Exhibit 13 Portions of LNC's 2001 Annual Report to Shareholders
Selected Quarterly Financial Data
(in millions, except per share data)
Operating Results by Quarter 1st Qtr 2nd Qtr 3rd Qtr 4th Qtr
- ---------------------------------------------------------------------------------------------------------------------
2001 Data
- ---------------------------------------------------------------------------------------------------------------------
Premiums and other considerations $1,045.8 $943.4 $960.7 $852.8
Net investment income 673.7 673.1 686.2 646.6
Realized gain (loss) on investments, derivative
instruments and sale of subsidiaries (20.7) (17.5) (37.7) (25.8)
Net income $160.2 $141.7 $119.1 $169.2
Net income per diluted share $0.83 $0.74 $0.61 $0.88
- ---------------------------------------------------------------------------------------------------------------------
2000 Data
- ---------------------------------------------------------------------------------------------------------------------
Premiums and other considerations $959.1 $1,029.2 $1,043.0 $1,101.4
Net investment income 711.1 673.8 690.0 672.1
Realized gain (loss) on investments (1.0) (10.4) (17.0) 0.1
Net income $170.2 $163.6 $138.6 $148.9
Net income per diluted share $0.87 $0.84 $0.71 $0.76
=====================================================================================================================
Selected Annual Financial Data
(millions of dollars, except per share data)
Year Ended December 31 2001 2000 1999 1998 1997
- ------------------------------------------------------------------------------------------------------------------------
Total revenue $6,380.6 $6,851.5 $6,803.7 $6,087.1 $4,898.5
Net income from continuing operations
before cumulative effect of accounting
changes(1) 605.8 621.4 460.4 509.8 22.2
Net income from discontinued operations -- -- -- -- 134.9
Gain on sale of discontinued operations -- -- -- -- 776.9
Cumulative effect of accounting changes (15.6) -- -- -- --
- ------------------------------------------------------------------------------------------------------------------------
Net income(1) $590.2 $621.4 $460.4 $509.8 $934.0
Per Share Data:(2)
Net income from continuing operations $3.05 $3.19 $2.30 $2.51 $0.11
Net income from discontinued operations -- -- -- -- 0.65
Gain on sale of discontinued operations -- -- -- -- 3.73
- ------------------------------------------------------------------------------------------------------------------------
Net Income - Diluted $3.05 $3.19 $2.30 $2.51 $4.49
Net Income - Basic $3.13 $3.25 $2.33 $2.54 $4.56
Common stock dividends $1.235 $1.175 $1.115 $1.055 $0.995
(millions of dollars, except per share data)
December 31 2001 2000 1999 1998 1997
- ------------------------------------------------------------------------------------------------------------------------
Assets $98,001.3 $99,844.1 $103,095.7 $93,836.3 $77,174.7
Long-term debt 861.8 712.2 712.0 712.2 511.0
Company-obligated mandatorily
redeemable preferred securities of
subsidiary trusts holding solely junior
subordinated debentures 474.7 745.0 745.0 745.0 315.0
Shareholders' equity 5,263.5 4,954.1 4,263.9 5,387.9 4,982.9
Per Share Data:(2)
Shareholders' equity (Securities at market) $28.10 $25.92 $21.76 $26.59 $24.63
Shareholders' equity (Securities at cost) 26.94 25.85 24.14 23.86 22.48
Market value of common stock $48.57 $47.31 $40.00 $40.91 $39.07
========================================================================================================================
(1) Factors affecting the comparability of income from continuing operations and net income from continuing operations
for the 1997-2001 period are shown on page 36 (see "Supplemental Data"). Other factors affecting comparability are
shown within the results of operations by segment (see pages 44 through 61).
(2) Per share amounts were affected by the issuance of 2,796,224 shares of common stock in 1997 and the retirement of
11,278,022; 6,222,581; 7,675,000; 1,246,562 and 9,897,800 shares of common stock in 2001, 2000, 1999, 1998, and
1997, respectively. In addition, 4,630,318 shares of common stock were issued in 2001 related to the settlement of
purchase contracts issued in conjunction with FELINE PRIDES financing.
Supplemental Data
The following table presents a reconciliation of "Income (Loss) from
Continuing Operations" to "Net Income from Continuing Operations"
determined in accordance with generally accepted accounting principles.
Income (Loss) from Continuing Operations is LNC's alternative measure of
operating performance which excludes the after-tax realized gain (loss) on
investments, derivative instruments and associated items, gain (loss) on
sale of subsidiaries (if applicable), restructuring charges and cumulative
effect of accounting changes.
Year Ended December 31(in millions) 2001 2000 1999 1998 1997
- -------------------------------------------------------------------------------------------------
Income (loss) from continuing operations(1) $689.0 $719.1 $475.5 $530.4 $(50.7)
Realized gain (loss) on investments and
derivative instruments, net of
associated amortization of deferred
policy acquisition costs, provision for
policyholder commitments, investment
expenses and income taxes (73.6) (17.5) 3.8 13.7 72.9
Gain on sale of subsidiaries 15.0 -- -- -- --
Restructuring charges, net of income taxes (24.6) (80.2) (18.9) (34.3) --
Cumulative effect of accounting changes (15.6) -- -- -- --
- -------------------------------------------------------------------------------------------------
Net Income from Continuing Operations $590.2 $621.4 $460.4 $509.8 $22.2
=================================================================================================
(1) Income (loss) from continuing operations for 2001 includes a change in estimate of premium
receivables on certain client-administered individual life reinsurance of $25.5 million
after-tax. 1999 includes net special charges of $149.4 million after-tax and 1997 includes
special charges of $418.6 million after-tax.
Management's Discussion and Analysis
INTRODUCTION
- -----------------------------------------------------------------------------
Lincoln National Corporation ("LNC") is a holding company. Through subsidiary
companies, LNC operates multiple insurance and investment management
businesses. The collective group of companies uses "Lincoln Financial
Group" as its marketing identity. LNC is the 34th largest (based on assets)
United States Corporation (2000 Fortune 500, Largest U.S. Corporations,
April 2001). Operations are divided into four business segments: 1) Annuities
(effective March 7, 2002, this segment will be known as Lincoln Retirement),
2) Life Insurance, 3) Investment Management and 4) Lincoln UK. LNC reports
operations not directly related to the business segments and unallocated
corporate items [i.e., corporate investment income, interest expense on
corporate debt, unallocated overhead expenses, and the operations of Lincoln
Financial Advisors ("LFA") and Lincoln Financial Distributors ("LFD")] in
"Other Operations." See "Reorganization of Reporting Segments" below for
further discussion of LNC's segment reporting structure. Prior to the fourth
quarter of 2001, LNC had a Reinsurance segment. LNC's reinsurance operations
were acquired by Swiss Re in December 2001 and the related segment information
was moved to Other Operations. Total employment of LNC at December 31, 2001
on a consolidated basis was 6,780.
Forward-Looking Statements - Cautionary Language
The pages that follow review results of operations of LNC Consolidated,
LNC's four business segments and "Other Operations;" LNC's consolidated
investments; and consolidated financial condition including liquidity, cash
flows and capital resources. Historical financial information is presented
and analyzed. Where appropriate, factors that may affect future financial
performance are identified and discussed. Certain statements made in this
report are "forward-looking statements" within the meaning of the
Securities Litigation Reform Act of 1995 (the "Act"). Forward-looking
statements include, without limitation, 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.
Forward-looking statements involve risks and uncertainties which may cause
actual results to differ materially from the results contained in the
forward-looking statements. These risks and uncertainties include, among
others, subsequent significant changes: in the company (e.g., acquisitions
and divestitures of legal entities and blocks of business - directly or by
means of reinsurance transactions including the recently completed
divestiture of LNC's reinsurance business and whether proceeds from such
divestiture can be used as planned); financial markets (e.g., interest
rates and securities markets); competitors and competing products and
services; legislation (e.g., corporate, individual, estate and product
taxation); the price of LNC's stock; accounting principles generally
accepted in the United States; regulations (e.g., insurance and securities
regulations); and debt and claims paying ratings issued by nationally
recognized statistical rating organizations. Other risks and uncertainties
include: whether necessary regulatory approvals are obtained (e.g.,
insurance department, Hart-Scott-Rodino, etc.) and, if obtained, whether
they are obtained on a timely basis; whether proceeds from dispositions can
be used as planned; litigation (e.g., adverse decisions in extracontractual
and class action damage cases, new appellate decisions which change the
law, unexpected trial court rulings, unavailability of witnesses and newly
discovered evidence); acts of God (e.g., hurricanes, earthquakes and
storms); stability of foreign governments in countries in which LNC does
business; and other insurance risks (e.g., policyholder mortality and
morbidity).
The risks included here are not exhaustive. Other sections of this report
include additional factors which could adversely impact LNC's business and
financial performance. Moreover, LNC operates in a rapidly changing and
competitive environment. New risk factors emerge from time to time and it
is not possible for management to predict all such risk factors. Further,
it is not possible to assess the impact of all risk factors on LNC's
business or the extent to which any factor or combination of factors, may
cause actual results to differ materially from those contained in any
forward-looking statements. Given these risks and uncertainties, investors
should not place undo reliance on forward-looking statements as a prediction
of actual results. In addition, LNC disclaims any obligation to update any
forward-looking statements to reflect events or circumstances that occur
after the date of this report.
Critical Accounting Policies
Given the nature of LNC's business, the Company's accounting policies require
the use of judgments relating to a variety of assumptions and estimates.
Because of the inherent uncertainty in the assumptions and estimates
underlying these accounting policies, under different conditions or
assumptions the amounts reported in LNC's financial statements could be
materially different. Throughout Management's Discussion and Analysis, the
application of these various critical accounting policies is addressed along
with the effect of changes in estimates and assumptions.
To provide an overall perspective on these critical accounting policies,
and guidance as to the specific areas within Management's Discussion and
Analysis where these critical accounting policies are discussed in detail,
a summary of critical accounting policies and the disclosure location is
presented below.
Accounting for intangible assets requires numerous assumptions, such as
estimates of expected future profitability for various LNC operations and
LNC's ability to retain its existing blocks of life and annuity business
in-force. LNC's accounting policies for the intangible assets of deferred
acquisition costs and the present value of acquired blocks of in-force
policies are discussed within the Annuities, Life Insurance and Lincoln UK
segments. LNC's overall accounting policy for other identified intangibles
and goodwill is discussed within Results of Consolidated Operations.
Determining whether a decline in current fair values for investment assets
is other than a temporary decline in value can frequently involve a variety
of assumptions and estimates, particularly for investments that are not
actively traded on established markets. For instance, assessing the value
of some investments requires an analysis of expected future cash flows.
Some investment structures, such as collateralized bond obligations, often
represent selected levels, or tranches, of underlying investments in a
wide variety of underlying issuers. LNC's accounting policies for its
invested assets are discussed within the Results of Consolidated Operations
and Consolidated Investments.
To protect itself from a variety of equity market and interest rate risks
that are inherent in many of LNC's life insurance and annuity products, LNC
uses various derivative instruments. Assessing the effectiveness of these
hedging programs and evaluating the carrying values of the related
derivatives often involves a variety of assumptions and estimates. LNC's
accounting policies for derivatives are discussed in the Results of
Consolidated Operations, Consolidated Investments and within the discussion
of Quantitative and Qualitative Disclosures About Market Risk.
Establishing adequate liabilities for LNC's obligations to its policyholders
requires assumptions to be made regarding mortality and morbidity. The effect
of variances in these assumptions is discussed within the Life Insurance
segment and within the discussion of the disposition of LNC's former
Reinsurance segment contained within Other Operations.
Pursuant to the accounting rules for LNC's obligations to employees under its
various retirement and welfare benefit plans, LNC is required to make a
large number of assumptions, such as the future performance of financial
markets and the composition of LNC's employee workforce in the future.
LNC's accounting for its employee plans is discussed in detail within
Note 6 Employee Benefit Plans, which is included in the notes to consolidated
financial statements.
Establishing reserves for litigation and compliance-related regulatory actions
inherently involve a variety of estimates of potential future outcomes.
These matters are discussed within Results of Consolidated Operations and
in the Lincoln UK segment, with additional detail provided within Note 7
Restrictions, Commitments and Contingencies which is included in the notes
to consolidated financial statements.
As LNC responds to an ever-changing business environment and continues to
adapt its organizational and operational structures, the frequency of
necessary restructuring activities increases. Establishing reserves for the
expected costs of these restructurings requires a variety of estimates and
assumptions. The accounting for LNC's restructurings is discussed within the
Results of Consolidated Operations and within the Results of Operations for
each affected business segment, as well as within Note 12 Restructuring Charges
included in the notes to consolidated financial statements.
Continued access to capital markets and maintenance of favorable debt and
claims paying ratings are critical to LNC's future success. LNC's accounting,
in a wide variety of areas, is inherently dependent upon continued access to
capital and maintenance of adequate ratings. Detailed discussion of LNC's
access to capital markets, liquidity status and ratings are contained
within the Review of Consolidated Financial Condition.
Finally, it is LNC's policy to provide disclosure of commitments or guarantees
so that its financial statements present as complete a picture of LNC's
financial condition as possible. The vast majority of these commitments or
guarantees relate to LNC's life insurance and annuity businesses and, as such,
are reflected on LNC's balance sheet. Any off-balance sheet commitments or
guarantees that LNC is subject to are disclosed within Review of
Consolidated Financial Condition and Note 7 Restrictions, Commitments and
Contingencies which is included in the notes to consolidated financial
statements.
On pages 38 through 61, the results of operations of LNC consolidated, LNC's
four business segments and "Other Operations" are presented and discussed.
Within these discussions of the results of operations, reference is made
to "Income from Operations." This alternative measure of earnings is defined
as "Net income less realized gain (loss) on sale of investments and associated
items, gain (loss) on sale of subsidiaries, restructuring charges and
cumulative effect of accounting changes, all net of taxes. Pages 62 through
65 discuss LNC's consolidated investments. Pages 65 through 69 discuss LNC's
consolidated financial condition including liquidity and cash flow, and
capital resources. Pages 69 through 76 provide LNC's quantitative and
qualitative disclosures about market risk. Please note that all amounts
stated in this "Management's Discussion and Analysis" are on an after-tax
basis except where specifically identified as pre-tax.
This "Management's Discussion and Analysis" should be read in conjunction
with the audited consolidated financial statements and accompanying notes
presented on pages 77 through 127.
OVERVIEW: RESULTS OF CONSOLIDATED OPERATIONS
- ------------------------------------------------------------------------------------------------------------------
Summary Information
Increase/(Decrease)
------------------
Year Ended December 31 (in millions) 2001 2000 1999 2001 2000
- ------------------------------------------------------------------------------------------------------------------
Life insurance and annuity premiums $1,363.4 $1,403.3 $1,183.0 (3%) 19%
Health insurance premiums 340.6 409.8 698.5 (17%) (41%)
Insurance fees 1,544.0 1,661.4 1,537.6 (7%) 8%
Investment advisory fees 197.2 213.2 223.8 (8%) (5%)
Net investment income 2,679.6 2,747.1 2,807.5 (2%) (2%)
Equity in earnings of unconsolidated affiliates 5.7 (0.4) 5.8
Realized gain (loss) on investments and
derivative instruments (114.5) (28.3) 3.0
Gain on sale of subsidiaries 12.8 -- --
Other revenue and fees 351.8 445.4 344.5 (21%) 29%
Life insurance and annuity benefits 3,107.6 3,108.2 3,145.3 -- (1%)
Health benefits 302.1 449.0 659.7 (33%) (32%)
Underwriting, acquisition, insurance
and other expenses 2,085.8 2,318.5 2,295.0 (10%) 1%
Interest and debt expenses 121.0 139.5 133.7 (13%) 4%
Federal income taxes 158.3 214.9 109.6
- ------------------------------------------------------------------------------------------------------------------
Net Income before cumulative effect
of accounting changes 605.8 621.4 460.4
Cumulative effect of accounting changes (15.6) -- --
- ------------------------------------------------------------------------------------------------------------------
Net Income 590.2 621.4 460.4 (5%) 35%
==================================================================================================================
Summary
Net income for 2001 was $590.2 million compared to $621.4 million for 2000,
a $31.2 million or 5% decrease. Restructuring charges net of reversals
included in net income in 2001 and 2000 were $24.6 million and $80.2
million, respectively. (Refer to page 41 in the MD&A for further discussion
of restructuring charges.) Contributing to the decrease in 2001 were
realized losses on investments and derivative instruments of $73.6 million
in 2001 compared to $17.5 million in 2000. These investment losses were due
primarily to losses of $41.8 million (pre-tax) taken on Enron and Argentina
securities in the fourth quarter of 2001 in addition to increased
write-downs of other securities throughout 2001 due to credit
deterioration. Partially offsetting the additional losses in 2001 was the
gain on sale of certain reinsurance stock companies to Swiss Re of $15.0
million. Income from operations was $689.0 million in 2001 compared to
$719.1 million in 2000. The decrease in 2001 was $30.1 million or 4%. The
decrease in income from operations between years was primarily the result
of decreased earnings from the Annuities and Investment Management
segments, as well as LNC's distributors, LFA and LFD, which are reported in
Other Operations. These negative variances were partially offset by
improved earnings from the Life Insurance segment and the former
Reinsurance segment, included within Other Operations. In addition,
included in income from operations for 2001 was one month's amortization of
the deferred gain on the business transferred to Swiss Re via indemnity
reinsurance. There was also a decrease in the net loss from LNC Financing
and Other Corporate within Other Operations.
Operating revenue (total revenue excluding realized gains and losses on
investments and derivative instruments and gain on sale of subsidiaries)
decreased by $397.6 million or 6% in 2001 due primarily to lower fee income
in the Annuities segment and lower investment advisory fees in the
Investment Management segment resulting from the depressed equity markets
over the last year and to a lesser extent to net cash outflows in annuities
in 2000 and investment products over the last two years. In addition,
Lincoln UK had a decrease in operating revenue due to lower business volume
along with lower fee income resulting from a downturn in the United Kingdom
equity markets over the last half of 2001. The former Reinsurance segment's
operating revenue was down in 2001 as its results only included eleven
months of activity which was partially offset by a change in accounting
estimate that increased segment revenue by $39.3 million (pre-tax) in the
first quarter of 2001. Finally, LFA and LFD included in Other Operations
had lower sales revenue largely attributable to the volatile equity
markets. Partially offsetting these negative variances, the Life Insurance
segment had increased operating revenue due to growth in life insurance
in-force.
Total operating expenses, exclusive of restructuring charges and Federal
income taxes, decreased by $331.6 million or 6% in 2001 due primarily to
decreased expenses in the Lincoln UK segment as a result of the decrease in
business volume along with effective expense management. The former
Reinsurance segment had a decrease due to only eleven months of expenses
being reported for its operations. However, included in 2001 expenses for
the former Reinsurance segment were losses recorded for the events of
September 11. The Annuities segment had a decrease in expenses due
primarily to less amortization of deferred acquisition costs and other
intangible assets partially offset by increased operating and
administrative expenses and benefits expenses. The Investment Management
segment also experienced decreased operating and administrative expenses
due to effective expense management and lower amortization of other
intangibles assets. Partially offsetting these positive variances were
increases in expenses in the Life Insurance segment, as well as LFD and
LFA. Expenses increased in the Life Insurance segment primarily as a result
of the growth in in-force, which drove interest credited to policyholders
higher. LFD had higher expenses primarily as a result of its investment in
new wholesalers during 2001 and LFA experienced an increase in general and
administrative expenses partially offset by a decrease in commissions and
other volume-related expenses. These expenses fell as a direct result of
lower sales volume in 2001.
Net income for 2000 was $621.4 million compared with $460.4 million for 1999.
Net income for 1999 included the following special items which decreased
earnings by $149.4 million: additions to HMO excess-of-loss and UK pension
reserves of $25.0 million and $126.1 million, respectively, a charge for
estimated settlement costs for participation in workers' compensation
carve-out business of $40.4 million and a tax benefit of $42.1 million
related to the decision in 1999 to explore exiting the UK insurance market.
Also, net income included realized losses on investments of $17.5 million
in 2000 compared to realized gains on investments of $3.8 million in 1999.
In addition, restructuring charges net of reversals included in net income
in 2000 and 1999 were $80.2 million and $18.9 million, respectively.
(Refer to page 41 in the MD&A for further discussion of restructuring
charges.) Income from operations was $719.1 million in 2000 compared to
$624.9 million in 1999, exclusive of the special items noted above. The
increase in income from operations in 2000 was $94.2 million or 15%. The
increase in income from operations between years (excluding special charges
recorded in 1999) was primarily the result of increased earnings from the
Annuities and Life Insurance segments and the former Reinsurance segment
now reported in Other Operations. For further discussion of the results of
operations, see the discussion of the results of operations by segment
starting on page 44.
Operating revenue (total revenue excluding realized gains and losses on
investments) increased by $79.1 million or 1% in 2000 reflecting increased
insurance fees in the Annuities and Life Insurance segments primarily due
to increased variable account values during the early part of 2000,
increased other revenue in the Investment Management segment along with
increased individual life insurance premiums and other revenue in the
former Reinsurance segment resulting from business volume growth. Also, the
Life Insurance segment and the former Reinsurance segment had increased
investment income due primarily to increased invested assets resulting from
business volume growth. These increases were partially offset by decreased
health premiums in the former Reinsurance segment resulting from business
volume decreases within its exited businesses, decreased investment
advisory fees in the Investment Management segment due to a decrease in
assets under management and decreased investment income in the Annuities
segment resulting from fixed annuity lapses and transfers.
Total operating expenses, exclusive of restructuring charges and Federal
income taxes, decreased $296.1 million or 4.8% in 2000 due to the absence
of special charges recorded in 1999 noted above and decreased annuity
benefits in the Annuities segment resulting from a decline in fixed annuity
account values. In addition, health benefits decreased in the former
Reinsurance segment due to business volume decreases within its exited
businesses. Underwriting, acquisition, insurance and other expenses
decreased due primarily to lower operating expenses in the Life Insurance
segment and the former Reinsurance segment resulting from lower year 2000
(Y2K) information technology costs. These decreases were partially offset
by increased volume-related expenses in all segments except for the Lincoln
UK segment. In addition, operating expenses increased in the Investment
Management segment due primarily to the implementation of initiatives to
improve the investment management process.
Accounting for Derivative Instruments and Hedging Activities
LNC adopted Statement of Financial Accounting Standards No. 133,
"Accounting for Derivative Instruments and Hedging Activities" ("FAS
133") on January 1, 2001. Upon adoption, the provisions of FAS 133 were
applied prospectively. The transition adjustments that LNC recorded upon
adoption of FAS 133 on January 1, 2001 resulted in a net loss of $4.3
million after-tax ($6.6 million pre-tax) recorded in net income, and a
net gain of $17.6 million after-tax ($27.1 million pre-tax) recorded as
a component of Other Comprehensive Income ("OCI") in equity. Deferred
acquisition costs of $4.8 million were restored and netted against the
transition loss on derivatives recorded in net income and deferred
acquisition costs of $18.3 million were amortized and netted against the
transition gain recorded in OCI. A portion of the transition adjustment
($3.5 million after-tax) recorded in net income upon adoption of FAS 133
was reclassified from the OCI account, Net Unrealized Gain on Securities
Available-for-Sale. These transition adjustments were reported in the
financial statements as the cumulative effect of a change in accounting
principle.
Recognition of Interest Income and Impairment on Purchased and Retained
Beneficial Interests in Securitized Financial Assets
On April 1, 2001, LNC adopted Emerging Issues Task Force Issue No. 99-20,
"Recognition of Interest Income and Impairment on Purchased and Retained
Beneficial Interests in Securitized Financial Assets" ("EITF 99-20"). EITF
99-20 was effective for fiscal quarters beginning after March 15, 2001.
EITF 99-20 changed the manner in which LNC determined impairment of certain
investments including collateralized bond obligations. Upon the adoption of
EITF 99-20, LNC recognized a net realized loss on investments of $11.3
million after-tax ($17.3 million pre-tax) reported as a cumulative effect
of change in accounting principle. In arriving at this amount, deferred
acquisition costs of $12.2 million were restored and netted against net
realized loss on investments.
Accounting for Business Combinations and Goodwill and Other Intangible
Assets
In June 2001, the Financial Accounting Standards Board issued Statements of
Financial Accounting Standards No. 141, "Business Combinations" ("FAS
141"), and No. 142, "Goodwill and Other Intangible Assets" ("FAS 142"). FAS
141 is effective for all business combinations initiated after June 30,
2001, and FAS 142 is effective for fiscal years beginning after December
15, 2001. Under the new rules, goodwill will no longer be amortized, but
will be subject to impairment tests conducted at least annually in
accordance with the new standards. Intangible assets that do not have
indefinite lives will continue to be amortized over their estimated useful
lives. LNC is required to adopt the new rules on accounting for goodwill
and other intangible assets effective January 1, 2002.
Although the review is ongoing regarding proper classification of goodwill
and other intangible assets on the consolidated balance sheet, LNC does not
expect to reclassify any goodwill or other intangible balances held as of
December 31, 2001. Application of the non-amortization provisions of the
new standards is expected to result in an increase in net income of $41.7
million ($0.22 per share based on the average diluted shares for the year
ended December 31, 2001) in 2002. During the first six months of 2002, LNC
will perform the first of the required impairment tests of goodwill as of
January 1, 2002. LNC expects that the valuation techniques to be used to
estimate the fair values of the group of assets comprising the different
reporting units will vary based on the characteristics of each reporting
unit's business and operations. A discounted cash flow model is expected to
be used to assess the goodwill in LNC's Life Insurance, Annuities and
Lincoln UK segments and a valuation technique combining multiples of
revenues, earnings before interest, taxes, depreciation and amortization
("EBITDA") and assets under management is expected to be used to assess the
goodwill in LNC's Investment Management segment. Based upon preliminary
analysis of the fair value of each reporting unit which has a goodwill
asset, the estimated fair value of each reporting unit exceeds the carrying
value of each reporting unit. Therefore, LNC does not expect to record an
impairment loss on its goodwill during the transition period for adoption
of FAS 142.
Accounting for the Impairment or Disposal of Long-Lived Assets
In August 2001, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 144, "Accounting for the Impairment
or Disposal of Long-Lived Assets" ("FAS 144"), which addresses financial
accounting and reporting for the impairment or disposal of long-lived
assets and supersedes SFAS No. 121, "Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to be Disposed Of," and the
accounting and reporting provisions of APB Opinion No. 30, "Reporting the
Results of Operations" for a disposal of a segment of a business. FAS 144
is effective for fiscal years beginning after December 15, 2001. LNC
expects to adopt FAS 144 as of January 1, 2002 and it does not expect that
the adoption of the Statement will have a significant impact on the
consolidated financial position and results of operations of LNC.
Reorganization of Reporting Segments and Changes Related to Inter-segment
Transactions
For discussion of the reorganization of the reporting segments and changes
to inter-segment transactions effective on January 1, 2001 refer to Note 9
to the consolidated financial statements.
Restructuring Charges
During 1998, LNC implemented a restructuring plan relating to the
integration of existing life and annuity operations with the new business
operations acquired from CIGNA Corporation ("CIGNA"). A second
restructuring plan relating to the streamlining of LNC's corporate center
operations was also implemented during 1998. The aggregate charges
associated with these two unrelated restructuring plans totaled $34.3
million after-tax ($52.8 million pre-tax). The restructuring plan relating
to the integration of existing life and annuity operations with the new
business operations acquired from CIGNA was completed in the first quarter
of 2000 and the restructuring plan relating to the streamlining of LNC's
corporate center was completed in the fourth quarter of 2000 except for the
ongoing rents on abandoned facilities which are expected to continue until
early 2002. During the fourth quarter of 2000, $0.5 million (pre-tax) of
the original charge was reversed as a reduction in restructuring costs, due
primarily to changes in severance and outplacement costs. More employees
whose positions were eliminated under the restructuring plan found
employment in other areas of LNC than had been originally anticipated;
therefore, actual severance and outplacement costs were less than
previously estimated. Actual pre-tax costs totaling $56.1 million have been
expended or written off for both plans through December 31, 2001. The
remaining aggregate reserve balance of $0.3 million for the restructuring
plan relating to LNC's corporate center is anticipated to be utilized in
the completion of this restructuring plan. (See Note 12 to the consolidated
financial statements for details regarding the 1998 restructuring plans.)
During 1999, LNC implemented restructuring plans relating to 1) the
downsizing and consolidation of the operations of Lynch & Mayer, Inc.
("Lynch & Mayer"); 2) the discontinuance of HMO excess-of-loss reinsurance
programs and 3) the streamlining of Lincoln UK's operations. The aggregate
charges associated with these three unrelated restructuring plans totaled
$21.8 million after-tax ($31.8 million pre-tax). During the fourth quarter
of 1999, $3.0 million (pre-tax) of the original charge recorded for the
Lynch & Mayer restructuring plan was reversed as a reduction of
restructuring costs due primarily to a change in estimate for costs
associated with abandoned leased office space. In addition, during the
fourth quarter of 1999, $1.5 million (pre-tax) associated with lease
terminations was released into income. During the fourth quarter of 2000,
the Lynch & Mayer restructuring plan was completed and $0.3 million
(pre-tax) of the original charge recorded was reversed as Lynch & Mayer was
able to successfully exit certain contracts without any further obligations
or penalties. Also, during the fourth quarter of 2000, $1.0 million
(pre-tax) of the original charge for the discontinuance of HMO
excess-of-loss reinsurance programs was reversed due primarily to changes
in severance and outplacement costs. More employees whose positions were
eliminated under the restructuring plan found employment in other areas of
LNC than had been originally anticipated; therefore, actual severance and
outplacement costs were less than previously estimated. During the fourth
quarter of 2001, the remaining restructuring charge liability of $0.2
million relating to the HMO excess-of-loss reinsurance programs was
transferred to Swiss Re as part of its acquisition of LNC's reinsurance
operations. Actual pre-tax costs totaling $24.3 million have been expended
or written-off for all three plans through December 31, 2001. As of
December 31, 2001, a balance of $3.0 million remains in the restructuring
reserve for the Lincoln UK plan and is expected to be utilized in the
completion of this plan. Details of each of these three restructuring plans
are discussed in Note 12 to the consolidated financial statements.
