2007 Form 10-K as updated by “Part II – Item 1A. Risk Factors” and “Forward-Looking Statements – Cautionary Language” in this report.
Insurance Fees
Details underlying insurance fees, account values and net flows (in millions) were as follows:
For the Three Months Ended September 30, | Change | For the Nine Months Ended September 30, | Change | |||||||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||||||||
Insurance Fees | ||||||||||||||||||
Annuity expense assessments | $ | 50 | $ | 59 | -15 | % | $ | 159 | $ | 174 | -9 | % | ||||||
Mutual fund fees | 5 | 4 | 25 | % | 14 | 12 | 17 | % | ||||||||||
Total expense assessments | 55 | 63 | -13 | % | 173 | 186 | -7 | % | ||||||||||
Surrender charges | 1 | 2 | -50 | % | 5 | 6 | -17 | % | ||||||||||
Total insurance fees | $ | 56 | $ | 65 | -14 | % | $ | 178 | $ | 192 | -7 | % | ||||||
Average Daily Variable Account Values | $ | 15,582 | $ | 18,162 | -14 | % | $ | 16,369 | $ | 18,043 | -9 | % | ||||||
Average Daily S&P 500 Index® | 1,255.42 | 1,489.60 | -16 | % | 1,325.03 | 1,470.65 | -10 | % | ||||||||||
As of September 30, | Change | ||||||||
2008 | 2007 | ||||||||
Account Values | |||||||||
Variable portion of variable annuities | $ | 13,480 | $ | 18,580 | -27 | % | |||
Fixed portion of variable annuities | 6,114 | 5,948 | 3 | % | |||||
Total variable annuities | 19,594 | 24,528 | -20 | % | |||||
Fixed annuities | 5,304 | 4,943 | 7 | % | |||||
Total annuities | 24,898 | 29,471 | -16 | % | |||||
Mutual funds | 7,675 | 7,165 | 7 | % | |||||
Total annuities and mutual funds | $ | 32,573 | $ | 36,636 | -11 | % | |||
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For the Three Months Ended September 30, | Change | For the Nine Months Ended September 30, | Change | |||||||||||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||||||||||||
Account Value Roll Forward – By Product | ||||||||||||||||||||||
Total Micro – Small Segment: | ||||||||||||||||||||||
Balance at beginning-of-period | $ | 7,286 | $ | 8,012 | -9 | % | $ | 7,798 | $ | 7,535 | 3 | % | ||||||||||
Gross deposits | 389 | 391 | -1 | % | 1,276 | 1,229 | 4 | % | ||||||||||||||
Withdrawals and deaths | (465 | ) | (481 | ) | 3 | % | (1,429 | ) | (1,366 | ) | -5 | % | ||||||||||
Net flows | (76 | ) | (90 | ) | 16 | % | (153 | ) | (137 | ) | -12 | % | ||||||||||
Transfers between fixed and variable accounts | — | — | NM | (12 | ) | (5 | ) | NM | ||||||||||||||
Inter-product transfer(1) | (653 | ) | — | NM | (653 | ) | — | NM | ||||||||||||||
Investment increase and change in market value | (767 | ) | 155 | NM | (1,190 | ) | 684 | NM | ||||||||||||||
Balance at end-of-period | $ | 5,790 | $ | 8,077 | -28 | % | $ | 5,790 | $ | 8,077 | -28 | % | ||||||||||
Total Mid – Large Segment: | ||||||||||||||||||||||
Balance at beginning-of-period | $ | 9,985 | $ | 8,555 | 17 | % | $ | 9,463 | $ | 6,975 | 36 | % | ||||||||||
Gross deposits | 687 | 861 | -20 | % | 2,203 | 2,162 | 2 | % | ||||||||||||||
Withdrawals and deaths | (222 | ) | (263 | ) | 16 | % | (679 | ) | (512 | ) | -33 | % | ||||||||||
Net flows | 465 | 598 | -22 | % | 1,524 | 1,650 | -8 | % | ||||||||||||||
Transfers between fixed and variable accounts | (4 | ) | (51 | ) | 92 | % | (44 | ) | (14 | ) | NM | |||||||||||
Inter-product transfer(1) | 653 | — | NM | 653 | — | NM | ||||||||||||||||
Investment increase and change in market value | (789 | ) | 130 | NM | (1,286 | ) | 621 | NM | ||||||||||||||
Balance at end-of-period | $ | 10,310 | $ | 9,232 | 12 | % | $ | 10,310 | $ | 9,232 | 12 | % | ||||||||||
TotalMulti-Fund® and Other Variable Annuities: | ||||||||||||||||||||||
Balance at beginning-of-period | $ | 17,771 | $ | 19,396 | -8 | % | $ | 18,797 | $ | 19,146 | -2 | % | ||||||||||
Gross deposits | 258 | 273 | -5 | % | 827 | 894 | -7 | % | ||||||||||||||
Withdrawals and deaths | (554 | ) | (648 | ) | 15 | % | (1,588 | ) | (1,979 | ) | 20 | % | ||||||||||
Net flows | (296 | ) | (375 | ) | 21 | % | (761 | ) | (1,085 | ) | 30 | % | ||||||||||
Transfers between fixed and variable accounts | (1 | ) | (1 | ) | — | (1 | ) | (5 | ) | 80 | % | |||||||||||
Inter-segment transfer | — | — | NM | 295 | — | NM | ||||||||||||||||
Investment increase and change in market value | (1,001 | ) | 307 | NM | (1,857 | ) | 1,271 | NM | ||||||||||||||
Balance at end-of-period | $ | 16,473 | $ | 19,327 | -15 | % | $ | 16,473 | $ | 19,327 | -15 | % | ||||||||||
Total Annuities and Mutual Funds: | ||||||||||||||||||||||
Balance at beginning-of-period | $ | 35,042 | $ | 35,963 | -3 | % | $ | 36,058 | $ | 33,656 | 7 | % | ||||||||||
Gross deposits | 1,334 | 1,525 | -13 | % | 4,306 | 4,285 | 0 | % | ||||||||||||||
Withdrawals and deaths | (1,241 | ) | (1,392 | ) | 11 | % | (3,696 | ) | (3,857 | ) | 4 | % | ||||||||||
Net flows | 93 | 133 | -30 | % | 610 | 428 | 43 | % | ||||||||||||||
Transfers between fixed and variable accounts | (5 | ) | (52 | ) | 90 | % | (57 | ) | (24 | ) | NM | |||||||||||
Inter-segment transfer | — | — | NM | 295 | — | NM | ||||||||||||||||
Investment increase and change in market value | (2,557 | ) | 592 | NM | (4,333 | ) | 2,576 | NM | ||||||||||||||
Balance at end-of-period(2) | $ | 32,573 | $ | 36,636 | -11 | % | $ | 32,573 | $ | 36,636 | -11 | % | ||||||||||
(1) | The Lincoln Employee 401(k) Plan transferred from DIRECTORSM toLincoln Alliance® effective September 30, 2008. |
(2) | Includes mutual fund account values. Mutual funds are not included on our Consolidated Balance Sheets. |
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For the Three Months Ended September 30, | Change | For the Nine Months Ended September 30, | Change | |||||||||||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||||||||||||
Net Flows | ||||||||||||||||||||||
Variable portion of variable annuity deposits | $ | 532 | $ | 564 | -6 | % | $ | 1,767 | $ | 1,795 | -2 | % | ||||||||||
Variable portion of variable annuity withdrawals | (723 | ) | (810 | ) | 11 | % | (2,202 | ) | (2,370 | ) | 7 | % | ||||||||||
Variable portion of variable annuity net flows | (191 | ) | (246 | ) | 22 | % | (435 | ) | (575 | ) | 24 | % | ||||||||||
Fixed portion of variable annuity deposits | 94 | 84 | 12 | % | 279 | 272 | 3 | % | ||||||||||||||
Fixed portion of variable annuity withdrawals | (228 | ) | (235 | ) | 3 | % | (620 | ) | (704 | ) | 12 | % | ||||||||||
Fixed portion of variable annuity net flows | (134 | ) | (151 | ) | 11 | % | (341 | ) | (432 | ) | 21 | % | ||||||||||
Total variable annuity deposits | 626 | 648 | -3 | % | 2,046 | 2,067 | -1 | % | ||||||||||||||
Total variable annuity withdrawals | (951 | ) | (1,045 | ) | 9 | % | (2,822 | ) | (3,074 | ) | 8 | % | ||||||||||
Total variable annuity net flows | (325 | ) | (397 | ) | 18 | % | (776 | ) | (1,007 | ) | 23 | % | ||||||||||
Fixed annuity deposits | 196 | 221 | -11 | % | 623 | 565 | 10 | % | ||||||||||||||
Fixed annuity withdrawals | (183 | ) | (215 | ) | 15 | % | (541 | ) | (520 | ) | -4 | % | ||||||||||
Fixed annuity net flows | 13 | 6 | 117 | % | 82 | 45 | 82 | % | ||||||||||||||
Total annuity deposits | 822 | 869 | -5 | % | 2,669 | 2,632 | 1 | % | ||||||||||||||
Total annuity withdrawals | (1,134 | ) | (1,260 | ) | 10 | % | (3,363 | ) | (3,594 | ) | 6 | % | ||||||||||
Total annuity net flows | (312 | ) | (391 | ) | 20 | % | (694 | ) | (962 | ) | 28 | % | ||||||||||
Mutual fund deposits | 512 | 656 | -22 | % | 1,637 | 1,653 | -1 | % | ||||||||||||||
Mutual fund withdrawals | (107 | ) | (132 | ) | 19 | % | (333 | ) | (263 | ) | -27 | % | ||||||||||
Mutual fund net flows | 405 | 524 | -23 | % | 1,304 | 1,390 | -6 | % | ||||||||||||||
Total annuity and mutual fund deposits | 1,334 | 1,525 | -13 | % | 4,306 | 4,285 | 0 | % | ||||||||||||||
Total annuity and mutual fund withdrawals | (1,241 | ) | (1,392 | ) | 11 | % | (3,696 | ) | (3,857 | ) | 4 | % | ||||||||||
Total annuity and mutual fund net flows | $ | 93 | $ | 133 | -30 | % | $ | 610 | $ | 428 | 43 | % | ||||||||||
We charge expense assessments to cover insurance and administrative expenses. Expense assessments are generally equal to a percentage of the daily variable account values. Our expense assessments include fees we earn for the services that we provide to our mutual fund programs. In addition, we collect surrender charges when contract holders surrender their contracts during the surrender charge periods to protect us from premature withdrawals.
New deposits are an important component of our effort to grow our business. Although deposits do not significantly impact current period income from operations, they are an important indicator of future profitability.
The other component of net flows relates to the retention of the business. One of the key assumptions in pricing a product is the account persistency, which we refer to as the lapse rate. The lapse rate compares the amount of withdrawals to the average account values.
We serve the mid-large case 401(k) and 403(b) markets with our mutual fund programs. Our programs bundle our fixed annuity products with mutual funds, along with record keeping and employee education components. The amounts associated with the mutual fund programs are not included in the assets or liabilities reported on our Consolidated Balance Sheets.
The distribution model for the micro-small case 401(k) market is focused on driving growth through financial intermediaries. As of September 30, 2008, we had approximately 70 wholesalers in place to support this business and plan for additional growth during the remainder of 2008. We are beginning to experience an increase in new business activity as a result of building our own wholesaling force for this market.
Comparison of the Three and Nine Months Ended September 30, 2008 to 2007
The decrease in expense assessments was driven by lower average daily variable annuity account values due to unfavorable equity markets, customer transfers out of variable and into fixed account values and an overall shift in business mix toward products with lower expense assessment rates.
Overall lapse rates for our annuity products for the three and nine months ended September 30, 2008, were 14% and 15%, respectively, compared to 16% and 15%, respectively, for the same periods in 2007. The return on assets, calculated as income
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divided by average assets under management, forMulti-Fund® and Other Variable Annuities, our oldest block of annuity business, is more than two times that of new deposits. Therefore, a substantial increase in new deposit production in other products is necessary to maintain earnings at current levels.
As of September 30, 2008, $12.1 billion, or 62%, of variable annuity contract account values contained a return of premium death benefit feature, and the net amount at risk related to these contracts was $115 million. The remaining variable annuity contract account values contain no GDB feature.
Additionally, deposits in our mid-large segment (including mutual fund program fixed annuity deposits) increased for the nine months ended September 30, 2008, compared to the same period in 2007 due to an increase in the number of mutual fund program accounts, which resulted in both an increase in initial deposits and an increase in ongoing periodic deposits.
Net Investment Income and Interest Credited
Details underlying net investment income, interest credited (in millions) and our interest rate spread were as follows:
For the Three Months Ended September 30, | Change | For the Nine Months Ended September 30, | Change | |||||||||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||||||||||
Net Investment Income | ||||||||||||||||||||
Fixed maturity securities, mortgage loans on real estate and other, net of investment expenses | $ | 165 | $ | 161 | 2 | % | $ | 489 | $ | 485 | 1 | % | ||||||||
Commercial mortgage loan prepayment and bond makewhole premiums(1) | 5 | 2 | 150 | % | 7 | 5 | 40 | % | ||||||||||||
Alternative investments(2) | — | (3 | ) | 100 | % | (2 | ) | 2 | NM | |||||||||||
Surplus investments(3) | 11 | 13 | -15 | % | 33 | 43 | -23 | % | ||||||||||||
Total net investment income | $ | 181 | $ | 173 | 5 | % | $ | 527 | $ | 535 | -1 | % | ||||||||
Interest Credited | $ | 107 | $ | 104 | 3 | % | $ | 320 | $ | 314 | 2 | % | ||||||||
(1) | See “Consolidated Investments – Commercial Mortgage Loan Prepayment and Bond Makewhole Premiums” below for additional information. |
(2) | See “Consolidated Investments – Alternative Investments” below for additional information. |
(3) | Represents net investment income on the required statutory surplus for this segment. |
For the Three Months Ended September 30, | Basis Point Change | For the Nine Months Ended September 30, | Basis Point Change | |||||||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||||||||
Interest Rate Spread | ||||||||||||||||||
Fixed maturity securities, mortgage loans on real estate and other, net of investment expenses | 5.94 | % | 6.04 | % | (10 | ) | 5.91 | % | 6.04 | % | (13 | ) | ||||||
Commercial mortgage loan prepayment and bond makewhole premiums | 0.17 | % | 0.07 | % | 10 | 0.08 | % | 0.06 | % | 2 | ||||||||
Alternative investments | -0.01 | % | -0.10 | % | 9 | -0.02 | % | 0.02 | % | (4 | ) | |||||||
Net investment income yield on reserves | 6.10 | % | 6.01 | % | 9 | 5.97 | % | 6.12 | % | (15 | ) | |||||||
Interest rate credited to contract holders | 3.77 | % | 3.84 | % | (7 | ) | 3.79 | % | 3.82 | % | (3 | ) | ||||||
Interest rate spread | 2.33 | % | 2.17 | % | 16 | 2.18 | % | 2.30 | % | (12 | ) | |||||||
Note: The yields, rates and spreads above are calculated using whole dollars instead of dollars rounded to millions.
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For the Three Months Ended September 30, | Change | For the Nine Months Ended September 30, | Change | |||||||||||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||||||||||||
Average invested assets on reserves | $ | 11,146 | $ | 10,666 | 5 | % | $ | 11,034 | $ | 10,721 | 3 | % | ||||||||||
Average fixed account values, including the fixed portion of variable | 11,321 | 10,905 | 4 | % | 11,233 | 10,944 | 3 | % | ||||||||||||||
Net flows for fixed annuities, including the fixed portion of variable | (121 | ) | (145 | ) | 17 | % | (259 | ) | (387 | ) | 33 | % |
A portion of our investment income earned is credited to the contract holders of our fixed annuity products, including the fixed portion of variable annuity contracts. We expect to earn a spread between what we earn on the underlying general account investments supporting the fixed annuity product line, including the fixed portion of variable annuity contracts, and what we credit to our fixed annuity contract holders’ accounts, including the fixed portion of variable annuity contracts. The interest rate spread for this segment represents the excess of the yield on invested assets on reserves over the average crediting rate. The yield on invested assets on reserves is calculated as net investment income, excluding the amounts attributable to our surplus investments, reverse repurchase agreement interest expense, inter-segment cash management account interest expense and interest on collateral, divided by average invested assets on reserves. The average invested assets on reserves are calculated based upon total invested assets, excluding hedge derivatives. The average crediting rate is calculated as interest credited before DSI amortization, plus the immediate annuity reserve change (included within benefits), divided by the average fixed account values, including the fixed portion of variable annuities. Commercial mortgage loan prepayments and bond makewhole premiums, investment income on alternative investments and surplus investment income can vary significantly from period to period due to a number of factors and, therefore, may contribute to investment income results that are not indicative of the underlying trends.