During 2000, LNC implemented restructuring plans relating to 1) the
downsizing and consolidation of the operations of Vantage Global Advisors,
Inc. ("Vantage"); 2) the exit of all direct sales and sales support
operations of Lincoln UK and the consolidation of its Uxbridge home office
with its Barnwood home office, and 3) the downsizing and consolidation of
the investment management operations of Lincoln Investment Management. The
Vantage restructuring charge was recorded in the second quarter, the
Lincoln UK restructuring charge was recorded in the third and fourth
quarters, and the Lincoln Investment Management restructuring charge was
recorded in the fourth quarter of 2000. The aggregate charges associated
with all restructuring plans entered into during 2000 totaled $81.8 million
after-tax ($107.4 million pre-tax). The component elements of these
aggregate pre-tax costs include employee severance and termination benefits
of $33.8 million, write-off of impaired assets of $40.9 million and other
exit costs of $32.7 million. During the fourth quarter of 2000, $0.6
million (pre-tax) of the original charge recorded for the Vantage
restructuring plan was reversed as a reduction of restructuring costs due
primarily to changes in estimates associated with severance and abandoned
leased office space costs. Actual pre-tax costs totaling $90.6 million have
been expended or written off for these plans through December 31, 2001. As
of December 31, 2001, a balance of $16.2 million remains in the
restructuring reserves for these plans and is expected to be utilized in
the completion of the plans. Details of each of these restructuring plans
are discussed in Note 12 to the consolidated financial statements.
During 2001, LNC implemented restructuring plans relating to 1) the
consolidation of the Syracuse operations of Lincoln Life & Annuity Company
of New York into the Annuities segment operations in Fort Wayne, Indiana
and Portland, Maine; 2) the elimination of duplicative functions in the
Schaumburg, Illinois operations of First Penn-Pacific, and the absorption
of these functions into the Annuities and Life Insurance segment operations
in Fort Wayne, Indiana and Hartford, Connecticut; 3) the reorganization of
the life wholesaling function within the independent planner distribution
channel, consolidation of retirement wholesaling territories, and
streamlining of the marketing and communications functions in LFD; 4) the
reorganization and consolidation of the life insurance operations in
Hartford, Connecticut related to the streamlining of underwriting and new
business processes and the completion of outsourcing of administration of
certain closed blocks of business; 5) the consolidation of the Boston,
Massachusetts investment office with the Philadelphia, Pennsylvania
investment operations in order to eliminate redundant facilities and
functions within the Investment Management segment 6) the combination of
LFD channel oversight, positioning of LFD to take better advantage of
ongoing "marketplace consolidation" and expansion of the customer base of
wholesalers in certain territories and 7) the consolidation of operations
and space in LNC's Fort Wayne, Indiana operations. In light of LNC's
divestiture of its reinsurance operations, which were headquartered in Fort
Wayne, excess space and printing capacity will not be used. The Syracuse
restructuring charge was recorded in the first quarter of 2001, the
Schaumburg, Illinois restructuring charge was recorded in the second
quarter of 2001, the LFD restructuring charges were recorded in the second
and fourth quarters of 2001, and the remaining restructuring charges were
all recorded in the fourth quarter of 2001. The aggregate charges
associated with all restructuring plans entered into during 2001 totaled
$24.6 million after-tax ($38.0 million pre-tax). The component elements of
these aggregate pre-tax costs include employee severance and termination
benefits of $12.2 million, write-off of impaired assets of $3.3 million and
other exit costs of $22.5 million primarily related to the termination of
equipment leases ($1.4 million) and rent on abandoned office space ($20.0
million). Actual pre-tax costs totaling $6.1 million have been expended or
written off for these plans through December 31, 2001. As of December 31,
2001, a balance of $31.9 million remains in the restructuring reserves for
these plans and is expected to be utilized in the completion of the plans.
Details of each of these restructuring plans are discussed in Note 12 to
the consolidated financial statements.
Divestiture
On December 7, 2001, Swiss Re acquired LNC's reinsurance operation for
$2.0 billion. In addition, LNC retained the capital supporting the
reinsurance operation. After giving affect to the increased levels of
capital needed within the Life Insurance and Annuity segments that
result from the change in the ongoing mix of business under LNC's
internal capital allocation models, the disposition of LNC's reinsurance
operation has freed-up approximately $100 million of capital. The
transaction structure involved a series of indemnity reinsurance
transactions combined with the sale of certain stock companies that
comprised LNC's reinsurance operation. An immediate gain of $15.0
million after-tax was recognized on the sale of the stock companies.
Under the indemnity reinsurance agreements, Swiss Re reinsured certain
liabilities and obligations of LNC. Because LNC is not relieved of its
legal liability to the ceding companies, in accordance with Statement of
Financial Accounting Standards No. 113, "Accounting and Reporting for
Reinsurance of Short-Duration and Long-Duration Contracts" ("FAS 113"),
the liabilities and obligations associated with the reinsured contracts
remain on the consolidated balance sheets of LNC with a corresponding
reinsurance receivable from Swiss Re.
A gain of $723.1 million ($1.1 billion pre-tax) was generated under the
indemnity reinsurance agreements. This gain was recorded as a deferred
gain on LNC's consolidated balance sheet in accordance with the
requirements of FAS 113 and is being amortized into earnings at the rate
that earnings on the reinsured business are expected to emerge, over a
period of seven to 15 years on a declining basis. During 2001, LNC
recognized in Other Operations $5.0 million ($7.9 million pre-tax) of
deferred gain amortization. In addition, LNC recognized $7.9 million
($12.5 million pre-tax) of accelerated deferred gain amortization
relating to the fact that certain Canadian indemnity reinsurance
contracts were novated after the sale, but prior to year-end.
LNC and Swiss Re have not agreed upon the final closing financial
statements associated with the December 7, 2001 transactions. There are
currently disputed matters of approximately $500 million, which relate
primarily to personal accident business reserves and recoverables. LNC's
ongoing indemnification to Swiss Re on the underlying reinsurance
business is limited to the personal accident business. Pursuant to the
purchase agreement, LNC's exposure is capped at $100 million ($65
million after-tax) for net future payments under the personal accident
programs in excess of $148 million, which represents the personal
accident liabilities net of the assets held for reinsurance recoverable
at December 31, 2000. Up to $200 million of net payments in excess of
the net liabilities will be shared on a 50/50 basis between LNC and
Swiss Re. LNC has no continuing indemnification risk to Swiss Re on
other reinsurance lines of business including disability income, HMO
excess-of-loss, group carrier medical and property and casualty
reinsurance lines.
Under the timeframe provided for within the acquisition agreement for
dispute resolution, it is probable that the earliest point that these
matters will be agreed upon would be the second quarter of 2002. If the
parties are unable to reach agreement, and these matters go to
arbitration, an ultimate resolution of these matters may take several
additional months.
Upon reaching agreement as to the final closing financial statements, it
is possible that LNC could record adjustments to realized gain or loss
on the sale of subsidiaries, to income from operations, or to the amount
of deferred gain associated with the Swiss Re transaction. Another
aspect of a potential dispute resolution could result in LNC agreeing to
transfer assets to Swiss Re until the adequacy of certain reserves and
related recoverables can be determined. In that event, LNC's future
investment income would be reduced to the extent that any such dispute
resolution would result in Swiss Re's retention of the related
investment income during the time frame that Swiss Re would hold the
invested assets. While uncertainty exists as to how these disputed
matters will finally be resolved, at the present time LNC believes the
amounts reported within LNC's consolidated financial statements as of
and for the year ended December 31, 2001 represent the best estimate of
the ultimate outcome of Swiss Re's acquisition of LNC's reinsurance
business.
While LNC has limited its indemnification to Swiss Re, as previously
noted, under FAS 113 LNC will continue to report the reserves subject to
the indemnity reinsurance agreements with Swiss Re on LNC's consolidated
balance sheet with an offsetting reinsurance recoverable from Swiss Re.
In the event that future developments indicate that the reserves related
to certain businesses should be adjusted, LNC would be required under
FAS 113 to recognize the changes in reserves in earnings in the period
of change. Any change to the reinsurance recoverable from Swiss Re would
be recorded as an adjustment to the amount of deferred gain.
In addition to the transactions completed on December 7, 2001, LNC has
the right to "put" its interest in a subsidiary company containing LNC's
disability income reinsurance business to Swiss Re during May 2002 for
$10 million. Developments on the underlying disability income
reinsurance business will not affect the price at which LNC may put the
subsidiary company to Swiss Re. LNC is free to market this company to
other buyers. If, prior to May 31, 2002, LNC is unable to sell this
company to other bidders for more than $10 million, LNC intends to
exercise the Swiss Re put. The $10 million exercise price is
approximately equal to LNC's book basis in the subsidiary.
Approximately $565 million of the proceeds from the transaction will be
used to pay taxes and associated deal costs, leaving LNC with $1.4
billion of after-tax net proceeds from Swiss Re. In addition, LNC has
approximately $100 million of freed-up capital resulting from the
reinsurance disposition. Prior to December 31, 2001, LNC used $115
million to repurchase shares of LNC stock and $166.3 million was used to
reduce outstanding short-term debt. LNC may use the remainder of the
proceeds to purchase another organization or block of business within
the financial services industry or to repurchase its debt or stock. As
LNC evaluates opportunities in the financial services industry, it will
invest the proceeds in high quality, liquid investment instruments and
may retire additional portions of its debt and repurchase shares of its
common stock.
Effective with the closing of the transaction, the Reinsurance segment's
results for the eleven months ended November 30, 2001 and the years
ended December 31, 2000, 1999, 1998 and 1997 were moved into "Other
Operations."
RESULTS OF OPERATIONS BY SEGMENT
- --------------------------------------------------------------------------------------------------
Annuities
The Annuities segment (effective March 7, 2002, this segment will be known
as Lincoln Retirement), headquartered in Fort Wayne, Indiana, provides
tax-deferred investment growth and lifetime income opportunities for its
clients through the manufacture and sale of fixed and variable annuities.
Through a broad-based distribution network, the Annuities segment provides
an array of annuity products to individuals and employer-sponsored groups
in all 50 states of the United States. The Annuities segment distributes
some of its products through LNC's wholesaling unit, LFD, as well as LNC's
retail unit, LFA. In addition, the Annuities segment has alliances with a
variety of unrelated companies in which LNC provides the manufacturing
platform for annuity products and the alliance company provides investment
management, marketing and distribution.
Results of Operations(1): The Annuities segment's financial results and account values were as follows:
Year Ended December 31 (in millions) 2001 2000 1999 1998 1997
- ----------------------------------------------------------------------------------------------------------
Income from Operations $320.3 $362.0 $299.4 $262.4 $223.0
Realized Gain (Loss) on Investments and
Derivative Instruments (after-tax) (42.5) (3.4) (7.9) 11.4 40.3
Restructuring Charge (after-tax) (1.3) -- -- -- --
- ----------------------------------------------------------------------------------------------------------
Income before Cumulative Effect
of Accounting Changes 276.5 358.6 291.5 273.8 263.3
Cumulative Effect of Accounting Changes
(after-tax)(2) (7.3) -- -- -- --
- ----------------------------------------------------------------------------------------------------------
Net Income $269.2 $358.6 $291.5 $273.8 $263.3
==========================================================================================================
December 31 (in billions) 2001 2000 1999 1998 1997
- ----------------------------------------------------------------------------------------------------------
Account Values (3)
Variable Annuities $34.6 $39.4 $41.5 $33.4 $27.3
Fixed Annuities 18.0 16.6 18.2 18.1 17.2
Reinsurance Ceded (1.5) (1.2) (1.4) (1.6) (1.7)
- ----------------------------------------------------------------------------------------------------------
Total Fixed Annuities 16.5 15.4 16.8 16.5 15.5
- ----------------------------------------------------------------------------------------------------------
Total Account Values $51.1 $54.8 $58.3 $49.9 $42.8
==========================================================================================================
(1) The 1997-2000 data was restated from the prior year due to the
following changes which were effective on January 1, 2001: 1) management
and reporting of First Penn-Pacific's ("First Penn") annuities business was
moved from the Life Insurance segment to the Annuities segment; 2) certain
revenues and costs associated with the wholesale distribution of
annuities, life insurance and investment management products were moved to
LFD under "Other Operations" and a transfer pricing arrangement was
established between LFD and the affected segments to compensate LFD for
sales; and 3) a change in pricing of the management of general account
investments performed by the Investment Management segment to a "for
profit" basis from the previously reported "at cost" basis.
(2) Cumulative Effect of Accounting Changes relates to the transition
adjustment of $(3.6) million recorded in the first quarter of 2001 upon
adoption of FAS 133 and the adjustment of $(3.7) million recorded in the
second quarter of 2001 upon adoption of EITF 99-20. (Refer to page 40 for
further discussion of these items.)
(3) Account values for 1997-2000 were restated from the prior year due to
the change in reporting of First Penn's annuities business from the Life
Insurance segment to the Annuities segment effective January 1, 2001.
Comparison of 2001 to 2000
The $89.4 million or 25% decrease in net income was due in part to an
increase in realized loss on investments and derivative instruments of
$39.1 million. These investment losses were due primarily to losses taken
on Enron and Argentina securities in the fourth quarter of 2001 in addition
to increased write-downs of other securities throughout 2001 due to credit
deterioration. Net income for 2001 also included two restructuring charges
recorded in the first and second quarters of 2001 of $0.7 million and $0.6
million, respectively. The $0.7 million charge recorded in the first
quarter of 2001 related to the consolidation of the Syracuse operations of
Lincoln Life & Annuity Company of New York into the Annuities segment
operations in Fort Wayne, Indiana and Portland, Maine, in order to reduce
ongoing operating costs and eliminate redundant facilities. The $0.6
million charge recorded in the second quarter of 2001 related to a
restructuring plan for First Penn-Pacific with the objective of eliminating
duplicative functions in Schaumburg, Illinois by transitioning them into
the Annuities and Life Insurance segment operations in Fort Wayne, Indiana
and Hartford, Connecticut, respectively, in order to reduce ongoing
operating costs. For further discussion of these restructuring plans refer
to Note 12 to the consolidated financial statements. Discussion of the
other causes of the decrease in net income between years is included below
in the discussion of the change in income from operations.
The $41.7 million or 12% decrease in income from operations in 2001 was
primarily attributable to the weak equity markets that caused variable
annuity account values to be depressed throughout 2001. Fee income, which
is calculated daily based on the ending variable annuity account values,
decreased $48.9 million between years as a result of market depreciation
experienced in the last quarter of 2000 and overall in 2001 and to a lesser
extent, net cash outflows for variable annuities in 2000. Average variable
annuity account values decreased by $6.7 billion or 16.0% in 2001. Variable
annuity net cash flows (including the fixed portion of variable contracts)
were essentially zero for 2001 due to a strong second half of the year (see
below for further discussion of cash flows). Partially offsetting the
decrease in fee income was a $6.2 million positive fee income rate variance
related to a change in mix of the variable annuity business. The downturn
in the equity markets also contributed to an increase of $7.3 million in
benefit payments and reserve requirements for guaranteed minimum death
benefits. Average fixed annuity account values decreased by $331 million or
1.9% in 2001 due to net cash outflows in 2000. This decreased earnings by
$1.4 million between years. As a result of improved retention and lower
account values in 2001, surrender charges decreased $6.9 million between
years.
Increased operating and administrative expenses of $16.2 million also
contributed to the decrease in earnings between years. This increase was
due primarily to higher information technology costs including computer
software write-offs and equipment amortization, as well as increased
severance and relocation costs related to LNC's initiative to build a high
performance culture.
Net investment income decreased between years due primarily to reduced
earnings of $5.2 million on investment partnerships. Overall investment
spreads on fixed annuity products (excluding the impact of investment
income earned on surplus supporting the segment which includes investment
partnerships) were relatively flat between years: 1.54% in 2001 and 1.53%
in 2000. In reviewing the results of fixed annuities, investment spread is
a key performance measure. LNC defines investment spread as the difference
between the average net investment income earned on the underlying
investment portfolio and the average crediting rates paid on the fixed
annuity contracts. Net investment income includes investment management
expenses and portfolio risk management expenses.
Amortization of deferred acquisition costs ("DAC") is also impacted by the
change in market value of variable annuity accounts. Statement of Financial
Accounting Standard No. 97, "Accounting by Insurance Companies for Certain
Long-Duration Contracts & Realized Gains & Losses on Investment Sales"
("FAS 97") requires that acquisition costs for variable annuity contracts
be amortized over the lives of the contracts in relation to the incidence
of estimated gross profits. Estimated gross profits on variable annuity
contracts vary based on surrenders, fee income, expenses and realized
gains/losses on investments. The amortization is adjusted retrospectively
(DAC unlocking) when estimates of current or future gross profits to be
realized from variable annuity contracts are revised. Because equity market
movements have a significant impact on fee income, estimated future profits
increase or decrease accordingly. On a quarterly basis, LNC reviews the
assumptions of its DAC amortization model and records a retrospective
adjustment to the amount expended, (i.e. unlocks the DAC). On an annual
basis, LNC reviews and adjusts as necessary its assumptions for prospective
amortization of DAC, as well as its other intangible asset, present value
of in-force ("PVIF").
The Annuities segment experienced negative DAC unlocking in the first and
third quarters of 2001 and positive unlocking in the second and fourth
quarters of 2001 due to movements in the market. DAC unlocking created a
negative variance in earnings of $4.0 million compared to 2000. Due to
changes in assumptions for prospective DAC amortization made at the
beginning of 2001, the Annuities segment experienced a decrease in DAC
amortization expense of $37.8 million relative to 2000. Prospective
unlocking for PVIF is conducted in the fourth quarter of each year. This
unlocking created a positive variance of $4.5 million between years, which
was caused by improved persistency in 2001 and lower expense projections.
As illustrated in the discussion of the Annuities segment's results of
operations above, the segment earnings are extremely sensitive to swings in
the equity markets. Thus, in 2002, the following guidance can be used to
determine the estimated annualized impact on segment earnings of a one
percent change in the equity markets: total impact is $4.3 million
consisting of $2.5 million in fee income, $0.7 million in guaranteed
minimum death benefit reserves and claims, $0.4 million in DAC adjustments
and $0.7 million in other areas. These estimates could change if there is a
significant shift in the market and/or in the mix of business.
Comparison of 2000 to 1999
The $67.1 million or 23% increase in net income and the $62.6 million or
21% increase in income from operations in 2000 were primarily driven by
growth in fee income from variable annuities. Average variable annuity
account values for 2000 as compared to 1999 were $5.8 billion greater which
contributed $40.4 million of additional earnings. In addition, the mix of
variable annuity accounts changed in 2000 toward higher fee products, which
contributed $5.6 million of income. The Annuities segment also reported
additional earnings of $20.7 million due to increased dividend received
deductions flowing from variable annuity business. The Annuities segment
also had an increase in earnings of $7.4 million due to increased income on
surplus investments. Finally in 2000, changes in various assumptions
relating to a block of annuity business acquired from CIGNA in 1998
resulted in $6.1 million of income.
The noted increases in earnings for 2000 were partially offset by a $19.0
million decrease in earnings resulting from lower investment margins on
fixed annuities. This was attributed to a $684.0 million decrease in
average fixed annuity values coupled with an increase in crediting rates in
2000 as compared to 1999. Also, changes in assumptions underlying the
amortization of deferred acquisition costs and PVIF resulted in additional
expense of $8.2 million. The downturn in the equity markets and increase in
net cash outflows during 2000 resulted in lowered estimates of future gross
profits and increased amortization expense via DAC unlocking.
The investment spreads on fixed annuities were 1.53% and 1.62% in 2000 and
1999, respectively. The decrease between years resulted from a change in
mix of crediting rates on fixed annuities and the accelerated recognition
of amortization of premium on certain securities in accordance with
accounting guidelines.
Cash Flows (1)
The Annuities segment's product cash flows were as follows:
Year Ended December 31 (in billions) 2001 2000 1999 1998 1997
- --------------------------------------------------------------------------------------------------
Variable Portion of Annuity Deposits $3.1 $3.1 $2.6 $2.8 $2.7
Variable Portion of Annuity Withdrawals (3.9) (4.8) (3.8) (3.0) (2.0)
- --------------------------------------------------------------------------------------------------
Variable Portion of Annuity Net Flows (0.8) (1.7) (1.2) (0.2) 0.7
Fixed Portion of Variable Annuity Deposits 1.6 1.6 1.9 1.0 1.2
Fixed Portion of Variable Annuity
Withdrawals (0.8) (1.0) (1.2) (1.1) (1.0)
- --------------------------------------------------------------------------------------------------
Fixed Portion of Variable Annuity
Net Flows 0.8 0.6 0.7 (0.1) 0.2
Fixed Annuity Deposits 1.7 0.5 0.7 0.5 0.4
Fixed Annuity Withdrawals (1.6) (2.3) (1.4) (1.4) (1.2)
- --------------------------------------------------------------------------------------------------
Fixed Annuity Net Flows 0.1 (1.8) (0.7) (0.9) (0.8)
Total Annuity Net Flows $0.1 $(2.9) $(1.2) $(1.2) $0.1
Incremental Deposits (2) $5.8 $4.6 $4.7 $3.9 $4.0
(1) Cash flows for 1997-2000 were restated from the prior year due to the
change in reporting of First Penn's annuities business from the Life
Insurance segment to the Annuities segment effective January 1, 2001.
(2) Incremental Deposits represent gross deposits reduced by transfers from
other Lincoln Annuity products.
Key to sustaining profitable future earnings growth for both fixed and
variable annuity products is the ability to attract new deposits and to
retain existing accounts. In 2001, the Annuities segment achieved positive
net cash flows in a quarter and for the year for the first time since the
second quarter of 1997 and for the full year 1997, respectively. For 2001,
total annuity deposits were $6.4 billion and withdrawals were $6.3 billion,
resulting in positive net cash flows of $0.1 billion. LNC reached positive
net cash flows in the third quarter of 2001, which was one quarter earlier
than LNC's goal to achieve net positive cash flows for total annuities by
the fourth quarter of 2001. For 2000, total annuity deposits were $5.2
billion and withdrawals were $8.1 billion, resulting in net cash outflows of
$2.9 billion. For 1999, total annuity deposits were $5.2 billion and
withdrawals were $6.4 billion, resulting in net cash outflow of $1.2
billion. Total incremental deposits were $5.8 billion in 2001, $4.6 billion
in 2000 and $4.7 billion in 1999. Incremental deposits represent gross
deposits reduced by transfers from other Lincoln annuity products.
The growth rate of gross deposits in 2001 was 23%, while incremental
deposits grew 26% between years. Gross deposits were flat in 2000, while
incremental deposits decreased 2% between years. The significant growth in
gross deposits in 2001 was due to the reemergence of LNC's fixed annuity
products. Fixed annuity deposits (excluding the fixed portion of variable
annuity contracts) grew $1.2 billion or 240% in 2001. Fixed annuity
deposits were bolstered by two new product introductions,
StepFive(registered trademark) and Lincoln ChoicePlus(Service Mark) Fixed,
that occurred in the first quarter and second quarter of 2001,
respectively, along with overall increased demand for fixed annuities given
the uncertain equity markets. Variable annuity deposits (including the
fixed portion of variable annuity contracts) were flat between years. These
stable sales levels are counter to the overall industry, which experienced
a 16.7% downturn in sales due to the declining equity markets (VARDS - Top
100 Variable Annuity Contracts Ranked by New Sales - 2001). LNC's ability
to continue to generate significant variable annuity sales in such a
difficult market is due to a balanced array of products and distribution
breadth (see below for additional discussion of LNC's new product
introductions and product features). LNC's gross deposits growth rate
decreased from 1999 to 2000 and incremental deposits did not grow in 2000,
but the deposit trend did improve in the last quarter of 2000 after LNC
introduced many new variable annuity products in the third quarter of 2000.
Total account withdrawals decreased $1.8 billion or 22% in 2001. This was
in contrast to LNC's experience over the previous two years when
withdrawals grew $1.7 billion or 27% from 1999 to 2000. These results are
attributed to LNC's targeted conservation efforts on both fixed and
variable annuity product lines. In addition, heightened scrutiny by
regulators of tax-free exchanges of non-qualified variable annuity
contracts appears to be reducing the frequency of such exchanges on an
industry-wide basis. Finally, clients whose variable annuity contracts have
guaranteed minimum death benefits that are in the money due to the equity
market declines that have occurred over the last year or so are less likely
to transfer from these contracts.
In looking at annuity withdrawals and the overall profitability of the
business, it is important to look beyond the mere total dollar amount of
withdrawals and assess how total withdrawals compare to total retained
account values. These measures of account persistency are referred to as
lapse rates, which are key elements to assessing underlying profitability.
By comparing actual lapse rates to the rates assumed in designing the
annuity product, it is possible to gauge whether performance is better or
worse than pricing. Overall lapse rates were 9.72% in 2001, 11.95% in 2000
and 9.58% in 1999. In all three years, overall lapse rates have been more
favorable than expected in pricing assumptions. In 2001, the improvement in
persistency partially countered the reduction in fee income resulting from
lower average variable annuity account values caused by market
depreciation.
LNC is encouraged by the significant improvement in retention and by the
overall positive net cash flows in 2001, but needs to sustain and further
strengthen this positive trend into 2002 and beyond. LNC is continuing its
proactive two-pronged approach to strengthening annuity net cash flows:
retention of assets and growth of new deposits.
Retention of Assets
LNC has built a significant and seasoned book of business with many annuity
accounts out of the surrender charge period, which is the period during
which a policyholder must pay a surrender charge to terminate the account.
To illustrate this, LNC's variable annuity assets were the fourth highest
in the industry as of December 31, 2001 (VARDS - Top 25 Variable Annuity
Assets by Issuer 2001 Year-end), down from third highest in 2000 due to the
merger of two large competitors. Prior to the downturn in the equity
markets, this large and seasoned block of business was clearly more
vulnerable to competitors offering products with financial incentives
designed to increase market share. LNC's retention efforts on the
individual variable annuity side are focused on the rollout of exemptive
relief and the Income4Life(Service Mark) Solution (see Growth of New
Deposits below for further discussion of the Income4Life Solution). In
addition, on both the individual fixed and variable annuity side, targeted
conservation efforts with key accounts will continue in 2002.
With regard to exemptive relief, in December of 2000, the Annuities
segment filed with the SEC seven options for its American Legacy I and II
products. The options include a bonus on current account value, an enhanced
guaranteed death benefit rider or an estate enhancement death benefit
rider. In exchange for these favorable benefits to the contractholder, a
new surrender charge period applicable to the entire account would be
imposed. The surrender charge period would be for at least the same term
and of the same magnitude as the original surrender charge period. The
segment received approval from the SEC to upgrade out-of-surrender
contracts of existing American Legacy contractholders in 2001. However,
tentative approval of the exchange options was not received until the end
of the fourth quarter of 2001. This approval allows contractholders to
exchange existing American Legacy II contracts for either an American
Legacy III or American Legacy III Plus bonus contract. LNC plans to rollout
these approved programs on a pilot basis to select broker/dealers by the
second quarter of 2002.
LNC believes that the options and benefits that exemptive relief will
provide its more seasoned American Legacy contractholders, coupled with the
superior, long-term strength of the underlying investment options of the
product, American Funds Insurance Series(Service Mark), will help stem the
flow of exchanges to competitors' bonus products.
There have also been significant efforts on the employer-sponsored side of
the business to address redemptions in group contracts. The product
portfolio of this division includes the Multi-Fund(registered trademark)
Variable Annuity (group and individual), Group Variable Annuity, fixed
annuities and the Alliance Program. The account values of these products
represent approximately one-third of total annuity account values as of
December 31, 2001.
The Multi-Fund(registered trademark) product was ranked 19th in variable
annuity sales for 2001 (VARDS - Top 25 Variable Annuity Contract Sales -
2001 Year-end) and historically was the flagship product of the
employer-sponsored business. However, preferences of the marketplace have
changed and the Alliance Program has become the product of choice for new
programs and is now an essential part of the strategy to retain older
Multi-Fund business as well. Begun in 1998, the Alliance Program combines
plan expertise with the flexibility and performance of mutual funds and a
fixed annuity. It offers over 200 mutual fund families representing over
2000 mutual funds. Another effort to stem outflows from the
Multi-Fund(registered trademark) product line is based on exemptive relief.
An exemptive relief program for certain Multi-Fund(registered trademark)
variable annuity products was filed with the SEC in 2001. Like the American
Legacy exemptive relief program, this program, once approved by the SEC,
will be rolled out on a pilot basis to select broker/dealers. In 2001, as a
result of the ongoing efforts to retain and grow new business, the
employer-sponsored market's gross deposits grew 9% in 2001 and incremental
deposits increased by 10% from $1.60 billion in 2000 to $1.76 billion in
2001. Future net cash flows of employer-sponsored products, however, can be
extremely volatile quarter-to-quarter based on the large size of accounts
won and lost in this market.
Growth of New Deposits
LNC's efforts to grow new deposits over the last two years have focused on
both product and distribution breadth. LNC introduced more new annuity
products in the year 2000 than it had in the last five years. These product
introductions were concentrated in the third quarter of 2000. LNC continued
its focus on new and innovative product launches in 2001 when it introduced
a new L-share version for the American Legacy product line. LNC also
launched a new series of Lincoln ChoicePlus products which incorporate
LNC's new Elite Series fund line-up and includes an L-share version of the
product. A new series of variable annuity products was also developed for
sale by Wells Fargo in 2001; the New Directions Variable Annuity. This
series includes an L-share as well. L-shares are no front-end load shares
that carry a four-year surrender charge period with an up front commission
structure like that of B-shares, but trail commissions are higher. These
shares are preferred within the Financial Institutions channel. Finally, as
noted previously, two new fixed annuity products were introduced in 2001
which were the catalyst of the growth in total annuity deposits. The
StepFive Fixed Annuity introduced in the first quarter of 2001 and the
ChoicePlus Fixed Annuity introduced in the second quarter of 2001 gained
momentum throughout the year and accounted for $1.4 billion of gross
deposits for the year.
The Income4Life Solution is an innovative product feature that was
initially offered by LNC on most of its manufactured individual variable
annuities beginning in the third quarter of 2001. This feature allows
contractholders access and control during the distribution of their
retirement account assets. This added flexibility allows the contractholder
to access the account value daily for transfers, additional withdrawals and
other service features like portfolio rebalancing. Income4Life provides a
new value proposition in which a customer investing with LNC gains an
account balance that is also a death benefit plus an income stream. As
noted above, LNC does not only expect to attract new deposits with this
innovative feature, but is hoping that it will be a strong vehicle for
encouraging contractholders to maintain their accounts with LNC. The
initial response has been encouraging for this feature with over $50
million of elections received in the second half of 2001.
Another product feature to be introduced in the first quarter of 2002 is
the Accumulated Benefit Enhancement ("ABE") rider which lets clients
transfer their balances to LNC variable annuity products and retain the
death benefit of their prior variable annuity. This rider is available on
all share classes of most LNC variable annuity product lines with no
additional charge.
LNC also continues to build upon one of its key strengths, distribution
breadth. In 2001, LNC strengthened its American Funds Distributors ("AFD")
alliance by adding a team of 19 dedicated American Legacy Insurance
Planning Counselors ("Counselors"), who work exclusively with the AFD
wholesalers. An additional 10 Counselors are planned for 2002. Not only
does the AFD alliance provide LNC with distribution breadth, but it also
provides a product line with one of the most prominent and best performing
fund families in the industry, American Funds. According to the Variable
Annuity Research and Data Services ("VARDS"), the American Legacy III
Variable Annuity ranked number three out of 135 variable annuities for
asset-weighted performance for the three-year period ended December 31,
2001. Although the American Legacy variable annuity gross deposits of over
$1.9 billion for 2001 were down 10% from last year in what was a down
market for variable annuities, these results were again better than the
industry average. LNC's partnership with SEI Investments ("SEI") began in
the third quarter of 2000, but has been slow to take off. The SEI Variable
Annuity is manufactured by LNC and is distributed by SEI, a leader in the
largest distribution channel for annuities, the Independent Financial
Planner channel. Because of the slow sales of the SEI Variable Annuity ($82
million in 2001), LNC and SEI jointly committed to strengthen the alliance
by making revisions to the platform. In 2001, SEI hired a new national
sales manager with an annuity background and is adding a B-share product in
the second quarter of 2002.
LFD, LNC's wholesaling distribution arm and internal partner of the
Annuities segment, is providing a wholesaling unit for the distribution of
the Lincoln ChoicePlus(Service Mark) Variable Annuity, Lincoln ChoicePlus
Fixed Annuity and StepFive Fixed Annuity product lines. In 2001, LFD's
investment in dedicated annuity wholesalers in the Wire/Regional
distribution channel contributed greatly to the 19% increase in ChoicePlus
Variable Annuity sales which reached $747 million. LFD has also been a
driver of sales of the fixed annuity products through the Financial
Institutions channel and has partnered with Wells Fargo with a new variable
annuity product in this channel. LNC is continuing to build and reinvent
its strategic partnerships as part of its ongoing marketing strategy, while
selectively working on other alliances that will provide increased access
for LNC's annuity products through various distribution channels.
Outlook
With the objective of maintaining positive net cash flows in 2002, LNC is
aggressively pursuing ways to continue to grow deposits and retain existing
assets in what is considered a mature annuities market. At the same time,
LNC is focusing on effective expense management as a means to maintaining
profitability in an increasingly challenging market.
Life Insurance
The Life Insurance segment, headquartered in Hartford, Connecticut, focuses
on the creation and protection of wealth for its clients through the
manufacture and sale of life insurance products throughout the United
States. The Life Insurance segment offers, through its Hartford operations,
universal life, variable universal life, interest-sensitive whole life and
corporate owned life insurance. Additional offerings through its
Schaumburg, Illinois operations include term life, linked-benefit life,
universal life and variable universal life insurance products. All of the
Life Insurance segment's products are currently distributed through LFD
and LFA.
Results of Operations (1): The Life Insurance segment's financial results,
first year premiums by product, account values and in-force amounts were as
follows:
Year Ended December 31 (in millions) 2001 2000 1999 1998 1997
- --------------------------------------------------------------------------------------------------
Income from Operations $279.0 $259.9 $212.0 $149.2 $39.9
Realized Loss on Investments and
Derivative Instruments (after-tax) (36.9) (10.6) (0.5) (1.7) (0.8)
Restructuring Charges (after-tax) (3.5) -- -- (20.0) --
- --------------------------------------------------------------------------------------------------
Income before Cumulative Effect
of Accounting Changes 238.6 249.3 211.5 127.5 39.1
Cumulative Effect of Accounting Changes
(after-tax)(2) (5.5) -- -- -- --
- --------------------------------------------------------------------------------------------------
Net Income $233.1 $249.3 $211.5 $127.5 $39.1
First Year Premiums (by Product)
Universal Life $292.7 $289.3 $342.9 $233.0 $114.4
Variable Universal Life 219.5 208.6 128.7 86.0 52.9
Whole Life 26.4 22.4 24.0 19.5 4.5
Term 30.8 41.9 45.9 48.8 33.5
- --------------------------------------------------------------------------------------------------
Total Retail 569.4 562.2 541.5 387.3 205.3
Corporate Owned Life Insurance ("COLI") 47.2 87.0 14.7 4.0 0.0
- --------------------------------------------------------------------------------------------------
Total First Year Premiums $616.6 $649.2 $556.2 $391.3 $205.3
- --------------------------------------------------------------------------------------------------
December 31 (in billions) 2001 2000 1999 1998 1997
- --------------------------------------------------------------------------------------------------
Account Values
Universal Life $7.5 $6.9 $6.6 $6.3 $2.6
Variable Universal Life 1.7 1.8 1.6 1.2 0.5
Interest-Sensitive Whole Life 2.1 2.1 2.0 1.8 --
- --------------------------------------------------------------------------------------------------
Total Life Insurance Account Values $11.3 $10.8 $10.2 $9.3 $3.1
In Force - Face Amount
Universal Life and Other $121.2 $115.9 $109.3 $105.8 $32.8
Term Insurance 113.2 100.1 85.7 67.1 30.3
- --------------------------------------------------------------------------------------------------
Total In-Force $234.4 $216.0 $195.0 $172.9 $63.1
==================================================================================================
(1) See footnote (1) in the Annuities segment for a description of changes
in LNC's reported segments.
(2) Cumulative Effect of Accounting Changes relates to the transition
adjustment of $(0.2) million recorded in the first quarter of 2001 upon
adoption of FAS No. 133 and the adjustment of $(5.3) million recorded in
the second quarter of 2001 upon adoption of EITF 99-20. (Refer to page 40
for further discussion of these items.)
Comparison of 2001 to 2000
The $16.2 million or 6% decrease in net income in 2001 was due primarily to
increased realized losses on investments and derivative instruments of
$26.3 million. The Life Insurance segment also incurred two restructuring
charges in the second and fourth quarters of 2001 of $2.0 million and $1.5
million, respectively. The $2.0 million charge recorded in the second
quarter of 2001 related to a restructuring plan with the objective of
eliminating duplicative functions in the Schaumburg, Illinois operations of
First Penn-Pacific by transitioning them into the Annuities and Life
Insurance segment operations in Fort Wayne, Indiana and Hartford,
Connecticut, respectively, in order to reduce ongoing operating costs. The
$1.5 million charge recorded in the fourth quarter of 2001 was for the
reorganization and consolidation of the life insurance operations in
Hartford, Connecticut related to the streamlining of underwriting and new
business processes and the completion of outsourcing of administration of
certain closed blocks of business. For further discussion of these
restructuring plans refer to Note 12 to the consolidated financial
statements.
The $19.1 million or 7% increase in income from operations was primarily
attributable to growth in life insurance in-force from sales, favorable
persistency and lower general and administrative expenses partially offset
by unfavorable mortality and lower investment partnership earnings. General
and administrative expenses decreased due to expense reduction initiatives
implemented in the second half of 2001. LNC experienced poor mortality
throughout 2001 after having a favorable year in 2000. Partially
contributing to the downturn in mortality experience were the losses
recorded for the September 11 terrorist attacks. In the third quarter of
2001, LNC recorded a loss of $1.9 million related to the events of
September 11. However, in the fourth quarter of 2001, based upon actual
claims reported, a reduction in the estimated losses of $0.8 million was
recorded. Volatility is expected from mortality risk, but LNC attempts to
lessen the impact of volatility on earnings by reinsuring approximately 80%
of the Life Insurance segment's mortality risk.
FAS 97 requires that acquisition costs for universal life insurance ("UL")
policies and variable universal life insurance ("VUL") policies be
amortized over the lives of the contracts in relation to the incidence of
estimated gross profits, consistent with the treatment noted previously for
variable annuities. Factors affecting estimated gross profits are surrender
charges; investment, mortality net of reinsurance ceded and expense
margins; and realized gains/losses on investments. For VUL policies,
estimated gross profits are affected by fee income as well. For the Life
Insurance segment, based on the current mix of life insurance in-force on
the books, the factors that have the most significant impact on estimated
gross profits are mortality (net of reinsurance) and interest margins.
Market movement, which has the greatest impact on DAC amortization for the
Annuities segment relative to its variable annuity block of business, has
less impact on DAC amortization for the Life Insurance segment. The Life
Insurance segment earns fee income on its VUL product line based on the
ending daily VUL account values. While this line is the fastest growing
line for the segment, it only makes up 15% of the segment's total account
values at December 31, 2001. On a quarterly basis, LNC reviews the
assumptions of its DAC amortization model and records a retrospective
adjustment to the amount expended, (i.e. unlocks the DAC). In 2000 and
2001, the Life Insurance segment did not experience DAC unlocking that
resulted in a significant impact on earnings. On an annual basis, LNC
reviews and adjusts as necessary its assumptions for prospective
amortization of DAC, as well as its other intangible asset, PVIF.
Sales as measured by first year premiums were down overall in 2001 by $32.6
million or 5%. This decline was due to a $39.8 million decrease in
Corporate Owned Life Insurance ("COLI") sales. COLI sales, which consist of
very large cases, decreased from the prior year due to two large cases
accounting for $42.5 million in first year premiums recorded in the fourth
quarter of 2000. To bolster COLI sales in 2002 and beyond, LNC is
aggressively pursuing the COLI market, a market in which it has never
really been a significant player. To this end, LNC has hired new COLI
wholesalers and a new product developer.
First year premiums on retail products (excluding COLI) increased by $7.2
million or 1% between years. UL sales increased $3.4 million or 1% between
years. Although this overall increase is modest, sales in the fourth
quarter of 2001 were $98 million, a 20% increase over the prior year
quarter. Sales rebounded nicely in the fourth quarter after a volatile year
for UL sales. Due to the continued uncertainty surrounding the equity
markets going into 2002 along with new product introductions slated for the
first quarter of 2002, LNC expects to see strong sales growth in the
overall UL product line, including the survivorship UL product line. VUL
sales were up $10.9 million or 5% between years. These results were
encouraging given the performance of the equity markets in 2001. Over the
long-term, LNC expects that the VUL product line will be the greatest
contributor to sales growth, but in 2002, sales growth will be sensitive to
the performance of the equity markets given the sustained volatility that
has been experienced over the last year or so.
Partially offsetting the increased retail sales levels noted above was a
decrease in term life sales of $11.1 million or 26% between years. Term
life sales for the first six months of 2001 lagged the prior year period
largely due to strong first half of 2000 sales that were bolstered by the
impending enactment of the Valuation of Life Insurance Model Regulation
("Regulation XXX"). Regulation XXX required companies to increase reserves
relative to certain term life insurance policies as of January 1, 2000.
There was a rush of term business in anticipation of the related price
increases for implementation of Regulation XXX with sales up in the first
half of 2000 due to a backlog of business at December 31, 1999. Term sales
increased incrementally each quarter in 2001 and for the fourth quarter
were 20% higher compared to the same quarter in 2000. LNC is encouraged by
these results and based on the competitiveness of its product in the
marketplace expects sales to be strong in 2002.
Account values increased $0.5 billion or 5% to $11.3 billion at December
31, 2001 from $10.8 billion at the prior year-end. Positive cash flows for
the year of $1.2 billion were the main contributor to the increase between
years. Cash flows in 2001 were flat compared to the prior year. VUL account
values were down between years by $62 million due to market depreciation.
As illustrated in the discussion of the Life Insurance segment's results of
operations above, the segment earnings are not particularly sensitive to
swings in the equity markets. Thus, in 2002, the estimated annualized
impact on the segment earnings of a one percent change in the equity
markets (based on the S&P 500 index) is only $0.1 million.
Comparison of 2000 to 1999
The $37.8 million or 18% increase in net income and the $47.9 million or
23% increase in income from operations in 2000 were primarily attributable
to strong sales growth. Also contributing to the increased earnings were
favorable investment income and effective expense management. Non-volume
related expenses decreased in 2000 due primarily to lower year 2000 (Y2K)
information technology costs and lower general and administrative expenses.
First year premiums increased by $93 million or 17% in 2000. Account values
of universal life, variable universal life and interest-sensitive life
insurance products increased $0.6 billion or 6% from the end of 1999 to the
end of 2000. In-force increased $21 billion or 11% year-over-year. Policy
lapses in 2000 were in line with pricing assumptions for the year. The
sales growth was fueled by variable universal life ("VUL") and corporate
owned life insurance ("COLI") products, which had increased sales between
years of $79.9 million or 62% and $72.3 million or 492%, respectively.
The Life Insurance segment introduced two new single life VUL products in
1999 and a survivorship VUL product in May 2000, which were significant
drivers of this growth. Also, COLI sales were bolstered by a new corporate
VUL product, which was launched at the end of 1999. The increase in account
values was primarily due to the growth in business.
Product Development
Although the market response to VUL products has been the primary driver of
growth over the last three years, UL products have historically been the
flagship product line of the Life Insurance segment. To maintain its
competitive position with its flagship product line, UL, the Life Insurance
segment has had to continue to develop leading edge products that meet the
changing needs of its target market, the affluent. The segment introduced a
much anticipated new UL product in March of 2001 and the response to this
product has been very positive. Average first year premiums per month for
single-life UL sales over the last eight months of the year (since the
product's initial launch) were up over 80% from the monthly average for the
first four months of 2001.
The new UL product, Lincoln UL-III Life Protection, was designed to provide
flexibility and guaranteed death benefit coverage through its innovative
Lapse Protection Rider. The Rider is automatically included on all policies
at no additional charge. Unlike some premium-based guarantees, Lincoln
UL-III Life Protection and its Lapse Protection Rider offer policyholders
the flexibility to adjust or skip planned premium payments, borrow against
or withdraw a portion of the policy's cash value and make other policy
changes without totally forfeiting the death benefit guarantee. This
flexibility enables the product to be adapted to the changing financial
needs of policyholders. In July of 2001, the Life Insurance segment also
introduced Lincoln SUL-LPR, a new survivorship UL product with the Lapse
Protection Rider. In 2002, the segment plans to continue to be aggressive
in product development.
Estate Tax Reform
Coming into 2001, estate tax reform was a proposed federal measure that had
the life insurance industry in a state of flux. It was unclear what level
of reform or repeal would happen. The product line that was most vulnerable
to a change in estate tax legislation was survivorship life insurance. This
product line accounted for 25% of LNC's total first year premiums in 2000.
Finally in June of 2001, the estate tax reform legislation was passed which
calls for a very gradual decline in the maximum estate tax rate through
2009. The estate tax is slated to be repealed for one year in 2010 before a
sunset provision brings the rate back to the 55% rate in 2011. Based on
survivorship sales results for the year, the Life Insurance segment has
experienced little impact from the new estate tax reform law. During 2001,
total survivorship life insurance first year premiums increased $16.5
million or 10% from the prior year and during the last half of 2001 there
was a decrease of $4.4 million or 5% from same period in 2000. Of this
decrease, $3.6 million of it was experienced in the third quarter. Sales in
the third quarter were disrupted by the aftermath of the terrorist attacks
of September 11. LNC believes that the provisions of the estate tax reform
law that were passed in 2001 will not negatively impact future sales of
survivorship life insurance.
Outlook
The Life Insurance segment experienced modest retail sales growth in 2001
after three years of double-digit sales growth. Various events experienced
in 2001 caused a difficult sales environment for the overall life insurance
industry including the uncertainty during the first half of the year of the
impact of estate tax reform, the overall depressed equity markets during
the year and then the impact of the terrorist attacks of September 11. The
Life Insurance segment is positioned, however, to grow sales in the future
by building upon its strengths: the breadth and quality of its product
portfolio along with its commitment to exceptional customer service, its
product development capabilities, its extensive distribution network and
the growth opportunity offered by its target market, the affluent. The
optimization of these strengths through flawless execution is key to the
achievement of LNC's goal to place its life insurance operations among the
top five in the industry based on new premium. At the same time, the Life
Insurance segment continues to focus on effective expense management as a
means to maintain profitability.
Investment Management
The Investment Management segment, headquartered in Philadelphia,
Pennsylvania, offers a variety of asset management services to retail and
institutional clients located throughout the United States and certain
foreign countries. Its product offerings include mutual funds and managed
accounts. It also provides investment management and account administration
services for variable annuity products, and 401(k), pension, endowment and
trust accounts. The primary operating companies within this segment are the
subsidiaries of Delaware Management Holdings, Inc. ("Delaware"). Retail
products are distributed through both LFD and LFA. Institutional products,
including large case 401(k) plans, are marketed by a separate sales force
in conjunction with pension consultants.
Diversity of investment styles, as well as diversity of clients served are
prudent ways to manage risk in varying market environments. Delaware,
historically known for a conservative, "value" equity investment style has
now evolved into an investment manager with strong and diversified
offerings across all major asset classes including value and growth equity
investment styles; high-grade, high-yield and municipal fixed income
investment styles; balanced and quantitative investment styles; and the
international and global equity and fixed income investment styles.
Results of Operations (1): The Investment Management segment's financial
results and assets under management were as follows:
Year Ended December 31 (in millions) 2001 2000 1999 1998 1997
- --------------------------------------------------------------------------------------------------
Total Investment Advisory Fees (pre-tax) $284.7 $320.5 $332.2 $331.5 $298.4
Income from Operations 14.6 44.1 61.0 43.9 18.1
Realized Gain (Loss) on Investments
(after-tax) (2.3) (2.5) (0.1) 0.5 7.0
Restructuring Charges (after-tax) (0.4) (4.6) (9.3) -- --
- --------------------------------------------------------------------------------------------------
Income before Cumulative effect
of Accounting Change 11.9 37.0 51.6 44.4 25.1
Cumulative Effect of Accounting Change
(after-tax)(2) (0.1) -- -- -- --
- --------------------------------------------------------------------------------------------------
Net Income $11.8 $37.0 $51.6 $44.4 $25.1
Income from Operations-Excluding
Amortization of Intangibles $37.9 $70.9 $88.7 $72.6 $45.2
==================================================================================================
December 31 (in billions) 2001 2000 1999 1998 1997
- --------------------------------------------------------------------------------------------------
Assets Under Management
Regular Operations:
Retail-Equity $17.6 $21.2 $23.4 $22.1 $17.7
Retail-Fixed 7.0 6.5 7.5 8.2 8.1
- --------------------------------------------------------------------------------------------------
Total Retail 24.6 27.7 30.9 30.3 25.8
Institutional-Equity 17.8 19.1 23.6 24.2 24.9
Institutional-Fixed 5.5 6.1 6.9 7.0 5.7
- --------------------------------------------------------------------------------------------------
Total Institutional 23.3 25.2 30.5 31.2 30.6
Insurance Assets 38.1 35.7 35.9 39.4 35.7
- --------------------------------------------------------------------------------------------------
Total Assets Under Management $86.0 $88.6 $97.3 $100.9 $92.1
==================================================================================================
(1) See footnote (1) in the Annuities segment for a description of changes
in LNC's reported segments.
(2) Cumulative Effect of Accounting Change relates to the second quarter
2001 adoption of EITF 99-20. (Refer to page 40 for further discussion of
this item.)
Comparison of 2001 to 2000
The decreases in net income of $25.2 million or 68% and income from
operations of $29.5 million or 67% in 2001 were primarily attributable to
lower investment advisory fees and to a lesser extent reduced other revenue
partially offset by lower expenses. The decrease in total investment
advisory fees of $35.8 million (pre-tax) was due to an overall decrease in
external assets under management between years. The primary driver of the
decrease in external assets under management between years was prior year
net cash outflows of $7.2 billion that caused the beginning of year
external assets under management to be much lower than the prior year
beginning balance and to a lesser extent, market depreciation of $4.3
billion. Current year total net cash outflows of $0.7 billion also had a
slight negative impact on investment advisory fees. (See below for further
discussion of net cash flows.) Other revenue decreased as a result of
reduced distribution, shareholder servicing, and investment accounting
revenue associated with lower retail mutual fund sales and lower assets
under management.
The Investment Management segment has made significant investments in
upgrading talent and revamping investment processes over the last two
years; however, effective expense management has resulted in an overall
decrease in expenses. Expenses decreased by $10.9 million (pre-tax) or 3%
in 2001. This decrease was primarily due to the absence of significant
severance expenses incurred during 2000, lower amortization expense
associated with other intangible assets and effective management of other
expenses. Certain other intangible assets capitalized as part of LNC's
acquisition of Delaware Management Holdings, Inc. in 1995 had six-year
lives and were fully amortized in April of 2001. In addition, the segment
had lower incentive compensation expense accruals due primarily to the
declining financial results between years. Partially offsetting the
decreased expenses noted above was higher amortization of deferred broker
commissions due to an increase in the deferred broker commission asset and
expenses incurred during 2001 to close and/or merge a number of mutual
funds.
The change in net income for 2001 compared to 2000 also included the impact
of restructuring charges. The Investment Management segment incurred a
restructuring charge in the fourth quarter of 2001 of $0.4 million related
to the consolidation of the Boston, Massachusetts investment office with
the Philadelphia, Pennsylvania investment operations in order to eliminate
redundant facilities and functions within this business segment. In 2000,
the Investment Management segment incurred two restructuring charges of
$2.7 million and $2.5 million in the second and fourth quarters,
respectively. The objectives of the $2.7 million charge recorded in the
second quarter of 2000 were to combine the structured products team of
Delaware and Vantage in Philadelphia and to consolidate the back office
operations of Vantage into Delaware, in order to reduce ongoing operating
costs and to eliminate redundant facilities within this business segment.
The objectives of the $2.5 million charge recorded in the fourth quarter of
2000 were to combine the investment management operations for fixed income
products of Lincoln Investment Management and Delaware in Philadelphia, in
order to reduce ongoing operating costs and eliminate redundant facilities
within this business segment. In addition, in 2000 there were reversals
totaling $0.6 million related to the Lynch & Mayer restructuring charge
originally recorded in 1999 and the Vantage restructuring charge recorded
in 2000. For further discussion of these restructuring plans refer to Note
12 to the consolidated financial statements.
As illustrated in the discussion of the Investment Management segment's
results of operations above, the segment earnings are sensitive to swings
in the equity markets. Thus, in 2002, the estimated annualized impact on
the segment earnings of a one percent change in the overall equity markets
is approximately $0.75 million. This estimate could change if there is a
significant shift in the market and/or in the mix of business.
Comparison of 2000 to 1999
The decreases in net income of $14.6 million or 28% and income from
operations of $16.9 million or 28% in 2000 were attributable to lower
investment advisory fees and higher expenses partially offset by an
increase in other revenue. The decrease in investment advisory fees was due
to an overall decrease in external assets under management. The primary
cause of the decrease in external assets under management was net cash
outflows of $7.2 billion (see below for further discussion of net cash
flows) and market depreciation of $1.3 billion.
Overall, expenses increased $24.5 million (pre-tax) primarily as a result
of an increase in headcount of investment professionals, higher severance
costs related to turnover of investment professionals and higher commission
expense resulting from sales growth. These expense increases were partially
offset by cost savings achieved from consolidating both Lynch & Mayer and
Vantage into Delaware, as well as lower costs achieved from the
reorganization and decentralization of share services within the 401(k)
line of business and lower year 2000 (Y2K) information technology costs.
Other revenue increased due primarily to higher fees on the 401(k) line of
business resulting from higher balances and higher annual rates. In
addition, distribution income increased as a result of higher retail sales,
and accounting and record-keeping fees increased as a result of more
activity and more accounts being serviced in 2000.
The change in net income for 2000 compared to 1999 also included the impact
of restructuring charges. The Investment Management segment incurred total
restructuring charges net of reversals of $4.6 million in 2000 (see above
for further discussion of these plans). In 1999, the Investment Management
segment incurred a restructuring charge net of reversals of $9.3 million
related to the downsizing and consolidation of the back office operations
of Lynch & Mayer into Delaware, in order to reduce ongoing operating costs
and eliminate redundant facilities with this business segment. For further
discussion of these restructuring plans refer to Note 12 to the
consolidated financial statements.
Client Cash Flows: The Investment Management segment's net cash flows were as
follows:
Year Ended December 31 (in billions) 2001 2000 1999 1998 1997
- --------------------------------------------------------------------------------------------------
Retail:
Equity Sales $2.7 $4.0 $3.3 $3.6 $3.0
Equity Redemptions and Transfers (3.3) (4.5) (5.1) (1.7) (1.8)
- --------------------------------------------------------------------------------------------------
Net Flows (0.6) (0.5) (1.8) 1.9 1.2
Fixed Sales 1.2 0.7 1.0 1.1 1.0
Fixed Redemptions and Transfers (1.1) (1.7) (1.4) (1.2) (1.6)
- --------------------------------------------------------------------------------------------------
Net Flows 0.1 (1.0) (0.4) (0.1) (0.6)
Total Retail Net Flows (0.5) (1.5) (2.2) 1.8 0.6
- --------------------------------------------------------------------------------------------------
Institutional:
Equity Inflows 3.2 2.7 5.2 3.8 2.5
Equity Withdrawals and Transfers (2.8) (7.2) (7.8) (7.4) (6.5)
- --------------------------------------------------------------------------------------------------
Net Flows 0.4 (4.5) (2.6) (3.6) (4.0)
Fixed Inflows 0.6 0.8 2.0 2.2 2.5
Fixed Withdrawals and Transfers (1.2) (2.0) (1.7) (1.3) (0.8)
- --------------------------------------------------------------------------------------------------
Net Flows (0.6) (1.2) 0.3 0.9 1.7
- --------------------------------------------------------------------------------------------------
Total Institutional Net Flows (0.2) (5.7) (2.3) (2.7) (2.3)
- --------------------------------------------------------------------------------------------------
Total Retail and Institutional Net Flows $(0.7) $(7.2) $(4.5) $(0.9) $(1.7)
==================================================================================================
The Investment Management segment's trend of net cash outflows continued in
2001, but improved significantly over 2000. In 2001, the Investment
Management segment gained momentum in its ongoing initiative to increase
asset retention and attract new asset flows. Net cash outflows totaled $0.7
billion for 2001 consisting of $0.5 billion for retail accounts and $0.2
billion for institutional accounts. In 2000, net cash outflows totaled $7.2
billion with $5.7 billion for institutional accounts and $1.5 billion for
retail accounts. The improvement in net flows in 2001 was the result of
significant improvement in retention on the institutional side, as well as
improved institutional equity inflows and improved retention on the retail
side. In some cases in which there were institutional outflows during the
year, it was not due to the loss of major clients. Rather, the clients
repositioned their assets between Delaware and their other money managers.
This caused asset withdrawals, but not the termination of the relationship
with Delaware.
Management believes that the improvement in net asset flows and overall
retention is attributable to improving investment performance and client
service, and diversity of product offerings, along with increased customer
confidence in management's ability to sustain positive change. On the
retail side, for the 12 months ending December 31, 2001, 19 of Delaware's
25 largest mutual funds were in the top half of their Lipper universe. The
total mutual fund assets for the 19 funds that exceeded their benchmarks
were $8.5 billion, which accounted for 83% of assets under management in
the top 25 funds. For the year ending December 31, 2000, 13 of Delaware's
25 largest mutual funds were in the top half of their Lipper universe,
accounting for 49% of assets under management in the top 25 funds. In
addition, as of December 31, 2001, Delaware had 19 funds labeled Lipper
Leaders for "Consistent Return," as well as 14 funds named Lipper Leaders
for "Capital Preservation." Six funds were listed in both categories. With
regards to institutional performance, for the year ended December 31, 2001,
six composites outperformed their respective indices and those six
composites accounted for almost 90% of institutional assets. For the year
ended December 31, 2000, seven composites outperformed their respective
indices and those seven composites accounted for 95% of institutional
assets.
Although Delaware had strong investment performance throughout 2001 on both
the retail and institutional side, retail equity sales were down $1.3
billion or 33% from the prior year. Contributing significantly to the
downturn in sales for Delaware and throughout the industry were the
depressed equity markets, heightened by the terrorist attacks of September
11. Delaware's sales were hurt by other factors as well. Specifically, the
poor investment performance in years prior to 2000 has hurt sales overall
and specifically sales generated by LNC's retail distribution arm, LFA.
Sales of Delaware's mutual funds represented 5% and 8% of LFA's total
mutual fund sales in 2001 and 2000, respectively. In addition, LFD, the
internal wholesaling arm for distribution of Delaware's investment
products, was newly organized at the end of 2000 and was in the ramp up
stage throughout 2001. However, barring sustained volatility of the equity
markets in 2002, LNC believes that it is well positioned for 2002 because
of its strengths of asset class diversification, consistently strong
investment performance across all asset classes, and distribution breadth
supplied by LFA and LFD. In addition, Delaware was awarded 529 college
savings plans for the state of Hawaii and the Commonwealth of Pennsylvania
during 2001. Final contracts for these 529 plans are currently being
negotiated and, subject to finalization of these contracts, the 529 plans
are expected to be launched in the first half of 2002. These programs
provide Delaware with an opportunity to attract significant long-term
assets under management. To illustrate the significance of this
opportunity, 529 programs are projected to grow to over $51 billion by
2006. This represents a compound annual growth rate of nearly 50% (The
Cerulli Report Series, The State of the College Savings Market: 529 Plans
in Perspective). Although the launch of the 529 programs should have a
favorable impact on retail sales, positive earnings impact is not expected
to occur in 2002 because of significant first year distribution costs.
Outlook
In 2001, the Investment Management segment continued to build upon the
initiatives that were started in 2000. These initiatives included improving
investment performance, attracting and retaining client cash flows,
managing expenses and ultimately improving profitability. The Investment
Management segment has made measurable progress on the initiatives of
investment performance, asset retention and effective expense management,
but will continue to focus on sustaining and improving those results, which
should ultimately lead to positive cash flows and improved profitability.
Lincoln UK
Lincoln UK is headquartered in Barnwood, Gloucester, England, and is
licensed to do business throughout the United Kingdom ("UK"). Although
Lincoln UK transferred its sales force to Inter-Alliance Group PLC in the
third quarter of 2000, it continues to manage, administer and accept new
deposits on its current block of business and, as required by UK
regulation, accept new business for certain products. Lincoln UK's product
portfolio principally consists of unit-linked life and pension products,
which are similar to variable life and annuity products sold in the U.S.
Results of Operations: Lincoln UK's financial results, account values,
in-force and exchange rates were as follows:
Year Ended December 31 (in millions) 2001 2000 1999 1998 1997
- --------------------------------------------------------------------------------------------------
Income (Loss) from Operations(1) $60.2 $61.0 $(13.9) $70.9 $(108.3)
Realized Gain on Investments (after-tax) 8.7 2.3 2.2 0.8 1.5
Restructuring Charges (after-tax) -- (76.5) (6.5) -- --
- --------------------------------------------------------------------------------------------------
Net Income (Loss)(1) $68.9 $(13.2) $(18.2) $71.7 $(106.8)
==================================================================================================
December 31 (in billions) 2001 2000 1999 1998 1997
- --------------------------------------------------------------------------------------------------
Unit-Linked Assets $5.6 $6.4 $7.2 $6.3 $5.6
Individual Life Insurance In-Force $20.9 $24.3 $25.7 $25.0 $25.0
Exchange Rate Ratio - U.S. Dollars
to Pounds Sterling
Average for the Year 1.441 1.518 1.617 1.658 1.644
End of Year 1.456 1.493 1.615 1.660 1.651
==================================================================================================
(1) Income (loss) from operations and net income (loss) for 1999 and 1997
include charges of $126.1 million ($194.0 million pre- tax) and $174.9
million ($199.4 million pre-tax) for changes in the estimate of the cost of
settling pension mis-selling liabilities and 1999 includes a tax benefit of
$42.1 million relating to the decision to explore exiting the UK insurance
market (see below for discussion of these special items in 1999).