Comparison of the Three Months Ended September 30, 2008 to 2007
The increase in fixed maturity securities, mortgage loans on real estate and other net investment income was attributable primarily to the growth in the average fixed account values, including the fixed portion of variable, driven by transfers from variable to fixed, partially offset by the yield decline due to lower reinvestment rates. Towards the end of the third quarter of 2008, this segment held less cash than in previous periods in an effort to be more invested in higher yielding assets.
The increase in investment income on alternative investments was driven primarily by more favorable results from our limited partnership investments. Earnings on investments supporting statutory surplus were negatively impacted by unfavorable equity markets.
The increase in interest credited was primarily attributable to the growth in the average fixed account values, including the fixed portion of variable, driven by transfers from variable to fixed. In response to the competitive environment, during the third quarter of 2008, we reduced crediting rates by 10 basis points forMulti-Fund® products andLincoln Alliance® program fixed annuity products and increased new money rates by 25 basis points forMulti-Fund® products. For information on interest rate spreads and the interest rate risk due to falling interest rates, see “Item 3. Quantitative and Qualitative Disclosures About Market Risk.”
Comparison of the Nine Months Ended September 30, 2008 to 2007
The decrease in investment income on surplus and alternative investments was driven by less favorable results from our limited partnership investments.
The modest increase in fixed maturity securities, mortgage loans on real estate and other net investment income was attributable primarily to the growth in the average fixed account values, including the fixed portion of variable, driven by transfers from variable to fixed, partially offset by the yield decline due to lower reinvestment rates.
The increase in interest credited was attributable primarily to the growth in the average fixed account values, including the fixed portion of variable, driven by transfers from variable account values. The 10 basis point crediting rate reduction discussed above was the first such rate change in 2008, while the 25 basis point increase in new money rates followed a reduction in the previous quarter. We plan to take further crediting rate action in the fourth quarter of 2008, with the expectation of maintaining stable spreads over the near term, excluding the effects of prepayment and makewhole premiums.
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Underwriting, Acquisition, Insurance and Other Expenses
Details underlying underwriting, acquisition, insurance and other expenses (in millions) were as follows:
For the Three Months Ended September 30, | Change | For the Nine Months Ended September 30, | Change | |||||||||||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||||||||||||
Underwriting, Acquisition, Insurance and Other Expenses | ||||||||||||||||||||||
Commissions | $ | 17 | $ | 20 | -15 | % | $ | 56 | $ | 60 | -7 | % | ||||||||||
General and administrative expenses | 53 | 60 | -12 | % | 158 | 164 | -4 | % | ||||||||||||||
Taxes, licenses and fees | 3 | 2 | 50 | % | 10 | 12 | -17 | % | ||||||||||||||
Total expenses incurred | 73 | 82 | -11 | % | 224 | 236 | -5 | % | ||||||||||||||
DAC deferrals | (20 | ) | (24 | ) | 17 | % | (66 | ) | (68 | ) | 3 | % | ||||||||||
Total expenses recognized before amortization | 53 | 58 | -9 | % | 158 | 168 | -6 | % | ||||||||||||||
DAC and VOBA amortization, net of interest: | ||||||||||||||||||||||
Prospective unlocking – assumption changes | — | 3 | -100 | % | — | 3 | -100 | % | ||||||||||||||
Retrospective unlocking | 3 | 2 | 50 | % | 5 | 5 | 0 | % | ||||||||||||||
Other amortization, net of interest | 21 | 22 | -5 | % | 66 | 61 | 8 | % | ||||||||||||||
Total underwriting, acquisition, insurance and other expenses | $ | 77 | $ | 85 | -9 | % | $ | 229 | $ | 237 | -3 | % | ||||||||||
DAC deferrals | ||||||||||||||||||||||
As a percentage of sales/deposits | 1.5 | % | 1.6 | % | 1.5 | % | 1.6 | % |
Commissions and other costs, that vary with and are related primarily to the production of new business, excluding those associated with our mutual fund products, are deferred to the extent recoverable and are amortized over the lives of the contracts in relation to EGPs. We do not pay commissions on sales of our mutual fund products, and distribution expenses associated with the sale of these mutual fund products are not deferred and amortized, as is the case for our insurance products.
Comparison of the Three and Nine Months Ended September 30, 2008 to 2007
The decrease in expenses incurred was due in part to the implementation of several expense management controls and practices that are focused on aggressively managing expenses and lower incentive compensation accruals as a result of production performance relative to planned goals. Additionally, lower earnings for the nine months ended September 30, 2008, contributed to the decrease in incentive compensation accruals. The decrease in commissions was primarily a result of lower sales.
The third quarter and first nine months of 2007 had unfavorable prospective unlocking due to assumption changes primarily reflecting higher lapse rates and separate account fees partially offset by lower expenses.
The third quarter and first nine months of 2008 and 2007 had unfavorable retrospective unlocking due primarily to higher lapses and lower equity market performance than our model projections assumed.
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RESULTS OF INSURANCE SOLUTIONS
The Insurance Solutions business provides its products through two segments: Life Insurance and Group Protection. The Insurance Solutions – Life Insurance segment offers wealth protection and transfer opportunities through term insurance, a linked-benefit product (which is a UL policy linked with riders that provide for long-term care costs) and both single and survivorship versions of UL and VUL, including our Executive Benefits business’s corporate-owned UL and VUL (“COLI”) and bank-owned UL and VUL (“BOLI”) products. The Insurance Solutions – Group Protection segment offers group life, disability and dental insurance to employers and its products are marketed primarily through a national distribution system of regional group offices. These offices develop business through employee benefit brokers, third-party administrators and other employee benefit firms.
For factors that could cause actual results to differ materially from those set forth in this section, see “Part I – Item 1A. Risk Factors” in our 2007 Form 10-K as updated by “Part II – Item 1A. Risk Factors” and “Forward-Looking Statements – Cautionary Language” in this report.
Insurance Solutions – Life Insurance
Income from Operations
Details underlying the results for Insurance Solutions – Life Insurance (in millions) were as follows:
For the Three Months Ended September 30, | Change | For the Nine Months Ended September 30, | Change | |||||||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||||||||
Operating Revenues | ||||||||||||||||||
Insurance premiums | $ | 91 | $ | 85 | 7 | % | $ | 267 | $ | 261 | 2 | % | ||||||
Insurance fees | 449 | 469 | -4 | % | 1,380 | 1,283 | 8 | % | ||||||||||
Net investment income | 522 | 496 | 5 | % | 1,541 | 1,553 | -1 | % | ||||||||||
Other revenues and fees | 10 | 6 | 67 | % | 22 | 24 | -8 | % | ||||||||||
Total operating revenues | 1,072 | 1,056 | 2 | % | 3,210 | 3,121 | 3 | % | ||||||||||
Operating Expenses | ||||||||||||||||||
Interest credited | 305 | 293 | 4 | % | 902 | 875 | 3 | % | ||||||||||
Benefits | 398 | 266 | 50 | % | 1,000 | 780 | 28 | % | ||||||||||
Underwriting, acquisition, insurance and other expenses | 167 | 227 | -26 | % | 621 | 639 | -3 | % | ||||||||||
Total operating expenses | 870 | 786 | 11 | % | 2,523 | 2,294 | 10 | % | ||||||||||
Income from operations before taxes | 202 | 270 | -25 | % | 687 | 827 | -17 | % | ||||||||||
Federal income taxes | 65 | 88 | -26 | % | 229 | 279 | -18 | % | ||||||||||
Income from operations | $ | 137 | $ | 182 | -25 | % | $ | 458 | $ | 548 | -16 | % | ||||||
Comparison of the Three Months Ended September 30, 2008 to 2007
Income from operations for this segment decreased due primarily to the following:
A $9 million unfavorable retrospective unlocking of DAC, VOBA, DFEL, and reserves for life insurance products with secondary guarantees in 2008 compared to an $11 million favorable retrospective unlocking in 2007; and
A $21 million unfavorable prospective unlocking (a $34 million unfavorable unlocking from model refinements net of a $13 million favorable unlocking from assumption changes) of DAC, VOBA, DFEL and reserves for life insurance products with secondary guarantees in 2008 compared to a $4 million favorable prospective unlocking (a $12 million favorable unlocking from assumption changes net of an $8 million unfavorable unlocking from model refinements) in 2007.
The $9 million unfavorable retrospective unlocking and the $21 million unfavorable prospective unlocking to DAC, VOBA, DFEL and reserves for life insurance products with secondary guarantees discussed above resulted in an additional unfavorable earnings impact for the current period of $7 million that will recur in future periods.
The decrease in income from operations was partially offset by higher investment income from growth in fixed product account values driven by positive net flows and more favorable results from our alternative investments.
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Comparison of the Nine Months Ended September 30, 2008 to 2007
Income from operations for this segment decreased due primarily to the following:
A $17 million unfavorable retrospective unlocking of DAC, VOBA, and DFEL in 2008 compared to a $23 million favorable retrospective unlocking in 2007;
The impact of prospective unlocking discussed above;
Higher death claims resulting in increased benefits;2008 and lower benefits in the first quarter of 2007 partially related to a reduction in benefits related to a purchase accounting adjustment to the opening balance sheet of Jefferson-Pilot; and
Lower net investment income from a reduction in statutory reserves as a result of the merger of several of our insurance subsidiaries and certain assumption changes in the fourth quarter of 2007, capital transactions providing relief from AG38 reserve requirements in the fourth quarter of 2007 and less favorable results from our investment income on alternative investments and prepayment and bond makewhole premiums; and
A decrease attributable to unfavorable retrospective unlocking of DAC and VOBA for the second quarter of 2008 compared to favorable retrospective unlocking for the second quarter of 2007.premiums.
The decrease in income from operations was partially offset by the following:
Growthgrowth in insurance fees driven by an increase in business in force as a result of new sales since JuneSeptember 30, 2007, and favorable persistency partially offset by the impact on insurance fees from lower sales in the second quarter of 2008 compared to the second quarter of 2007 and adjustments during the second quarter of 2007 resulting from adjusting account values for certain of our life insurance policies and modifying the accounting for certain of our life insurance policies.
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Comparison of the Six Months Ended June 30, 2008 to 2007
Income from operations for this segment decreased due primarily to the following:
Higher death claims in 2008 and lower benefits in the first quarter of 2007 partially related to a $14 million reduction in benefits related to a purchase accounting adjustment to the opening balance sheet of Jefferson-Pilot;
Lower net investment income from a reduction in statutory reserves as a result of the merger of several of our insurance subsidiaries and certain assumption changes in the fourth quarter of 2007, capital transactions providing relief from AG38 reserve requirements in the fourth quarter of 2007 and less favorable results from our investment income on alternative investments and prepayment and bond makewhole premiums; and
A decrease attributable to unfavorable retrospective unlocking of DAC and VOBA for the first six months of 2008 compared to favorable retrospective unlocking for the first six months of 2007.
The decrease in income from operations was partially offset by the following:
Growth in insurance fees driven by an increase in business in force as a result of new sales since June 30, 2007, and favorable persistency partially offset by the impact on insurance fees from lower sales in the first six months of 2008 compared to the first six months of 2007 and adjustments during the second quarter of 2007 resulting from adjusting account values for certain of our life insurance policies and modifying the accounting for certain of our life insurance policies.
The foregoing items are discussed further below.
Insurance Premiums
Insurance premiums relate to traditional products and are a function of the rates priced into the product and the level of insurance in force. Insurance in force, in turn, is driven by sales, persistency and mortality experience.
Comparison of the Three and SixNine Months Ended JuneSeptember 30, 2008 to 2007
Traditional in-force face amount, and thus premiums, remained relatively flat.
Insurance Fees
Details underlying insurance fees, sales, net flows, account values and in-force face amount (in millions) were as follows:
For the Three Months Ended June 30, | For the Six Months Ended June 30, | For the Three Months Ended September 30, | Change | For the Nine Months Ended September 30, | Change | |||||||||||||||||||||||||||||||||||||||
2008 | 2007 | Change | 2008 | 2007 | Change | 2008 | 2007 | 2008 | 2007 | |||||||||||||||||||||||||||||||||||
Insurance Fees | ||||||||||||||||||||||||||||||||||||||||||||
Mortality assessments | $ | 321 | $ | 282 | 14 | % | $ | 633 | $ | 575 | 10 | % | $ | 332 | $ | 312 | 6 | % | $ | 982 | $ | 903 | 9 | % | ||||||||||||||||||||
Expense assessments | 164 | 148 | 11 | % | 330 | 301 | 10 | % | 178 | 160 | 11 | % | 520 | 472 | 10 | % | ||||||||||||||||||||||||||||
Surrender charges | 15 | 16 | -6 | % | 31 | 31 | 0 | % | 16 | 14 | 14 | % | 46 | 45 | 2 | % | ||||||||||||||||||||||||||||
DFEL: | ||||||||||||||||||||||||||||||||||||||||||||
Deferrals | (89 | ) | (112 | ) | 21 | % | (177 | ) | (178 | ) | 1 | % | (97 | ) | (85 | ) | -14 | % | (276 | ) | (265 | ) | -4 | % | ||||||||||||||||||||
Amortization, excluding unlocking | 38 | 41 | -7 | % | 73 | 68 | 7 | % | ||||||||||||||||||||||||||||||||||||
Amortization, net of interest: | ||||||||||||||||||||||||||||||||||||||||||||
Prospective unlocking – assumption changes | (4 | ) | — | NM | (4 | ) | — | NM | ||||||||||||||||||||||||||||||||||||
Prospective unlocking – model refinements | (25 | ) | 26 | NM | (25 | ) | 26 | NM | ||||||||||||||||||||||||||||||||||||
Retrospective unlocking | 11 | (7 | ) | 257 | % | 15 | (10 | ) | 250 | % | 12 | 1 | NM | 27 | (8 | ) | NM | |||||||||||||||||||||||||||
Other amortization, net of interest | 37 | 41 | -10 | % | 110 | 110 | 0 | % | ||||||||||||||||||||||||||||||||||||
Total insurance fees | $ | 460 | $ | 368 | 25 | % | $ | 905 | $ | 787 | 15 | % | $ | 449 | $ | 469 | -4 | % | $ | 1,380 | $ | 1,283 | 8 | % | ||||||||||||||||||||
5772
For the Three Months Ended June 30, | For the Six Months Ended June 30, | For the Three Months Ended September 30, | Change | For the Nine Months Ended September 30, | Change | |||||||||||||||||||||||||||||||||||||||
2008 | 2007 | Change | 2008 | 2007 | Change | 2008 | 2007 | 2008 | 2007 | |||||||||||||||||||||||||||||||||||
Sales by Product | ||||||||||||||||||||||||||||||||||||||||||||
UL: | ||||||||||||||||||||||||||||||||||||||||||||
ExcludingMoneyGuard® | $ | 124 | $ | 145 | -14 | % | $ | 237 | $ | 311 | -24 | % | $ | 144 | $ | 144 | 0 | % | $ | 382 | $ | 455 | -16 | % | ||||||||||||||||||||
MoneyGuard® | 12 | 10 | 20 | % | 23 | 17 | 35 | % | 14 | 11 | 27 | % | 37 | 28 | 32 | % | ||||||||||||||||||||||||||||
Total UL | 136 | 155 | -12 | % | 260 | 328 | -21 | % | 158 | 155 | 2 | % | 419 | 483 | -13 | % | ||||||||||||||||||||||||||||
VUL | 12 | 17 | -29 | % | 27 | 38 | -29 | % | 12 | 18 | -33 | % | 39 | 55 | -29 | % | ||||||||||||||||||||||||||||
COLI and BOLI | 13 | 18 | -28 | % | 54 | 52 | 4 | % | ||||||||||||||||||||||||||||||||||||
Term/whole life | 5 | 8 | -38 | % | 11 | 17 | -35 | % | 7 | 7 | 0 | % | 18 | 25 | -28 | % | ||||||||||||||||||||||||||||
Total sales | $ | 153 | $ | 180 | -15 | % | $ | 298 | $ | 383 | -22 | % | $ | 190 | $ | 198 | -4 | % | $ | 530 | $ | 615 | -14 | % | ||||||||||||||||||||
Net Flows | ||||||||||||||||||||||||||||||||||||||||||||
Deposits | $ | 952 | $ | 1,005 | -5 | % | $ | 1,919 | $ | 2,044 | -6 | % | $ | 1,082 | $ | 1,032 | 5 | % | $ | 3,276 | $ | 3,219 | 2 | % | ||||||||||||||||||||
Withdrawals and deaths | (325 | ) | (419 | ) | 22 | % | (712 | ) | (761 | ) | 6 | % | (392 | ) | (403 | ) | 3 | % | (1,258 | ) | (1,356 | ) | 7 | % | ||||||||||||||||||||
Net flows | $ | 627 | $ | 586 | 7 | % | $ | 1,207 | $ | 1,283 | -6 | % | $ | 690 | $ | 629 | 10 | % | $ | 2,018 | $ | 1,863 | 8 | % | ||||||||||||||||||||
Contract holder assessments | $ | 675 | $ | 586 | 15 | % | $ | 1,318 | $ | 1,188 | 11 | % | $ | 705 | $ | 623 | 13 | % | $ | 2,060 | $ | 1,845 | 12 | % | ||||||||||||||||||||
As of June 30, | Change | As of September 30, | Change | |||||||||||||||
2008 | 2007 | 2008 | 2007 | |||||||||||||||
Account Values | ||||||||||||||||||
UL | $ | 21,321 | $ | 20,261 | 5 | % | $ | 24,951 | $ | 23,896 | 4 | % | ||||||
VUL | 4,473 | 4,948 | -10 | % | 5,056 | 6,104 | -17 | % | ||||||||||
Interest-sensitive whole life | 2,283 | 2,256 | 1 | % | 2,276 | 2,266 | 0 | % | ||||||||||
Total account values | $ | 28,077 | $ | 27,465 | 2 | % | $ | 32,283 | $ | 32,266 | 0 | % | ||||||
In-Force Face Amount | ||||||||||||||||||
UL and other | $ | 288,668 | $ | 276,040 | 5 | % | $ | 306,293 | $ | 294,833 | 4 | % | ||||||
Term insurance | 234,109 | 236,155 | -1 | % | 233,671 | 236,414 | -1 | % | ||||||||||
Total in-force face amount | $ | 522,777 | $ | 512,195 | 2 | % | $ | 539,964 | $ | 531,247 | 2 | % | ||||||
Insurance fees relate only to interest-sensitive products and include mortality assessments, expense assessments (net of deferrals and amortization related to DFEL) and surrender charges. Mortality and expense assessments are deducted from our contract holders’ account values. These amounts are a function of the rates priced into the product and premiums received, face amount in force and account values. Insurance in force, in turn, is driven by sales, persistency and mortality experience. In-force growth should be considered independently with respect to term products versus UL and other products, as term products have a lower profitability relative to face amount compared to whole life and interest-sensitive products.