Comparison of 2001 to 2000
The increase in net income of $82.1 million in 2001 was due primarily to
the absence of restructuring charges of $76.5 million recorded in the third
and fourth quarters of 2000. These charges were both related to the
restructuring plan initiated to exit all direct sales and sales support
operations and consolidate the Uxbridge home office with the Barnwood home
office. This restructuring plan resulted from LNC's decisions to cease
writing new business in the UK through its sales force and transfer the
Lincoln UK's sales force to Inter-Alliance Group PLC (see Note 12 to the
consolidated financial statements for further discussion of this
restructuring plan). In addition, Lincoln UK had an increase in realized
gains on investments of $6.4 million between years. The gains reported in
2001 relate to the realignment of the investment portfolio to better match
invested assets with the liabilities they support.
The slight decrease in income from operations of $0.8 million or 1% in 2001
was due to a number of offsetting variances. Overall, the weak equity
markets in the UK over the last year have caused a decrease in fee income
on unit-linked investments under management. In addition, the downturn in
the equity markets during 2001 caused an increase in amortization of DAC
and PVIF. As required under FAS 97, acquisition costs for unit-linked
contracts are amortized over the lives of the contracts in relation to the
incidence of estimated gross profits. Estimated gross profits on
unit-linked contracts vary based on surrenders, fee income, expenses and
realized gains/losses on investments. The amortization is adjusted
retrospectively when estimates of current or future gross profits to be
realized from unit-linked contracts are revised. Because market movement has
such a significant impact on fee income, estimated future profits will go
up or down accordingly. On a quarterly basis, Lincoln UK reviews the
assumptions of its DAC amortization model and records a retrospective
adjustment to the amount expended, (i.e. unlocks the DAC). On an annual
basis, Lincoln UK reviews and adjusts as necessary its assumptions for
prospective amortization of DAC and PVIF. In addition to the increase in
DAC amortization in 2001 associated with retrospective unlocking for the
reduction in fee income, Lincoln UK experienced an increase in DAC and PVIF
amortization related to the prospective adjustment of assumptions made at
the beginning of 2001 related to the increase in surrenders projected as
result of the decisions to transfer the sales force and cease writing new
business through direct sales distribution. The increases in DAC and PVIF
amortization for 2001 were partially offset by increased DAC and PVIF
amortization at the end of 2000 related to an unlocking of DAC and PVIF for
a change in policy persistency assumptions. Over the last year, actual
surrenders have been in line with assumptions, but Lincoln UK continues to
evaluate the persistency assumptions on an ongoing basis.
The variance in earnings between years was also negatively impacted by
exchange rate movements. Partially offsetting the negative variances noted
above was a decrease in general and administrative expenses in 2001.
Lincoln UK continues to employ effective expense management. In addition,
the prior year included expenses related to the strategic review of Lincoln
UK and expenses that did not qualify under the restructuring plans.
Finally, Lincoln UK benefited from reduced federal income taxes associated
with favorable settlements of tax examinations for prior years.
As illustrated in the discussion of Lincoln UK's results of operations
above, the segment earnings are sensitive to swings in the equity markets.
Thus, in 2002, the estimated annualized impact on the segment earnings of a
one percent change in the equity markets (based on the FTSE 100 index) is
$0.9 million. This estimate could change if there is a significant shift in
the market and/or in the mix of business.
Comparison of 2000 to 1999
The $9.1 million or 13% decrease in income from operations excluding the
1999 special items totaling $84.0 million ($126.1 million pension
mis-selling costs less $42.1 million tax benefit) in 2000 was due primarily
to reduced sales volumes and increased expenses. Net income in 2000 was
also negatively impacted by the recording of restructuring charges in third
and fourth quarters of 2000 totaling $76.5 million after-tax. Sales volumes
were down during 2000 as a result of the transfer of the sales force in the
third quarter and sales force productivity suffered earlier in the year due
to uncertainty around the UK strategic review. Expenses increased in 2000
as a result of one-time items related to operational initiatives started in
the fourth quarter of 1999 and reserve strengthening for policies carrying
guaranteed annuity options. Also, there were additional expenses related to
the strategic review of Lincoln UK and expenses associated with the UK
restructuring plan that did not qualify for inclusion in the restructuring
charge. In addition, a change in assumptions governing the amortization of
deferred acquisition costs caused an increase in expenses. Partially
offsetting these increased expenses were lower volume-related expenses.
United Kingdom Selling Practices
Various selling practices of the Lincoln UK operations have come under
scrutiny by the UK regulators in recent years. These selling practices
include the sale and administration of individual pension products,
mortgage endowments and the selling practices of City Financial Partners
Limited ("CFPL"), a subsidiary company purchased in December 1997.
During the fourth quarter of 1999, LNC took a charge of $126.1 million or
$0.64 per share ($194.0 million pre-tax) to further strengthen its reserve
for pension mis-selling in the UK. This additional reserve strengthening
was made following: 1) the mandate issued by the Financial Services
Authority, the UK regulating body, for the use of more up to date mortality
rates in determining redress and reduced interest rate assumptions to be
used in calculating redress, thereby causing the amount of redress to
increase, 2) the change to guidance that would have allowed a simplified
process for the calculation and payment of redress for certain policy
groups and 3) the inclusion of redress relating to additional voluntary
contributions made to pension plans by individuals, retroactive to 1988.
(See Note 7 to the consolidated financial statements for an update on the
reserve for United Kingdom Selling Practices.)
Tax Benefit Relating to Decision to Explore Exit of UK Insurance Market
When LNC decided to explore exiting the UK insurance market in 1999, LNC
was required to change its method of accounting for Lincoln UK's taxes. In
the fourth quarter of 1999, LNC recorded a $42.1 million tax benefit
relating to this matter.
Exchange Rates
LNC's subsidiary in the UK, as with subsidiaries in other countries, has
its balance sheets and income statements translated at the current spot
exchange rate as of the year end and average spot exchange rate for the
year, respectively.
Outlook
During 2002, Lincoln UK will work to retain and manage its current block of
business while maximizing earnings through effective expense management.
Other Operations
Activity that is not included in the major business segments is reported in
"Other Operations." "Other Operations" includes operations not directly
related to the business segments and unallocated corporate items [i.e.,
corporate investment income, interest expense on corporate debt,
unallocated overhead expenses, and the operations of Lincoln Financial
Advisors ("LFA") and Lincoln Financial Distributors ("LFD")]. Starting in
1999, 100% of LNC's corporate overhead expenses were allocated to the
business segments.
Prior to the fourth quarter of 2001, LNC had a Reinsurance segment
("Lincoln Re"). LNC's reinsurance business was acquired by Swiss Re in
December 2001. As the majority of the business acquired by Swiss Re was via
indemnity reinsurance agreements, LNC is not relieved of its legal
liability to the ceding companies for this business. This means that the
liabilities and obligations associated with the reinsured contracts remain
on the consolidated balance sheets of LNC with a corresponding reinsurance
receivable from Swiss Re. In addition, the gain resulting from the
indemnity reinsurance portion of the transaction was deferred and is being
amortized into earnings at the rate that earnings on the reinsured business
are expected to emerge, over a period of seven to 15 years on a declining
basis. After the acquisition of this business by Swiss Re, the ongoing
management of the indemnity reinsurance contracts and the reporting of the
deferred gain will be within LNC's Other Operations. Given the lengthy
period of time over which LNC will continue to amortize the deferred gain,
and the fact that related assets and liabilities will continue to be
reported on LNC's financial statements, the historical results for the
Reinsurance segment prior to the close of the transaction with Swiss Re
will not be reflected in discontinued operations, but as a separate line in
Other Operations. The results for 2001 are for the eleven months ended
November 30, 2001.
Results of Operations(1): Other Operations' financial results were as
follows:
Year Ended December 31 (1) (in millions) 2001 2000 1999 1998 1997
- --------------------------------------------------------------------------------------------------
Financial Results by Source
LFA $(15.9) $(11.7) $(20.8) $(23.7) $(5.3)
LFD (30.7) (18.5) (14.0) (8.2) (11.2)
Reinsurance 128.8 122.5 40.1 104.9 (150.1)
Amortization of Deferred Gain 12.9 -- -- -- --
LNC Financing (77.9) (84.9) (83.5) (70.0) (50.0)
Other Corporate (2.4) (15.4) (4.9) 1.0 (6.7)
- --------------------------------------------------------------------------------------------------
Income (Loss) from Operations 14.8 (8.0) (83.1) 4.0 (223.3)
Realized Gain (Loss) on Investments and
Derivative Instruments (after-tax) (0.4) (3.2) 10.2 2.7 24.9
Gain on Sale of Reinsurance Subsidiaries
(after-tax) 15.0 -- -- -- --
Restructuring Charges (after-tax) (19.5) 1.0 (3.2) (14.3) --
- --------------------------------------------------------------------------------------------------
Income before Cumulative Effect
of Accounting Changes (2) 9.9 (10.2) (76.1) (7.6) (198.4)
Cumulative Effect of Accounting Changes
(after-tax) (2.7) -- -- -- --
- --------------------------------------------------------------------------------------------------
Net Income (Loss) $7.2 $(10.2) $(76.1) $(7.6) $(198.4)
==================================================================================================
(1) See footnote (1) in the Annuities segment for a description of changes
to LNC's reported segments. In addition, the 1997-2000 data was restated
from the prior year due to the movement of the former Reinsurance segment
into "Other Operations" upon the acquisition of the Reinsurance business by
Swiss Re on December 7, 2001. The Amortization of Deferred Gain line
represents the amortization of the deferred gain on the indemnity
reinsurance portion of the transaction with Swiss Re.
(2) Cumulative Effect of Accounting Changes relates to the transition
adjustment of $(0.5) million recorded in the first quarter of 2001 upon
adoption of FAS No. 133 and the adjustment of $(2.2) million recorded in
the second quarter of 2001 upon adoption of EITF 99-20. (Refer to page 40
for further discussion of these items.)
Other Operations reported net income of $7.2 million in 2001 and net losses
of $10.2 million in 2000 and $76.1 million in 1999. Other Operations
reported income from operations of $14.8 million in 2001 and losses from
operations of $8.0 million in 2000 and $83.1 million in 1999. In 1999, loss
from operations was $17.7 million excluding special charges reported in the
Reinsurance line of $65.4 million for reserve strengthening in the HMO
excess-of-loss business ($25.0 million) and settlement costs associated
with the workers' compensation carve-out business underwritten by Unicover
Managers, Inc. ($40.4 million).
Net income for 2001 included the impact of three restructuring charges
totaling $19.5 million: two charges were recorded in the LFD line in the
second and fourth quarters for $1.2 million and $2.5 million, respectively
and the other charge was recorded in the fourth quarter for $15.8 million.
The objectives of the plan for the $1.2 million restructuring charge
recorded by LFD in the second quarter of 2001 were to reorganize the life
wholesaling function within the independent planner distribution channel,
consolidate retirement wholesaling territories, and streamline the
marketing and communications functions in LFD. The objectives of the plan
for the $2.5 million restructuring charge recorded by LFD in the fourth
quarter of 2001 were to combine channel oversight, position LFD to take
better advantage of ongoing "marketplace consolidation" and to expand the
customer base of wholesalers in certain territories. The objectives of the
plan for the $15.8 million restructuring charge recorded in the fourth
quarter of 2001 were to consolidate operations and reduce excess space in
LNC's Fort Wayne, Indiana operations. In light of LNC's divestiture of its
reinsurance operations, which were headquartered in Fort Wayne, excess
space and printing capacity will not be used. Net income for 2000 included
a $0.3 million reversal of part of the restructuring charge originally
recorded in 1998 as a result of the organizational/expense review of the
parent company, as well as a reversal of $0.7 million related to the HMO
excess-of-loss restructuring charge originally recorded by the former
Reinsurance segment in 1999. Net income for 1999 included a restructuring
charge of $3.2 million recorded in the third quarter by the former
Reinsurance segment related to the decision to discontinue writing new HMO
excess-of-loss reinsurance programs. See Note 12 to the consolidated
financial statements for further discussion of these restructuring
activities.
Net income for 2001 also included the impact of a $15.0 million gain on
sale of reinsurance subsidiaries. Discussion of the other causes of the
change in net income between years is included below in the discussion of
the change in income from operations.
Comparison of 2001 to 2000
The positive variance in income from operations of $22.8 million in 2001
was due to a number of offsetting items. LNC Financing and Other Corporate
had positive variances between years of $7.0 million or 8% and $13.0
million or 84%, respectively. In addition, the Reinsurance line had a
positive variance of $6.3 million or 5% and the amortization of deferred
gain for 2001 yielded a positive variance of $12.9 million. Partially
offsetting the positive variances were increased losses from LNC's
distribution organizations, LFA had an increased loss of $4.2 million or
36% and LFD had an increased loss of $12.2 million or 66%.
The loss in Financing decreased $7.0 million between years primarily due to
lower long-term debt costs and lower short-term borrowing costs resulting
from the ten Fed rate cuts that occurred in 2001. The decrease in long-term
debt costs was related to several corporate finance activities. On August
16, 2001, the FELINE PRIDES converted resulting in the issuance of 4.63
million shares of LNC common stock and the retirement of $225 million in
related trust preferred securities. On September 13, 2001, $215 million
8.75% Quarterly Income Preferred Securities were called. This transaction
was funded with low interest short-term borrowings. LNC replaced short-term
borrowings in the fourth quarter with two financing arrangements. On
November 19, 2001, $172.5 million 7.65% Trust Preferred Securities were
issued and on December 7, 2001, $250 million 10 year 6.20% senior notes
were issued.
Other Corporate experienced a positive variance of $13.0 million between
years primarily as a result of non-recurring items from 2000. In the first
quarter of 2000, there were offsetting litigation items that created a loss
of $2.6 million. In addition, there was a $2.4 million loss related to
AnnuityNet. AnnuityNet is accounted for using the equity method of
accounting. In 2000, LNC recognized losses for AnnuityNet up to the amount
of its investment. Therefore, no further activity is expected to be
recorded for AnnuityNet unless further investments are made or until it has
earnings. There was also an increase of $8.6 million in incentive
compensation in 2000 resulting from the achievement of the three-year
long-term incentive compensation goals. This expense was not allocated to
the business segments.
The Reinsurance line, which includes the historical earnings of the former
Reinsurance segment had an increase in income from operations of $6.3
million in 2001. The 2001 results, however, only represent eleven months of
earnings through November 30, 2001. Even with just eleven months of
earnings for 2001, Lincoln Re had an improvement over the prior full year
primarily as a result of a change in accounting estimate recorded in the
individual markets line of business in the first quarter of 2001. Lincoln
Re refined its estimate of due and unpaid premiums on its
client-administered individual life reinsurance business. Lincoln Re
recorded income of $25.5 million ($39.3 million pre-tax) in the first
quarter of 2001 related to periods prior to 2001.
Reinsurance was also positively impacted by the re-evaluation of reserves
in its exited lines of business which resulted in $15 million of earnings,
primarily within the HMO excess-of-loss line of business. Partially
offsetting the positive variance was the impact of losses incurred for the
September 11 terrorist attacks which totaled $23.4 million (composed of a
charge of $31.3 million recorded in the third quarter of 2001 and a
reversal of $7.9 million recorded in the fourth quarter of 2001 due to
updated information for incurred but not reported claims).
The Amortization of Deferred Gain line includes the amortization of the
deferred gain on the indemnity reinsurance portion of the transaction with
Swiss Re for December ($5.0 million) along with the recognition of
accelerated amortization of the deferred gain on Canadian reinsurance
business that was novated to Swiss Re after December 7, 2001 ($7.9
million), but prior to year-end. In accordance with FAS 113, the gain
associated with the indemnity reinsurance portion of the transaction with
Swiss Re was recorded as a deferred gain and is being amortized into
earnings at the rate that earnings on the reinsured business are expected
to emerge, over a period of seven to 15 years on a declining basis. Upon
novation (transfer of the legal liability), generally accepted accounting
principles provide for immediate recognition in earnings of the deferred
gain related to the novated business.
LFA had an increased loss from operations of $4.2 million between years due
primarily to a decrease in sales revenue. LFA, a fee-based investment
planning firm and broker/dealer, experienced a decrease in sales across all
product lines: annuities, life insurance and other investment products. The
downturn in the equity markets over the last year caused a difficult sales
environment for broker/dealers. Sales in the fourth quarter of 2001
rebounded from the lower levels experienced in the first three quarters of
2001 and contributed to positive earnings for the quarter which helped
reduce the loss for the year. This fourth quarter increase in sales is
consistent with the trend experienced over the prior three years and can be
explained as a seasonal improvement related to the year-end increase in tax
planning and other related activities. In addition, in 2001, the events of
September 11 derailed sales in the third quarter which created increased
demand in the fourth quarter and possibly into 2002. In addition to lower
revenues, LFA had an increase in overall expenses in 2001 as a result of
increased salaries and other general and administrative expenses partially
offset by reduced commissions and other volume related expenses. In 2002,
LFA will be focused on its growth strategy to increase its financial
planner base in order to expand sales while employing effective expense
management.
LFD had an increased loss from operations of $12.2 million between years
due to decreased sales revenue and increased expenses. LFD experienced
slightly lower retail sales in 2001, and revenue decreased as a result of
changes in the mix of business. In addition, LFD had lower sales of
corporate owned life insurance as previously discussed in the Life
Insurance segment's result of operations. Retail sales were bolstered by
strong second half sales of the StepFive(registered trademark) Fixed
Annuity, Lincoln ChoicePlus(Service Mark) Variable Annuity product line and
the MoneyGuard universal life product which includes a long-term care benefit.
Mutual fund sales, however, were weak throughout the year due primarily to
the poor performance of the equity markets. In addition, LFD's wholesaling
force was not at full strength until the end of the year. LFD had higher
expenses primarily as a result of its investment in new wholesalers during
2001 partially offset by the positive impact on expenses of the two
restructuring plans implemented in 2001 (see above for further discussion),
as well as other targeted expense reduction activities. LFD started with
221 wholesalers at the beginning of 2001 and had 241 at December 31, 2001.
LFD's on-going strategy is to target key accounts across all distribution
channels. Product improvements that occurred in 2001 including a common
fund line-up across variable annuity and life products, sales incentives
and the momentum from increased sales levels in the second half of 2001
should bode well for the future. However, given the current uncertainty of
the equity markets, LNC is cautious about sales expectations for 2002.
Comparison of 2000 to 1999
The positive variance in loss from operations (exclusive of the special
charges of $65.4 million recorded in the Reinsurance line in 1999) was $9.7
million or 55% due to offsetting items. The Reinsurance line had an
increase in income from operations (exclusive of the 1999 special charges)
of $17 million or 16% between years due to offsetting results by business
source. In addition, LFA had a positive variance in loss from operations of
$9.1 million or 44%. Partially offsetting these positive variances were
negative variances in LNC Financing and Other Corporate of $1.4 million or
2% and $10.5 million or 214%, respectively. In addition, LFD had an
increased loss between periods of $4.5 million or 32%.
LFA had a decreased loss between years of $9.1 million or 44% as a result
of increased sales volumes and decreased general and administrative
expenses. LFD had an increased loss between years of $4.5 million or 32%
resulting primarily from investments in wholesaling and sales management
resources which were initiated during the second half of 2000. LNC
Financing had a negative variance of $1.4 million or 2% between years due
primarily to an increase in short-term borrowing costs caused by both an
increase in the average outstanding commercial paper balance and an
increase in interest rates. Other Corporate had a negative variance between
years of $10.5 million or 214% due primarily to an increase in incentive
compensation in 2000 resulting from the achievement of the three-year
long-term incentive compensation goals. This expense was not allocated to
the business segments. In addition, offsetting litigation settlements
contributed to the increased loss between years (see Litigation below for
further discussion).
Litigation
During the first quarter of 2000, the appellate court upheld LNC's position
in litigation relating to the 1992 sale of the Employee Life-Health Benefit
business segment. As a result of this favorable decision, LNC's earnings
increased by approximately $11.2 million ($17.2 million pre-tax).
During the fourth quarter of 2000, Lincoln National Life Insurance Company
("LNL") reached an agreement in principle to settle all class action
lawsuits alleging fraud in the sale of LNL non-variable universal life and
participating whole life insurance policies. It requires that LNL provide
benefits and a claim process to policyholders who purchased non-variable
universal life and participating whole life policies between January 1,
1981 and December 31, 1998. The settlement covers approximately 431,000
policies. Owners of approximately 4,300 policies have excluded themselves
(opted-out) from the settlement and, with respect to these policies, will
not be bound by the settlement. Total charges recorded during 2000 for this
settlement aggregated $42.1 million after-tax ($64.7 million pre-tax). With
the court's approval of the settlement in the second quarter of 2001 and
the expiration in the third quarter of 2001 of the time to file an appeal,
the case was concluded for all policyholders not previously opting out.
During the third quarter of 2001, settlement was reached with some of the
owners of policies who opted-out of the original settlement. Overall, the
third quarter developments relating to these matters were slightly
favorable when compared to the assumptions underlying the estimates made in
2000 when the related charges were taken; however, there is continuing
uncertainty as to the ultimate costs of settling the remaining opt-out
cases. It is management's opinion that such future developments will not
materially affect the consolidated financial position of LNC.
In December 2000, LNC received a $43 million (pre-tax) cash payment in
exchange for agreeing to modify certain non-compete terms included in an
acquisition completed by LNC prior to 1999. In LNC's purchase accounting
for this acquisition, the non-compete terms of the acquisition agreement
were believed to have only negligible value and there was no reasonable
basis for estimating the additional business and profits, if any, that
might result from these non-compete terms. Under these facts and
circumstances, LNC concluded that no separately identifiable intangible
asset should be recorded for the non-compete terms. However, events in 2000
resulted in a substantial increase in the value of these non-compete terms,
culminating with the receipt of the $43 million payment. LNC does not
believe that the forfeiture of its remaining non-compete rights and
benefits, which would have otherwise expired in 2001, diminishes the value
of goodwill recorded in the acquisition. As a result, LNC recorded the
$28.0 million ($43 million pre-tax) payment in fourth quarter 2000 net
income.
CONSOLIDATED INVESTMENTS
- ----------------------------------------------------------------------------
The consolidated assets under management including consolidated investments
and assets held in separate accounts on the balance sheet, and external
assets under management classified by investment advisor, mean invested
assets, net investment income and investment yield are as follows:
December 31 (in billions) 2001 2000 1999 1998 1997
- --------------------------------------------------------------------------------------------------
Assets Managed by Advisor
Investment Management Segment(1):
External Assets $47.9 $52.9 $61.4 $61.5 $56.4
Insurance Assets 38.1 35.7 35.9 39.4 35.7
Lincoln UK 6.9 7.9 8.6 7.6 6.8
Within Business Units (Policy Loans) 1.9 1.9 1.9 1.8 0.8
Non-LNC Affiliates 31.4 32.9 32.7 23.5 19.4
- --------------------------------------------------------------------------------------------------
Total Assets Managed $126.2 $131.3 $140.5 $133.8 $119.1
Mean Invested Assets $37.62 $37.47 $39.03 $36.50 $30.34
Adjusted Net Investment Income(2) $2.69 $2.75 $2.82 $2.69 $2.26
Investment Yield (ratio of net investment
income to mean invested assets) 7.14% 7.35% 7.21% 7.36% 7.46%
==================================================================================================
(1) See Investment Management segment data starting on page 53 for additional detail.
(2) Includes tax-exempt income.
Investment Objective: Invested assets are an integral part of the
Annuities, Life Insurance and Lincoln UK segments' operations. For
discussion of external assets under management, i.e. retail and
institutional assets, see the Investment Management segment discussion
starting on page 53. LNC follows a balanced approach of investment for both
current income and prudent risk management, with an emphasis on generating
sufficient current income to meet LNC's obligations. This approach requires
the evaluation of risk and expected return of each asset class utilized,
while still meeting the income objectives of LNC. This approach also
permits LNC to be more effective in its asset-liability management, since
decisions can be made based upon both the economic and current investment
income considerations affecting assets and liabilities.
Investment Portfolio Composition and Diversification: Fundamental to LNC's
investment policy is diversification across asset classes. LNC's 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. LNC purchases
investments for its segmented portfolios that have yield, duration and
other characteristics that take into account the liabilities of the
products being supported. The dominant investments held are fixed maturity
securities, which represent approximately 78% of the investment portfolio.
The total investment portfolio increased $744.4 million in 2001 and
decreased $209.7 million in 2000. The increase in 2001 was due to the
purchase of investments from cash flow generated by the business units,
positive net cash flows for fixed annuity portfolios and market
appreciation of fixed maturity securities due to the significant decline in
interest rates during 2001. The decrease in 2000 was due primarily to net
cash outflows for fixed annuity portfolios. This decline was partially
offset by new purchases of investments from cash flow generated by the
business units and market appreciation of fixed maturity securities due to
the decline in interest rates during 2000.
Fixed Maturity Security Ratings: LNC maintains a high-quality fixed
maturity securities portfolio. As of December 31, 2001, $6.7 billion or
23.6% of its fixed maturity securities portfolio had ratings of AA or
better. Fixed maturity securities with below-investment grade ratings (BB
or less) were $2.4 billion or 8.3% of the total fixed maturity securities
portfolio (see Note 3 to the consolidated financial statements). The
below-investment-grade fixed maturity securities represent 6.5% of LNC's
total investment portfolio. The interest rates available on these
below-investment-grade securities are significantly higher than are
available on other corporate debt securities. Also, the risk of loss due to
default by the borrower is significantly greater with respect to such below
investment grade securities because these securities are generally
unsecured, often subordinated to other creditors of the issuer and issued
by companies that usually have high levels of indebtedness. LNC attempts to
minimize the risks associated with these below investment grade securities
by limiting the exposure to any one issuer and by closely monitoring the
credit worthiness of such issuers. For the year ended December 31, 2001,
the aggregate cost of below investment grade securities purchased was
$107.3 million. Aggregate proceeds from such investments sold were $121.0
million, resulting in a realized pre-tax loss at the time of sale of $2.4
million.
Securities Available-for-Sale: LNC's entire fixed maturity and equity
securities portfolio is classified as "available-for-sale" and is carried
at fair value on its balance sheet. Because the general intent of the
"available-for-sale" accounting rules is to reflect shareholders' equity as
if unrealized gains and losses were actually recognized, it is necessary
for LNC to 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
deferred acquisition costs, policyholder commitments and deferred income
taxes. Adjustments to each of these balances are charged or credited
directly to shareholders' equity as part of LNC's "available-for-sale"
accounting. For instance, deferred acquisition costs are adjusted upon the
recognition of unrealized gains or losses since the amortization of
deferred acquisition costs is based upon an assumed emergence of gross
profits on certain insurance business. In a similar manner, adjustments to
the balances of policyholder reserves or commitments are made because LNC
has either a contractual obligation or has a consistent historical practice
of making allocations of investment gains or losses to certain
policyholders. Deferred income tax balances are also adjusted, since
unrealized gains or losses do not affect actual taxes currently paid. See
Note 3 to the consolidated financial statements for details of the gross
unrealized gains and losses as of December 31, 2001.
Mortgaged-Backed Securities: LNC's fixed maturity securities
available-for-sale include mortgage-backed securities. The mortgage-backed
securities included in LNC's investment portfolio are subject to risks
associated with variable prepayments. This may result in these securities
having a different actual cash flow and maturity than expected at the time
of purchase. 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, LNC 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. LNC may incur
disinvestment risks if market yields are higher than the book yields earned
on the securities and LNC is forced to sell the securities. The degree to
which a security is susceptible to either gains or losses is influenced by
1) the difference between its amortized cost and par, 2) the relative
sensitivity of the underlying mortgages backing the assets to prepayment
in a changing interest rate environment and 3) the repayment priority of
the securities in the overall securitization structure.
LNC limits the extent of its risk on mortgage-backed securities by
prudently limiting exposure to the asset class, by generally avoiding the
purchase of securities with a cost that significantly exceeds par, by
purchasing securities backed by stable collateral, and by concentrating on
securities with enhanced priority in their trust structure. Such securities
with reduced risk typically have a lower yield (but higher liquidity) than
higher-risk mortgage-backed securities. At selected times, higher-risk
securities may be purchased if they do not compromise the safety of the
general portfolio. At December 31, 2001, LNC did not have a significant
amount of higher-risk mortgage-backed securities. There are negligible
default risks in the mortgage-backed securities portfolio as a whole as the
vast majority of the assets are either guaranteed by U.S.
government-sponsored entities or are supported in the securitization
structure by junior securities enabling the assets to achieve high
investment grade status. See Note 3 to the consolidated financial
statements for additional detail about the underlying collateral.
Mortgage Loans on Real Estate and Real Estate: As of December 31, 2001,
mortgage loans on real estate and investments in real estate represented
12.6% and 0.7% of the total investment portfolio. As of December 31, 2001,
the underlying properties supporting the mortgage loans on real estate
consisted of 34.8% in commercial office buildings, 25.6% in retail stores,
15.5% in industrial buildings, 12.4% in apartments, 7.8% in hotels/motels
and 3.9% in other. Mortgage loans on real estate in California and Texas
accounted for approximately 30% of the total carrying value of mortgage
loans.
LNC completed securitizations of commercial mortgage loans in both the
fourth quarter of 2000 and the fourth quarter of 2001. In each
securitization, the loans were transferred to a trust held in a "qualified"
off-balance sheet special purpose entity ("SPE") which is therefore not
consolidated into LNC. In the first securitization, the loans had a fair
value of $186.0 million and a carrying value of $185.7 million. LNC
retained a 6.3% interest in the securitized assets. LNC received $172.7
million from the trust for the sale of the senior trust certificates
representing the other 93.7% beneficial interest. A realized gain of $0.4
million pre-tax was recorded on this sale. A recourse liability was not
recorded since LNC is not obligated to repurchase any loans from the trust
that may later become delinquent. Cash flows received during 2001 and 2000
from interests retained in the trust were $2.6 million and $0.4 million,
respectively.
In the second securitization completed in 2001, the loans had a fair value
of $209.7 million and a carrying value of $198.1 million. LNC received
$209.7 million from the trust for the sale of the loans. A recourse
liability was not recorded since LNC is not obligated to repurchase any
loans from the trust that may later become delinquent. Servicing fees of
$0.03 million were received in 2001. The transaction was hedged with total
return swaps to lock in the value of the loans. LNC recorded a loss on the
hedge of $10.1 million pre-tax and a realized gain on the sale of $11.6
million pre-tax resulting in a net gain of $1.5 million pre-tax. Upon
securitization, LNC did not retain an interest in the securitized assets;
however, LNC later invested $14.3 million of its general account assets in
the certificates issued by the trust. This investment is included in fixed
maturity securities on the consolidated balance sheet.
Limited Partnership Investments: As of December 31, 2001, there were $329.5
million of limited partnership investments included in consolidated
investments. These include investments in approximately 50 different
partnerships that allow LNC to gain exposure to a broadly diversified
portfolio of asset classes such as venture capital, hedge funds, and oil
and gas. They are generally fairly large partnerships with several third
party partners. These partnerships do not represent off-balance sheet
financing to LNC. Select partnerships contain "capital calls" which require
LNC to contribute capital upon notification by the general partner. These
capital calls are contemplated during the initial investment decision and
are planned for well in advance of the call date. The capital calls are not
material in size and pose no threat to LNC's liquidity. The capital calls
are included on LNC's table of contingent commitments on page 67. Limited
partnership investments are accounted for using the equity method of
accounting and the majority of these investments are included in "Other
Investments" on the consolidated balance sheets.
Net Investment Income: Net Investment income decreased $67.5 million or 2%
in 2001 due to a decrease in the yield on investments from 7.35% to 7.14%
(all calculations on a cost basis). The decrease in the yield on
investments was primarily due to lower interest rates on new securities
purchased along with an increase in security defaults resulting from the
weak economy in 2001. In addition, LNC transferred higher yielding invested
assets and received current fair value as part of the close of the sale of
the reinsurance business to Swiss Re on December 7, 2001. The proceeds of
the sale were invested in lower yielding highly liquid short-term
investments. Mean invested assets only increased 0.4% in 2001. Net
investment income decreased $60.4 million or 2% in 2000 due to a 4%
decrease in mean invested assets partially offset by an increase in the
yield on investments from 7.21% to 7.35% (all calculations on a cost
basis). The decrease in mean invested assets in 2000 was due primarily to
net cash outflows from fixed annuities in the Annuities segment.
Realized Gain (Loss) on Investments and Derivative Instruments: The pre-tax
realized gain (loss) on investments, net of associated amortization of
deferred acquisition costs and expenses, was $(114.5) million, $(28.3)
million and $3.0 million in 2001, 2000 and 1999, respectively. The
after-tax gain (loss) in 2001, 2000 and 1999 was $(73.6) million, $(17.5)
million and $3.8 million, respectively. The loss in 2001 was primarily the
result of the write-down and provision for losses on investments due to
credit deterioration, and to a lesser extent the sale of investments.
Losses and write-downs recorded in the fourth quarter of 2001 on Enron and
Argentina investments totaled $41.8 million (pre-tax). The loss in 2000 was
primarily the result of the sale of investments, and to a lesser extent the
write-down and provision for losses on investments. The gain in 1999 was
primarily the result of the sale of investments. Write-downs and provisions
for losses offset a portion of the realized gain.
Write-Downs and Allowance for Losses: Securities available-for-sale,
mortgage loans on real estate and real estate that were deemed to have
declines in fair value that were other than temporary were written down.
The fixed maturity securities to which these write-downs apply were
generally of investment grade quality at the time of purchase, but were
classified as "below-investment grade" at the time of the write-downs. EITF
99-20 changed the manner in which impairment on certain investments in
collateralized securities is determined. The cumulative effect adjustment
that LNC recorded in connection with the adoption of EITF 99-20 in the
second quarter of 2001 was a net realized loss on investments of $11.3
million after-tax ($17.3 million pre-tax). Also, write-downs and allowances
for losses on select mortgage loans on real estate, real estate and other
investments were established when the underlying value of the property was
deemed to be less than the carrying value. These write-downs and provisions
for losses are disclosed within the notes to the accompanying consolidated
financial statements (see Note 3 to the consolidated financial statements).
Use of Derivatives: The primary use of derivatives at LNC is to hedge
interest rate risk that is embedded in either life insurance and annuity
product liabilities or investment portfolios. To a lesser extent,
derivatives are also used to hedge exposures to foreign currency and equity
market risks. Derivatives held at December 31, 2001 contain industry
standard terms and are entered into with financial institutions with
long-standing, superior performance records.
REVIEW OF CONSOLIDATED FINANCIAL CONDITION
- -----------------------------------------------------------------------------
Liquidity and Cash Flow
Liquidity refers to the ability of an enterprise to generate adequate
amounts of cash from its normal operations to meet cash requirements with a
prudent margin of safety. Because of the interval of time from receipt of
deposit or premium until payment of benefits or claims, LNC and other
insurers employ investment portfolios as an integral element of operations.
By segmenting its investment portfolios along product lines, LNC enhances
the focus and discipline it can apply to managing the liquidity, as well as
the interest rate and credit risk of each portfolio commensurate with the
profile of the liabilities. For example, portfolios backing products with
less certain cash flows and/or withdrawal provisions are kept more liquid
than portfolios backing products with more predictable cash flows.
The consolidated statements of cash flows on page 82 indicate that
operating activities provided cash of $1.3 billion, $2.0 billion and $2.3
billion in 2001, 2000 and 1999, respectively. This statement also
classifies the other sources and uses of cash by investing activities and
financing activities and discloses the amount of cash available at the end
of the year to meet LNC's obligations.
Although LNC generates adequate cash flow to meet the needs of its normal
operations, periodically LNC may issue debt or equity securities to fund
internal expansion, acquisitions, investment opportunities and the
retirement of LNC's debt and equity. LNC had an unused balance as of
December 31, 2001 of $402.5 million on its existing shelf registration
filed in December 1998 that would allow LNC to issue various securities. The
hybrid securities utilize four subsidiaries (Lincoln National Capital III,
IV, V and VI) which were formed for the specific purpose of issuing
securities. All of these subsidiaries' common securities are owned by LNC.
Cash funds are also available from LNC's revolving credit agreements, which
provide for borrowing up to $700 million (see Note 5 to the consolidated
financial statements).
LNC purchased and retired 11,278,022; 6,222,581; and 7,675,000 shares of
common stock at a cost of $503.7 million, $210.0 million and $377.7 million
in 2001, 2000 and 1999, respectively. In May 1999, the LNC board authorized
$500 million to repurchase LNC securities. The shares repurchased in 1999
included 4,875,600 shares at a cost of $236.6 million that were purchased
under the May 1999 board authorization. In November 2000, the LNC board
authorized an additional $500 million to repurchase LNC securities. At the
time of this authorization, there was $99.7 million remaining under the May
1999 board authorization. All of the shares repurchased in 2000 came under
the May 1999 board authorization. In July 2001, the LNC board authorized an
additional $500 million to repurchase LNC securities. In 2001, the
remaining amount ($53.4 million) under the May 1999 board authorization was
used and $450.4 million under the November 2000 board authorization was
used. At December 31, 2001, this leaves amounts under the November 2000 and
July 2001 board authorizations to repurchase an additional $549.6 million
of LNC securities.
On August 16, 2001, LNC settled mandatory stock purchase contracts issued
in conjunction with the FELINE PRIDES financing. This action resulted in
the issuance of 4.6 million shares of LNC stock at $49.67 per share.
Investors had the option of settling the purchase contract with separate
cash or by having the collateral securing their purchase obligations sold.
In the case of investors who held the Trust Originated Preferred Securities
("TOPrS") as collateral for the purchase contracts, they were permitted to
enter into a remarketing process with proceeds used to settle the
contracts. On August 13, 2001, the remarketing failed resulting in the
retirement of $225 million TOPrS. A total of $5 million of two-year TOPrS
remain outstanding which represents investors who chose to settle with
separate cash and hold onto their TOPrS until maturity.
On September 13, 2001, LNC redeemed all 8.6 million shares of the $215
million outstanding 8.75% Cumulative Quarterly Income Preferred Securities,
Series A that were issued by Lincoln National Capital I and guaranteed by
LNC. On December 7, 2001, LNC announced plans to call $100 million 8.35%
TOPrS issued by Lincoln Capital II and guaranteed by LNC. The redemption
date was January 7, 2002.
On November 19, 2001, LNC issued 6.9 million shares of $172.5 million 7.65%
Trust Preferred Securities ("TRUPS") through Lincoln National Capital V. On
December 7, 2001, LNC issued $250 million 6.20% ten-year senior notes.
On December 7, 2001, Swiss Re acquired LNC's reinsurance operation for $2.0
billion. In addition, LNC retained the capital supporting the reinsurance
operation. After giving affect to the increased levels of capital needed
within the Life Insurance and Annuity segments that result from the change
in the ongoing mix of business under LNC's internal capital allocation
models, the disposition of LNC's reinsurance operation has freed-up
approximately $100 million of capital. The transaction structure involved a
series of indemnity reinsurance transactions combined with the sale of
certain stock companies that comprised LNC's reinsurance operation. An
immediate gain of $15.0 million after-tax was recognized on the sale of the
stock companies. Approximately $565 million of the proceeds from the
transaction will be used to pay taxes and associated deal costs, leaving
LNC with $1.4 billion of after-tax net proceeds from Swiss Re. Prior to
December 31, 2001, LNC used $115 million to repurchase shares of LNC stock
and $166.3 million was used to reduce outstanding short-term debt. LNC may
use the remainder of the proceeds to purchase another organization or block
of business within the financial services industry or to repurchase its
debt or stock. As LNC evaluates opportunities in the financial services
industry, it will invest the proceeds in high quality, liquid investment
instruments and may retire additional portions of its debt and repurchase
shares of its common stock.
In order to maximize the use of available cash, the holding company (LNC)
maintains a facility 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. 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. In addition to facilitating the
management of cash, the holding company receives dividends from its
subsidiaries, invests in operating companies, maintains an investment
portfolio and pays shareholder dividends and certain corporate expenses.
LNC's insurance subsidiaries are subject to certain insurance department
regulatory restrictions as to the transfer of funds and payment of
dividends to the holding company. Generally, these restrictions pose no
short-term liquidity concerns for the holding company. However, as
discussed in detail within Note 7 to the consolidated financial statements,
the acquisition of two blocks of business in 1998 resulted in negative
statutory earned surplus for LNL which triggered certain approval
requirements in order for LNL to declare and pay dividends to LNC. As a
result of negative earned surplus, LNL was required to obtain the prior
approval of the Indiana Insurance Commissioner ("Commissioner") before
paying any dividends to LNC until its statutory earned surplus became
positive. LNL recently received approval from the Commissioner to
reclassify total dividends of $495 million paid to LNC in 2001 from LNL's
earned surplus to paid-in-capital. This change plus the increase in statutory
earned surplus from the indemnity reinsurance transaction with Swiss Re
resulted in positive statutory earned surplus for LNL at December 31, 2001.
As long as LNL's earned surplus remains positive, future dividends not in
excess of earned surplus will be deemed ordinary, not requiring prior
approval from the Commissioner.
LNL is recognized as an accredited reinsurer in the state of New York,
which effectively enables it to conduct reinsurance business with unrelated
insurance companies that are domiciled within the state of New York. As a
result, in addition to regulatory restrictions imposed by the state of
Indiana, LNL is also subject to the regulatory requirements that the State
of New York imposes upon accredited reinsurers.
The tables below summarize LNC's obligations and commitments to make future
payments under contracts in place at December 31, 2001, as well as
contingent commitments in place at December 31, 2001.
Contractual Obligations
Future Amount
Amor- Per
There- tization/ Balance
Contractual Obligations (in millions) 2002 2003 2004 2005 2006 after Total Adjustment Sheet
- --------------------------------------------------------------------------------------------------------------------------------
Short-Term Debt (1) $350.2 $-- $-- $-- $-- $-- $350.2 $-- $350.2
Long-Term Debt -- -- -- 193.0 -- 670.3 863.3 (1.6) 861.7
Company-obligated
mandatorily redeemable
preferred securities of
subsidiary trusts holding
solely junior subordinated
debentures 100.0 (2) 5.0 -- -- -- 372.5 477.5 (2.8) 474.7
Operating Leases 73.4 65.5 62.3 58.9 56.1 142.4 458.6 -- --
Information Technology
Contract (3) 75.0 75.0 75.0 6.3 -- -- 231.3 -- --
- --------------------------------------------------------------------------------------------------------------------------------
Totals $598.6 $145.5 $137.3 $258.2 $56.1 $1,185.2 $2,380.9 $(4.4) $1,686.6
================================================================================================================================
Contingent Commitments
Amount of Commitment Expiring per Period
- --------------------------------------------------------------------------------------------------------------------------------
Total
Amount Less than After
Commitments (in millions) Committed 1 Year 1-3 Years 4-5 Years 5 Years
- --------------------------------------------------------------------------------------------------------------------------------
Lines of Credit (amount outstanding
at 12/31/2001 is $0) $700.0 $400.0 $-- $300.0 $--
Standby Letters of Credit
(amount outstanding at 12/31/2001
is $765.7 million) 800.0 800.0 -- -- --
Guarantees 23.9 0.1 0.7 1.6 21.5
Investment Commitments 219.5 (4) 80.4 87.5 51.5 0.1
Standby Commitments to Purchase
Real Estate upon Completion
and Leasing 276.6 114.7 161.9 -- --
- --------------------------------------------------------------------------------------------------------------------------------
$2,020.0 $1,395.2 $250.1 $353.1 $21.6
================================================================================================================================
(1) Includes the current portion of long-term debt.
(2) The 8.35% Trust Originated Preferred Securities were redeemed on January 7, 2002.
(3) The future minimum annual costs under LNC's information technology contract with IBM which expires on January 1, 2005,
range from $40.9 million - $56.8 million per year. However, based on usage, the fees are estimated to range from
$65 million - $75 million per year.
(4) Total includes $68.3 million of capital calls on limited partnership investments, $108.1 million of real estate pre-buys,
and $27.6 million and $15.5 million of commitments for mortgage loans and private placement securities, respectively.
As of December 31, 2001, LNC's senior debt ratings were Moody's at A3
("Upper Medium Grade"), Standard and Poor's at A- ("Strong"), Fitch at A+
("Strong") and A.M. Best at a ("Strong"), and LNC's commercial paper
ratings included Moody's at P-2 ("Strong"), Standard and Poor's at A-2
("Satisfactory") and Fitch at F-1 ("Very Strong"). In October of 2000,
Moody's downgraded LNC's senior debt from A2 ("Upper Medium Grade") to A3
("Upper Medium Grade") and LNC's commercial paper from P-1 ("Superior") to
P-2 ("Strong"). Although there are less investors for A-2/P-2 commercial
paper and there are periods in which there is weak investor interest in
A-2/P-2 commercial paper, through December 31, 2001, LNC's liquidity has
not been adversely impacted. LNC can also draw upon alternative short-term
borrowing facilities such as revolving lines of bank credit. LNC's
commercial paper is supported by two short-term bank borrowing facilities,
a $400 million 364-day revolving credit facility maturing in December 2002
and a $300 million revolving credit facility maturing in December 2005.
LNC's revolving credit facilities do not contain ratings-based default
triggers or material adverse change provisions. LNC's 364-day revolving
credit contains a one-year term-out feature which allows LNC to convert any
loans outstanding on the maturity date of the credit facility into a
one-year term loan subject to a floating interest rate.
From late December 2000 through early January 2001, and again immediately
following the events of September 11, 2001, LNC experienced periods of
greater volatility in commercial paper borrowing rates as an A-2/P-2 issuer
with the spread above A-1/P-1 rates ranging from 0.25% to 0.50%. During
such times of greater volatility, LNC may experience difficulty in placing
longer-term commercial paper (defined as 30-90 day maturities), and as a
result, experience increased short-term financing costs.
As of December 31, 2001, Lincoln National (UK) PLC's commercial paper
ratings were Standard and Poor's at A-2 ("Satisfactory") and Moody's at P-2
("Strong"). In March of 2001, Standard and Poor's affirmed Lincoln National
(UK) PLC's commercial paper rating at A-2. After the events of September
11, 2001, the European Commercial Paper ("ECP") market contracted, but in
late October 2001 the markets began to normalize. During the time of the
market contraction, Lincoln National (UK) PLC was able to draw upon
alternative borrowing facilities in the form of bank loans. This form of
short-term borrowing causes an increase in the borrowing rate of
approximately 0.15% per annum. However, this was countered by a decrease in
interest rates, effectively lowering the overall cost of borrowing. In
addition, due to an increase in cash flow generated from operations,
Lincoln UK reduced its commercial paper borrowings from $164.6 million at
December 31, 2000 to $96.0 million at December 31, 2001. Lincoln UK's
average commercial paper borrowings for the year ended December 31, 2001
and 2000 were $129.4 million and $156.0 million, respectively.
LNC's current ratings from Standard and Poor's, Moody's and Fitch are on
"stable outlook" and ratings from A.M. Best are on "positive outlook". The
term "stable outlook" suggests no ratings action is anticipated in the next
12 months. The A.M. Best "positive outlook" suggests conditions are present
for potential upgrade within the next 12 months. LNC undergoes significant
annual reviews by all the major rating agencies, which focus on the
detailed financial performance in each line of business and take into
account company and industry trends. In addition, LNC maintains regular
dialogue with the agencies throughout the year on material company and/or
industry developments. During 2001, dialogue included detailed information
exchanged on the effects of the events of September 11, the Enron
bankruptcy, and other industry and company issues as they arose. The rating
agencies have all affirmed both LNC and LNL's current ratings as of
December 31, 2001. If current debt ratings and claims paying ratings were
downgraded in the future, certain covenants of various contractual
obligations may be triggered which could impact overall liquidity. In
addition, contractual selling agreements with intermediaries could be
negatively impacted which could have an adverse impact on overall sales of
annuities, life insurance and investment products.
Effect of Inflation
LNC's insurance affiliates, as well as other companies in the insurance
industry, attempt to minimize the effect of inflation on their revenues and
expenses by anticipating inflationary trends in the pricing of their
products. Inflation, except for changes in interest rates, does not have a
significant effect on LNC's balance sheet due to the minimal amount of
dollars invested in property, plant and equipment and the absence of
inventories.
CAPITAL RESOURCES
- ------------------------------------------------------------------------------
Total shareholders' equity increased $309.4 million during the year ended
December 31, 2001. Excluding the increase of $205.2 million related to the
increase in the unrealized gain on securities available-for-sale and
derivative instruments and the cumulative effect of accounting change
related to derivative instruments, shareholders' equity increased $104.2
million. This increase in shareholders' equity was the net result of
increases due to $590.2 million of net income, $90.5 million from the
issuance of common stock related to benefit plans and $230.0 million from
the settlement of LNC stock purchase contracts issued in conjunction with
FELINE PRIDES financing, partially offset by $30.0 million related to a
decrease in the accumulated foreign exchange gain, $36.0 million related to
a minimum pension liability adjustment, $231.8 million related to the
declaration of dividends to shareholders, $503.7 million for the retirement
of common stock, $4.7 million for the cancellation of shares related to the
acquisition of subsidiaries and $0.3 million for the forfeiture of shares
under benefit plans.
During May 1999, LNC's Board of Directors approved a two-for-one stock
split for its common stock. The record date for the stock split was June 4,
1999 and the additional shares were distributed to shareholders on June 21,
1999.
Capital adequacy is a primary measure used by insurance regulators to
determine the financial stability of an insurance company. In the U.S.,
risk-based capital guidelines are used by the National Association of
Insurance Commissioners to determine the amount of capital that represents
minimum acceptable operating amounts related to insurance and investment
risks. Regulatory action is triggered when an insurer's statutory-basis
capital falls below the formula-produced capital level. At December 31,
2001, statutory-basis capital for each of LNC's U.S. insurance subsidiaries
was in excess of regulatory action levels of risk-based capital required by
the jurisdiction of domicile.
The National Association of Insurance Commissioners revised the Accounting
Practices and Procedures Manual in a process referred to as Codification.
The revised manual became effective January 1, 2001. The domiciliary states
of LNC's U.S. insurance subsidiaries have adopted the provisions of the
revised manual. The revised manual has changed, to some extent, prescribed
statutory accounting practices and has resulted in changes to the
accounting practices that LNC's U.S. insurance subsidiaries use to prepare
their statutory-basis financial statements. The impact of these changes to
LNC and its U.S. insurance subsidiaries' statutory-based capital and
surplus as of January 1, 2001 was not significant.
As noted above, shareholders' equity includes net unrealized gain (loss) on
securities available-for-sale. In addition, effective January 1, 2001, upon
the adoption of FAS 133, shareholders' equity includes net unrealized gain
(loss) on derivative instruments. At December 31, 2001, the book value of
$28.10 per share included $1.16 of unrealized gains on securities and
derivative instruments. At December 31, 2000, the book value of $25.92 per
share included $0.07 of unrealized gains on securities.
CONTINGENCIES
- ------------------------------------------------------------------------------
See Note 7 to the consolidated financial statements for information regarding
contingencies.
LEGISLATION
- ------------------------------------------------------------------------------
The Financial Services Modernization Act was passed in November 1999 and
repeals the Glass-Steagall Act of 1993 and expands the Bank Holding Company
Act of 1956. This act allows, among other things, cross-ownership by banks,
securities firms and insurance companies. In 2001, there were some
cross-ownership activities in the financial services industry, however,
there was minimal impact on LNC's operations. Tax legislation could
increase or reduce tax-advantages for some of LNC's life and annuity
products. LNC continues to support reductions in the tax burden imposed on
its businesses, employees and policyholders.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
- ------------------------------------------------------------------------------
Market Risk Exposures of Financial Instruments
LNC analyzes and manages 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 of the entire
enterprise, LNC estimates, reviews and in some cases manages the risk to
its earnings and shareholder value. LNC has exposures to several market
risks including interest rate, default risk, foreign currency exchange,
liquidity and equity price risks.
The exposures of financial instruments to market risks, and the related
risk management processes, are most important in the Annuities and Life
Insurance segments. It is within these segments where most of the invested
assets support accumulation and investment oriented insurance products. As
an important element of its integrated asset-liability management process,
LNC uses derivatives to minimize the effects of changes in interest levels
and the shape of the yield curve. In this context, derivatives are
designated as a hedge and serve to reduce interest rate risk by mitigating
the effect of significant increases in interest rates on LNC's earnings.
Additional market exposures exist in LNC's other general account insurance
products and in its debt structure and derivatives positions. The primary
sources of market risk are: 1) substantial, relatively rapid and sustained
increases or decreases in interest rates, 2) fluctuations in currency
exchange rates or 3) a sharp drop in equity market values. Each of these
market risks are discussed in detail in the following pages.
1) Interest Rate Risk
Accumulation and Investment Oriented Insurance Products. General account
assets supporting accumulation and investment oriented insurance products
total $24.6 billion or 68% and $23.1 billion or 65% of total invested
assets at December 31, 2001 and 2000, respectively.
With respect to these products, LNC seeks to earn a stable and profitable
spread between investment income and interest credited to account values.
If LNC has adverse experience on investments that cannot be passed onto
customers, its spreads are reduced. Alternatively, LNC may seek to maintain
spreads and this may result in crediting rates that are not competitive in
the market place. This strategy could result in adverse surrender
experience on policies and could force LNC to liquidate a portion of its
portfolio to fund cash surrender value benefits.
LNC does 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 minimize 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.
Fixed Deferred Annuities. Assets of $16.5 billion and $15.5 billion at
December 31, 2001 and 2000, respectively, support the largest category of
accumulation and investment oriented insurance products, fixed deferred
annuities. For these products, LNC may adjust renewal crediting rates
monthly or quarterly, subject to guaranteed minimums ranging from 3% to 5%.
The higher minimums apply to in-force blocks of older products that no
longer are sold. Annuity insurance customers have the right to surrender
their policies at account value less a surrender charge that grades to zero
over periods ranging from 5 to 10 years from policy issue date or, in some
cases, the date of each premium received. In some cases, a market value
adjustment may also apply. Due to LNC's ability to change crediting rates
to reflect investment experience on the majority of its traditional annuity
products, the underlying assets are assumed to be a good proxy for the
interest rate risk inherent in these liabilities. This assumption is
appropriate for probable movements in interest rates over the next 12
months. This assumption may not be appropriate for a substantial,
relatively rapid increase or decrease in interest rates that is then
sustained over a long period.
Universal Life. LNC had $6.2 billion and $5.8 billion in assets at December
31, 2001 and 2000, respectively, supporting universal life insurance on
which it has the right to adjust renewal crediting rates subject to
guaranteed minimums ranging from 4% to 6% at December 31, 2001. Similar to
annuities, universal life insurance customers have the right to surrender
their policies at account value less a surrender charge that grades to zero
over periods ranging from 10 to 20 years from policy issue date or, in some
cases, the date of each premium received.
Guaranteed Interest Contracts and Group Pension Annuities. LNC had assets
totaling $1.9 billion and $1.8 billion at December 31, 2001 and 2000,
respectively that support guaranteed interest contracts, group pension
annuities and immediate annuities. Generally, the cash flows expected on
these liabilities do not vary with fluctuations in market interest rates
and are not adjustable by LNC. Accordingly, if experience on the assets
supporting these products is more adverse than the assumptions used in
pricing the products, spreads will tend to be below expectations. LNC
limits exposure to interest rate risk by managing the duration and maturity
structure of each investment portfolio in relation to the liabilities it
supports.
Other General Account Insurance Products. LNC had $11.5 billion and $12.3
billion of assets at December 31, 2001 and 2000, respectively, supporting
general account products, including disability income and term life
insurance. For these products, the liability cash flows may have actuarial
uncertainty. However, their amounts and timing do not vary significantly
with interest rates. LNC limits interest rate risk by analyzing the
duration of the projected cash flows and structuring investment portfolios
with similar durations.
Interest Rate Risk - Falling Rates. Interest rates declined in 1998, rose
in 1999 and declined again in 2000 and 2001. For example, the five-year
Treasury yield decreased from 5.7% in 1997 to 4.5% by the end of 1998,
increased to 6.3% by the end of 1999, and declined from 5.0% at the end of
2000 to 4.3% at the end of 2001. Under scenarios in which interest rates
fall and remain at levels significantly lower than those prevailing at
December 31, 2001, minimum guarantees on annuity and universal life
insurance policies (generally 3% to 5% or an average of approximately 4%)
could cause the spread between the yield on the portfolio and the interest
rate credited to policyholders to deteriorate. Select contracts that
specify these minimum guarantees can be amended periodically to reflect
current interest rate conditions. The earned rate on the annuity and
universal life insurance portfolios averaged 7.3% and 7.7%, respectively,
for the year ended December 31, 2001, providing a cushion for a decline
before the earned rates would be insufficient to cover minimum guaranteed
rates plus the target spread. The maturity structure and call provisions of
the related portfolios are structured to afford protection against erosion
of this cushion for a period of time. However, spreads would be at risk if
interest rates continued to fall and remained lower for a long period. LNC
devotes extensive effort to evaluating these risks by simulating asset and
liability cash flows for a wide range of interest rate scenarios. LNC
manages these exposures by maintaining a suitable maturity structure and by
limiting its exposure to call risk in each respective investment portfolio.
LNC believes that the portfolios supporting its accumulation and investment
oriented insurance products have a prudent degree of call protection
individually and on a consolidated basis. As of December 31, 2001, the
mortgage-backed securities ("MBS") and asset-backed securities ("ABS")
portion represented a total of $3.5 billion or 14% of the $24.6 billion of
general account assets supporting such products. Of this portfolio, 9% of
general account assets or $2.2 billion is subject to residential prepayment
risk from investments made in Collateralized Mortgage Obligations ("CMOs"),
mortgage pass-throughs, manufactured housing and home equity loans. As of
December 31, 2000, the MBS and ABS portion of the portfolio represented a
total of $4.2 billion or 18% of the $23.1 billion of general account assets
supporting such products. LNC's MBS portfolio has equal to or slightly less
prepayment risk than the MBS pass-through market in general primarily due
to holding more seasoned securities in the portfolio.
Interest Rate Risk - Rising Rates. For both annuities and universal life
insurance, a rapid and sustained rise in interest rate 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 by slowing MBS prepayments. The greater and faster the rise in
interest rates, the more the earned rate will tend to lag behind market
rates. If LNC sets renewal crediting rates to earn the desired spread, the
gap between its renewal crediting rates and competitors' new money rates
may be wide enough to cause increased surrenders. If LNC credits more
competitive renewal rates to limit surrenders, its spreads will narrow. LNC
devotes 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 (see discussion below). With these instruments
in place, the potential adverse impact of a rapid and sustained rise in
rates is kept within corporate risk tolerances.
Debt. As of December 31, 2001, LNC had short-term debt, long-term debt and
company-obligated mandatorily redeemable preferred securities of subsidiary
trusts holding solely junior subordinated debentures totaling $1.69 billion
($1.44 billion with fixed rates and $0.25 billion with floating rates). As
of December 31, 2000, LNC had short-term debt, long-term debt and minority
interest-preferred securities of subsidiary companies totaling $1.77
billion ($1.46 billion with fixed rates and $0.31 billion with floating
rates). LNC manages 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. As indicated in Note 7 to the consolidated financial
statements, LNC has entered into derivative transactions to reduce its
exposure to rapid rises in interest rates. The four programs discussed
below are used to help LNC achieve more stable margins while providing
competitive crediting rates to policyholders during periods when interest
rates are rising. Failure to maintain competitive crediting rates could
cause policyholders to withdraw their funds and place them in more
competitive products.
LNC uses interest rate cap agreements to hedge against the negative impact
of a significant and sustained rise in interest rates. Interest rate caps
are contracts that require counterparties to pay LNC at specified future
dates the amount, if any, by which a specified market interest rate exceeds
the cap rate stated in the agreements, applied to a notional amount. As of
December 31, 2001 and 2000, LNC had agreements with notional amounts of 1.3
billion and 1.6 billion, respectively. At December 31, 2001, the agreements
had cap rates ranging from 300 to 750 basis points above prevailing
interest rates. The cap rates in some contracts increase over time. These
agreements expire in 2002 through 2006.
LNC also uses swaptions to hedge against the negative impact of a
significant and sustained rise in interest rates. Swaptions are options to
enter into a swap at a specified future date. If the option is exercised at
expiration, the option is either settled in cash or exercised into a swap
agreement. LNC purchases swaptions to be settled in cash. At expiration,
the counterparty is required to pay LNC the amount, if any, of the present
value of the difference between the fixed rate on a market rate swap and
the strike rate stated in the agreement, applied to a notional amount. As
of December 31, 2001 and 2000, LNC had agreements with notional amounts of
1.8 billion. At December 31, 2001, the agreements had strike rates ranging
from 400 to 500 basis points above prevailing interest rates. These
agreements expire in 2002 through 2003.
Notional for interest rate caps decreased by 0.3 billion as a result of
expirations. No additional interest rate caps and swaptions were purchased
during the year.