Sales in the table above and as discussed below were reported as follows:
| UL (excluding linked-benefit products) and VUL (including COLI and BOLI) – first year commissionable premiums plus 5% of • MoneyGuard® (our linked-benefit product) – 15% of premium deposits; and Whole life and term – 100% of first year paid premiums. Sales are not recorded as a component of revenues (other than for traditional products) and do not have a significant impact on current quarter income from operations but are indicators of future profitability. Generally, we have higher sales during the last half of the year with the fourth quarter being our strongest; however, expectations for this year are muted given the current economic conditions. We have screening procedures to identify sales that we believe have characteristics associated with stranger-originated life insurance in order to prevent policies with these characteristics from being issued. However, accurate identification of these policies can be difficult, and we continue to modify our screening procedures. We believe that our sales of UL products include some sales with stranger-originated life insurance characteristics. We expect no significant impact to our profitability; however, returns on UL business sold as part of stranger-originated designs are believed to be lower than traditional estate planning UL sales due in part to no expected lapses. UL and VUL products with secondary guarantees represented approximately 33% of interest-sensitive life insurance in force as of Comparison of the Three and The growth in mortality and expense assessments was attributable primarily to The The third quarter of 2008 had favorable retrospective unlocking
The first projections assumed. The first Net Investment Income and Interest Credited Details underlying net investment income, interest credited (in millions) and our interest rate spread were as follows:
Note: The yields, rates and spreads above are calculated using whole dollars instead of dollars rounded to millions.
A portion of the investment income earned for this segment is credited to contract holder accounts. Invested assets will typically grow at a faster rate than account values because of the AG38 reserve
Comparison of the Three Months Ended The increase in fixed maturity securities, mortgage loans on real estate and other net investment income was due to continued growth of business in force partially offset by the impact of reductions in statutory reserves. The 75 reserve liabilities on UL policies with secondary guarantees contributed to invested asset growth. At June 30, 2007, we reduced statutory reserves related to our secondary guarantee UL products by approximately $150 million, which has reduced the amount of net investment income allocated to this segment by $2 million per quarter. This statutory reserve reduction related to modifying the accounting for certain of our life insurance policies. In October 2007, we released approximately $300 million of capital that had previously supported our UL products with secondary guarantees as a result of executing on a capital transaction to provide AG38 relief. This release of capital lowered the level of assets supporting this business and has reduced net investment income by approximately $5 million per quarter. As of December 31, 2007, we reduced statutory reserves related primarily to legal entity consolidation by $344 million, which has reduced the amount of net investment income allocated to this segment by approximately $5 million in the first quarter of 2008. This reduction in statutory reserves was primarily a result of the merger of several of our insurance subsidiaries. The increase in interest credited was attributable primarily to growth in UL account values. On June 1, 2007, we implemented a 10 basis point decrease in crediting rates on most interest-sensitive products not already at contractual guarantees, which has increased spreads approximately 5 basis points. On June 1, 2008, we implemented a 10 basis point decrease in crediting rates on most interest-sensitive products not already at contractual guarantees, which At the end of the Comparison of the The increase in fixed maturity securities, mortgage loans on real estate and other net investment income was due to continued growth of business in force partially offset by the impact of reductions in statutory reserves. The decrease in investment income on alternative investments was driven primarily by less favorable results from limited partnership investments. Benefits Details underlying benefits (dollars in millions) were as follows:
Benefits for this segment include death claims incurred during the period in excess of the associated reserves for its interest-sensitive and traditional products. In addition, benefits include the change in reserves for our products with secondary guarantees. The reserve for secondary guarantees is impacted by changes in expected future trends of claims and assessments causing unlocking adjustments to this liability similar to DAC, VOBA and DFEL. 76 Comparison of the Three Months Ended The increase in benefits, excluding unlocking, was due primarily to an increase in reserves for products with secondary guarantees from continued growth The third quarter of 2008 had unfavorable prospective unlocking – assumption changes, which reflected primarily improved lapse rates and improved investment spreads. Comparison of the Nine Months Ended September 30, 2008 to 2007 The increase in benefits, excluding unlocking, was due primarily to an increase in reserves for products with secondary guarantees from continued growth of business in force and the effects of model refinements and higher mortality due to an increase in the average attained age of the in-force block (which also led to increases in insurance fees as discussed above) and
The nine months ended September 30, 2008, had unfavorable prospective unlocking – assumption changes, discussed above. Underwriting, Acquisition, Insurance and Other Expenses Details underlying underwriting, acquisition, insurance and other expenses (in millions) were as follows:
Commissions and other general and administrative expenses that vary with and are related primarily to the production of new business are deferred to the extent recoverable and for our interest-sensitive products are generally amortized over the lives of the contracts in relation to EGPs. For our traditional products, DAC and VOBA are amortized on either a straight-line basis or as a level percent of premium of the related contracts, depending on the block of business.
Comparison of the Three and Nine Months Ended The decrease in expenses incurred was primarily a result of lower The decrease in DAC and VOBA amortization, net of interest and excluding unlocking, was The The third quarter of 2007 had favorable prospective unlocking – assumption changes, which reflected primarily improved lapse, expense and interest rates. The third quarter of 2008 had unfavorable retrospective unlocking The The first nine months of 2008 had unfavorable retrospective unlocking due primarily to lower premiums received and higher death claims than our model projections assumed and model adjustments on certain life insurance policies, partially offset by lower maintenance expenses than our model projections assumed. The first nine months of 2007 had favorable retrospective unlocking due primarily to higher persistency, higher investment income on alternative investments and prepayment and bond makewhole premiums
Income from Operations Details underlying the results for
Comparison of the Three Months Ended Income from operations for this segment
Comparison of the Income from operations for this segment modestly increased due primarily to
The increase in income from operations was partially offset by an increase to underwriting, acquisition, insurance and other expenses due to growth in our business in force, higher 401(k) expenses, elevated costs associated with investments in strategic initiatives and an increase in the allocation of expenses to this segment. The foregoing items are discussed further below. 79 Insurance Premiums Details underlying insurance premiums (in millions) were as follows:
Our cost of insurance and policy administration charges are embedded in the premiums charged to our customers. The premiums are a function of the rates priced into the product and our business in force. Business in force, in turn, is driven by sales and persistency experience. Sales in the table above and as discussed below are the combined annualized premiums for our life, disability and dental products. Sales relate to long-duration contracts sold to new contract holders and new programs sold to existing contract holders. The trend in sales is an important indicator of development of business in force over time. Comparison of the Three and The increase in insurance premiums in our non-medical business reflects normal business growth and favorable persistency experience. Net Investment Income We use our interest income to build the associated policy reserves, which is a function of our insurance premiums and the yields on our invested assets. Comparison of the Three and Net investment income remained relatively flat as continued growth of business in force was offset by lower yields on
Benefits and Interest Credited Details underlying benefits and interest credited (in millions) were as follows:
Note: Loss ratios presented above are calculated using whole dollars instead of dollars rounded to millions. Management Comparison of the Three We experienced Comparison of the Nine Months Ended September 30, 2008 to 2007 Our
Underwriting, Acquisition, Insurance and Other Expenses Details underlying underwriting, acquisition, insurance and other expenses (in millions) were as follows:
Expenses, excluding broker commissions, that vary with and are related primarily to the production of new business are deferred to the extent recoverable and are amortized on either a straight-line basis or as a level percent of premium of the related contracts depending on the block of business. Comparison of the Three Months Ended The increase in underwriting, acquisition, insurance and other expenses was in line with the increase in insurance premiums. Comparison of the Nine Months Ended September 30, 2008 to 2007 The increase in underwriting, acquisition, insurance and other expenses was in line with the increase in insurance premiums and
RESULTS OF INVESTMENT MANAGEMENT The Investment Management segment, through Delaware Investments, provides a broad range of managed account portfolios, mutual funds, sub-advised funds and other investment products to individual investors and to institutional investors such as private and public pension funds, foundations and endowment funds. Delaware Investments is the marketing name for Delaware Management Holdings, Inc. and its subsidiaries. Income from Operations Details underlying the results for Investment Management (in millions) were as follows:
Comparison of the Three and Nine Months Ended Income from operations
The decrease in income from operations was partially offset by lower expenses due to exiting certain businesses, lower asset-based expenses and lower incentive compensation accruals as a result of lower earnings and production performance relative to planned goals.
The foregoing items are discussed further Impact of Current Market Conditions The October 2008 daily average of the S&P 500 Index® declined 17% from its value as of September 30, 2008, negatively impacting our assets under management and seed capital investments. Consequently, we expect lower earnings in the fourth quarter as a result of lower investment advisory fees and negative returns on seed capital, partially offset by lower asset-based expenses. For factors that could cause actual results to differ materially from those set forth in this section, see “Part I – Item 1A. Risk Factors” in our 2007 Form 10-K as updated by “Part II – Item 1A. Risk Factors” and “Forward-Looking Statements – Cautionary Language” in this report. 83 Investment Advisory Fees Details underlying assets under management and net flows (in millions) were as follows:
84
Investment advisory fees are generally a function of the rates priced into the product and our average assets under management, which is driven by net flows and Investment advisory fees – inter-segment consists of fees for asset management services this segment provides to The level of net flows may vary considerably from period to period, and therefore results in one period are not indicative of net flows in subsequent periods. Comparison of the Three Months Ended Investment advisory fees – external decreased due primarily to lower third-party average assets under management as a result of On October 31, 2007, we sold certain institutional taxable fixed income business to an unaffiliated investment management company. As a result of this transaction, assets under management decreased by $12.3 billion, which resulted in Investment advisory fees – inter-segment decreased due to lower average inter-segment assets under management as a result of market declines and negative net flows. 85 Comparison of the Investment advisory fees – external decreased due primarily to lower third-party average assets under management as a result of
2007 fixed income transaction, as discussed above. Market value changes on assets under management in the first Investment advisory fees – inter-segment decreased due to Other Revenues and Fees Comparison of the Three and Other revenues and fees decreased for the three and Operating Expenses Comparison of the Three Operating expenses decreased due primarily to selling certain fixed income business to an unaffiliated investment management company and transitioning the investment accounting function to a third party. Also, accruals for variable compensation based on revenue and results decreased. These reductions were partially offset by an accrual for legal expenses. Comparison of the Nine Months Ended September 30, 2008 to 2007 Operating expenses decreased due primarily to the elimination of certain expenses as a result of transferring the investment advisory role of Lincoln Variable Insurance Trust to another internal advisor, selling certain fixed income business to an unaffiliated investment management company and transitioning the investment accounting function to a third party. Also, accruals for variable compensation based on revenue and results have decreased.
RESULTS OF LINCOLN UK Lincoln UK is headquartered in Barnwood, Gloucester, England, and is licensed to do business throughout the United Kingdom. Lincoln UK primarily focuses For factors that could cause actual results to differ materially from those set forth in this section, see “Part I – Item 1A. Risk Factors” in our 2007 Form 10-K as updated by “Part II – Item 1A. Risk Factors” and “Forward-Looking Statements – Cautionary Language” in this report. Income from Operations Details underlying the results for Lincoln UK (in millions) were as follows:
Comparison of the Three Months Ended
An unfavorable adjustment in 2007 to our mis-selling reserves; and The recording of a Value Added Tax (“VAT”) refund in 2008. The increase in income from operations was partially offset by the following: A reduction in premiums due to declines in the annuitization of vesting pension policies and the face amount of our insurance in force attributable to the maturity of the block of business; and A $3 million unfavorable prospective unlocking (a $13 million unfavorable unlocking from model refinements net of a $10 million favorable 87 Comparison of the
A favorable An unfavorable adjustment in 2007 to our mis-selling reserves; and The recording of a VAT refund in 2008. The increase in income from operations was partially offset by the following: A reduction in The impact of prospective unlocking discussed The foregoing items are discussed further below.
Insurance Premiums Insurance premiums are primarily a function of the rates priced into the product and face amount of our insurance in force. Comparison of the Three Months Ended
Comparison of the
Our annualized policy lapse rate as of the Insurance Fees Details underlying insurance fees, business in force and unit-linked assets (in millions) were as follows:
88
The insurance fees reflect mortality and expense assessments on unit-linked account values to cover insurance and administrative charges. These assessments are primarily a function of the rates priced into the product, the face amount of insurance in force and the average unit-linked assets, which is driven by net flows on the account values and the financial markets. Although the use of the reversion to the mean process has lessened the impact of short-term volatility in equity markets, the segment’s fee income remains subject to volatility in the equity markets as it affects the level of the underlying assets that drive the fee income.