For future periods, the fair value of LNC's interest rate caps and
swaptions depends on the levels of future U.S. Treasury and U.S. dollar
swap interest rates. The table below shows estimates of fair value levels
for the cap and swaption portfolio at December 31, 2001 for future time
periods and selected potential future interest rate levels.
Year Ended December 31, 2001 (in millions) 2001 2002 2003 2004 2005 2006
- --------------------------------------------------------------------------------------------------------
No change $0.7 $0.2 $0.1 $-- $-- $--
Up 2% 8.4 2.7 1.2 0.3 -- --
Up 4% 45.7 14.5 6.4 2.8 0.3 --
Up 6% 114.6 47.2 19.2 11.2 5.3 1.6
=========================================================================================================
LNC uses exchange-traded financial futures contracts to hedge against
interest rate risks on a portion of its fixed maturity securities.
Financial futures contracts obligate LNC to buy or sell a financial
instrument at a specified future date for a specified price. They may be
settled in cash or through delivery of the financial instrument. Cash
settlements on the change in market values of financial futures contracts
are made daily. As of December 31, 2001, LNC did not have any open futures.
LNC uses interest rate swap agreements to hedge its exposure to floating
rate bond coupon payments, replicating a fixed rate bond. An interest rate
swap is a contractual agreement to exchange payments at one or more times
based on the actual or expected price level, performance or value of one or
more underlying interest rates. LNC is required to pay the counterparty the
stream of variable interest payments based on the coupon payments from the
hedged bonds, and in turn, receives a fixed payment from the counterparty,
at a predetermined interest rate. In addition, LNC uses interest rate swap
agreements to hedge its exposure to interest rate fluctuations related to
the forecasted purchase of assets to support newly acquired blocks of
business or certain other portfolios of assets. Finally, LNC uses interest
rate swap agreements to hedge the risk of paying a higher fixed rate
interest on company-obligated mandatorily redeemable preferred securities
of subsidiary trusts holding solely junior subordinated debentures than can
be paid on long-term debt based on current interest rates in the
marketplace. As of December 31, 2001 and 2000, LNC had swap agreements with
a notional amount of 507.6 million and 708.2 million, respectively. The
agreements expire in 2002 through 2050. Notional for interest rate swaps
decreased 200.6 million during 2001 primarily as a result of terminating
interest rate swaps hedging the exposure to interest rate fluctuations
related to the forecasted purchase of assets. The interest rate swaps were
terminated during 2001 after LNC purchased fixed rate securities and
mortgage loans as the hedged items.
LNC used a treasury lock agreement to hedge its exposure to variability in
future semi-annual interest payments, attributable to changes in the
benchmark interest rate, related to the issuance of its 10-year $250
million senior debt. The debt was issued in December 2001. A treasury lock
is an agreement that allows the holder to lock in a benchmark interest
rate, so that if the benchmark interest rate increases, the holder is
entitled to receive a payment from the counterparty equal to the present
value of the difference in the benchmark interest rate at the determination
date and the locked-in benchmark interest rate. If the benchmark interest
rate decreases, the holder must pay the counterparty an amount equal to the
present value of the difference in the benchmark interest rate at the
determination date and the locked-in benchmark interest rate. As of
December 31, 2001, LNC did not have any open treasury locks.
In addition to continuing existing programs, LNC may use derivative
products in other strategies to limit risk and enhance returns,
particularly in the management of investment spread businesses. LNC has
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 LNC's operations.
Table of Significant Exposures. The table below provides a general measure
of LNC's significant interest rate risk (principal amounts are shown by
year of maturity and notional amounts for interest rate caps and swaptions
are shown by amount outstanding at the year-end given) as of December 31,
2001.
There- Fair
(in millions) 2002 2003 2004 2005 2006 after Total Value
- -----------------------------------------------------------------------------------------------------------
Rate Sensitive Assets
Fixed interest
rate securities $868.7 $1,193.6 $1,041.8 $1,691.3 $2,021.1 $20,658.2 $27,474.7 $26,380.6
Average interest rate 7.17% 7.14% 7.14% 6.99% 6.76% 7.49% 7.37%
Variable interest
rate securities $54.7 $51.9 $85.5 $196.5 $67.4 $2,698.2 $3,154.2 $1,965.1
Average interest rate 13.37% 13.64% 7.01% 9.63% 9.77% 7.15% 7.81%
Mortgage loans $337.2 $204.3 $552.2 $263.5 $349.3 $2,832.4 $4,538.9 $4,691.1
Average interest rate 8.31% 8.24% 8.03% 8.56% 7.85% 8.13% 8.15%
Rate Sensitive
Liabilities
Guaranteed Interest
Contracts:
Interest paid
at maturity $2.0 $21.0 $32.0 $22.0 $-- $-- $77.0 $89.0
Average interest rate 6.18% 10.67% 10.71% 10.72% 10.60%
Investment type
insurance contracts,
excluding guaranteed
interest contracts (1) $885.4 $877.8 $965.4 $973.0 $1,433.8 $13,905.7 $19,041.1 $18,297.1
Average interest rate 7.46% 7.80% 7.59% 7.36% 6.95% 7.74% 7.64%
Debt (2) $350.2 $5.0 $-- $193.0 $-- $1,142.8 $1,691.0 $1,703.6
Average interest rate 4.39% 5.67% 7.25% 7.29% 6.68%
Rate Sensitive
Derivative Financial
Instruments:
Interest Rate and
Foreign Currency
Swaps:
Pay variable/
receive fixed 23.3 110.0 5.0 52.8 14.0 397.1 602.2 24.1
Average pay rate 4.9% 2.2% 3.6% 4.3% 2.8% 2.7% 2.9%
Average receive rate 6.9% 5.3% 5.9% 6.9% 6.7% 7.1% 6.9%
Interest Rate Caps
and Swaptions: (3)
Outstanding notional 2,542.3 659.3 250.0 250.0 113.7 0.7
Average strike rate (4) 8.9% 8.9% 8.4% 8.4% 8.4%
Forward CMT curve (5) 5.9% 6.4% 6.6% 6.7% 6.8%
===========================================================================================================
The table shows the principal amounts and fair values of assets,
liabilities and derivatives having significant interest rate risks as of
December 31, 2000.
Principal Fair
(in millions) Amount Value
- ---------------------------------------------------------------------------
Fixed interest rate securities $28,536.8 $26,430.8
Variable interest rate securities 1,945.2 1,019.0
Mortgage loans 4,663.6 4,702.5
Guaranteed interest contracts 110.0 121.0
Investment type insurance contracts (1) 18,773.5 17,318.3
Debt (2) 1,771.2 1,743.0
Interest rate and foreign currency swaps 745.7 40.6
Interest rate caps and swaptions -- 1.3
(1) The information shown is for the fixed maturity securities and mortgage
loans that support these insurance contracts.
(2) Includes company-obligated mandatorily redeemable preferred securities
of subsidiary trusts holding solely junior subordinated debentures.
(3) Swaptions notional is shown converted to cap equivalent.
(4) The indexes are a mixture of five-year and ten-year Constant Maturity
Treasury ("CMT") and Constant Maturity Swap ("CMS").
(5) The CMT curve is the five-year constant maturity treasury forward curve.
2) Foreign Currency Risk
Foreign Currency Denominated Investments. LNC invests in foreign currency
denominated securities for incremental return and risk diversification
relative to United States Dollar-Denominated ("USD") securities. The fair
value of foreign securities totaled $97.9 million as of December 31, 2001.
LNC periodically uses foreign exchange forward contracts and foreign
currency swaps to hedge some of the foreign exchange risk related to its
investment in securities denominated in foreign currencies. The currency
risk is hedged using foreign currency derivatives of the same currency as
the bonds. The table below shows LNC's exposure to foreign currency
securities. Also included is the relevant information relating to the
foreign currency derivatives that are hedging the currency risk of these
securities. The table below presents the principal or notional amount in
U.S. dollar equivalents by expected maturity for LNC's foreign currency
denominated investments and foreign currency swaps as of December 31, 2001.
There- Fair
(in millions) 2002 2003 2004 2005 2006 after Total Value
- ----------------------------------------------------------------------------------------------------------------
Currencies:
Canadian Dollar $7.0 $-- $-- $-- $-- $5.9 $12.9 $13.5
Interest Rate 7.47% 6.00% 6.79%
British Pound -- 68.5 -- -- -- 12.3 80.8 76.2
Interest Rate 7.02% 10.07% 7.52%
Philippine Peso 3.9 1.7 -- -- -- -- 5.6 5.6
Interest Rate 13.78% 13.15% 13.58%
All Other Currencies 2.8 2.8 2.6
Interest Rate 9.96% 9.96%
Total Currencies 10.9 70.2 -- -- -- 21.0 102.1 97.9
Derivatives:
Foreign Currency Swaps 8.3 68.8 -- 13.5 4.0 -- 94.6 5.9
================================================================================================================
The table below presents the principal or notional amount in U.S. dollar
equivalents of LNC's foreign currency denominated investments and foreign
currency swaps as of December 31, 2000.
Principal/ Fair
(in millions) Notional Value
- --------------------------------------------------------------------------
Currencies:
Canadian Dollar $81.4 $83.8
British Pound 19.9 22.0
Argentine Peso 17.0 15.2
All other currencies 7.7 7.4
- --------------------------------------------------------------------------
Total Currencies $126.0 $128.4
Derivatives:
Foreign Currency Swaps $37.5 $2.5
==========================================================================
Foreign Currency Forward Contracts. LNC uses foreign currency forward
contracts to hedge some of the foreign exchange risk related to its
investments in fixed maturity securities denominated in foreign currencies.
LNC typically engages in short term currency forward contracts of less than
six months and actively monitors currency markets in determining those
currencies to hedge, the duration of the hedge and the nominal amount to
hedge. A foreign currency forward contract obligates LNC to deliver a
specified amount of currency at a future date at a specified exchange rate.
The value of the foreign exchange forward contracts at any given point
fluctuates according to the underlying level of exchange rate and interest
rate differentials.
Foreign Currency Swaps. 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. LNC uses foreign currency swaps to convert the
cash flow of foreign currency securities to U.S. dollars.
3) Equity Market Exposures
LNC's revenues, assets, liabilities and derivatives are exposed to equity
market risk.
Fee Revenues. The fee revenues of LNC's 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 LNC's fixed-income
accounts and the transfer of funds to LNC from its competitors' customers.
Assets. While LNC invests in equity assets with the expectation of
achieving higher returns than would be available in its core-fixed-income
investments, the returns on, and values of, these equity investments are
subject to somewhat greater market risk than its fixed income investments.
These investments, however, add diversification benefits to LNC's fixed
income investments. The table below shows the sensitivity of price changes
to LNC's equity assets owned.
December 31, 2001 December 31, 2000
-----------------------------------------------------------------------------------------
10% Fair 10% Fair
Carrying Fair Value Value Carrying Fair
(in millions) Value Value Increase Decrease Value Value
- --------------------------------------------------------------------------------------------------------------------------
U.S. Equities $154.2 $154.2 $169.6 $138.8 $200.1 $200.1
Foreign Equities 309.6 309.6 340.6 278.6 337.1 337.1
Emerging Market Equities 6.7 6.7 7.4 6.0 12.5 12.5
- --------------------------------------------------------------------------------------------------------------------------
Subtotal 470.5 470.5 517.6 423.4 549.7 549.7
Real Estate 267.9 296.9 326.6 267.2 282.0 323.0
S&P 500 Index Call Options -- -- -- -- 19.3 19.3
Other Equity Interests 366.7 356.9 392.5 321.3 388.3 399.3
- --------------------------------------------------------------------------------------------------------------------------
Total $1,105.1 $1,124.3 $1,236.7 $1,011.9 $1,239.3 $1,291.3
==========================================================================================================================
Liabilities. Prior to the sale of LNC's reinsurance business on December 7,
2001, LNC had exposure to U.S. equity markets through reinsurance contracts
that reinsure equity-indexed annuities. The aggregate amount of account
value of these annuities was $19.3 million at December 31, 2000. LNC has
exposure to U.S. equity markets through stock appreciation rights ("SARs")
issued in 2000 and 2001. The aggregate value for vested and non-vested SARs
was $6.5 million and $15.3 million at December 31, 2001, respectively. The
aggregate value for vested and non-vested SARs was $3.1 million and $13.9
million at December 31, 2000, respectively. This program is being hedged
with equity derivatives as discussed below.
Derivatives Hedging Equity Risks. Prior to December 7, 2001, LNC hedged
equity market risk in annuities that contained equity features. LNC
currently hedges equity market risk in stock appreciation rights on LNC
stock. Both programs are described below.
Prior to the sale of LNC's reinsurance business on December 7, 2001, LNC
used OTC equity call options on the S&P 500 index to hedge against the
increase in its liabilities resulting from certain reinsurance agreements
which guaranteed payment of the appreciation of the S&P 500 index on
certain underlying annuity products. These call options required the
counterparty to pay LNC at specified future expiration dates the amount, if
any, of the percentage increase in the S&P 500 index over the strike price
defined in the contract, applied to the notional amount. The reinsurance
agreement then required LNC to pay appreciation on the S&P 500 index to the
reinsurance client. The call options were transferred to Swiss Re, the
acquirer of LNC's reinsurance business, on December 7, 2001, and none were
outstanding at December 31, 2001. LNC had agreements with notional amounts
of 183.3 million at December 31, 2000. The call option expirations were
matched to the liabilities and expired in 2002 through 2007.
LNC uses OTC equity call options on LNC stock to hedge against the increase
in its liabilities arising from stock appreciation rights granted on LNC
stock in 2000 and 2001. These call options require the counterparty to pay
LNC at specified future expiration dates the amount, if any, of the
increase in LNC's stock price over the strike price of the option, applied
to the number of contracts. LNC had 1.1 million and 0.6 million call
options on an equal number of shares of LNC stock at December 31, 2001 and
2000, respectively. The call options expirations are matched to the
liabilities and expire in 2005 and 2006.
Default Risk. LNC's portfolio of invested assets was $36.1 billion as of
December 31, 2001. Of this total, $23.1 billion consists of corporate bonds
and $4.5 billion consists of commercial mortgages. LNC manages the risk of
adverse default experience on these investments by applying disciplined
credit evaluation and underwriting standards, prudently limiting
allocations to lower-quality, higher-yielding investments, and diversifying
exposures by issuer, industry, region and property type. For each
counterparty or borrowing entity and its affiliates, LNC's exposures from
all transactions are aggregated and managed in relation to formal limits
set by rating quality and industry group. LNC remains exposed to occasional
adverse cyclical economic downturns during which default rates may be
significantly higher than the long-term historical average used in pricing.
As of December 31, 2000, LNC had a portfolio of invested assets of $35.4
billion.
LNC is 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, LNC diversifies its exposures among several dealers and limits the
amount of exposure to each in accordance with the credit rating of each
dealer or its guarantor. LNC generally limits its selection of
counterparties that are obligated under these derivative contracts to those
with an A credit rating or above.
Credit-Related Derivatives. LNC periodically uses spread-lock agreements to
hedge a portion of the value of its fixed maturity investments against the
risk of widening in the spreads between their yields and the yields of
comparable maturity U.S. or other Government obligations. As of December
31, 2001, LNC did not have any open spread-lock agreements. LNC used put
options, combined with various perpetual fixed-income securities and
interest rate swaps to replicate fixed-income, fixed-maturity investments.
The risk being hedged was a drop in bond prices due to credit concerns with
the international bond issuers. The put options allowed LNC to put the
bonds back to the counterparties at original par. As of December 31, 2001,
LNC did not have any open put options.
LNC uses credit default swaps to hedge against a drop in bond prices due to
credit concerns of certain bond issuers. A credit swap allows LNC to put
the bond back to the counterparty at par upon a credit event by the bond
issuer. A credit event is defined as bankruptcy, failure to pay, or
obligation acceleration. As of December 31, 2001 and 2000, LNC had credit
swaps with a notional amount of 29.0 million. The credit swaps expire in
2002 through 2006.
LNC used total return swaps to hedge its exposure to interest rate and
spread risk resulting from the forecasted sale of assets in a
securitization of certain LNC mortgage loans. A total return swap is an
agreement that allows the holder to protect itself against loss of value by
effectively transferring the economic risk of asset ownership to the
counterparty. The holder pays (receives) the total return equal to interest
plus capital gains or losses on a referenced asset and receives a floating
rate of interest. As of December 31, 2001, LNC did not have any open total
return swaps.
Ratings-based Termination Events. LNC and LNL are required to maintain
minimum ratings as a matter of routine practice in negotiating
International Swaps and Derivatives Association ("ISDA") agreements. Under
the majority of ISDA agreements and as a matter of policy, LNL has agreed
to maintain financial strength or claims-paying ratings of S&P BBB and
Moody's Baa2. A downgrade below these levels would result in termination of
the derivatives contract at which time any amounts payable by LNC would be
dependent on the market value of the underlying derivative contract. In
certain transactions, LNC and the counterparty have entered into a
collateral support agreement requiring LNC to post collateral upon
significant downgrade. LNC is required to maintain long-term senior debt
ratings of S&P BBB- and Moody's Baa3. LNC also requires for its own
protection minimum rating standards for counterparty credit protection. LNL
is required to maintain financial strength or claims-paying ratings of S&P
A- and Moody's A3 under certain ISDA agreements, which collectively do not
represent material notional exposure. LNC does not believe the inclusion of
termination or collateralization events pose any threat to its liquidity
position.
Consolidated Financial Statements
The consolidated financial statements and notes to consolidated financial
statements of Lincoln National Corporation and Subsidiaries follow on pages
77 through 127.
Consolidated Statements of Income
Year Ended December 31
(000s omitted except for per share amounts) 2001 2000 1999
- -------------------------------------------------------------------------------------------------------------
Revenue:
Insurance premiums $1,704,002 $1,813,111 $1,881,515
Insurance fees 1,544,041 1,661,442 1,537,605
Investment advisory fees 197,150 213,065 223,803
Net investment income 2,679,617 2,747,118 2,807,512
Equity in earnings (losses) of unconsolidated affiliates 5,672 (379) 5,797
Realized gain (loss) on investments
and derivative instruments (114,457) (28,295) 2,955
Realized gain on sale of subsidiaries 12,848 -- --
Other revenue and fees 351,765 445,445 344,513
- -------------------------------------------------------------------------------------------------------------
Total Revenue 6,380,638 6,851,507 6,803,700
Benefits and Expenses:
Benefits 3,409,740 3,557,160 3,805,024
Underwriting, acquisition,
insurance and other expenses 2,085,740 2,318,518 2,295,015
Interest and debt expense 121,019 139,538 133,697
- -------------------------------------------------------------------------------------------------------------
Total Benefits and Expenses 5,616,499 6,015,216 6,233,736
- -------------------------------------------------------------------------------------------------------------
Income before Federal Income Taxes
and Cumulative Effect of Accounting Changes 764,139 836,291 569,964
Federal Income Taxes 158,362 214,898 109,610
- -------------------------------------------------------------------------------------------------------------
Income before Cumulative Effect of Accounting Changes 605,777 621,393 460,354
Cumulative Effect of Accounting Changes (net of
Federal income taxes) (15,566) -- --
- -------------------------------------------------------------------------------------------------------------
Net Income $590,211 $621,393 $460,354
Earnings Per Common Share - Basic:
Net Income $3.13 $3.25 $2.33
Earnings Per Common Share - Diluted:
Net Income $3.05 $3.19 $2.30
=============================================================================================================
See notes to the consolidated financial statements on pages 83 through 127.
Consolidated Balance Sheets
December 31
(000s omitted) 2001 2000
- -------------------------------------------------------------------------------------------------------------
Assets
Investments:
Securities available-for-sale, at fair value:
Fixed maturity (cost: 2001 - $27,955,981; 2000 - $27,377,065) $28,345,673 $27,449,773
Equity (cost: 2001 - $444,398; 2000 - $462,813) 470,459 549,709
Mortgage loans on real estate 4,535,550 4,662,983
Real estate 267,882 282,014
Policy loans 1,939,683 1,960,899
Derivative instruments 46,445 --
Other investments 507,386 463,270
- -------------------------------------------------------------------------------------------------------------
Total Investments 36,113,078 35,368,648
Investment in unconsolidated affiliates 8,134 6,401
Cash and invested cash 3,095,480 1,927,393
Property and equipment 257,518 228,211
Deferred acquisition costs 2,885,311 3,070,507
Premiums and fees receivable 400,076 296,705
Accrued investment income 563,490 546,393
Assets held in separate accounts 44,833,419 50,579,915
Federal income taxes 15,117 207,548
Amounts recoverable from reinsurers 6,030,368 3,747,734
Goodwill 1,211,794 1,285,993
Other intangible assets 1,412,596 1,556,975
Other assets 1,174,923 1,021,636
- -------------------------------------------------------------------------------------------------------------
Total Assets $98,001,304 $99,844,059
=============================================================================================================
Consolidated Balance Sheets
December 31
(000s omitted) 2001 2000
- --------------------------------------------------------------------------------------------------------
Liabilities and Shareholders' Equity
Liabilities:
Insurance and Investment Contract Liabilities:
Insurance policy and claim reserves $21,609,269 $21,728,098
Contractholder funds 19,247,894 18,377,061
Liabilities related to separate accounts 44,833,419 50,579,915
- --------------------------------------------------------------------------------------------------------
Total Insurance and Investment Contract Liabilities 85,690,582 90,685,074
Short-term debt 350,203 312,927
Long-term debt 861,754 712,231
Company-obligated mandatorily redeemable preferred
securities of subsidiary trusts holding solely junior
subordinated debentures 474,656 745,000
Other liabilities 4,216,095 2,434,743
Deferred gain on indemnity reinsurance 1,144,530 --
- --------------------------------------------------------------------------------------------------------
Total Liabilities 92,737,820 94,889,975
Shareholders' Equity:
Series A preferred stock - 10,000,000 shares authorized
(2001 liquidation value - $1,843) 762 857
Common stock - 800,000,000 shares authorized 1,255,112 1,003,651
Retained earnings 3,834,427 3,915,598
Accumulated Other Comprehensive Income (Loss):
Foreign currency translation adjustment (8,062) 21,930
Net unrealized gain on securities available-for-sale 195,681 12,048
Net unrealized gain on derivative instruments 21,523 --
Minimum pension liability adjustment (35,959) --
- --------------------------------------------------------------------------------------------------------
Total Accumulated Other Comprehensive Income 173,183 33,978
- --------------------------------------------------------------------------------------------------------
Total Shareholders' Equity 5,263,484 4,954,084
- --------------------------------------------------------------------------------------------------------
Total Liabilities and Shareholders' Equity $98,001,304 $99,844,059
========================================================================================================
See notes to the consolidated financial statements on pages 83 through 127.
Consolidated Statements of Shareholders' Equity
Year Ended December 31
(000s omitted except for per share amounts) 2001 2000 1999
- -------------------------------------------------------------------------------------------------------------
Series A Preferred Stock:
Balance at beginning-of-year $857 $948 $1,083
Conversion into common stock (95) (91) (135)
- -------------------------------------------------------------------------------------------------------------
Balance at End-of-Year 762 857 948
Common Stock:
Balance at beginning-of-year 1,003,651 1,007,099 994,472
Conversion of series A preferred stock 95 91 135
Issued for benefit plans 90,527 33,609 51,288
Shares forfeited under benefit plans (268) (868) (3,274)
Cancelled/issued for acquisition of subsidiaries (4,740) 893 2,793
Retirement of common stock (64,147) (37,173) (38,315)
FELINE PRIDES conversion 229,994 -- --
- -------------------------------------------------------------------------------------------------------------
Balance at End-of-Year 1,255,112 1,003,651 1,007,099
Retained Earnings:
Balance at beginning-of-year 3,915,598 3,691,470 3,790,038
Comprehensive income (loss) 729,416 1,091,020 (577,643)
Less other comprehensive income (loss):
Foreign currency translation adjustment (29,992) (8,119) (19,930)
Net unrealized gain (loss) on securities
available-for-sale 183,633 477,746 (1,018,067)
Net unrealized gain on derivative instruments 21,523 -- --
Minimum pension liability adjustment (35,959) -- --
- -------------------------------------------------------------------------------------------------------------
Net Income 590,211 621,393 460,354
Retirement of common stock (439,603) (172,848) (339,404)
Dividends declared:
Series A preferred ($3.00 per share) (71) (78) (89)
Common (2001 - $1.235; 2000 - $1.175; 1999 - $1.115) (231,708) (224,339) (219,429)
- -------------------------------------------------------------------------------------------------------------
Balance at End-of-Year 3,834,427 3,915,598 3,691,470
Foreign Currency Translation Adjustment:
Balance at beginning-of-year 21,930 30,049 49,979
Change during the year (29,992) (8,119) (19,930)
- -------------------------------------------------------------------------------------------------------------
Balance at End-of-Year (8,062) 21,930 30,049
Net Unrealized Gain (Loss) on Securities
Available-for-Sale:
Balance at beginning-of-year 12,048 (465,698) 552,369
Change during the year 183,633 477,746 (1,018,067)
- -------------------------------------------------------------------------------------------------------------
Balance at End-of-Year 195,681 12,048 (465,698)
Net Unrealized Gain on Derivative Instruments:
Balance at beginning-of-year -- -- --
Cumulative effect of accounting change 17,583 -- --
Change during the year 3,940 -- --
- -------------------------------------------------------------------------------------------------------------
Balance at End-of-Year 21,523 -- --
Minimum Pension Liability Adjustment:
Balance at beginning-of-year -- -- --
Change during the year (35,959) -- --
- -------------------------------------------------------------------------------------------------------------
Balance at End-of-Year (35,959) -- --
- -------------------------------------------------------------------------------------------------------------
Total Shareholders' Equity at End-of-Year $5,263,484 $4,954,084 $4,263,868
=============================================================================================================
Consolidated Statements of Shareholders' Equity
Year Ended December 31
(Number of Shares) 2001 2000 1999
- -------------------------------------------------------------------------------------------------------------
Series A Preferred Stock:
Balance at beginning-of-year 25,980 28,857 32,959
Conversion into common stock (2,946) (2,877) (4,102)
- -------------------------------------------------------------------------------------------------------------
Balance at End-of-Year 23,034 25,980 28,857
Common Stock:
Balance at beginning-of-year 190,748,050 195,494,898 202,111,174
Conversion of series A preferred stock 47,136 46,032 65,632
Issued for benefit plans 2,911,250 1,435,015 1,026,130
Shares forfeited under benefit plans (7,000) (29,698) (100,933)
Cancelled/issued for acquisition of subsidiaries (107,994) 24,384 67,895
Retirement of common stock (11,278,022) (6,222,581) (7,675,000)
FELINE PRIDES conversion 4,630,318 -- --
- -------------------------------------------------------------------------------------------------------------
Balance Issued and Outstanding at End-of-Year 186,943,738 190,748,050 195,494,898
Common Stock at End-of-Year:
Assuming conversion of preferred stock 187,312,282 191,163,730 195,956,610
Diluted basis 191,143,748 195,230,153 197,003,999
=============================================================================================================
See notes to the consolidated financial statements on pages 83 through 127.
Consolidated Statements of Cash Flows
Year Ended December 31
(000s omitted) 2001 2000 1999
- -------------------------------------------------------------------------------------------------------------
Cash Flows from Operating Activities:
Net income $590,211 $621,393 $460,354
Adjustments to reconcile net income to net cash
provided by (used in) operating activities:
Deferred acquisition costs (343,663) (423,087) (314,607)
Premiums and fees receivable 63,931 (37,075) (14,817)
Accrued investment income (47,860) (13,210) (4,683)
Policy liabilities and accruals (491,417) 120,480 622,766
Contractholder funds 1,119,013 1,020,756 1,446,336
Amounts recoverable from reinsurers (81,461) 206,611 (316,982)
Federal income taxes 111,078 225,553 31,072
Provisions for depreciation 30,765 41,552 57,169
Amortization of goodwill and other intangible assets 168,253 195,460 167,173
Realized gain (loss) on investments 114,457 28,295 (2,955)
Gain on sale of subsidiary (12,848) -- --
Other 32,571 (1,140) 201,787
- -------------------------------------------------------------------------------------------------------------
Net Adjustments 662,819 1,364,195 1,872,259
- -------------------------------------------------------------------------------------------------------------
Net Cash Provided by Operating Activities 1,253,030 1,985,588 2,332,613
Cash Flows from Investing Activities:
Securities-available-for-sale:
Purchases (11,113,886) (4,926,319) (6,255,493)
Sales 5,989,074 4,005,859 4,210,498
Maturities 2,520,373 1,866,911 2,279,680
Purchase of other investments (1,832,593) (1,902,639) (1,948,818)
Sale or maturity of other investments 1,862,704 1,743,972 1,812,079
Sale of unconsolidated affiliates -- 85,000 (490,381)
Purchase of affiliates/business -- -- 11,086
Proceeds from disposition of business 2,036,238 -- --
Increase (decrease) in cash collateral on loaned securities 78,259 236,811 (485,792)
Other (158,011) (202,760) (271,992)
- -------------------------------------------------------------------------------------------------------------
Net Cash Provided by (Used in) Investing Activities (617,842) 906,835 (1,139,133)
Cash Flows from Financing Activities:
Decrease in long-term debt (includes payments and
transfers to short-term debt) (99,968) -- (476)
Retirement/call of preferred securities of subsidiary trusts (440,038) -- --
Issuance of long-term debt 249,220 -- --
Net increase (decrease) in short-term debt 48,031 (147,226) 145,543
Issuance of preferred securities of subsidiary companies 169,694 -- --
Universal life and investment contract deposits 4,897,828 3,543,763 4,139,492
Universal life and investment contract withdrawals (3,288,290) (4,524,371) (4,683,705)
Investment contract transfers (373,000) (1,347,000) (793,000)
Common stock issued for benefit plans 90,259 32,741 48,014
Nonqualified employee stock option exercise tax benefit 13,040 13,862 9,338
Retirement of common stock (503,750) (210,021) (377,719)
Dividends paid to shareholders (230,127) (222,661) (218,434)
- -------------------------------------------------------------------------------------------------------------
Net Cash Provided by (Used in) Financing Activities 532,899 (2,860,913) (1,730,947)
- -------------------------------------------------------------------------------------------------------------
Net Increase (Decrease) in Cash and Invested Cash 1,168,087 31,510 (537,467)
- -------------------------------------------------------------------------------------------------------------
Cash and Invested Cash at Beginning-of-Year 1,927,393 1,895,883 2,433,350
- -------------------------------------------------------------------------------------------------------------
Cash and Invested Cash at End-of-Year $3,095,480 $1,927,393 $1,895,883
=============================================================================================================
See notes to the consolidated financial statements on pages 83 through 127.
Notes to Consolidated Financial Statements
1. Summary of Significant Accounting Policies
Basis of Presentation. The accompanying consolidated financial statements
include Lincoln National Corporation ("LNC") and its majority-owned
subsidiaries. Through subsidiary companies, LNC operates multiple insurance
and investment management businesses divided into four business segments
(see Note 9). The collective group of companies uses "Lincoln Financial
Group" as its marketing identity. Less than majority-owned entities in
which LNC has at least a 20% interest are reported on the equity basis.
These consolidated financial statements have been prepared in conformity
with accounting principles generally accepted in the United States.
Use of Estimates. The nature of the insurance and investment management
businesses requires management to make estimates and assumptions that
affect the amounts reported in the consolidated financial statements and
accompanying notes. Actual results could differ from those estimates.
Investments. LNC classifies its fixed maturity and equity securities as
available-for-sale and, accordingly, such securities are carried at fair
value. The cost of fixed maturity securities is adjusted for amortization
of premiums and discounts. The cost of fixed maturity and equity securities
is reduced to fair value with a corresponding charge to realized loss on
investments for declines in value that are other than temporary.
For the mortgage-backed securities portion of the fixed maturity securities
portfolio, LNC recognizes income using a constant effective yield based on
anticipated prepayments and the estimated economic life of the securities.
When estimates of prepayments change, the effective yield is recalculated
to reflect actual payments to date and anticipated future payments. The net
investment in the securities is adjusted to the amount that would have
existed had the new effective yield been applied at the time of
acquisition. This adjustment is reflected in net investment income.
Mortgage loans on real estate are carried at the outstanding principal
balances adjusted for amortization of premiums and discounts. Investment
real estate is carried at cost less accumulated depreciation. The cost for
both mortgage loans on real estate and investment real estate is adjusted
for declines in value that are other than temporary. Also, allowances for
losses are established, as appropriate, for real estate holdings that are
in the process of being sold. Real estate acquired through foreclosure
proceedings is recorded at fair value on the settlement date which
establishes a new cost basis. If a subsequent periodic review of a
foreclosed property indicates the fair value, less estimated costs to sell,
is lower than the carrying value at the settlement date, the carrying value
is adjusted to the lower amount. Any changes to the reserves for mortgage
loans on real estate and real estate are reported as realized gain (loss)
on investments.
Policy loans are carried at aggregate unpaid balances.
Cash and invested cash are carried at cost and include all highly liquid
debt instruments purchased with a maturity of three months or less.
Realized gain (loss) on investments is recognized in net income, net of
associated amortization of deferred acquisition costs and investment
expenses, using the specific identification method. Changes in the fair
values of securities carried at fair value are reflected directly in
shareholders' equity, after deductions for related adjustments for deferred
acquisition costs and amounts required to satisfy policyholder commitments
that would have been recorded had these securities been sold at their fair
value, and after deferred taxes or credits to the extent deemed
recoverable.
Realized gain (loss) on sale of subsidiaries, net of taxes, is recognized
in net income. Realized gain (loss) on sale of minority interests in
subsidiaries is reflected directly in shareholders' equity net of deferred
taxes, if any.
Derivative Instruments. For the years ended December 31, 2001, 2000 and
1999, LNC hedged certain portions of its exposure to interest rate
fluctuations, the widening of bond yield spreads over comparable maturity
U.S. Government obligations, credit risk, foreign exchange risk, commodity
risk and equity risk fluctuations by entering into derivative transactions.
A description of LNC's accounting for its hedging of such risks is
discussed in the following paragraphs.
Effective upon the adoption of Statement of Financial Accounting Standard
No. 133, "Accounting for Derivative Instruments and Hedging Activities,"
("FAS 133") on January 1, 2001, LNC recognizes all derivative instruments
as either assets or liabilities in the consolidated balance sheet at fair
value. FAS 133 standardized the accounting for derivative instruments,
including certain derivative instruments embedded in other contracts. The
accounting for changes in the fair value of a derivative instrument depends
on whether it has been designated and qualifies as part of a hedging
relationship and further, on the type of hedging relationship. For those
derivative instruments that are designated and qualify as hedging
instruments, LNC must designate the hedging instrument based upon the
exposure being hedged - as a cash flow hedge, fair value hedge or a hedge
of a net investment in a foreign operation. As of December 31, 2001, LNC
had derivative instruments that were designated and qualified as cash flow
hedges and fair value hedges. In addition, LNC had derivative instruments
that are economic hedges, but are not designated as hedging instruments
under FAS 133. Finally, LNC did not have derivative instruments that were
designated as hedges of a net investment in a foreign operation.
For derivative instruments that are designated and qualify as a cash flow
hedge, the effective portion of the gain or loss on the derivative
instrument is reported as a component of other comprehensive income ("OCI")
and reclassified into net income in the same period or periods during which
the hedged transaction affects net income. The remaining gain or loss on
the derivative instrument in excess of the cumulative change in the present
value of designated future cash flows of the hedged item (hedge
ineffectiveness), if any, is recognized in current income during the period
of change. For derivative instruments that are designated and qualify as a
fair value hedge, the gain or loss on the derivative instrument as well as
the offsetting loss or gain on the hedged item attributable to the hedged
risk are recognized in current income during the period of change in fair
values. For derivative instruments that are designated and qualify as a
hedge of a net investment in a foreign operation, the gain or loss is
reported in OCI as part of the cumulative translation adjustment to the
extent it is effective. For derivative instruments not designated as
hedging instruments, the gain or loss is recognized in current income
during the period of change.
See Note 7 for further discussion of LNC's accounting policy for derivative
instruments.
Prior to January 1, 2001, derivative instruments were carried in other
investments. The premiums paid for interest rate caps and swaptions were
deferred and amortized to net investment income on a straight-line basis
over the term of the respective derivative. Interest rate caps that hedged
interest credited on fixed annuity liabilities were carried at amortized
cost. Any settlement received in accordance with the terms of the interest
rate caps was also recorded as net investment income. Realized gain (loss)
from the termination of the interest rate caps was included in net income.
Swaptions, put options, spread-lock agreements, interest rate swaps,
commodity swaps and financial futures that hedge fixed maturity securities
available-for-sale were carried at fair value. The change in fair value was
reflected directly in shareholders' equity. Settlements on interest rate
swaps and commodity swaps were recognized in net investment income.
Realized gain (loss) from the termination of swaptions, put options,
spread-lock agreements, interest rate swaps, commodity swaps and financial
futures were deferred and amortized over the life of the hedged assets as
an adjustment to the yield. Forward-starting interest rate swaps were also
used to hedge the forecasted purchase of investments. These interest rate
swaps were carried off-balance sheet until the occurrence of the forecasted
transaction at which time the interest rate swaps were terminated and any
gain (loss) on termination was used to adjust the basis of the forecasted
purchase. If the forecasted purchase did not occur or the interest rate
swaps were terminated early, changes in the fair value of the swaps were
recorded in net income.
Over-the-counter call options which hedged liabilities tied to the S&P
stock index were carried at fair value. The change in fair value was
reflected directly in net income. Gain (loss) realized upon termination of
these call options was included in net income. Over-the-counter call
options which hedge stock appreciation rights were carried at fair value
when hedging vested stock appreciation rights and at cost when hedging
unvested stock appreciation rights. The change in fair value of call
options hedging vested stock appreciation rights was included in net
income. Gain (loss) upon termination was reported in net income.
Foreign exchange forward contracts which hedged debt issued by Lincoln UK
in a foreign currency were carried at fair value. The change in fair value
was included in income. Gain (loss) upon termination was reported in net
income. Foreign currency swaps, which hedged some of the foreign exchange
risk of investments in fixed maturity securities denominated in foreign
currencies, were carried at fair value. The change in fair value was
included in shareholders' equity. Realized gain (loss) from the termination
of such derivatives was included in net income. Foreign exchange forward
contracts were also used to hedge LNC's net investment in a foreign
subsidiary. These foreign exchange forward contracts were initially carried
at zero. Carrying value was adjusted for changes in the currency spot rate,
as well as amortization of forward points. Changes in carrying value were
recorded in the foreign currency translation adjustment.
Prior to January 1, 2001, hedge accounting was applied as indicated above
after LNC determined that the items to be hedged exposed LNC to interest
rate fluctuations, the widening of bond yield spreads over comparable
maturity U.S. Government obligations, credit risk, foreign exchange risk or
equity risk. Moreover, the derivatives used to hedge these exposures were
designated as hedges and reduced the indicated risk demonstrating a high
correlation between changes in the value of the derivatives and the items
being hedged at both the inception of the hedge and throughout the hedge
period. Should such criteria have not been met or if the hedged items were
sold, terminated or matured, the change in value of the derivatives was
included in net income.
Loaned Securities. Securities loaned are treated as collateralized
financing transactions and a liability is recorded equal to the cash
collateral received which is typically greater than the market value of the
related securities loaned. In other instances, LNC will hold as collateral
securities with a market value at least equal to the securities loaned.
Securities held as collateral are not recorded in LNC's consolidated
balance sheet in accordance with accounting guidance for secured borrowings
and collateral. LNC's agreements with third parties generally contain
contractual provisions to allow for additional collateral to be obtained
when necessary. LNC values collateral daily and obtains additional
collateral when deemed appropriate.
Property and Equipment. Property and equipment owned for company use is
carried at cost less allowances for depreciation.
Premiums and Fees. Revenue for universal life and other interest-sensitive
insurance policies consists of policy charges for the cost of insurance,
policy initiation and administration, and surrender charges that have been
assessed. Traditional individual life-health and annuity premiums are
recognized as revenue over the premium-paying period of the policies. Group
health premiums were prorated over the contract term of the policies.
Investment Advisory Fees. As specified in the investment advisory
agreements with the mutual funds, fees are determined and recognized as
revenues monthly, based on the average daily net assets of the mutual funds
managed. Investment advisory contracts generally provide for the
determination and payment of advisory fees based on market values of
managed portfolios at the end of a calendar month or quarter. Investment
management and advisory contracts typically are renewable annually with
cancellation clauses ranging up to 90 days.
Assets Held in Separate Accounts/Liabilities Related to Separate Accounts.
These assets and liabilities represent segregated funds administered and
invested by LNC's insurance subsidiaries for the exclusive benefit of
pension and variable life and annuity contractholders. Both the assets and
liabilities are carried at fair value. The fees earned by LNC's insurance
subsidiaries for administrative and contractholder maintenance services
performed for these separate accounts are included in insurance fee
revenue.
Deferred Acquisition Costs. Commissions and other costs of acquiring
universal life insurance, variable universal life insurance, unit-linked
products, traditional life insurance and annuities, which vary with and are
primarily related to the production of new business, have been deferred to
the extent recoverable. The methodology for determining the amortization of
acquisition costs varies by product type based on two different accounting
pronouncements: Statement of Financial Accounting Standards No. 97,
"Accounting by Insurance Companies For Certain Long-Duration Contracts &
Realized Gains & Losses on Investment Sales" ("FAS 97") and Statement of
Financial Accounting Standards No. 60, "Accounting and Reporting by
Insurance Enterprises" ("FAS 60"). Under FAS 97, acquisition costs for
investment-type products which include universal and variable universal
life policies, unit-linked products and fixed and variable deferred
annuities are amortized over the lives of the policies in relation to the
incidence of estimated gross profits from surrender charges; investment,
mortality net of reinsurance ceded and expense margins; and actual realized
gain (loss) on investments. Amortization is adjusted retrospectively when
estimates of current or future gross profits to be realized from a group of
products are revised. Policy lives for universal and variable universal
life policies are estimated to be 30 years based on the expected lives of
the policies and are variable based on the inception of each policy for
unit-linked policies. Policy lives for fixed and variable deferred
annuities are a period of 15 years for more recently developed product
policies, and the surrender charge period (ranging from 5 to 10 years) for
all other policies.
Under FAS 60, acquisition costs for traditional life insurance products,
which include whole life, term life and personal health insurance contracts
are amortized over periods of 10 to 30 years on either a straight-line
basis or as a level percent of premium of the related policies depending on
the block of business. There are currently no deferred acquisition costs
being amortized under FAS 60 for fixed and variable payout annuities.
For all FAS 97 and FAS 60 policies, amortization is based on assumptions
consistent with those used in the development of the underlying policy form
adjusted for emerging experience.
Benefits and Expenses. Benefits and expenses for universal life-type and
other interest-sensitive life insurance products include interest credited
to policy account balances and benefit claims incurred during the period in
excess of policy account balances. Interest crediting rates associated with
funds invested in the general account of LNC's insurance subsidiaries
during 1999 through 2001 ranged from 4.50% to 7.25%. For traditional life,
group health and disability income products, benefits and expenses, other
than deferred acquisition costs, are recognized when incurred in a manner
consistent with the related premium recognition policies.
Interest and debt expense includes interest on company-obligated
mandatorily redeemable preferred securities of subsidiary trusts holding
solely junior subordinated debentures.
Goodwill and Other Intangible Assets. Prior to January 1, 2002, goodwill,
as measured by the excess of the cost of acquired subsidiaries or
businesses over the fair value of net assets acquired, was amortized using
the straight-line method over periods of 20 to 40 years in accordance with
the benefits expected to be derived from the acquisitions. Effective
January 1, 2002, goodwill will not be amortized, but is subject to
impairment tests conducted at least annually.
Insurance businesses typically produce on-going profit streams from
expected new business generation that extend significantly beyond the
maximum 40-year period allowed for goodwill amortization. Accordingly, for
acquired insurance businesses where financial modeling indicated that
anticipated new business benefits would extend for 40 years or longer,
goodwill was amortized over a 40-year period.
Other intangible assets for acquired insurance businesses consist of the
value of existing blocks of business (referred to as the "present value of
in-force"). The present value of in-force is amortized over the expected
lives of the block of insurance business in relation to the incidence of
estimated profits expected to be generated on investment type products
acquired, (i.e. variable products) and over the premium paying period for
insurance products acquired, (i.e., traditional life insurance products).
Amortization is based upon assumptions used in pricing the acquisition of
the block of business and is adjusted for emerging experience. Accordingly,
amortization periods and methods of amortization for present value of
in-force vary depending upon the particular characteristics of the
underlying blocks of acquired insurance business.
Prior to January 1, 2002, goodwill relating to acquisitions of investment
management subsidiaries was amortized on a straight-line method, over a 25
year period. Effective January 1, 2002, goodwill will not be amortized, but
is subject to impairment tests conducted at least annually. Other
intangible assets relating to these acquisitions include institutional
customer relationships, covenants not to compete and mutual fund customer
relationships. These assets are still required to be amortized on a
straight-line basis over their useful life for periods ranging from 6 to 15
years depending upon the characteristics of the particular underlying
relationships for the intangible asset.
Prior to January 1, 2002, the carrying values of goodwill and other
intangibles assets were reviewed periodically for indicators of impairment
in value that are other than temporary, including unexpected or adverse
changes in the following: (1) the economic or competitive environments in
which the company operates, (2) profitability analyses, (3) cash flow
analyses, and (4) the fair value of the relevant subsidiary. If there was
an indication of impairment then the cash flow method would be used to
measure the impairment and the carrying value would be adjusted as
necessary. However, effective January 1, 2002, goodwill will be subject to
impairment tests conducted at least annually. Other intangible assets will
continue to be reviewed periodically for indicators of impairment
consistent with the policy that was in place prior to January 1, 2002.
Insurance and Investment Contract Liabilities. The liabilities for future
policy benefits and claim reserves for universal and variable universal
life insurance policies consist of policy account balances that accrue to
the benefit of the policyholders, excluding surrender charges. The
liabilities for future insurance policy benefits and claim reserves for
traditional life policies are computed using assumptions for investment
yields, mortality and withdrawals based principally on generally accepted
actuarial methods and assumptions at the time of policy issue. Interest
assumptions for traditional direct individual life reserves for all
policies range from 2.25% to 6.75% depending on the time of policy issue.
The interest assumptions for immediate and deferred paid-up annuities range
from 3.00% to 13.55%.
With respect to its insurance and investment contract liabilities, LNC
continually reviews its: 1) overall reserve position; 2) reserving
techniques and 3) reinsurance arrangements. As experience develops and new
information becomes known, liabilities are adjusted as deemed necessary.
The effects of changes in estimates are included in the operating results
for the period in which such changes occur.
Reinsurance. LNC's insurance companies enter into reinsurance agreements
with other companies in the normal course of business. Prior to the
acquisition of LNC's reinsurance operations by Swiss Re on December 7,
2001, LNC's insurance subsidiaries assumed reinsurance from unaffiliated
companies. The transaction with Swiss Re involved a series of indemnity
reinsurance transactions combined with the sale of certain stock companies
that comprised LNC's reinsurance operations. Assets/liabilities and
premiums/ benefits from certain reinsurance contracts that granted
statutory surplus to other insurance companies are netted on the
consolidated balance sheets and income statements, respectively, since
there is a right of offset. All other reinsurance agreements including the
Swiss Re indemnity reinsurance transaction are reported on a gross basis.
Depreciation. Provisions for depreciation of investment real estate and
property and equipment owned for company use are computed principally on
the straight-line method over the estimated useful lives of the assets.
Postretirement Medical and Life Insurance Benefits. LNC accounts for its
postretirement medical and life insurance benefits using the full accrual
method.
Stock Options. LNC recognizes compensation expense for its stock option
incentive plans using the intrinsic value method of accounting. Under the
terms of the intrinsic value method, compensation cost is the excess, if
any, of the quoted market price of the stock at the grant date, or other
measurement date, over the amount an employee must pay to acquire the
stock.
Foreign Exchange. LNC's foreign subsidiaries' balance sheet accounts and
income statement items are translated at the current exchange and average
exchange rates for the year, respectively. Resulting translation
adjustments are reported as a component of shareholders' equity. Other
translation adjustments for foreign currency transactions that affect cash
flows are reported in comprehensive income.
Earnings per Share. Basic earnings per share is computed by dividing
earnings available to common shareholders by the average common shares
outstanding. Diluted earnings per share is computed assuming the conversion
or exercise of dilutive convertible preferred securities, non-vested stock,
stock options and deferred compensation shares outstanding during the year.
Reclassifications. Certain amounts reported in prior years' consolidated
financial statements have been reclassified to conform with the
presentation adopted in the current year. These reclassifications have no
effect on net income or shareholders' equity of the prior years.
2. Changes in Estimates and Changes in Accounting Principles
Change in Estimate for HMO Excess-of-Loss Reinsurance Programs. During the
third quarter of 1999, reported claims experience for certain HMO
excess-of-loss reinsurance programs deteriorated causing loss ratios to
significantly exceed pricing assumptions. The unfavorable loss ratio
development related primarily to business written in 1998 and 1997. Time
lags in the reporting of claims experience to LNC's former Reinsurance
segment ("Lincoln Re) by clients and larger than anticipated costs for
prescription drugs were significant factors that led to losses exceeding
pricing assumptions. As a result of these developments, the reserve level
for these programs was deemed inadequate to meet future obligations.
Consequently, Lincoln Re took a charge in the third quarter of 1999 of
$25.0 million after-tax or $0.12 per share ($38.5 million pre-tax) to
strengthen reserves for claims on the HMO excess-of-loss reinsurance
programs.
Change in Estimate for United Kingdom Pension Mis-Selling. During
the fourth quarter of 1999, LNC recorded a charge of $126.1 million
after-tax or $0.64 per share ($194.0 million pre-tax) to further strengthen
its reserve for pension mis-selling in the UK. The additional reserve
strengthening was made following: 1) the mandate issued by Financial
Services Authority, the UK regulating body, for the use of more up to date
mortality rates in determining redress and reduced interest rate
assumptions to be used in calculating redress, thereby causing the amount
of redress to increase and 2) the change to guidance that would have
allowed a simplified process for the calculation and payment of redress for
certain policy groups and the inclusion of redress relating to additional
voluntary contributions made to pension plans by individuals, retroactive
to 1988.
Change in Estimate for Personal Accident Programs. During the fourth
quarter of 1999, LNC's former Reinsurance segment conducted an in-depth
review of its exposure related to its participation in workers'
compensation carve-out (i.e., life and health risks associated with
workers' compensation coverage) programs managed by Unicover Managers, Inc.
As a result of this review as well as settlement proceedings conducted to
resolve this issue, LNC took a charge of $40.4 million after-tax or $0.20
per share ($62.2 million pre-tax) in the fourth quarter of 1999.
Change in Estimate of Premium Receivables on Certain Client-Administered
Individual Life Reinsurance. During the first quarter of 2001, LNC's former
Reinsurance segment refined its estimate of due and unpaid premiums on its
client-administered individual life reinsurance business. As a result of
the significant growth in the individual life reinsurance business
generated in recent years, the Reinsurance segment initiated a review of
the block of business in the last half of 2000. An outgrowth of that
analysis resulted in a review of the estimation of premiums receivable for
due and unpaid premiums on client-administered business. During the first
quarter of 2001, the Reinsurance segment completed the review of this
matter, and concluded that enhanced information flows and refined actuarial
techniques provided a basis for a more precise estimate of premium
receivables on this business. As a result, the Reinsurance segment recorded
income of $25.5 million or $0.13 per share ($39.3 million pre-tax) related
to periods prior to 2001.
Accounting for Derivative Instruments and Hedging Activities. In June 1998,
the Financial Accounting Standards Board ("FASB") issued Statement of
Financial Accounting Standards No. 133, "Accounting for Derivative
Instruments and Hedging Activities" ("FAS 133"). In July 1999, the FASB
issued Statement of Financial Accounting Standards No. 137, "Accounting for
Derivative Instruments and Hedging Activities-Deferral of the Effective
Date of FASB Statement No. 133" ("FAS 137"), which delayed the effective
date of FAS 133 one year (i.e., adoption required no later than the first
quarter of 2001). In June 2000, the FASB issued Statement of Financial
Accounting Standards No. 138, "Accounting for Certain Derivative
Instruments and Certain Hedging Activities" ("FAS 138"), which addresses a
limited number of implementation issues arising from FAS 133.
LNC adopted FAS 133 on January 1, 2001. Upon adoption, the provisions of
FAS 133 were applied prospectively. The transition adjustments that LNC
recorded upon adoption of FAS 133 on January 1, 2001 resulted in a net loss
of $4.3 million after-tax or $0.02 per share ($6.6 million pre-tax)
recorded in net income, and a net gain of $17.6 million after-tax or $0.09
per share ($27.1 million pre-tax) recorded as a component of Other
Comprehensive Income ("OCI") in equity. Deferred acquisition costs of $4.8
million were restored and netted against the transition loss on derivatives
recorded in net income and deferred acquisition costs of $18.3 million were
amortized and netted against the transition gain recorded in OCI. A portion
of the transition adjustment ($3.5 million after-tax) recorded in net
income upon adoption of FAS 133 was reclassified from the OCI account, Net
Unrealized Gain on Securities Available-for-Sale. These transition
adjustments were reported in the financial statements as the cumulative
effect of a change in accounting principle.
Recognition of Interest Income and Impairment on Purchased and Retained
Beneficial Interests in Securitized Financial Assets. On April 1, 2001, LNC
adopted Emerging Issues Task Force Issue No. 99-20, "Recognition of
Interest Income and Impairment on Purchased and Retained Beneficial
Interests in Securitized Financial Assets" ("EITF 99-20"). EITF 99-20 is
effective for fiscal quarters beginning after March 15, 2001. EITF 99-20
changed the manner in which LNC determined impairment of certain
investments including collateralized bond obligations. Upon the adoption of
EITF 99-20, LNC recognized a net realized loss on investments of $11.3
million after-tax or $0.06 per share ($17.3 million pre-tax) reported as a
cumulative effect of change in accounting principle. In arriving at this
amount, deferred acquisition costs of $12.2 million were restored and
netted against net realized loss on investments.
Accounting for Business Combinations and Goodwill and Other Intangible
Assets. In June 2001, the Financial Accounting Standards Board issued
Statements of Financial Accounting Standards No. 141, "Business
Combinations" ("FAS 141"), and No. 142, "Goodwill and Other Intangible
Assets" ("FAS 142"). FAS 141 is effective for all business combinations
initiated after June 30, 2001, and FAS 142 is effective for fiscal years
beginning after December 15, 2001. Under the new rules, goodwill will no
longer be amortized, but will be subject to impairment tests conducted at
least annually in accordance with the new standards. Intangible assets that
do not have indefinite lives will continue to be amortized over their
estimated useful lives. LNC is required to adopt the new rules on
accounting for goodwill and other intangible assets effective January 1,
2002.
Although the review is ongoing regarding proper classification of goodwill
and other intangible assets on the consolidated balance sheet, LNC does not
expect to reclassify any goodwill or other intangible balances held as of
December 31, 2001. Application of the non-amortization provisions of the
new standards is expected to result in an increase in net income of $41.7
million ($0.22 per share based on the average diluted shares for the year
ended December 31, 2001) in 2002. During the first six months of 2002, LNC
will perform the first of the required impairment tests of goodwill as of
January 1, 2002. LNC expects that the valuation techniques to be used to
estimate the fair values of the group of assets comprising the different
reporting units will vary based on the characteristics of each reporting
unit's business and operations. A discounted cash flow model is expected to
be used to assess the goodwill in LNC's Life Insurance, Annuities and
Lincoln UK segments and a valuation technique combining multiples of
revenues, earnings before interest, taxes, depreciation and amortization
("EBITDA") and assets under management is expected to be used to assess the
goodwill in LNC's Investment Management segment. Based upon preliminary
analysis of the fair value of each reporting unit which has a goodwill
asset, the estimated fair value of each reporting unit exceeds the carrying
value of each reporting unit. Therefore, LNC does not expect to record an
impairment loss on its goodwill during the transition period for adoption
of FAS 142.
Accounting for the Impairment or Disposal of Long-Lived Assets. In August
2001, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 144, "Accounting for the Impairment or
Disposal of Long-Lived Assets" ("FAS 144"), which addresses financial
accounting and reporting for the impairment or disposal of long-lived
assets and supersedes SFAS No. 121, "Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to be Disposed Of", and the
accounting and reporting provisions of APB Opinion No. 30, "Reporting the
Results of Operations" for a disposal of a segment of a business. FAS 144
is effective for fiscal years beginning after December 15, 2001. LNC
expects to adopt FAS 144 as of January 1, 2002 and it does not expect that
the adoption of the Statement will have a significant impact on the
consolidated financial position and results of operations of LNC.
3. Investments
The amortized cost, gross unrealized gains and losses, and fair value of
securities available-for-sale are as follows:
Amortized Fair
December 31 (in millions) Cost Gains Losses Value
- ----------------------------------------------------------------------------------------------------------------
2001:
Corporate bonds $22,934.8 $742.8 $(572.5) $23,105.1
U.S. Government bonds 357.9 57.4 (4.8) 410.5
Foreign government bonds 1,117.3 70.1 (12.7) 1,174.7
Asset and mortgage-backed securities:
Mortgage pass-through securities 609.9 15.1 (7.4) 617.6
Collateralized mortgage obligations 1,479.1 63.7 (5.5) 1,537.3
Other asset-backed securities 1,328.5 52.7 (11.3) 1,369.9
State and municipal bonds 45.9 0.3 (1.5) 44.7
Redeemable preferred stocks 82.6 3.5 (0.2) 85.9
- ----------------------------------------------------------------------------------------------------------------
Total fixed maturity securities 27,956.0 1,005.6 (615.9) 28,345.7
Equity securities 444.4 69.8 (43.7) 470.5
- ----------------------------------------------------------------------------------------------------------------
Total $28,400.4 $1,075.4 $(659.6) $28,816.2
================================================================================================================
2000:
Corporate bonds $21,369.6 $514.1 $(634.0) $21,249.7
U.S. Government bonds 479.9 71.8 (8.9) 542.8
Foreign government bonds 1,264.0 74.1 (17.0) 1,321.1
Asset and mortgage-backed securities:
Mortgage pass-through securities 970.8 13.1 (10.6) 973.3
Collateralized mortgage obligations 1,675.7 59.6 (14.7) 1,720.6
Other asset-backed securities 1,440.8 36.5 (10.8) 1,466.5
State and municipal bonds 14.6 0.1 (0.1) 14.6
Redeemable preferred stocks 161.7 0.9 (1.4) 161.2
- ----------------------------------------------------------------------------------------------------------------
Total fixed maturity securities 27,377.1 770.2 (697.5) 27,449.8
Equity securities 462.8 106.8 (19.9) 549.7
- ----------------------------------------------------------------------------------------------------------------
Total $27,839.9 $877.0 $(717.4) $27,999.5
================================================================================================================
Future maturities of fixed maturity securities available-for-sale are as follows:
Amortized Fair
December 31, 2001 (in millions) Cost Value
- ----------------------------------------------------------------------------------------
Due in one year or less $861.6 $873.5
Due after one year through five years 6,121.2 6,247.6
Due after five years through ten years 9,100.5 9,082.4
Due after ten years 8,455.2 8,617.4
- ----------------------------------------------------------------------------------------
Subtotal 24,538.5 24,820.9
Asset and mortgage-backed securities 3,417.5 3,524.8
- ----------------------------------------------------------------------------------------
Total $27,956.0 $28,345.7
========================================================================================
The foregoing data is based on stated maturities. Actual maturities will differ
in some cases because borrowers may have the right to call or pre-pay
obligations.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Par value, amortized cost and estimated fair value of investments in asset and
mortgage-backed securities summarized by interest rates of the underlying
collateral are as follows:
Par Amortized Fair
December 31, 2001 (in millions) Value Cost Value
- -----------------------------------------------------------------
Below 7% $1,089.6 $409.3 $412.3
7% - 8% 1,902.9 1,888.5 1,937.2
8% - 9% 725.0 720.0 754.8
Above 9% 401.5 399.7 420.5
- -----------------------------------------------------------------
Total $4,119.0 $3,417.5 $3,524.8
=================================================================
The quality ratings for fixed maturity securities
available-for-sale are as follows:
December 31 2001
- -----------------------------------------------------------------
Treasuries and AAA 17.3%
AA 6.4
A 30.3
BBB 37.7
BB 5.1
Less than BB 3.2
- -----------------------------------------------------------------
100.0%
=================================================================
The major categories of net investment income are as follows:
Year Ended December 31 (in millions) 2001 2000 1999
- ----------------------------------------------------------------------------------------------------
Fixed maturity securities $2,121.0 $2,148.7 $2,232.9
Equity securities 17.6 19.4 20.1
Mortgage loans on real estate 374.5 373.8 369.2
Real estate 49.5 51.8 64.1
Policy loans 125.3 125.0 116.5
Invested cash 68.4 87.2 110.2
Other investments 69.5 66.9 51.8
- ----------------------------------------------------------------------------------------------------
Investment revenue 2,825.8 2,872.8 2,964.8
Investment expense 146.2 125.7 157.3
- ----------------------------------------------------------------------------------------------------
Net investment income $2,679.6 $2,747.1 $2,807.5
====================================================================================================
The realized gain (loss) on investments is as follows:
Year Ended December 31 (in millions) 2001 2000 1999
- ----------------------------------------------------------------------------------------------------
Fixed maturity securities available-for-sale
Gross gain $193.0 $146.5 $129.1
Gross loss (435.3) (218.2) (251.7)
Equity securities available-for-sale
Gross gain 30.2 58.0 97.0
Gross loss (24.4) (48.6) (36.5)
Other investments 33.7 5.9 49.3
Associated amortization of deferred acquisition costs,
provision for policyholder commitments and
investment expenses 97.6 28.1 15.8
- ----------------------------------------------------------------------------------------------------
Total Investments (105.2) (28.3) 3.0
Derivative Instruments net of associated amortization
of deferred acquisition costs (9.3) -- --
- ----------------------------------------------------------------------------------------------------
Total Investments and Derivative Instruments $(114.5) $(28.3) $3.0
====================================================================================================
Provisions (credits) for write-downs and net changes in allowances for
loss, which are included in the realized gain (loss) on investments shown
above, are as follows:
Year Ended December 31 (in millions) 2001 2000 1999
- ----------------------------------------------------------------------------------------------------
Fixed maturity securities $237.2 $41.2 $29.3
Equity securities 15.7 14.6 5.6
Mortgage loans on real estate (2.7) 0.2 (0.1)
Real estate 0.7 -- --
Other long-term investments 0.9 -- (7.6)
Guarantees -- -- --
- ----------------------------------------------------------------------------------------------------
Total $251.8 $56.0 $27.2
====================================================================================================
The change in net unrealized appreciation (depreciation) on investments in
fixed maturity and equity securities available-for-sale is as follows:
Year Ended December 31 (in millions) 2001 2000 1999
- ----------------------------------------------------------------------------------------------------
Fixed maturity securities $317.0 $741.2 $(2,261.8)
Equity securities (60.8) (35.6) 16.4
- ----------------------------------------------------------------------------------------------------
Total $256.2 $705.6 $(2,245.4)
====================================================================================================
During the second quarter of 1998, LNC purchased three bonds issued with
offsetting interest rate characteristics. Subsequent to the purchase of
these bonds, interest rates increased and the value of one of these bonds
decreased. This bond was sold at the end of the second quarter 1998 and a
realized loss of $28.8 million ($18.7 million after-tax) was recorded. The
other two bonds are still owned by LNC and are producing net investment
income on an annual basis of $9.9 million ($6.4 million after-tax).