Comparison of the Three and Excluding the The three and nine months ended September 30, 2007, had unfavorable prospective unlocking – assumption changes related primarily to refinements to the methodology regarding future expectations of Net Investment Income We use our interest income to build the associated policy reserves, which is a function of our insurance premiums and the yields on our invested assets. Comparison of the Three Months Ended
Comparison of the
Benefits Benefits for this segment include claims incurred during the period in excess of the associated account balance for its unit-linked products. Benefits are recognized when incurred. Comparison of the Three Months Ended
89 Comparison of the Nine Months Ended September 30, 2008 to 2007 Excluding the effects of the exchange rate, benefits decreased 11% due primarily to a reduction
Underwriting, Acquisition, Insurance and Other Expenses Details underlying underwriting, acquisition, insurance and other expenses (in millions) were as follows:
Commissions and other costs, which vary with and are related primarily to the production of new business, are deferred to the extent recoverable. DAC and VOBA related to unit-linked business are amortized over the lives of the contracts in relation to EGPs. For our traditional products, DAC and VOBA are amortized on either a straight-line basis or as a level percent of premium of the related contracts depending on the block of business. Comparison of the Three and Nine Months Ended September 30, 2008 to 2007
The three and nine months ended September 30, 2008, had favorable prospective unlocking – assumption changes related primarily to lower maintenance costs and higher persistency than our model projections assumed. The three and nine months ended September 30, 2007, had favorable prospective unlocking – assumption changes related primarily to changes in investment income, expense and mortality expectations. 90 RESULTS OF OTHER OPERATIONS Other Operations includes investments related to the excess capital in our insurance subsidiaries, investments in media properties and other corporate investments, benefit plan net assets, the unamortized deferred gain on indemnity reinsurance, which was sold to Swiss Re in 2001, corporate debt and corporate reinsurance. We are actively managing our remaining radio station clusters to maximize performance and future value. Other Operations also includes the Institutional Pension business, which was previously reported in Employer Markets – Retirement Loss from Operations Details underlying the results for Other Operations (in millions) were as follows:
Comparison of the Three Months Ended Loss from operations for this segment decreased due primarily to the following: Lower other expenses due primarily to higher merger-related expenses in 2007 and a separation benefit recorded in the third quarter of 2007, partially offset by increases in litigation expense; and Unfavorable mortality in our Institutional Pension business in the third quarter of 2007. The decrease in loss from operations was partially offset by the following: Lower media earnings related primarily to lower advertising revenues caused by market conditions; and Less favorable tax items that impacted the effective tax rate. 91 Comparison of the Nine Months Ended September 30, 2008 to 2007 Loss from operations for this segment increased due primarily to the following:
Lower media earnings related primarily to lower advertising revenues caused by market conditions;
Higher other expenses attributable primarily
Higher interest and debt expenses from increased debt; and
Less favorable tax items that impacted the effective tax rate. The increase in loss from operations was partially offset by the following:
Higher net investment income from an increase in invested assets driven by distributable earnings received from our insurance segments, dividends received from our other segments and issuances of debt as these items exceeded share repurchases and dividends paid to stockholders; and
Unfavorable mortality in our Institutional Pension business in Certain of the foregoing items are discussed further Impact of Current Market Conditions Media earnings continue to experience deterioration as customers reduce their advertising expenses in response to the credit markets. Due to seasonality, the fourth quarter is generally our strongest quarter; however, expectations for this year are that fourth quarter will be the lowest quarter in 2008 given the current economic conditions; Investment income is expected to be lower as a result of lower dividend income from our holdings of Bank of America common stock, following its announcement in early October to reduce its dividend rate by half; and Additional other-than-temporary impairments that will further reduce investment income for this segment. See below for further detail on this impact. For factors that could cause actual results to differ materially from those set forth in this section, see “Part I – Item 1A. Risk Factors” in our 2007 Form 10-K as updated by “Part II – Item 1A. Risk Factors” and “Forward-Looking Statements – Cautionary Language” in this report. Net Investment Income and Interest Credited We utilize an internal formula to determine the amount of capital that is allocated to our business segments. Investment income on capital in excess of the calculated amounts is reported in Other Operations. If regulations require increases in our insurance segments’ statutory reserves and surplus, the amount of capital allocated to Other Operations would decrease and net investment income would be negatively impacted. In addition, as discussed below in “Review of Consolidated Financial Condition – Alternative Sources of Liquidity,” the holding company maintains an inter-segment cash management account where other segments can borrow from or lend money to the holding company. The inter-segment cash management account affects net investment income for Other Operations, as all inter-segment eliminations are reported within Other Operations. Write-downs for other-than-temporary impairments decrease the recorded value of our invested assets owned by our business segments. These write-downs are not included in the income from operations of our operating segments. When impairment occurs, assets are transferred to the business segments’ portfolios and will reduce the future net investment income for Other Operations, but should not have an impact on a consolidated basis unless the impairments are related to defaulted securities. Statutory reserve adjustments for our business segments can also cause allocations of invested assets between the affected segments and Other Operations. The majority of our interest credited relates to our reinsurance operations sold to Swiss Re in 2001. A substantial amount of the business was sold through indemnity reinsurance transactions resulting in some of the business still flowing through our consolidated financial statements. The interest credited corresponds to investment income earnings on the assets we continue to hold for this business. There is no impact to income or loss in Other Operations or on a consolidated basis for these amounts. Comparison of the Three Months Ended The decrease in net investment income was attributable to a decrease in 92 Comparison of the The increase in net investment income was attributable to an increase in invested assets that was driven by distributable earnings received from our insurance segments, dividends received from our other segments and issuances of debt. These items exceeded the amount of share repurchases, dividends paid to stockholders and transfers to other segments for other-than-temporary impairments.
Benefits Benefits are recognized when incurred for Institutional Pension products. Comparison of the Three and The decrease in benefits was a result of unfavorable mortality in our Institutional Pension business in the second Other Expenses Details underlying other expenses (in millions) were as follows:
Other expenses for Other Operations includes expenses that are corporate in nature such as merger-related expenses, restructuring costs, branding, charitable contributions, certain litigation reserves, amortization of Comparison of the Three Months Ended The Comparison of the The increase in other expenses was attributable primarily to the impact of the one-time curtailment gain recorded in the second quarter of 2007 related to our employee pension plan and relocation costs associated with the move of our corporate office and an increase in incentive compensation expense, strategic costs and facilities expense. These increases in other expenses were partially offset by a decrease in merger-related expenses as a result of higher system integration work related to our administrative systems in 2007 and a separation benefit related to the retirement of certain key executives recorded in the third quarter of 2007. Merger-related expenses were the result of actions undertaken by us to eliminate duplicate operations and functions as a result of the Jefferson-Pilot merger along with costs related to the implementation of our new unified product portfolio and other initiatives. These actions will be ongoing and are expected to be substantially complete by the first half of 2009. Our current estimate of the cumulative integration expenses is approximately $215 million to $225 million, pre-tax, and excludes amounts capitalized or recorded to goodwill. 93 Interest and Debt Expense The timing and/or discretionary nature of uses of cash for the repurchase of stock, incentive compensation and the availability of funds from our cash management account may result in changes in external financing and volatility in interest expense. For additional information on our financing activities, see “Review of Consolidated Financial Condition – Liquidity and Capital Resources – Sources of Liquidity and Cash Flow – Financing Activities” below.
Comparison of the Three and Nine Months Ended The
Federal Income Tax Benefit Comparison of the Three and The decrease in the federal income tax benefit was due to less favorable tax items that impacted the effective tax rate related primarily to changes in tax preferred investments.
REALIZED Details underlying realized
95 Operating Realized Gain Details underlying operating realized gain (dollars in millions) were as follows:
Operating realized gain includes the following:
GLB – Represents the portion of the GLB rider fees calculated as the attributed fees in excess of the net valuation premium. Net valuation premium represents a level portion of rider fees required to fund potential claims for living benefits. The attributed fees are the fees used in the calculation of the embedded
GDB hedge cost – Represents the change in the fair value of the derivatives that offsets the benefit ratio unlocking of our SOP 03-1 reserves on our GDB riders, including our expected cost of the hedging
Realized Gain (Loss) Related to Certain Investments See “Consolidated Investments – Realized Gain (Loss) Related to Investments” below. Gain (Loss) on Certain Reinsurance Derivative/Trading Securities Gain (loss) on certain reinsurance derivative/trading securities represents changes in the fair values of total return swaps (embedded derivatives) theoretically included in our various modified coinsurance and coinsurance with funds withheld reinsurance arrangements that have contractual returns related to various assets and liabilities associated with these arrangements. Changes in the fair value of these derivatives are offset by the change in fair value of trading securities in the portfolios that support these arrangements. GLB Net Derivatives Results and GDB Derivatives Results Details underlying GLB net derivatives results and GDB derivative results (dollars in millions) were as follows:
Our GLB net derivatives results represents the net valuation premium, the change in the fair value of the embedded derivative liabilities of our GLB products and the change in the fair value of the derivative instruments we own to hedge. This includes the cost of purchasing the hedging instruments. Our GDB derivatives results represents the net difference between the benefit ratio unlocking of SOP 03-1 reserves on our GDB riders and the change in the fair value of the derivatives excluding our expected cost of the hedging instruments.
97 The GLB guarantees in our variable annuity products are considered embedded derivatives and are recorded on our Consolidated Balance Sheets at fair value under SFAS 133 and SFAS 157. We use derivative instruments to hedge our exposure to the risks and earnings volatility that result from the embedded derivatives for GLBs. The change in fair value of these instruments tends to move in the opposite direction of the change in fair value of the embedded derivatives. In the table above, we have presented the components of our GLB results, which can be volatile especially when sudden and significant changes in equity markets and/or interest rates occur. When we assess the effectiveness of our hedge program, we exclude the impact of the change in the liability not hedged. This reserve represents the portion of our GLB liabilities related to the NPR required by SFAS 157. This component of the liability is not included in our hedging program. The impact of the change in NPR has had the effect of reducing our GLB liabilities on our balance sheet by $481 million since the adoption of SFAS 157 on January 1, 2008. For additional information on our guaranteed benefits, see “Critical Accounting Policies and Estimates – Derivatives – Guaranteed Living Benefits” above. For additional information on our hedge program see “Reinsurance” below.
Comparison of the Three and The The increased GLB The third quarter of 2008 had favorable GLB change in reserves hedged on our prospective unlocking due to assumption changes reflecting primarily updates to implied ultimate volatility. The third quarter of 2007 had unfavorable GLB change in reserves hedged prospective unlocking due to assumption changes reflecting improved persistency experience. The third quarter of 2008 had unfavorable GLB DAC, VOBA, DSI and DFEL prospective unlocking reflecting the impact of incorporating the related GLB gross profits due to the change in reserves hedged prospective unlocking discussed above into the DAC, VOBA, DSI and DFEL models. The unfavorable GDB derivatives results, excluding the retrospective unlocking of DAC, VOBA, DSI and DFEL were driven primarily by current period unfavorable fund performance of our hedges designed to mitigate our basis risk over the long-term, losses from the strengthening of the dollar as compared to the euro, pound and yen, and unfavorable and volatile capital market conditions that resulted in non-linear changes in reserves that our derivatives are not specifically designed to mitigate. See “Market Risk – Credit Risk” for information on our counterparty exposure. 98 Indexed Annuity Forward-Starting Option
The liability for the forward-starting option reflects changes in the fair value of embedded derivative liabilities related to index call options we may purchase in the future to hedge contract holder index allocations applicable to future reset periods for our indexed annuity products as required under SFAS 133 and SFAS 157. These fair values represent an estimate of the cost of the options we will purchase in the future, discounted back to the date of the balance sheet, using current market indications of volatility and interest rates, which can vary significantly from period to period due to a number of factors and therefore can provide results that are not indicative of the underlying trends.
Gain on Sale of Subsidiaries/Businesses See “Acquisitions and Dispositions – Fixed Income Management Business” for details.
CONSOLIDATED INVESTMENTS Details underlying our consolidated investment balances (in millions) were as follows:
Investment Objective Invested assets are an integral part of our operations. We follow a balanced approach to investing for both current income and prudent risk management, with an emphasis on generating sufficient current income, net of income tax, to meet our obligations to customers, as well as other general liabilities. This balanced approach requires the evaluation of expected return and risk of each asset class utilized, while still meeting our income objectives. This approach is important to our asset-liability management, since decisions can be made based upon both the economic and current investment income considerations affecting assets and liabilities. For a discussion on our risk management process, see “Item 3. Quantitative and Qualitative Disclosures About Market Risk.” Investment Portfolio Composition and Diversification Fundamental to our investment policy is diversification across asset classes. Our investment portfolio, excluding cash and invested cash, is composed of fixed maturity securities, mortgage loans on real estate, real estate (either wholly-owned or in joint ventures) and other long-term investments. We purchase investments for our segmented portfolios that have yield, duration and other characteristics that take into account the liabilities of the products being supported. We have the ability to maintain our investment holdings throughout credit cycles because of our capital position, the long-term nature of our liabilities and the matching of our portfolios of investment assets with the liabilities of our various products. Fixed Maturity and Equity Securities Portfolios Fixed maturity securities and equity securities consist of portfolios classified as available-for-sale and trading. Mortgage-backed and private securities are included in both available-for-sale and trading portfolios. Details underlying our fixed maturity and equity securities portfolios by industry classification (in millions) are presented in the below tables. These tables agree in total with the presentation of available-for-sale securities in Note 4; however, the categories below represent a more detailed breakout of the available-for-sale portfolio; therefore, the investment classifications listed below do not agree to the investment categories provided in Note 4.
102 Available-for-Sale Securities Because the general intent of the available-for-sale accounting guidance is to reflect stockholders’ equity as if unrealized gains and
losses were actually recognized, it is necessary that we consider all related accounting adjustments that would occur upon such a hypothetical recognition of unrealized gains and losses. Such related balance sheet effects include adjustments to the balances of DAC, VOBA, DFEL, other contract holder funds and deferred income taxes. Adjustments to each of these balances are charged or credited to accumulated other comprehensive income. For instance, DAC is adjusted upon the recognition of unrealized gains or losses since the amortization of DAC is based upon an assumed emergence of gross profits on certain insurance business. Deferred income tax balances are also adjusted, since unrealized gains or losses do not affect actual taxes currently paid. As of As more fully described in Note 1 of our 2007 Form 10-K, we regularly review our investment holdings for other-than-temporary impairments. Based on this review, the cause of the The quality of our available-for-sale fixed maturity securities portfolio, as measured at estimated fair value and by the percentage of fixed maturity securities invested in various ratings categories, relative to the entire fixed maturity available-for-sale security portfolio (in millions) was as follows:
Comparisons between the National Association of Insurance Commissioners (“NAIC”) ratings and rating agency designations are published by the NAIC. The NAIC assigns securities quality ratings and uniform valuations, which are used by insurers when preparing their annual statements. The NAIC ratings are similar to the rating agency designations of the Nationally Recognized Statistical Rating Organizations for marketable bonds. NAIC ratings 1 and 2 include bonds generally considered investment grade (rated Baa3 or higher by Moody’s, or rated BBB- or higher by S&P and Fitch), by such ratings organizations. NAIC ratings 3 through 6 include bonds generally considered below investment grade (rated Ba1 or lower by Moody’s, or rated BB+ or lower by S&P and Fitch). The estimated fair value for all private securities was Trading Securities Trading securities, which support certain reinsurance funds withheld and our Modco reinsurance agreements, are carried at estimated fair value and changes in estimated fair value are recorded in net income as they occur. 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. Offsetting these amounts are corresponding changes in the fair value of the embedded derivative liability associated with the underlying reinsurance arrangement. See Note 1 in our 2007 Form 10-K for more information regarding our accounting for Modco. Mortgage-Backed Securities (Included in Available-for-Sale and Trading Securities) Our fixed maturity securities include mortgage-backed securities. These securities are subject to risks associated with variable prepayments. This may result in differences between the actual cash flow and maturity of these securities than that expected at the time of purchase. Securities that have an amortized cost greater than par and are backed by mortgages that prepay faster than expected will incur a reduction in yield or a loss. Those securities with an amortized cost lower than par that prepay faster than expected will generate an increase in yield or a gain. In addition, we may incur reinvestment risks if market yields are lower than the book yields earned on the securities. Prepayments occurring slower than expected have the opposite impact. We may incur reinvestment risks if market yields are higher than the book yields earned on the securities and we are forced to sell the securities. The degree to which a security is susceptible to either gains or losses is influenced by: the difference between its amortized cost and par; the relative sensitivity of the underlying mortgages backing the assets to prepayment in a changing interest rate environment; and the repayment priority of the securities in the overall securitization structure. We limit the extent of our 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. As of Our exposure to subprime mortgage lending is limited to investments in banks and other financial institutions that may be impacted by subprime lending and direct investments in asset-backed securities collateralized debt obligations, asset-backed securities (“ABS”) and residential mortgage-backed securities (“RMBS”). Mortgage-related ABS are backed by home equity loans and RMBS are backed by residential mortgages. These securities are backed by loans that are characterized by borrowers of differing levels of creditworthiness: prime, Alt-A and subprime. Prime lending is the origination of residential mortgage loans to customers with excellent credit profiles. Alt-A lending is the origination of residential mortgage loans to customers who have Prime credit profiles but lack documentation to substantiate income. Subprime lending is the origination of loans to customers with weak or impaired credit profiles. The slowing U.S. housing market, increased interest rates and relaxed underwriting standards for some originators of residential mortgage loans and home equity loans have recently led to higher delinquency rates, especially for loans originated in the past few years. We expect delinquency rates and loss rates on residential mortgages and home equity loans to increase in the future; however, we continue to expect to receive payments in accordance with contractual terms for a significant amount of our securities, largely due to the seniority of the claims on the collateral of the securities that we own. The tranches of the securities will experience losses according to their seniority level with the least senior (or most junior), typically the unrated residual tranche, taking the initial loss. The credit ratings of our securities reflect the seniority of the securities that we own. Our RMBS had a market value of
The market value of investments backed by subprime loans was
None of these investments include any direct investments in subprime lenders or mortgages. We are not aware of material exposure to subprime loans in our alternative asset portfolio. The following summarizes our investments in available-for-sale securities backed by pools of consumer loan asset-backed securities (in millions):
The following summarizes our investments in available-for-sale securities backed by pools of commercial mortgages (in millions):
Monoline insurers provide guarantees on debt for issuers, often in the form of credit wraps, which enhance the credit of the issuer. Monoline insurers guarantee the timely repayment of bond principal and interest when a bond issuer defaults and generally provide credit enhancement for bond issues such as municipal bonds and private placements as well as other types and structures of securities. Our direct exposure represents our bond holdings of the actual Monoline insurers. Our insured bonds represent our holdings in bonds of other issuers that are insured by Monoline insurers. The following summarizes our exposure to Monoline insurers (in millions):
Credit-Linked Notes As of We earn a spread between the coupon received on the credit-linked Consistent with other debt market instruments, we are exposed to credit losses within the structure of the credit-linked notes, which could result in principal losses to our investments. However, we have attempted to protect our investments from credit losses through the multi-tiered class structure of the credit-linked note, which requires the subordinated classes of the investment pool to absorb all of the initial credit losses. LNL owns the mezzanine tranche of these
108 As in the general markets, spreads on these transactions have widened, causing unrealized losses. As of
The following summarizes the exposure of the credit-linked notes’ underlying collateral by industry and rating as of
Additional Details on our Unrealized Losses on Available-for-Sale Securities When considering unrealized gain and loss information, it is important to recognize that the information relates to the status of securities at a particular point in time and may not be indicative of the status of our 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 our investment portfolios. These are important considerations that should be included in any evaluation of the potential impact of unrealized loss securities on our future earnings.
We have no concentrations of issuers or guarantors of fixed maturity and equity securities. The composition by industry categories of securities subject to enhanced analysis and monitoring for potential changes in unrealized loss status (in millions), was as follows:
The composition by industry categories of all securities in unrealized loss status (in millions), was as follows:
112 Unrealized Loss on Below-Investment-Grade Available-for-Sale Fixed Maturity Securities Gross unrealized losses on available-for-sale below-investment-grade fixed maturity securities represented
Details underlying fixed maturity securities below investment grade and in an unrealized loss position (in millions) were as follows:
114 Unrealized Loss on Fixed Maturity and Equity Securities Available-for-Sale in Excess of $10 million As of
115
116 As of September 30, 2008, available-for-sale fixed maturity and equity securities with gross unrealized losses greater than $10 million (in millions) for non investment grade securities were as follows:
The information
Mortgage Loans on Real Estate The following summarizes key information on mortgage loans (in millions):
All mortgage loans that are impaired have an established allowance for credit loss. Changing economic conditions impact our valuation of mortgage loans. Changing vacancies and rents are incorporated into the discounted cash flow analysis that we perform for monitored loans and may contribute to the establishment of (or an increase or decrease in) an allowance for credit losses. In addition, we continue to monitor the entire commercial mortgage loan portfolio to identify risk. Areas of emphasis are properties that have deteriorating credits or have experienced debt coverage reduction. Where warranted, we have established or increased loss reserves based upon this analysis. There were no impaired mortgage loans as of
Alternative Investments The carrying value of our consolidated alternative investments by business segment (in millions), which consists primarily of investments in limited partnerships, were as follows:
Income derived from our consolidated alternative investments by business segment (in millions) was as follows:
The decline in our investment income on alternative investments presented in the table above when comparing the first nine months of 2008 to the corresponding period in 2007 was due to deterioration of the financial markets during As of Non-Income Producing Investments As of
Net Investment Income Details underlying net investment income (in millions) and our investment yield were as follows:
We earn investment income on our general account assets supporting fixed annuity, term life, whole life, UL and interest-sensitive whole life insurance products. The profitability of our fixed annuity and life insurance products is affected by our ability to achieve target spreads, or margins, between the interest income earned on the general account assets and the interest credited to the contract holder on our average fixed account values, including the fixed portion of variable. Net investment income and the
interest rate yield table each include commercial mortgage loan prepayments and bond makewhole premiums, alternative investments and contingent interest and standby real estate equity commitments. These items can vary significantly from period to period due to a number of factors and therefore can provide results that are not indicative of the underlying trends. 120 The decline in net investment income when comparing the first Commercial Mortgage Loan Prepayment and Bond Makewhole Premiums Prepayment and makewhole premiums are collected when borrowers elect to call or prepay their debt prior to the stated maturity. A prepayment or makewhole premium allows investors to attain the same yield as if the borrower made all scheduled interest payments until maturity. These premiums are designed to make investors indifferent to prepayment. The decline in prepayment and makewhole premiums when comparing the Realized The detail of the realized gain (loss) related to investments (in millions) was as follows:
Amortization expense of DAC, VOBA, DSI, DFEL and changes in other contract holder funds reflects an assumption for an expected level of credit-related investment losses. When actual credit-related investment losses are realized, we recognize a true up to our DAC, VOBA, DSI and DFEL amortization and changes in other contract holder funds within realized gain (loss) reflecting the incremental impact of actual versus expected credit-related investment losses. These actual to expected amortization adjustments could create volatility in net realized gains (loss). The write-down for impairments includes both credit-related and interest-rate related impairments. Realized gains and losses generally originate from asset sales to reposition the portfolio or to respond to product experience. During the first
monitoring, assessing value relative to other comparable securities and overall portfolio maintenance. Although our portfolio managers may, at a given point in time, believe that the preferred course of action is to hold securities with unrealized losses that 121 are considered temporary until such losses are recovered, the dynamic nature of portfolio management may result in a subsequent decision to sell. These subsequent decisions are consistent with the classification of our investment portfolio as available-for-sale. We expect to continue to manage all non-trading invested assets within our portfolios in a manner that is consistent with the available-for-sale classification. We consider economic factors and circumstances within countries and industries where recent write-downs have occurred in our assessment of the status of securities we own of similarly situated issuers. While it is possible for realized or unrealized losses on a particular investment to affect other investments, our risk management has been designed to identify correlation risks and other risks inherent in managing an investment portfolio. Once identified, strategies and procedures are developed to effectively monitor and manage these risks. The areas of risk correlation that we pay particular attention to are risks that may be correlated within specific financial and business markets, risks within specific industries and risks associated with related parties. When the detailed analysis by our credit analysts and investment portfolio managers leads to the conclusion that a security’s decline in fair value is other-than-temporary, the security is written down to estimated fair value. In instances where declines are considered temporary, the security will continue to be carefully monitored. See “Item 7. Management’s Discussion and Analysis – Introduction – Critical Accounting Policies and Estimates” in our 2007 Form 10-K for additional information on our portfolio management strategy. Details underlying write-downs taken as a result of other-than-temporary impairments (in millions) were as follows:
The
REINSURANCE Our insurance companies cede insurance to other companies. The portion of risks exceeding each of our insurance companies’ retention limits is reinsured with other insurers. We seek reinsurance coverage within the businesses that sell life insurance to limit our exposure to mortality losses and enhance our capital management. Portions of our deferred annuity business have been reinsured on a modified coinsurance basis with other companies to limit our exposure to interest rate risks. As of Our amounts recoverable from reinsurers represent receivables from and reserves ceded to reinsurers. As of Included in the business sold to Swiss Re through indemnity reinsurance in 2001 was disability income business. Swiss Re is disputing its obligation to pay approximately On July 31, 2007, we entered into a reinsurance arrangement with Swiss Re coveringLincoln SmartSecurity® Advantage, our rider related to our During the third quarter of 2006, one of our reinsurers, Scottish Re Group Ltd (“Scottish Re”), received rating downgrades from various rating agencies. Of the As of We have a reinsurance treaty between LNL and a subsidiary of LNC, Lincoln National Reinsurance Company (Barbados) Limited (“LNBAR”) under which LNL reinsures its variable annuity product guarantees, including GDB and GLB riders. This treaty is a traditional reinsurance program where LNL pays premiums to LNBAR and LNBAR assumes the variable annuity guarantee reserves. LNBAR has a hedge program that is designed to mitigate selected risk and income statement volatility from changes in
123 equity markets, interest rates and volatility associated with the guaranteed benefit features of these variable annuity products. In addition to mitigating selected risk and income statement volatility, the hedge program is also focused on long-term performance of the hedge program recognizing that any material potential claims under the GLBs are approximately a decade in the future. The LNBAR hedge program uses put options to hedge a portion of the liability related to our variable annuity products with a GLB feature. Put options are contracts that require counterparties to pay us at a specified future date the amount, if any, by which a specified equity index is less than the strike rate stated in the agreement, applied to a notional amount. Variance swaps are used to hedge the liability exposure on certain options in variable annuity products. Variance swaps are contracts entered into at no cost and whose payoff is the difference between the realized variance of an underlying index and the fixed variance rate determined at inception. Equity futures are used to hedge a portion of the liability related to our variable annuity products with GLB and GDB features. These futures contracts require payment between us and our counterparty on a daily basis for changes in the futures index price. For more information on the results of our hedge program, see “Realized Loss” above. 124 REVIEW OF CONSOLIDATED FINANCIAL CONDITION Liquidity and Capital Resources Sources of 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. Our principal sources of cash flow from operating activities are insurance premiums and fees, investment advisory fees and investment income, while sources of cash flows from investing activities result from maturities and sales of invested assets. Our operating activities provided cash of The sources of liquidity of the holding company are principally comprised of 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 public financing under an SEC-filed shelf registration statement. 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. Details underlying the primary sources of our holding company cash flows (in millions) were as follows:
The table above focuses on significant and recurring cash flow items and excludes the effects of certain financing activities, namely the periodic issuance and retirement of debt and cash flows related to our inter-company cash management account (discussed below). Taxes have been eliminated from the analysis due to a tax sharing agreement among our 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.
Subsidiaries Our insurance subsidiaries are subject to certain insurance department regulatory restrictions as to the transfer of funds and payment of dividends to the holding company. Under Indiana laws and regulations, our Indiana insurance subsidiaries, including our primary insurance subsidiary, LNL, may pay dividends to LNC without prior approval of the Indiana Insurance Commissioner (the “Commissioner”) up to a certain threshold, or must receive prior approval of the Commissioner to pay a dividend if such dividend, along with all other dividends paid within the preceding twelve consecutive months exceed the statutory limitation. The current statutory limitation is the greater of 10% of the insurer’s contract holders’ surplus, as shown on its last annual statement on file with the Commissioner or the insurer’s statutory net gain from operations for the prior calendar year. Indiana law gives the Commissioner broad discretion to disapprove requests for dividends in excess of these limits. New York, the state of domicile of our other major insurance subsidiary, Lincoln Life & Annuity Company of New York, has similar restrictions, except that in New York it is the lesser of 10% of surplus to contract holders as of the immediately preceding calendar year or net gain from operations for the immediately preceding calendar year, not including realized capital gains.
Our insurance subsidiaries have statutory surplus and RBC levels well above current regulatory required levels. As mentioned earlier, more than Included in the letters of credit (“LOCs”) issued as of
As a result of the unfavorable impacts from equity markets in the third quarter of 2008, we recognized higher reserves under Commissioners Annuity Reserve Valuation Method (“CARVM”) for our annuity products and higher reserves for GDB riders, which are only partially reinsured. CARVM is the current statutory actuarial method used for determining reserves for the base annuity contract. The impact of these items reduced the statutory surplus of LNL by approximately $110 million in the third quarter of 2008. We estimate that a 30% drop in the equity markets from September 30, 2008, levels could require an increase in statutory reserves, and thereby, further reduce statutory surplus of LNL by $275-$300 million at the end of the fourth quarter of 2008, related primarily to CARVM. As a result, we estimate that LNL’s estimated RBC ratio at the end of September 30, 2008, would be reduced by approximately 25 percentage points. The estimated potential increase to statutory reserves is based on the current statutory reserve formulas and does not take into account the reserve and asset adequacy analysis performed by our actuaries on an annual basis to determine appropriateness of the reserves at year-end. This analysis incorporates the adequacy of assets in LNBAR, our captive reinsurance company, supporting the liabilities that it assumes from LNL. The outcome of this analysis may result in an additional reserve increase and could further reduce the RBC ratio. 126 The sensitivity of our statutory reserves and surplus established for our variable annuity base contracts and riders to changes in the equity markets will vary depending on the magnitude of the decline. The sensitivity will also be affected by the level of account values relative to the level of guaranteed amounts, product design and reinsurance. Because the calculation of statutory reserves for variable annuities depends upon the cumulative equity market impacts on the business in-force, the reserves do not move in a linear relationship with respect to the level of equity market performance within any given reporting period. The RBC ratio is also affected by the product mix of the in-force book of business; i.e. the amount of business without guarantees is not subject to the same level of reserves as the business with guarantees. All of these factors affect the RBC ratio of LNL, which is an important factor in the determination of the credit and financial strength ratings of LNC and its subsidiaries. We have a reinsurance treaty between LNL and LNBAR under which LNL reinsures its variable annuity products, including GDB and GLB riders. We also entered into a reinsurance arrangement where Swiss Re provides 50% quota share coinsurance of the certain GLB business written in 2007 and 2008, up to a total of $3.8 billion in rider sales. These reinsurance arrangements serve to reduce LNL’s exposure to changes in the statutory reserves associated with changes in the equity markets. Both LNBAR and Swiss Re have established reserves for the business assumed and hold assets to support both the reserves and capital required by the respective regulatory agencies. For more details on LNBAR, see “Reinsurance” above. Lincoln UK’s operations consist primarily of unit-linked life and pension products, which are similar to U.S. produced variable life and annuity products. Lincoln UK’s insurance subsidiaries are regulated by the U.K. Financial Services Authority (“FSA”) and are subject to capital requirements as defined by the U.K. Capital Resources Requirement. All insurance companies operating in the U.K. also have to complete an RBC assessment to demonstrate to the FSA that they hold sufficient capital to cover their risks.
RBC requirements in the U.K. are different than the NAIC requirements. In addition, the FSA has imposed certain minimum capital requirements for the combined U.K. subsidiaries. Lincoln UK typically 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 U.S., changes to regulatory capital requirements can impact the dividend capacity of the U.K. insurance subsidiaries and cash flow to the holding company. Financing Activities Although our subsidiaries generate adequate cash flow to meet the needs of our normal operations, periodically we may issue debt or equity securities to fund internal growth, acquisitions and the retirement of our debt and equity securities. We currently have an effective shelf registration statement, which allows us to issue, in unlimited amounts, securities, including debt securities, preferred stock, common stock, warrants, stock purchase contracts, stock purchase units and trust preferred securities of our affiliated trusts. 127 Details underlying debt and financing activity (in millions) were as follows:
Details underlying our credit facilities with a group of domestic and foreign banks (in millions) were as follows:
The LOCs support inter-company reinsurance transactions and specific treaties associated with our former Reinsurance segment. LOCs are primarily used to satisfy the U.S. regulatory requirements of domestic clients of the former Reinsurance segment who have contracted with the reinsurance subsidiaries not domiciled in the U.S. and, as discussed above, for the reserve credit provided by our affiliated offshore reinsurance company to our domestic insurance companies for ceded business. Under the credit agreements, we must maintain a minimum consolidated net worth level. In addition, the agreements contain covenants restricting our ability to incur liens, merge or consolidate with another entity where we are not the surviving entity and dispose of all or substantially all of our assets. As of If current debt ratings and claims paying ratings were downgraded in the future, 128 investment products. As of
Alternative Sources of Liquidity In order to maximize the use of available cash, the holding company maintains an inter-company cash management account where subsidiaries can borrow from the holding company to meet their short-term needs and can invest their short-term funds with the holding company. The holding company finances this program from its primary sources of cash flow discussed above. Depending on the overall cash availability or need, the holding company invests excess cash in short-term investments or borrows funds in the financial markets. The holding company had an average Our insurance subsidiaries, by virtue of their general account fixed income investment holdings, can access liquidity through securities lending programs and repurchase agreements. As of LNC has a $1.0 billion commercial paper program that is rated A-1, P-2 and The Federal Reserve Board authorized the Commercial Paper Funding Facility (“CPFF”) on October 7, 2008, under Section 13(3) of the Federal Reserve Act to provide a liquidity backstop to U.S. issuers of commercial paper. The CPFF is intended to improve liquidity in short-term funding markets by increasing the availability of term commercial paper funding to issuers and by providing greater assurance to both issuers and investors that firms will be able to roll over their maturing commercial paper. The commercial paper must be U.S. dollar-denominated and rated A-1/P-1/F1 by at least two rating agencies to be eligible for the program. On October 29, 2008, we were granted approval to participate in the CPFF, under which we may issue up to $575 million of commercial paper. Access to the CPFF is scheduled to terminate on April 30, 2009, unless such date is extended by the Federal Reserve. Divestitures For a discussion of our divestitures, see “Introduction – Acquisitions and Dispositions.” Uses of Capital Our principal uses of cash are to pay policy claims and benefits, operating expenses, commissions and taxes, to purchase new investments, to purchase reinsurance, to fund policy surrenders and withdrawals, to pay dividends to our stockholders and to repurchase our stock and debt securities.
Return of Capital to Stockholders One of the holding company’s primary goals is to provide a return to our stockholders. Through dividends and stock repurchases, we have an established record of providing cash returns to our stockholders. In determining dividends, the Board takes into consideration items such as current and expected earnings, capital needs, rating agency considerations and requirements for financial flexibility. Details underlying this activity (in millions, except per share data) were as follows:
Note: Average price per share above is calculated using whole dollars instead of dollars rounded to millions
On Significant Trends in Sources and Uses of Cash Flow As stated above, LNC’s cash flow, as a holding company, is largely dependent upon the dividend capacity and surplus note interest payments of its insurance company subsidiaries. The insurance company subsidiaries’ dividend capacity is impacted by factors influencing their risk-based capital and statutory earnings performance. OTHER MATTERS Other Factors Affecting Our Business In general, our businesses are subject to a changing social, economic, legal, legislative and regulatory environment. Some of the changes include initiatives to require more reserves to be carried by our insurance subsidiaries, to make permanent recent reductions in individual tax rates, to permanently repeal the estate tax and to increase regulation of our annuity and investment management businesses. Although the eventual effect on us of the changing environment in which we operate remains uncertain, these factors and others could have a material effect on our results of operations, liquidity and capital resources. For factors that could cause actual results to differ materially from those set forth in this section, see “Part I – Item Recent Accounting Pronouncements See Note 2 to our consolidated financial statements for a discussion of recent accounting pronouncements that have been implemented during the periods presented or that have been issued and are to be implemented in the future.
We analyze and manage the risks arising from market exposures of financial instruments, as well as other risks, in an integrated asset-liability management process that takes diversification into account. By aggregating the potential effect of market and other risks on the entire enterprise, we estimate, review and in some cases manage the risk to our earnings and shareholder value. We have exposures to several market risks including interest rate risk, foreign currency exchange risk, equity market risk, default risk, basis risk and credit risk. The exposures of financial instruments to market risks, and the related risk management processes, are most important Interest Rate Risk With respect to accumulation and investment-oriented products, we seek to earn a stable and profitable spread, or margin, between investment income and interest credited to account values. If we have adverse experience on investments that cannot be passed on to customers, our spreads are reduced. Provided interest rates continue to gradually return to levels that are more typical from a long-term perspective, we do not view the near term risk to spreads over the next twelve months to be material. The combination of a probable range of interest rate changes over the next twelve months, asset-liability management strategies, flexibility in adjusting policy crediting rate levels and protection afforded by policy surrender charges and other switching costs all work together to mitigate this risk. The interest rate scenarios of concern are those in which there is a substantial, relatively rapid increase or decrease in interest rates that is then sustained over a long period.
Interest Rate Risk – Falling Rates The spreads on our fixed annuity and interest-sensitive whole life, universal life (“UL”) and fixed portion of variable universal life (“VUL”) insurance policies are at risk if interest rates decline and remain low for a period of time, which has generally been the case in recent years. Should interest rates remain at current levels that are significantly lower than those existing prior to the declines of recent years, the average earned rate of return on our annuity and UL investment portfolios will continue to decline. Declining portfolio yields may cause the spreads between investment portfolio yields and the interest rate credited to contract holders to deteriorate as our ability to manage spreads can become limited by minimum guaranteed rates on annuity and UL policies. Minimum guaranteed rates on annuity and UL policies generally range from 1.5% to 5.0%, with an average guaranteed rate of approximately 4%. The following table provides detail on the percentage differences between the current interest rates being credited to contract holders and the respective minimum guaranteed policy rate, broken out by contract holder account values reported within the
The maturity structure and call provisions of the related portfolios are structured to afford protection against erosion of investment portfolio yields during periods of declining interest rates. We devote extensive effort to evaluating the risks associated with falling interest rates by simulating asset and liability cash flows for a wide range of interest rate scenarios. We seek to manage these exposures by maintaining a suitable maturity structure and by limiting our exposure to call risk in each respective investment portfolio.
Interest Rate Risk – Rising Rates For both annuities and UL, a rapid and sustained rise in interest rates poses risks of deteriorating spreads and high surrenders. The portfolios supporting these products have fixed-rate assets laddered over maturities generally ranging from one to ten years or more. Accordingly, the earned rate on each portfolio lags behind changes in market yields. As rates rise, the lag may be increased 132 by slowing mortgage-backed securities prepayments. The greater and faster the rise in interest rates, the more the earned rate will tend to lag behind market rates. If we set renewal crediting rates to earn the desired spread, the gap between our renewal crediting rates and competitors’ new money rates may be wide enough to cause increased surrenders that could cause us to liquidate a portion of our portfolio to fund these surrenders. If we credit more competitive renewal rates to limit surrenders, our spreads will narrow. We devote extensive effort to evaluating these risks by simulating asset and liability cash flows for a wide range of interest rate scenarios. Such analysis has led to adjustments in the target maturity structure and to hedging the risk of rising rates by buying out-of-the-money interest rate cap agreements and swaptions. With these instruments in place, the potential adverse impact of a rapid and sustained rise in rates is kept within our risk tolerances. Debt We manage the timing of maturities and the mixture of fixed-rate and floating-rate debt as part of the process of integrated management of interest rate risk for the entire enterprise. Derivatives We have entered into derivative transactions to reduce our exposure to rapid changes in interest rates. The derivative programs are used to help us achieve more stable margins while providing competitive crediting rates to policyholders during periods when interest rates are changing. Such derivatives include interest rate swaps, interest rate futures, interest rate caps and treasury locks. During the first
Interest rate cap agreements with a notional amount of
We entered into and terminated forward-starting interest rate swap agreements with a notional amount of In addition to continuing existing programs, we may use derivative instruments in other strategies to limit risk and enhance returns, particularly in the management of investment spread businesses. We have established policies, guidelines and internal control procedures for the use of derivatives as tools to enhance management of the overall portfolio of risks assumed in our operations. Annually, our Board of Directors reviews our derivatives policy. Foreign Currency Exchange Risk Foreign Currency Denominated Investments We invest in foreign currency securities for incremental return and risk diversification relative to United States Dollar-Denominated (“USD”) securities. We use foreign currency swaps and foreign currency forwards to hedge some of the foreign exchange risk related to our investment in securities denominated in foreign currencies. The currency risk is hedged using foreign currency derivatives of the same currency as the bonds. We use foreign currency swaps to convert the cash flow of foreign currency securities to U.S. dollars. A foreign currency swap is a contractual agreement to exchange the currencies of two different countries at a specified rate of exchange in the future. 133 We use foreign currency forward contracts to hedge dividends received from our U.K. based subsidiary, Lincoln UK. The foreign currency forward contracts obligate us to deliver a specified amount of currency at a future date and a specified exchange rate.
During the first
We entered into and terminated foreign exchange forward contracts with a notional amount of Equity Market Risk Our revenues, assets, liabilities and derivatives are exposed to equity market risk. Due to the use of our reversion to the mean (“RTM”) process and our hedging strategies, we expect that, in general, short-term fluctuations in the equity markets should not have a significant impact on our quarterly earnings from unlocking of assumptions for deferred acquisition costs (“DAC”), deferred sales inducements (“DSI”), value of business acquired (“VOBA”) and deferred front-end sales loads (“DFEL”). However, there is an impact to earnings from the effects of equity market movements on account values and assets under management and the related fees we earn on those assets. Refer to our Critical Accounting Policy – DAC, VOBA, DSI and DFEL for further discussion on the impact of equity markets on our RTM. Fee Revenues The fee revenues of our Investment Management segment and fees earned from variable annuities and variable life insurance products are exposed to the risk of a decline in equity market values. These fees are generally a fixed percentage of the market value of assets under management. In a severe equity market decline, fee income could be reduced by not only reduced market valuations but also by customer withdrawals and redemptions. Such withdrawals and redemptions from equity funds and accounts might be partially offset by transfers to our fixed-income accounts and the transfer of funds to us from our competitors’ customers. Assets and Liabilities While we invest in equity assets with the expectation of achieving higher returns than would be available in our core fixed-income investments, the returns on, and values of, these equity investments are subject to somewhat greater market risk than our fixed-income investments. These investments, however, add diversification benefits to our fixed-income investments. We have exposure to changes in our stock price through stock appreciation rights issued. This program is being hedged with equity derivatives. Derivatives Hedging Equity Market Risk During the first
We had less than one million call options on an equal number of shares of Lincoln National Corporation (“LNC”) stock hedging the increase in liabilities arising from stock appreciation rights granted on LNC stock;
We entered into and terminated variance swaps used to hedge the liability exposure on certain options in variable annuity products with a notional amount of
We entered into Standard & Poor’s (“S&P”) 500 Index® call options with a notional amount of $2.1 billion, call options with a notional amount of $2.0 billion expired and terminated, resulting in a remaining notional amount of $3.0 billion to hedge the impact of the equity-index interest credited to our equity annuity products. A loss of $10 million was recognized on the terminations;
We entered into and terminated put option agreements with a notional amount of
We had net purchases and terminations in financial futures with a notional amount of
Impact of Equity Market Sensitivity Due to the use of our RTM process and our hedging strategies as described in
The impact on earnings summarized above is an expected annual effect. The result of the above factors should be multiplied by 25% to arrive at an estimated quarterly effect. The effect of quarterly equity market changes upon fee revenues and asset-based expenses will not be fully recognized in the current quarter due to the fact that fee revenues are earned and related expenses are incurred based upon daily variable account values. The difference between the current period average daily variable account values compared to the end of period variable account values impacts fee revenues in subsequent periods. Additionally, the impact on earnings may not necessarily be symmetrical with comparable increases in the equity markets. This discussion concerning the estimated effects of ongoing equity market volatility on the fees we earn from account values and assets under management is intended to be illustrative. Actual effects may vary depending on a variety of factors, many of which are outside of our control, such as changing customer behaviors that might result in changes in the mix of our business between variable and fixed annuity contracts, switching among investment alternatives available within variable products, changes in sales production levels or changes in policy persistency. For purposes of this guidance, the change in account values is assumed to correlate with the change in the relevant index. Default Risk Our portfolio of invested assets was We are depending on the ability of derivative product dealers and their guarantors to honor their obligations to pay the contract amounts under various derivatives agreements. In order to minimize the risk of default losses, we diversify our exposures among several dealers and limit the amount of exposure to each in accordance with the credit rating of each dealer or its guarantor. We generally limit our selection of counterparties that are obligated under these derivative contracts to those with an A credit rating or above.
Credit-Related Derivatives
Credit Risk By using derivative instruments, we are exposed to credit risk (our counterparty fails to make payment) and market risk (the value of the instrument We have derivative positions with counterparties. Assuming zero recovery value, our exposure is the positive market value of the derivative positions with a counterparty, less collateral, that would be lost if the counterparty were to default. As of September 30, 2008, and December 31, 2007, our counterparty risk exposure, net of collateral, was $429 million and $781 million, respectively. Of this exposure, $300 million and $567 million, respectively was related to our program to hedge our variable annuity guaranteed benefits. We have exposure to 17 counterparties, with a maximum exposure of $88 million, net of collateral, to a single counterparty. The credit risk associated with such agreements is minimized by purchasing such agreements from financial institutions with long-standing, superior performance records. Additionally, we maintain a policy of requiring all derivative contracts to be governed by an International Swaps and Derivatives Association (“ISDA”) Master Agreement.
Conclusions Regarding Disclosure Controls and Procedures We maintain disclosure controls and procedures, which are designed to ensure that information required to be disclosed in the reports we file or submit 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 our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. As of the end of the period covered by this report, we, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of our disclosure controls and procedures (as that term is defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act). Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are effective in timely alerting them to material information relating to us and our consolidated subsidiaries required to be disclosed in our periodic reports under the Exchange Act. Changes in Internal Control Over Financial Reporting There was no change in our internal control over financial reporting (as that term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the quarter ended A control system, no matter how well designed and operated, can provide only reasonable assurance that the control system’s objectives will be met. Further, because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, within the company have been detected. Projections of any evaluation of controls effectiveness to future periods are subject to risks. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures.
PART II – OTHER INFORMATION
Information regarding reportable legal proceedings is contained in “Part I – Item 3. Legal Proceedings” in our Annual Report on Form 10-K for the year ended December 31, 2007.
The risk factors set forth below update those set forth in our Form 10-K for the year ended December 31, 2007. You should carefully consider the risks described below before investing in our securities. The risks and uncertainties described are not the only ones facing our company. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also impair our business operations. If any of these risks actually occur, our business, financial condition and results of operations could be materially affected. In that case, the value of our securities could decline substantially. Adverse capital and credit market conditions may significantly affect our ability to meet liquidity needs, access to capital and cost of capital. The capital and credit markets have been experiencing extreme volatility and disruption for more than twelve months. Over the last month, the volatility and disruption have reached unprecedented levels. In some cases, the markets have exerted downward pressure on availability of liquidity and credit capacity for certain issuers. We need liquidity to pay our operating expenses, interest on our debt and dividends on our capital stock, maintain our securities lending activities and replace certain maturing liabilities. Without sufficient liquidity, we will be forced to curtail our operations, and our business will suffer. As a holding company with no direct operations, our principal asset is the capital stock of our insurance and investment management subsidiaries. Our ability to meet our obligations for payment of interest and principal on outstanding debt obligations and to pay dividends to shareholders and corporate expenses depends significantly upon the surplus and earnings of our subsidiaries and the ability of our subsidiaries to pay dividends or to advance or repay funds to us. Payments of dividends and advances or repayment of funds to us by our insurance subsidiaries are restricted by the applicable laws of their respective jurisdictions, including laws establishing minimum solvency and liquidity thresholds. Changes in these laws can constrain the ability of our subsidiaries to pay dividends or to advance or repay funds to us in sufficient amounts and at times necessary to meet our debt obligations and corporate expenses. For our insurance subsidiaries, the principal sources of our liquidity are insurance premiums and fees, annuity considerations, investment advisory fees, and cash flow from our investment portfolio and assets, consisting mainly of cash or assets that are readily convertible into cash. At the holding company level, sources of liquidity in normal markets also include a variety of short- and long-term instruments, including repurchase agreements, credit facilities, commercial paper, and medium- and long-term debt. In the event current resources do not satisfy our needs, we may have to seek additional financing. The availability of additional financing will depend on a variety of factors such as market conditions, the general availability of credit, the volume of trading activities, the overall availability of credit to the financial services industry, our credit ratings and credit capacity, as well as the possibility that customers or lenders could develop a negative perception of our long- or short-term financial prospects if we incur large investment losses or if the level of our business activity decreased due to a market downturn. Similarly, our access to funds may be impaired if regulatory authorities or rating agencies take negative actions against us. Our internal sources of liquidity may prove to be insufficient, and in such case, we may not be able to successfully obtain additional financing on favorable terms, or at all. Disruptions, uncertainty or volatility in the capital and credit markets may also limit our access to capital required to operate our business, most significantly our insurance operations. Such market conditions may limit our ability to replace, in a timely manner, maturing liabilities; satisfy statutory capital requirements; generate fee income and market-related revenue to meet liquidity needs; and access the capital necessary to grow our business. As such, we may be forced to delay raising capital, issue shorter tenor securities than we prefer, or bear an unattractive cost of capital which could decrease our profitability and significantly reduce our financial flexibility. Recently, our credit spreads have widened considerably which increases the interest rate we must pay on any new debt obligation we may issue. Our results of operations, financial condition, cash flows and statutory capital position could be materially adversely affected by disruptions in the financial markets. Difficult conditions in the global capital markets and the economy generally may materially adversely affect our business and results of operations and we do not expect these conditions to improve in the near future. Our results of operations are materially affected by conditions in the global capital markets and the economy generally, both in the U.S. and elsewhere around the world. The stress experienced by global capital markets that began in the second half of 2007 137 continued and substantially increased during the third quarter of 2008. Recently, concerns over inflation, energy costs, geopolitical issues, the availability and cost of credit, the U.S. mortgage market and a declining real estate market in the U.S. have contributed to increased volatility and diminished expectations for the economy and the markets going forward. These factors, combined with volatile oil prices, declining business and consumer confidence and increased unemployment, have precipitated an economic slowdown and fears of a possible recession. In addition, the fixed-income markets are experiencing a period of extreme volatility which has negatively impacted market liquidity conditions. Initially, the concerns on the part of market participants were focused on the subprime segment of the mortgage-backed securities market. However, these concerns have since expanded to include a broad range of mortgage-and asset-backed and other fixed income securities, including those rated investment grade, the U.S. and international credit and interbank money markets generally, and a wide range of financial institutions and markets, asset classes and sectors. As a result, the market for fixed income instruments has experienced decreased liquidity, increased price volatility, credit downgrade events, and increased probability of default. Securities that are less liquid are more difficult to value and may be hard to dispose of. Domestic and international equity markets have also been experiencing heightened volatility and turmoil, with issuers (such as our company) that have exposure to the real estate, mortgage and credit markets particularly affected. These events and the continuing market upheavals may have an adverse effect on us, in part because we have a large investment portfolio and are also dependent upon customer behavior. Our revenues are likely to decline in such circumstances and our profit margins could erode. In addition, in the event of extreme prolonged market events, such as the global credit crisis, we could incur significant losses. Even in the absence of a market downturn, we are exposed to substantial risk of loss due to market volatility. We are a significant writer of variable annuity products. The account values of these products will be affected by the downturn in capital markets. Any decrease in account values will decrease the fees generated by our variable annuity products. Factors such as consumer spending, business investment, government spending, the volatility and strength of the capital markets, and inflation all affect the business and economic environment and, ultimately, the amount and profitability of our business. In an economic downturn characterized by higher unemployment, lower family income, lower corporate earnings, lower business investment and lower consumer spending, the demand for our financial and insurance products could be adversely affected. In addition, we may experience an elevated incidence of claims and lapses or surrenders of policies. Our policyholders may choose to defer paying insurance premiums or stop paying insurance premiums altogether. Adverse changes in the economy could affect earnings negatively and could have a material adverse effect on our business, results of operations and financial condition. The current mortgage crisis has also raised the possibility of future legislative and regulatory actions in addition to the recent enactment of the Emergency Economic Stabilization Act of 2008 (the “EESA”) that could further impact our business. We cannot predict whether or when such actions may occur, or what impact, if any, such actions could have on our business, results of operations and financial condition. A further material deterioration in economic conditions may require us to raise additional capital or consider other transactions to manage our capital position or our liquidity. There can be no assurance that actions of the U.S. Government, Federal Reserve and other governmental and regulatory bodies for the purpose of stabilizing the financial markets will achieve the intended effect. In response to the financial crises affecting the banking system and financial markets and going concern threats to investment banks and other financial institutions, on October 3, 2008, President Bush signed the EESA into law. Pursuant to the EESA, the U.S. Treasury has the authority to, among other things, purchase up to $700 billion of mortgage-backed and other securities from financial institutions for the purpose of stabilizing the financial markets. The Federal Government, Federal Reserve and other governmental and regulatory bodies have taken or are considering taking other actions to address the financial crisis. There can be no assurance as to what impact such actions will have on the financial markets, including the extreme levels of volatility currently being experienced. As of September 30, 2008 our residential mortgage-backed securities balance was $9.2 billion, of which 96% was rated AA or above, and our unrealized loss was $897 million. Such continued volatility could materially and adversely affect our business, financial condition and results of operations, or the trading price of our common stock. See “Item 7–Management’s Discussion and Analysis of Financial Condition and Results of Operations – Consolidated Investments – Fixed Maturity and Equity Securities Portfolios” for additional information on our investment portfolio. The impairment of other financial institutions could adversely affect us. We have exposure to many different industries and counterparties, and routinely execute transactions with counterparties in the financial services industry, including brokers and dealers, commercial banks, investment banks, and other institutions. Many of these transactions expose us to credit risk in the event of default of our counterparty. In addition, with respect to secured transactions, our credit risk may be exacerbated when the collateral held by us cannot be realized upon or is liquidated at prices not sufficient to recover the full amount of the loan or derivative exposure due to it. We also may have exposure to these financial institutions in the form of unsecured debt instruments, derivative transactions and/or equity investments. There can be no assurance that any such losses or impairments to the carrying value of these assets would not materially and adversely affect our business and results of operations. 138 Our participation in a securities lending program subjects us to potential liquidity and other risks. We participate in a securities lending program for our general account whereby fixed income securities are loaned by our agent bank to third parties, primarily major brokerage firms and commercial banks. The borrowers of our securities provide us with collateral, typically in cash, which we separately maintain. We invest such cash collateral in other securities, primarily in commercial paper and money market or other short term funds. Securities with a cost or amortized cost of $481 million and $612 million and an estimated fair value of $435 million and $634 million were on loan under the program at September 30, 2008, and December 31, 2007, respectively. Securities loaned under such transactions may be sold or repledged by the transferee. We were liable for cash collateral under our control of $463 million and $655 million at September 30, 2008, and December 31, 2007, respectively. As of September 30, 2008, approximately all securities on loan under the program could be returned to us by the borrowers at any time. Returns of loaned securities would require us to return the cash collateral associated with such loaned securities. In addition, in some cases, the maturity of the securities held as invested collateral (i.e., securities that we have purchased with cash received from the third parties) may exceed the term of the related securities loan and the market value may fall below the amount of cash received as collateral and invested. If we are required to return significant amounts of cash collateral on short notice and we are forced to sell securities to meet the return obligation, we may have difficulty selling such collateral that is invested in securities in a timely manner, be forced to sell securities in a volatile or illiquid market for less than we otherwise would have been able to realize under normal market conditions, or both. In addition, under stressful capital market and economic conditions, such as those conditions we have experienced recently, liquidity broadly deteriorates, which may further restrict our ability to sell securities. Our reserves for future policy benefits and claims related to our current and future business as well as businesses we may acquire in the future may prove to be inadequate. Our reserves for future policy benefits and claims may prove to be inadequate. We establish and carry, as a liability, reserves based on estimates of how much we will need to pay for future benefits and claims. For our life insurance and annuity products, we calculate these reserves based on many assumptions and estimates, including estimated premiums we will receive over the assumed life of the policy, the timing of the event covered by the insurance policy, the lapse rate of the policies, the amount of benefits or claims to be paid and the investment returns on the assets we purchase with the premiums we receive. The assumptions and estimates we use in connection with establishing and carrying our reserves are inherently uncertain. Accordingly, we cannot determine with precision the ultimate amounts that we will pay, or the timing of payment of, actual benefits and claims or whether the assets supporting the policy liabilities will grow to the level we assume prior to payment of benefits or claims. If our actual experience is different from our assumptions or estimates, our reserves may prove to be inadequate in relation to our estimated future benefits and claims. As a result, we would incur a charge to our earnings in the quarter in which we increase our reserves. Because the equity markets and other factors impact the profitability and expected profitability of many of our products, changes in equity markets and other factors may significantly affect our business and profitability. The fee revenue that we earn on equity-based variable annuities, unit-linked accounts, VUL insurance policies and investment advisory business is based upon account values. Because strong equity markets result in higher account values, strong equity markets positively affect our net income through increased fee revenue. Conversely, a weakening of the equity markets results in lower fee income and may have a material adverse effect on our results of operations and capital resources. The increased fee revenue resulting from strong equity markets increases the expected gross profits (“EGPs”) from variable insurance products as do better than expected lapses, mortality rates and expenses. As a result, the higher EGPs may result in lower net amortized costs related to deferred acquisition costs (“DAC”), deferred sales inducements (“DSI”), value of business acquired (“VOBA”), and deferred front-end sales loads (“DFEL”). However, a decrease in the equity markets as well as worse than expected increases in lapses, mortality rates and expenses depending upon their significance, may result in higher net amortized costs associated with DAC, DSI, VOBA and DFEL and may have a material adverse effect on our results of operations and capital resources. For example, if equity markets continued to decline by 20% and remained at those levels during the fourth quarter of 2008, we may have to reset our “reversion to the mean” (RTM) process that we use to compute our best estimate of long-term gross growth rate assumption. We estimate that such a reset would result in a cumulative unfavorable prospective unlocking in the range of approximately $200-$300 million, after-tax. For more information on DAC, DSI, VOBA and DFEL amortization, see “Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operation – Critical Accounting Policies and Estimates” on page 40 of our Annual Report on Form 10-K for the year ended December 31, 2007, and “Part I. Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operation – Critical Accounting Policies and Estimates” above. 139 Changes in the equity markets, interest rates and/or volatility affects the profitability of our products with guaranteed benefits; therefore, such changes may have a material adverse effect on our business and profitability. Certain of our variable annuity products include guaranteed minimum benefit riders. These include guaranteed minimum death benefit (“GDB”), guaranteed minimum withdrawal benefit (“GWB”) and guaranteed minimum income benefit (“GIB”) riders. The amount of reserves related to GDB for variable annuities is tied to the difference between the value of the underlying accounts and the guaranteed death benefit, calculated using a benefit ratio approach. The GDB reserves take into account the present value of total expected GDB payments and the present value of total expected assessments over the life of the contract and claims and assessments to date. The amount of reserves related to GWB and GIB for variable annuities is based on the fair value of the underlying benefit. Both the level of expected GDB payments and expected total assessments used in calculating the benefit ratio are affected by the equity markets. The liabilities related to GWB and GIB benefits valued at fair value are impacted by changes in equity markets, interest rates and volatility. Accordingly, strong equity markets will decrease the amount of GDB reserves that we must carry, and strong equity markets, increases in interest rates and decreases in volatility will generally decrease the fair value of the liabilities underlying the GWB and GIB benefits. Conversely, a decrease in the equity markets will increase the net amount at risk under the GDB benefits we offer as part of our variable annuity products, which has the effect of increasing the amount of GDB reserves that we must carry. Also, a decrease in the equity market along with a decrease in interest rates and an increase in volatility will generally result in an increase in the fair value of the liabilities underlying GWB and GIB benefits, which has the effect of increasing the amount of GWB and GIB reserves that we must carry. Such an increase in reserves would result in a charge to our earnings in the quarter in which we increase our reserves. We maintain a customized dynamic hedge program that is designed to mitigate the risks associated with income volatility around the change in reserves on guaranteed benefits. However, the hedge positions may not be effective to exactly offset the changes in the carrying value of the guarantees due to, among other things, the time lag between changes in their values and corresponding changes in the hedge positions, high levels of volatility in the equity markets and derivatives markets, extreme swings in interest rates, contract holder behavior different than expected, and divergence between the performance of the underlying funds and hedging indices. For example, the quarter ended September 30, 2008, we experienced a breakage between the change in our guaranteed benefit reserve and the value of our hedges of $252 million. Breakage is defined as the difference between the change in the fair value of the liabilities, excluding the amount related to the non-performance risk component and the change in the fair value of the derivatives. The breakage also excludes the amount we determine to be the cost of hedging. In addition, we remain liable for the guaranteed benefits in the event that derivative counterparties are unable or unwilling to pay, and we are also subject to the risk that the cost of hedging these guaranteed benefits increases, resulting in a reduction to net income. We also must consider our own credit standing, which is not hedged, in the valuation of certain of these liabilities. A decrease in our own credit spread could cause the value of these liabilities to increase, resulting in a reduction to net income. For more information on our hedging program, see “Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operation – Critical Accounting Policies and Estimates – Future Contract Benefits and Other Contract Holder Funds” on page 47 of our Annual Report on Form 10-K for the year ended December 31, 2007. These, individually or collectively, may have a material adverse effect on net income, financial condition or liquidity. Changes in interest rates may cause interest rate spreads to decrease and may result in increased contract withdrawals. Because the profitability of our fixed annuity and interest-sensitive whole life, universal life (“UL”) and fixed portion of variable universal life (“VUL”) insurance business depends in part on interest rate spreads, interest rate fluctuations could negatively affect our profitability. Changes in interest rates may reduce both our profitability from spread businesses and our return on invested capital. Some of our products, principally fixed annuities and interest-sensitive whole life, universal life and the fixed portion of variable universal life insurance, have interest rate guarantees that expose us to the risk that changes in interest rates will reduce our “spread,” or the difference between the amounts that we are required to pay under the contracts and the amounts we are able to earn on our general account investments intended to support our obligations under the contracts. Declines in our spread or instances where the returns on our general account investments are not enough to support the interest rate guarantees on these products could have a material adverse effect on our businesses or results of operations. In periods of increasing interest rates, we may not be able to replace the assets in our general account with higher yielding assets needed to fund the higher crediting rates necessary to keep our interest sensitive products competitive. We therefore may have to accept a lower spread and thus lower profitability or face a decline in sales and greater loss of existing contracts and related assets. In periods of declining interest rates, we have to reinvest the cash we receive as interest or return of principal on our investments in lower yielding instruments then available. Moreover, borrowers may prepay fixed-income securities, commercial mortgages and mortgage-backed securities in our general account in order to borrow at lower market rates, which exacerbates this risk. Because we are entitled to reset the interest rates on our fixed rate annuities only at limited, pre-established intervals, and since many of our contracts have guaranteed minimum interest or crediting rates, our spreads could decrease and potentially become negative. 140 Increases in interest rates may cause increased surrenders and withdrawals of insurance products. In periods of increasing interest rates, policy loans and surrenders and withdrawals of life insurance policies and annuity contracts may increase as contract holders seek to buy products with perceived higher returns. This process may lead to a flow of cash out of our businesses. These outflows may require investment assets to be sold at a time when the prices of those assets are lower because of the increase in market interest rates, which may result in realized investment losses. A sudden demand among consumers to change product types or withdraw funds could lead us to sell assets at a loss to meet the demand for funds. Our requirements to post collateral or make payments related to declines in market value of specified assets may adversely affect our liquidity and expose us to counterparty credit risk. Many of our transactions with financial and other institutions specify the circumstances under which the parties are required to post collateral. The amount of collateral we may be required to post under these agreements may increase under certain circumstances, which could adversely affect our liquidity. In addition, under the terms of some of our transactions we may be required to make payment to our counterparties related to any decline in the market value of the specified assets. Defaults on our mortgage loans and volatility in performance may adversely affect our profitability. Our mortgage loans face default risk and are principally collateralized by commercial and residential properties. Mortgage loans are stated on our balance sheet at unpaid principal balance, adjusted for any unamortized premium or discount, deferred fees or expenses, and are net of valuation allowances. We establish valuation allowances for estimated impairments as of the balance sheet date based information such as the market value of the underlying real estate securing the loan, any third party guarantees on the loan balance or any cross collateral agreements and their impact on expected recovery rates. At September 30, 2008, no loans were either delinquent or in the process of foreclosure for our mortgage loan investments. The performance of our mortgage loan investments, however, may fluctuate in the future. In addition, some of our mortgage loan investments have balloon payment maturities. An increase in the default rate of our mortgage loan investments could have a material adverse effect on our business, results of operations and financial condition. Further, any geographic or sector exposure in our mortgage loans may have adverse effects on our investment portfolios and consequently on our consolidated results of operations or financial condition. While we seek to mitigate this risk by having a broadly diversified portfolio, events or developments that have a negative effect on any particular geographic region or sector may have a greater adverse effect on the investment portfolios to the extent that the portfolios are exposed. Our investments are reflected within the consolidated financial statements utilizing different accounting basis and accordingly we may not have recognized differences, which may be significant, between cost and fair value in our consolidated financial statements. Our principal investments are in fixed maturity and equity securities, mortgage loans on real estate, real estate (either wholly owned or in joint ventures), policy loans, short-term investments, derivative instruments and limited partnerships and other invested assets. The carrying value of such investments is as follows: Fixed maturity and equity securities are classified as available-for-sale, except for those designated as trading securities, and are reported at their estimated fair value. The difference between the estimated fair value and amortized cost of such securities, i.e., unrealized investment gains and losses, are recorded as a separate component of other comprehensive income or loss, net of policyholder related amounts and deferred income taxes. Fixed maturity and equity securities designated as trading securities, which support certain reinsurance arrangements, are recorded at fair value with subsequent changes in fair value recognized in realized gains and losses. However, offsetting the changes to fair value of the trading securities are corresponding changes in the fair value of the embedded derivative liability associated with the underlying reinsurance arrangement. In other words, the investment results for the trading securities, including gains and losses from sales, are passed directly to the reinsurers through the contractual terms of the reinsurance arrangements. Short-term investments include investments with remaining maturities of one year or less, but greater than three months, at the time of acquisition and are stated at amortized cost, which approximates fair value. Mortgage loans are stated at unpaid principal balance, adjusted for any unamortized premium or discount, deferred fees or expenses, net of valuation allowances. Policy loans are stated at unpaid principal balances. Real estate joint ventures and other limited partnership interests are carried using the equity method of accounting. Other invested assets consist principally of derivatives with positive fair values. Derivatives are carried at fair value with changes in fair value reflected in income from non-qualifying derivatives and derivatives in fair value hedging relationships. Derivatives in cash flow hedging relationships are reflected as a separate component of other comprehensive income or loss. 141 Investments not carried at fair value in our consolidated financial statements — principally, mortgage loans, policy loans and real estate — may have fair values which are substantially higher or lower than the carrying value reflected in our consolidated financial statements. In addition, unrealized losses are not reflected in net income unless we realize the losses by either selling the security at below amortized cost or determine that the decline in fair value is deemed to be other than temporary, i.e., impaired. Each of such asset classes is regularly evaluated for impairment under the accounting guidance appropriate to the respective asset class. Our valuation of fixed maturity, equity and trading securities may include methodologies, estimations and assumptions which are subject to differing interpretations and could result in changes to investment valuations that may materially adversely affect our results of operations or financial condition. Fixed maturity, equity, trading securities and short-term investments which are reported at fair value on the consolidated balance sheet represented the majority of our total cash and invested assets. Pursuant to Statement of Financial Accounting Standards No. 157 (“SFAS No. 157”) “Fair Value Measurements,” we have categorized these securities into a three-level hierarchy, based on the priority of the inputs to the respective valuation technique. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). An asset or liability’s classification within the fair value hierarchy is based of the lowest level of significant input to its valuation. SFAS No. 157 defines the input levels as follows: Level 1 – inputs to the valuation methodology are quoted prices available in active markets for identical investments as of the reporting date. “Blockage discounts” for large holdings of unrestricted financial instruments where quoted prices are readily and regularly available for an identical asset or liability in an active market are prohibited; Level 2 – inputs to the valuation methodology are other than quoted prices in active markets, which are either directly or indirectly observable as of the reporting date, and fair value can be determined through the use of models or other valuation methodologies; and Level 3 – inputs to the valuation methodology are unobservable inputs in situations where there is little or no market activity for the asset or liability and the reporting entity makes estimates and assumptions related to the pricing of the asset or liability, including assumptions regarding risk. At September 30, 2008, approximately .5%, 90.4%, and 9.1% of these securities represented Level 1, Level 2 and Level 3, respectively. The Level 1 securities primarily consist of certain U.S. Treasury and agency fixed maturity securities and exchange-traded common stock. The Level 2 assets include fixed maturity securities priced principally through independent pricing services including most U.S. Treasury and agency securities as well as the majority of U.S. and foreign corporate securities, residential mortgage-backed securities, commercial mortgage-backed securities, state and political subdivision securities, foreign government securities, and asset-backed securities as well as equity securities, including non-redeemable preferred stock, priced by independent pricing services. Management reviews the valuation methodologies used by the pricing services on an ongoing basis and ensures that any valuation methodologies are justified. Level 3 assets include fixed maturity securities priced principally through independent broker quotes or market standard valuation methodologies. This level consists of less liquid fixed maturity securities with very limited trading activity or where less price transparency exists around the inputs to the valuation methodologies including: U.S. and foreign corporate securities — including below investment grade private placements; residential mortgage-backed securities; asset backed securities; and other fixed maturity securities such as structured securities. Equity securities classified as Level 3 securities consist principally of common stock of privately held companies and non-redeemable preferred stock where there has been very limited trading activity or where less price transparency exists around the inputs to the valuation. Prices provided by independent pricing services and independent broker quotes can vary widely even for the same security. The determination of fair values in the absence of quoted market prices is based on: (i) valuation methodologies; (ii) securities we deem to be comparable; and (iii) assumptions deemed appropriate given the circumstances. The fair value estimates are made at a specific point in time, based on available market information and judgments about financial instruments, including estimates of the timing and amounts of expected future cash flows and the credit standing of the issuer or counterparty. Factors considered in estimating fair value include: coupon rate, maturity, estimated duration, call provisions, sinking fund requirements, credit rating, industry sector of the issuer, and quoted market prices of comparable securities. The use of different methodologies and assumptions may have a material effect on the estimated fair value amounts. During periods of market disruption including periods of significantly rising or high interest rates, rapidly widening credit spreads or illiquidity, it may be difficult to value certain of our securities, if trading becomes less frequent and/or market data becomes less observable. There may be certain asset classes that were in active markets with significant observable data that become illiquid due to the current financial environment. In such cases, more securities may fall to Level 3 and thus require more subjectivity and management judgment. As such, valuations may include inputs and assumptions that are less observable or require greater 142 estimation as well as valuation methods which are more sophisticated or require greater estimation thereby resulting in values which may be less than the value at which the investments may be ultimately sold. Further, rapidly changing and unprecedented credit and equity market conditions could materially impact the valuation of securities as reported within our consolidated financial statements and the period-to-period changes in value could vary significantly. Decreases in value may have a material adverse effect on our results of operations or financial condition. Some of our investments are relatively illiquid and are in asset classes that have been experiencing significant market valuation fluctuations. We hold certain investments that may lack liquidity, such as privately placed fixed maturity securities; mortgage loans; policy loans; and equity real estate, including real estate joint venture; and other limited partnership interests. These asset classes represented 27% of the carrying value of our total cash and invested assets as of September 30, 2008. Even some of our very high quality assets have been more illiquid as a result of the recent challenging market conditions. If we require significant amounts of cash on short notice in excess of normal cash requirements or are required to post or return collateral in connection with our investment portfolio, derivatives transactions or securities lending activities, we may have difficulty selling these investments in a timely manner, be forced to sell them for less than we otherwise would have been able to realize, or both. The reported value of our relatively illiquid types of investments, our investments in the asset classes described in the paragraph above and, at times, our high quality, generally liquid asset classes, do not necessarily reflect the lowest current market price for the asset. If we were forced to sell certain of our assets in the current market, there can be no assurance that we will be able to sell them for the prices at which we have recorded them and we may be forced to sell them at significantly lower prices. We invest a portion of our invested assets in investment funds, many of which make private equity investments. The amount and timing of income from such investment funds tends to be uneven as a result of the performance of the underlying investments, including private equity investments. The timing of distributions from the funds, which depends on particular events relating to the underlying investments, as well as the funds’ schedules for making distributions and their needs for cash, can be difficult to predict. As a result, the amount of income that we record from these investments can vary substantially from quarter to quarter. Recent equity and credit market volatility may reduce investment income for these types of investments. The determination of the amount of allowances and impairments taken on our investments is highly subjective and could materially impact our results of operations or financial position. The determination of the amount of allowances and impairments vary by investment type and is based upon our periodic evaluation and assessment of known and inherent risks associated with the respective asset class. Such evaluations and assessments are revised as conditions change and new information becomes available. Management updates its evaluations regularly and reflects changes in allowances and impairments in operations as such evaluations are revised. There can be no assurance that our management has accurately assessed the level of impairments taken and allowances reflected in our financial statements. Furthermore, additional impairments may need to be taken or allowances provided for in the future. Historical trends may not be indicative of future impairments or allowances. For example, the cost of our fixed maturity and equity securities is adjusted for impairments in value deemed to be other-than-temporary in the period in which the determination is made. The assessment of whether impairments have occurred is based on management’s case-by-case evaluation of the underlying reasons for the decline in fair value. In evaluating whether a decline in value is other-than-temporary, we consider several factors including, but not limited to: 1) our ability and intent to hold the security for a sufficient period of time to allow for a recovery in value; 2) the cause of the decline; 3) fundamental analysis of the liquidity, business prospects and overall financial condition of the issuer; and 4) severity of the decline in value. Additionally, our management considers a wide range of factors about the security issuer and uses their best judgment in evaluating the cause of the decline in the estimated fair value of the security and in assessing the prospects for recovery. Inherent in management’s evaluation of the security are assumptions and estimates about the operations of the issuer and its future earnings potential. Another key factor in whether determining an other-than-temporary impairment has occurred is our “intent or ability to hold to recovery or maturity.” In the event that we determine that we do not have the intent or ability to hold to recovery or maturity, we are required to write down the security. A write-down is necessary even in situations where the unrealized loss is not due to an underlying credit issue, but may be solely related to the impact of changes in interest rates on the fair value of the security. Where such analysis results in a conclusion that declines in fair values are other-than-temporary, the security is written down to fair value. 143 Our gross unrealized losses on fixed maturity securities available-for-sale at September 30, 2008, were $4.8 billion pre-tax and the component of gross unrealized losses for securities trading down 20% or more for six months is approximately $2.4 billion pre-tax. Related to our unrealized losses we establish deferred tax assets for the tax benefit we may receive in the event that losses are realized. The realization of significant realized losses could result in an inability to recover the tax benefits and may result in the establishment of valuation allowances against our deferred tax assets. Realized losses or impairments may have a material adverse impact on our results of operation and financial position. A downgrade in our financial strength or credit ratings could limit our ability to market products, increase the number or value of policies being surrendered and/or hurt our relationships with creditors. Nationally recognized rating agencies rate the financial strength of our principal insurance subsidiaries and rate our debt. Ratings are not recommendations to buy our securities. Each of the rating agencies reviews its ratings periodically, and our current ratings may not be maintained in the future. Please see “Item 1 – Business – Ratings” on page 20 of our Annual Report on Form 10-K for the year ended December 31, 2007, for a complete description of our ratings. Our financial strength ratings, which are intended to measure our ability to meet contract holder obligations, are an important factor affecting public confidence in most of our products and, as a result, our competitiveness. A downgrade of the financial strength rating of one of our principal insurance subsidiaries could affect our competitive position in the insurance industry and make it more difficult for us to market our products as potential customers may select companies with higher financial strength ratings. This could lead to a decrease in fees as outflows of assets increase, and therefore, result in lower fee income. Furthermore, sales of assets to meet customer withdrawal demands could also result in losses, depending on market conditions. The interest rates we pay on our borrowings are largely dependent on our credit ratings. A downgrade of our debt ratings could affect our ability to raise additional debt, including bank lines of credit, with terms and conditions similar to our current debt, and accordingly, likely increase our cost of capital. In addition, a downgrade of these ratings could make it more difficult to raise capital to refinance any maturing debt obligations, to support business growth at our insurance subsidiaries and to maintain or improve the current financial strength ratings of our principal insurance subsidiaries described above. Our businesses are heavily regulated and changes in regulation may reduce our profitability. Our insurance subsidiaries are subject to extensive supervision and regulation in the states in which we do business. The supervision and regulation relate to numerous aspects of our business and financial condition. The primary purpose of the supervision and regulation is the protection of our insurance contract holders, and not our investors. The extent of regulation varies, but generally is governed by state statutes. These statutes delegate regulatory, supervisory and administrative authority to state insurance departments. This system of supervision and regulation covers, among other things: Standards of minimum capital requirements and solvency, including risk-based capital measurements; Restrictions of certain transactions between our insurance subsidiaries and their affiliates; Restrictions on the nature, quality and concentration of investments; Restrictions on the types of terms and conditions that we can include in the insurance policies offered by our primary insurance operations; Limitations on the amount of dividends that insurance subsidiaries can pay; The existence and licensing status of the company under circumstances where it is not writing new or renewal business; Certain required methods of accounting; Reserves for unearned premiums, losses and other purposes; and Assignment of residual market business and potential assessments for the provision of funds necessary for the settlement of covered claims under certain policies provided by impaired, insolvent or failed insurance companies. In any particular year, statutory surplus amounts and RBC ratios may increase or decrease depending on a variety of factors – the amount of statutory income or losses generated by our insurance subsidiaries (which itself is sensitive to equity market and credit market conditions), the amount of additional capital our insurance subsidiaries must hold to support business growth, changes in equity market levels, the value of certain fixed-income and equity securities in our investment portfolio, the value of certain derivative instruments that do not get hedge accounting, changes in interest rates and foreign currency exchange rates, as well as changes to the NAIC RBC formulas. Most of these factors are outside of our control. LNC’s credit ratings are significantly influenced by the statutory surplus amounts and RBC ratios of our insurance company subsidiaries. In addition, rating agencies may implement changes to their internal models that have the effect of increasing or decreasing the amount of statutory capital we must hold in order to maintain our current ratings. In addition, in extreme scenarios of equity market declines, the amount of additional statutory reserves that we are required to hold for our variable annuity products increases at a greater than linear rate. This reduces the statutory surplus used in calculating our RBC ratios. To the extent that our statutory capital resources are deemed 144 to be insufficient to maintain a particular rating by one or more rating agencies, we may seek to raise additional capital. Alternatively, if we were not to raise additional capital in such a scenario, either at our discretion or because we were unable to do so, our financial strength and credit ratings might be downgraded by one or more rating agencies. We may be unable to maintain all required licenses and approvals and our business may not fully comply with the wide variety of applicable laws and regulations or the relevant authority’s interpretation of the laws and regulations, which may change from time to time. Also, regulatory authorities have relatively broad discretion to grant, renew or revoke licenses and approvals. If we do not have the requisite licenses and approvals or do not comply with applicable regulatory requirements, the insurance regulatory authorities could preclude or temporarily suspend us from carrying on some or all of our activities or impose substantial fines. Further, insurance regulatory authorities have relatively broad discretion to issue orders of supervision, which permit such authorities to supervise the business and operations of an insurance company. As of 2008, no state insurance regulatory authority had imposed on us any substantial fines or revoked or suspended any of our licenses to conduct insurance business in any state or issued an order of supervision with respect to our insurance subsidiaries, which would have a material adverse effect on our results of operations or financial condition. In addition, LFN and LFD, as well as our variable annuities and variable life insurance products, are subject to regulation and supervision by the SEC and FINRA. Our Investment Management segment, like other investment management companies, is subject to regulation and supervision by the SEC, FINRA, the Municipal Securities Rulemaking Board, the Pennsylvania Department of Banking and jurisdictions of the states, territories and foreign countries in which they are licensed to do business. Lincoln UK is subject to regulation by the FSA in the U.K. These laws and regulations generally grant supervisory agencies and self-regulatory organizations broad administrative powers, including the power to limit or restrict the subsidiaries from carrying on their businesses in the event that they fail to comply with such laws and regulations. Finally, our radio operations require a license, subject to periodic renewal, from the Federal Communications Commission to operate. While management considers the likelihood of a failure to renew remote, any station that fails to receive renewal would be forced to cease operations. Many of the foregoing regulatory or governmental bodies have the authority to review our products and business practices and those of our agents and employees. In recent years, there has been increased scrutiny of our businesses by these bodies, which has included more extensive examinations, regular “sweep” inquiries and more detailed review of disclosure documents. These regulatory or governmental bodies may bring regulatory or other legal actions against us if, in their view, our practices, or those of our agents or employees, are improper. These actions can result in substantial fines, penalties or prohibitions or restrictions on our business activities and could have a material adverse effect on our business, results of operations or financial condition. For further information on regulatory matters relating to us, see “Item 1. Business – Regulatory,” beginning on page 21 of our Annual Report on Form 10-K for the year ended December 31, 2007. 145
(c) The following table summarizes purchases of equity securities by the issuer during the quarter ended September 30, 2008 (dollars in millions, except per share data):
(a) (1) On November 6, 2008, J. Patrick Barrett, a director and the non-executive Chairman of the Board of Directors, informed the Board that pursuant to the retirement age policy set forth in Lincoln National Corporation’s (the “Company”) corporate governance guidelines, he would be retiring and resigning from the board at the end of the second day immediately preceding the 2009 annual meeting of shareholders, or May 12, 2009. (2) Effective November 6, 2008, the board of directors approved amendments to the Company’s Bylaws. The amendments made the following substantive changes:
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(b) The description in (a)(2)(iii) above is incorporated herein by reference
The Exhibits included in this report are listed in the Exhibit Index beginning on page E-1, which is incorporated herein by reference.
SIGNATURES 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.
Date:
LINCOLN NATIONAL CORPORATION Exhibit Index for the Report on Form 10-Q For the Quarter Ended
E-1 |