Subsequent to these transactions being recorded, the Emerging Issues Task
Force of the Financial Accounting Standards Board reached consensus with
regard to accounting for this type of investment strategy. LNC is not
required to apply the new accounting rules, however, if such rules were
applied, the realized loss on the sale of $28.8 million ($18.7 million
after-tax) on one of these bonds recorded at the end of the second quarter
of 1998 would be reduced to $8.8 million ($5.7 million after-tax) and the
difference would be applied as a change in the carrying amount of the two
bonds that remain in LNC's portfolio. Also, net investment income for the
year ended December 31, 2001, 2000 and 1999 would be less than reported by
$2.7 million ($1.8 million after-tax), $2.5 million ($1.6 million
after-tax) and $2.3 million ($1.5 million after-tax), respectively.
The balance sheet captions, "Real Estate" and " Property and Equipment,"
are shown net of allowances for depreciation as follows:
December 31 (in millions) 2001 2000
- ----------------------------------------------------------------------------------------------------
Real estate $38.4 $40.4
Property and equipment 211.7 247.9
====================================================================================================
Mortgage loans on real estate which are primarily held in the Life
Insurance and Annuities segments are considered impaired when, based on
current information and events, it is probable that LNC will be unable to
collect all amounts due according to the contractual terms of the loan
agreement. When LNC determines that a loan is impaired, the cost is
adjusted or a provision for loss is established equal to the difference
between the initial cost of the mortgage loan and the estimated value.
Estimated value is based on: 1) the present value of expected future cash
flows discounted at the loan's effective interest rate; 2) the loan's
observable market price; or 3) the fair value of the collateral. The
provision for losses is reported as realized gain (loss) on investments.
Mortgage loans deemed to be uncollectible are charged against the allowance
for losses and subsequent recoveries, if any, are credited to the allowance
for losses.
The allowance for losses is maintained at a level believed adequate by
management to absorb estimated probable credit losses. Management's
periodic evaluation of the adequacy of the allowance for losses is based on
LNC's past loan loss experience, known and inherent risks in the portfolio,
adverse situations that may affect the borrower's ability to repay
(including the timing of future payments), the estimated value of the
underlying collateral, composition of the loan portfolio, current economic
conditions and other relevant factors. This evaluation is inherently
subjective, as it requires estimating the amounts and timing of future cash
flows expected to be received on impaired loans that may be susceptible to
significant change.
Impaired mortgage loans along with the related allowance for losses are as
follows:
December 31 (in millions) 2001 2000
- ----------------------------------------------------------------------------------------------------
Impaired loans with allowance for losses $25.6 $26.9
Allowance for losses (2.2) (4.9)
- ----------------------------------------------------------------------------------------------------
Net impaired loans $23.4 $22.0
====================================================================================================
A reconciliation of the mortgage loan allowance for losses for these impaired
mortgage loans is as follows:
Year Ended December 31 (in millions) 2001 2000 1999
- ----------------------------------------------------------------------------------------------------
Balance at beginning-of-year $4.9 $4.7 $4.8
Provisions for losses 0.7 1.8 0.8
Releases due to principal paydowns (3.4) (1.6) (0.9)
Releases due to foreclosures -- -- --
- ----------------------------------------------------------------------------------------------------
Balance at end-of-year $2.2 $4.9 $4.7
====================================================================================================
The average recorded investment in impaired mortgage loans and the interest
income recognized on impaired mortgage loans were as follows:
Year Ended December 31 (in millions) 2001 2000 1999
- ----------------------------------------------------------------------------------------------------
Average recorded investment in impaired loans $25.0 $27.9 $29.6
Interest income recognized on impaired loans 3.0 2.6 2.9
====================================================================================================
All interest income on impaired mortgage loans was recognized on the cash
basis of income recognition.
As of December 31, 2001 and 2000, LNC had restructured mortgage loans of
$5.2 million and $4.1 million, respectively. LNC recorded $0.5 million and
$0.3 million of interest income on these restructured mortgage loans in
2001 and 2000, respectively. Interest income in the amount of $0.5 million
and $0.4 million would have been recorded on these mortgage loans according
to their original terms in 2001 and 2000, respectively. As of December 31,
2001 and 2000, LNC had no outstanding commitments to lend funds on
restructured mortgage loans.
An investment in real estate is considered impaired when the projected
undiscounted cash flow from the investment is less than the carrying value.
When LNC determines that an investment in real estate is impaired, it is
written-down to reduce the carrying value to the estimated value.
As of December 31, 2001, LNC's investment commitments for fixed maturity
securities (primarily private placements), mortgage loans on real estate
and real estate were $496.1 million. This includes $276.6 million of
standby commitments to purchase real estate upon completion and leasing.
For the year ended December 31, 2001, fixed maturity securities
available-for-sale, mortgage loans on real estate and real estate
investments which were non-income producing were not significant. As of
December 31, 2001 and 2000, the carrying value of non-income producing
securities was $32.4 million and $11.3 million, respectively.
The cost information for mortgage loans on real estate, real estate and
other long-term investments is net of allowances for losses. The balance
sheet account for other liabilities includes a reserve for guarantees of
third-party debt. The amount of allowances and reserves for such items is
as follows:
December 31 (in millions) 2001 2000
- ----------------------------------------------------------------------------------------------------
Mortgage loans on real estate 2.2 4.9
Real estate -- --
Guarantees 0.3 0.3
====================================================================================================
During the fourth quarter of 2000, LNC completed a securitization of
commercial mortgage loans. In the aggregate, the loans had a fair value of
$186.0 million and carrying value of $185.7 million. LNC retained a 6.3%
beneficial interest in the securitized assets. LNC received $172.7 million
from the trust for the sale of the senior trust certificates representing
the other 93.7% beneficial interest. A realized gain of $0.4 million
pre-tax was recorded on this sale. A recourse liability was not recorded
since LNC is not obligated to repurchase any loans from the trust that may
later become delinquent. Cash flows received during 2001 and 2000 from
interests retained in the trust were $2.6 million and $0.4 million,
respectively. The fair values of the mortgage loans were based on a
discounted cash flow method based on credit rating, maturity and future
income. Prepayments are expected to be less than 1% with an expected
weighted-average life of 6.4 years. Credit losses are anticipated to be
minimal over the life of the trust.
During the fourth quarter of 2001, LNC completed a second securitization
of commercial mortgage loans. In the aggregate, the loans had a fair
value of $209.7 million and a carrying value of $198.1 million. LNC
received $209.7 million from the trust for the sale of the loans. A
recourse liability was not recorded since LNC is not obligated to
repurchase any loans from the trust that may later become delinquent.
Servicing fees of $0.03 million were received in 2001. The transaction
was hedged with total return swaps to lock in the value of the loans.
LNC recorded a loss on the hedge of $10.1 million pre-tax and a realized
gain on the sale of $11.6 million resulting in a net gain of $1.5
million pre-tax. Upon securitization, LNC did not retain an interest in
the securitized assets; however, LNC later invested $14.3 million of its
general account assets in the certificates issued by the trust. This
investment is included in fixed maturity securities on the balance sheet.
4. Federal Income Taxes
The Federal income tax expense (benefit) is as follows:
Year Ended December 31 (in millions) 2001 2000 1999
- ----------------------------------------------------------------------------------------------------
Current $489.6 $25.2 $(55.5)
Deferred (331.2) 189.7 165.1
- ----------------------------------------------------------------------------------------------------
Total tax expense $158.4 $214.9 $109.6
====================================================================================================
The effective tax rate on pre-tax income is lower than the prevailing
corporate Federal Income tax rate. A reconciliation of this difference
is as follows:
2001 2000 1999
- ----------------------------------------------------------------------------------------------------
Tax rate times pre-tax income from continuing operations $267.5 $292.7 $199.5
Effect of:
Tax-preferred investment income (62.6) (64.3) (47.7)
Change in valuation allowance -- -- (38.2)
UK taxes (28.5) (14.0) 5.6
Other items (18.0) 0.5 (9.6)
- ----------------------------------------------------------------------------------------------------
Provision for income taxes $158.4 $214.9 $109.6
Effective tax rate 21% 26% 19%
====================================================================================================
The Federal income tax recoverable asset (liability) is as follows:
December 31 (in millions) 2001 2000
- ----------------------------------------------------------------------------------------------------
Current $(439.0) $(73.8)
Deferred 454.1 281.3
- ----------------------------------------------------------------------------------------------------
Total Federal income tax asset $15.1 $207.5
====================================================================================================
December 31 (in millions) 2001 2000
- ----------------------------------------------------------------------------------------------------
Deferred tax assets:
Insurance and investment contract liabilities $978.4 $1,218.3
Reinsurance deferred gain 437.9 --
Net operating loss carryforwards 69.8 170.0
Postretirement benefits other than pensions 42.5 48.4
Compensation related 66.9 69.6
Other 126.8 93.4
- ----------------------------------------------------------------------------------------------------
Total deferred tax assets 1,722.3 1,599.7
Valuation allowance for deferred tax assets 51.2 --
- ----------------------------------------------------------------------------------------------------
Net deferred tax assets 1,671.1 1,599.7
Deferred tax liabilities:
Deferred acquisition costs 515.0 541.2
Premiums and fees receivable -- 83.0
Investment related 57.9 134.8
Net unrealized gain on securities available-for-sale 135.4 17.0
Present value of business in-force 391.5 423.4
Other 117.2 119.0
- ----------------------------------------------------------------------------------------------------
Total deferred tax liabilities 1,217.0 1,318.4
- ----------------------------------------------------------------------------------------------------
Net deferred tax asset $454.1 $281.3
====================================================================================================
Cash paid for federal income taxes in 2001 was $57.6 million. Cash received
for Federal income taxes in 2000 was $79.1 million due to the carry back of
1999 tax losses.
LNC is required to establish a valuation allowance for any gross
deferred tax assets that are unlikely to reduce taxes payable in future
years' tax returns. At December 31, 2001, LNC established a valuation
allowance of $51.2 million for the gross deferred tax assets relating to
net operating losses of its remaining foreign life reinsurance
subsidiary. The net operating losses of this subsidiary are subject to
Federal income tax limitations that only allow the losses to be used to
offset future taxable income of the subsidiary. Due to the disposition
of its reinsurance operations, LNC believes that it is more likely than
not that LNC will not realize the tax benefits associated with this
subsidiary's net operating losses. Because LNC has been required to
defer recognition of the gain on the portion of the disposition of its
reinsurance operation that was structured as indemnity reinsurance, the
establishment of this valuation allowance was recorded as a decrease in
the after-tax amount of the reinsurance deferred gain carried on LNC's
consolidated balance sheet. Accordingly, the establishment of this
valuation allowance did not affect 2001 net income.
At December 31, 2000, LNC concluded that it was more likely than not
that all gross deferred tax assets will reduce taxes payable in future
years. Accordingly, no valuation allowance was necessary at December 31,
2000. During 2000, the net unrealized capital loss position that existed
at December 31, 1999 for LNC's fixed maturity and equity securities was
eliminated primarily due to changes in market conditions. The deferred
tax asset valuation allowance of $229 million that was established in
1999 due to the uncertainty of realizing the tax benefits associated
with the unrealized capital losses that existed at December 31, 1999 was
reversed in 2000. Because this valuation allowance was established in
shareholder's equity at December 31, 1999, LNC recorded the reversal of
this tax valuation allowance during 2000 in shareholders' equity.
When LNC management announced its intention to explore exiting the UK
insurance market in 1999, LNC was required to change its method of
accounting for Lincoln UK's taxes. Previously, taxes were computed based
upon LNC's intention to permanently reinvest earnings in the UK
subsidiaries. Under this approach, Lincoln UK was unable to recognize UK
tax benefits for a portion of the pension mis-selling losses recorded in
1997, since UK tax law restricted the use of these losses. However, when
the decision was made in the fourth quarter of 1999 that earnings would no
longer be permanently reinvested, U.S. tax rules rather than U.K. tax rules
became the primary factor in determining the overall deferred taxes for the
segment. LNC was required to adjust the level of deferred taxes based upon
U.S. tax rules, under the new operating assumption that earnings from
Lincoln UK will ultimately be repatriated to LNC. Accordingly, LNC
eliminated the $38.2 million valuation allowance and reduced its deferred
tax liabilities by another $3.9 million in the fourth quarter of 1999. A
tax benefit of $42.1 million was reported in net income by LNC in 1999
relating to these matters.
At December 31, 2001, LNC had net operating losses for Federal income
tax purposes of: $146.3 million for its remaining foreign life
reinsurance company that expire in the year 2014; $1.7 million for
Delaware Management Holdings, Inc. ("Delaware") that expire in the year
2008; $36.3 million for Lincoln Life & Annuity Company of New York
("Lincoln Life New York") that expire in the year 2013 and $15.3 million
of net capital losses for Lincoln Life & Annuity Company of New York
that expire in the year 2006. In contrast to the net operating losses of
the foreign life reinsurance subsidiary, the Delaware and Lincoln Life
New York net operating losses and net capital losses can be used in
future LNC consolidated U.S. tax returns. Accordingly, LNC believes that
it is more likely than not that the Delaware and Lincoln New York net
operating losses and capital losses will be fully utilized within the
allowable carryforward period.
Under prior Federal income tax law, one-half of the excess of a life
insurance company's income from operations over its taxable investment
income was not taxed, but was set aside in a special tax account designated
as "Policyholders' Surplus." At December 31, 2001, LNC has approximately
$196.0 million of untaxed "Policyholders' Surplus" on which no payment of
Federal income taxes will be required unless it is distributed as a
dividend, or under other specified conditions. Barring the passage of
unfavorable tax legislation, LNC does not believe that any significant
portion of the account will be taxed in the foreseeable future.
Accordingly, no deferred tax liability has been recognized relating to
LNC's Policyholders' Surplus balance. If the entire Policyholders' Surplus
balance became taxable at the current Federal rate, the tax would be
approximately $68.6 million.
5. Supplemental Financial Data
Reinsurance transactions included in the income statement captions,
"Insurance Premiums" and "Insurance Fees", are as follows:
Year Ended December 31 (in millions) 2001* 2000 1999
- ----------------------------------------------------------------------------------------------------
Insurance assumed $1,457.6 $1,299.8 $1,509.3
Insurance ceded 993.9 559.9 621.0
- ----------------------------------------------------------------------------------------------------
Net reinsurance premiums $463.7 $739.9 $888.3
====================================================================================================
* The reinsurance activity for the year ended December 31, 2001 includes
the activity of the Reinsurance segment for the eleven months ended
November 30, 2001 and the activity related to the indemnity reinsurance
transaction with Swiss Re for the one month ended December 31, 2001.
The income statement caption, "Benefits," is net of reinsurance recoveries
of $0.637 billion, $0.448 billion and $0.611 billion for the years ended
December 31, 2001, 2000 and 1999, respectively. Details underlying the
income statement caption, "Underwriting, Acquisition, Insurance and Other
Expenses," are as follows:
Year Ended December 31 (in millions) 2001 2000 1999
- ----------------------------------------------------------------------------------------------------
Commissions $860.3 $919.1 $961.0
Other volume related expenses 186.7 262.8 205.5
Operating and administrative expenses 1,049.0 1,148.0 1,156.9
Deferred acquisition costs net of amortization (343.7) (423.1) (314.6)
Restructuring charges 38.0 104.9 27.3
Goodwill amortization 43.4 45.1 49.1
Other 252.0 261.7 209.8
- ----------------------------------------------------------------------------------------------------
Total $2,085.7 $2,318.5 $2,295.0
====================================================================================================
The income statement caption, "Underwriting, Acquisition, Insurance and
Other Expenses," includes amortization of deferred acquisition costs of
$370.0 million, $340.1 million and $302.0 million for the years ended
December 31, 2001, 2000 and 1999, respectively. An additional $96.3
million, $38.5 million and $26.9 million of deferred acquisition costs was
restored (amortized) and netted against "Realized Gain (Loss) on
Investments" for the years ended December 31, 2001, 2000 and 1999,
respectively.
A reconciliation of the present value of insurance business acquired
included in other intangible assets is as follows:
Year Ended December 31 (in millions) 2001 2000 1999
- ----------------------------------------------------------------------------------------------------
Balance at beginning of year $1,483.3 $1,654.2 $1,753.3
Adjustments to balance (0.7) (15.6) 3.4
Interest accrued on unamortized balance 84.5 92.2 69.9
(Interest rates range from 5% to 7%)
Amortization (197.6) (224.9) (163.7)
Foreign exchange adjustment (7.0) (22.6) (8.7)
- ----------------------------------------------------------------------------------------------------
Balance at end-of-year 1,362.5 1,483.3 1,654.2
Other intangible assets (non-insurance) 50.1 73.7 92.3
- ----------------------------------------------------------------------------------------------------
Total other intangible assets at end-of-year $1,412.6 $1,557.0 $1,746.5
====================================================================================================
Future estimated amortization of insurance business acquired net of
interest on unamortized balance for LNC's insurance subsidiaries is as
follows (in millions):
- ----------------------------------------------------------------------------------------------------
2002 - $109.4 2004 - $99.6 2006 - $93.6
2003 - 103.9 2005 - 95.9 Thereafter - 860.1
====================================================================================================
Details underlying the balance sheet caption, "Contractholder Funds,"
are as follows:
December 31 (in millions) 2001 2000
- ----------------------------------------------------------------------------------------------------
Premium deposit funds $18,585.0 $17,715.5
Undistributed earnings on participating business 100.2 139.4
Other 562.7 522.2
- ----------------------------------------------------------------------------------------------------
Total $19,247.9 $18,377.1
====================================================================================================
Details underlying the balance sheet captions related to total debt are as
follows:
December 31 (in millions) 2001 2000
- ----------------------------------------------------------------------------------------------------
Short-term debt:
Commercial paper $221.7 $311.9
Other short-term notes 28.5 0.8
Current portion of long-term debt 100.0 0.2
- ----------------------------------------------------------------------------------------------------
Total short-term debt 350.2 312.9
Long-term debt less current portion:
7.625% notes payable, due 2002 -- 99.9
7.250% notes payable, due 2005 192.2 192.0
6.5% notes payable, due 2008 100.1 100.1
6.20% notes payable, due 2011 249.2 --
7% notes payable, due 2018 200.3 200.3
9.125% notes payable, due 2024 119.9 119.9
- ----------------------------------------------------------------------------------------------------
Total long-term debt 861.7 712.2
Company-obligated mandatorily redeemable preferred securities of
subsidiary trusts holding solely junior subordinated debentures:
8.75% Quarterly Income Preferred Securities -- 215.0
8.35% Trust Originated Preferred Securities (redeemed on January 7, 2002) 100.0 100.0
7.40% Trust Originated Preferred Securities 200.0 200.0
7.75% FELINE PRIDES 5.0 230.0
7.65% Trust Preferred Securities 169.7 --
- ----------------------------------------------------------------------------------------------------
Total 474.7 745.0
- ----------------------------------------------------------------------------------------------------
Total Debt $1,686.6 $1,770.1
====================================================================================================
The combined U.S. and U.K. commercial paper outstanding at December 31,
2001 and 2000, had a blended weighted average interest rate of
approximately 3.10% and 6.81%, respectively.
Future maturities of long-term debt including the current portion are as follows (in millions):
- ----------------------------------------------------------------------------------------------------
2002 - $100.0 2004 - $-- 2006 - $--
2003 - -- 2005 - 193.0 Thereafter - 670.3
====================================================================================================
LNC also has access to capital from minority interest in preferred
securities of subsidiary companies. In May 1996, LNC filed a shelf
registration with the Securities and Exchange Commission that would allow
LNC to offer and sell up to $500 million of various forms of hybrid
securities. These securities, which combine debt and equity
characteristics, are offered through a series of three subsidiaries
(Lincoln National Capital I, II and III). These subsidiaries were formed
solely for the purpose of issuing preferred securities and lending the
proceeds to LNC. The common securities of these subsidiaries are owned by
LNC. The only assets of Lincoln National Capital I, II, and III are the
notes receivable from LNC for such loans. Distributions are paid by these
subsidiaries to the preferred securityholders on a quarterly basis. The
principal obligations of these subsidiaries are irrevocably guaranteed by
LNC. Upon liquidation of these subsidiaries, the holders of the preferred
securities would be entitled to a fixed amount per share plus accumulated
and unpaid distributions. LNC reserves the right to: 1) redeem the
preferred securities at a fixed price plus accumulated and unpaid
distributions and; 2) extend the stated redemption date up to 19 years if
certain conditions are met.
In April 1998, LNC filed a shelf registration with the Securities and
Exchange Commission, that would allow LNC to offer and sell up to $1.3
billion of various securities, including regular debt, preferred stock,
common stock or hybrid securities. This filing included an aggregate of
$300 million from a previous filing that had not been utilized. In
conjunction with this shelf registration, three additional subsidiaries
were added (Lincoln National Capital IV, V and VI) to accommodate the
issuance of additional preferred securities. The purpose and terms of these
new subsidiaries essentially parallel Lincoln National Capital I, II and
III.
In July 1996, Lincoln National Capital I issued 8,600,000 shares or $215
million, 8.75% Quarterly Income Preferred Securities ("QUIPS"). In August
1996, Lincoln National Capital II issued 4,000,000 shares or $100 million,
8.35% Trust Originated Preferred Securities ("TOPrS"). Both issues mature
in 2026 at $25 per share and the QUIPS and 8.35% TOPrS are redeemable in
whole or in part at LNC's option any time after July 2001 and August 2001,
respectively (see 2001 update below). In March 1998, LNC issued notes of 1)
$100 million, 6.5% due 2008 and 2) $200 million, 7% due 2018. In July 1998,
Lincoln National Capital III issued 8,000,000 shares or $200 million of
7.4% TOPrS which mature in 2028 at $25 per share and are redeemable in
whole or in part at LNC's option anytime after July 2003. In August 1998,
Lincoln National Capital IV issued 9,200,000 shares or $230 million of
7.75% FELINE PRIDES (service mark of Merrill Lynch & Co. Inc.). The
purchasers of such securities were also provided stock purchase contract
agreements that indicated they would receive a specified amount of LNC
common stock on or before the August 2001 maturity date of the FELINE
PRIDES. A portion of the issuance costs associated with this offering along
with the present value of the payments associated with the stock purchase
agreements were charged to the common stock line within shareholders'
equity.
The funds raised in 1998 from the various public offerings of hybrid
securities described above were used to acquire a block of individual life
insurance business from Aetna Inc.
On August 16, 2001, LNC settled mandatory stock purchase contracts issued
in conjunction with the FELINE PRIDES financing. This action resulted in
the issuance of 4,630,318 shares of LNC stock at $49.67 per share.
Investors had the option of settling the purchase contract with separate
cash or by having the collateral securing their purchase obligations sold.
In the case of investors who held the TOPrS as collateral for the purchase
contracts, they were permitted to enter into a remarketing process with
proceeds used to settle the contracts. On August 13, 2001, the remarketing
failed resulting in the retirement of $225 million TOPrS. A total of $5
million of two-year TOPrS remain outstanding which represents investors who
chose to settle with separate cash and hold onto their TOPrS until
maturity. In September 2001, LNC redeemed all 8,600,000 shares of the $215
million, 8.75% QUIPS. In November 2001, Lincoln National Capital V issued
6,900,000 shares of $172.5 million 7.65% Trust Preferred Securities
("TRUPS"). In December 2001, LNC issued $250 million 6.20% ten-year senior
notes. In December 2001, LNC called $100 million 8.35% TOPrS issued by
Lincoln Capital II and guaranteed by LNC. The redemption date was January
7, 2002.
In December 1998, LNC filed a shelf registration with the Securities
Exchange Commission that combined unused portions of the April 1998
registration ($640 million) and the May 1996 registration ($185 million)
resulting in an active shelf registration allowing LNC to sell up to an
additional $825 million of securities. As of December 31, 2001, the
remaining amount under the December 1998 shelf registration was $402.5
million.
Finally, LNC maintains two revolving credit agreements with a group of
domestic and foreign banks totaling $700 million. One agreement, in the
amount of $300 million, expires in December 2005 and the second agreement,
in the amount of $400 million, expires in December 2002. Both agreements
provide for interest on borrowings based on various money market indices.
Under both agreements, LNC must maintain senior unsecured long-term debt
ratings of at least S&P A- and Moody's A3 or be restricted by an adjusted
debt to capitalization ratio. At December 31, 2001, LNC had no outstanding
borrowings under these agreements. During 2001, 2000 and 1999, fees paid
for maintaining revolving credit agreements amounted to $650,000, $642,000
and $633,000, respectively.
Cash paid for interest for 2001, 2000 and 1999 was $123.1 million, $145.4
million and $132.2 million, respectively.
6. Employee Benefit Plans
Pension and Other Postretirement Benefit Plans - U.S. LNC maintains funded
defined benefit pension plans for most of its U.S. employees and, prior to
January 1, 1995, most full-time agents. Effective January 1, 2002, the
employees' pension plan has a cash balance formula. Employees retiring
before 2012 will have their benefits calculated under both the old and new
formulas and will receive the better of the two calculations. Employees
retiring in 2012 or after will receive benefits under the amended plan.
Benefits under the old employees' plan are based on total years of service
and the highest 60 months of compensations during the last 10 years of
employment. Under the amended plan, employees have guaranteed account
balances that grow with pay and interest credits each year. The amendment
to the employees' pension plan resulted in a $27.8 million pre-tax negative
unrecognized prior service cost in 2001 that will be evenly recognized over
future periods. All benefits applicable to the defined benefit plan for
agents were frozen as of December 31, 1994. The plans are funded by
contributions to tax-exempt trusts. LNC's funding policy is consistent with
the funding requirements of Federal law and regulations. Contributions are
intended to provide not only the benefits attributed to service to date,
but also those expected to be earned in the future.
LNC sponsors three types of unfunded, nonqualified, defined benefit plans
for certain U.S. employees and agents: supplemental retirement plans, a
salary continuation plan, and supplemental executive retirement plans.
The supplemental retirement plans provide defined benefit pension benefits
in excess of limits imposed by Federal tax law. Effective January 1, 2000,
one of these plans was amended to limit the maximum compensation recognized
for benefit payment calculation purposes. The effect of this amendment was
to reduce the pension benefit obligation by $5.4 million.
The salary continuation plan provides certain officers of LNC defined
pension benefits based on years of service and final monthly salary upon
death or retirement.
The supplemental executive retirement plan provides defined pension
benefits for certain executives who became employees of LNC as a result of
the acquisition of a block of individual life insurance and annuity
business from CIGNA Corporation ("CIGNA"). Effective January 1, 2000, this
plan was amended to freeze benefits payable under this plan. The effect of
this plan curtailment was to decrease the pension benefit obligation by
$2.4 million. Effective January 1, 2000, a second supplemental executive
retirement plan was established for this same group of executives to
guarantee that the total benefit payable under the LNC employees' defined
benefit pension plan benefit formula will be determined using an average
compensation not less than the minimum three-year average compensation as
of December 31, 1999. All benefits payable from this plan are reduced by
benefits payable from the LNC employees' defined benefit pension plan.
LNC also sponsors unfunded plans that provide postretirement medical,
dental and life insurance benefits to full-time U.S. employees and agents
who, depending on the plan, have worked for LNC 10 years and attained age
55 (60 for agents). Medical and dental benefits are also available to
spouses and other dependents of employees and agents. For medical and
dental benefits, limited contributions are required from individuals who
retired prior to November 1, 1988. Contributions for later retirees, which
can be adjusted annually, are based on such items as years of service at
retirement and age at retirement. Life insurance benefits are
noncontributory; however, participants can elect supplemental contributory
life benefits up to age 70. Effective July 1, 1999, the agents'
postretirement plan was changed to require agents retiring on or after that
date to pay the full medical and dental premium costs. This change in the
plan resulted in a one-time curtailment gain of $10.2 million pre-tax.
Beginning January 1, 2002, The employees' postretirement plan was changed
to require employees not yet age 50 with five years of service by year end
2001 to pay the full medical and dental premium cost when they retire. This
change in the plan resulted in the immediate recognition at the end of 2001
of a one-time curtailment gain of $11.3 million pre-tax.
On December 1, 2001, Swiss Re acquired LNC's reinsurance business. This
transaction resulted in the immediate recognition of a one-time curtailment
gain on post retirement benefits of $6 million pre-tax and additional
expense of $1.4 million pre-tax related to pension benefits for a net
curtailment gain of $4.6 million pre-tax. This net curtailment gain was
included in the gain on sale of subsidiaries for the year ended December
31, 2001. Due to the release of the pension obligations on these former LNC
employees, there was a $16 million gain in the pension plan that was used
to offset prior plan losses.
Information with respect to defined benefit plan asset activity and defined
benefit plan obligations is as follows:
Other Postretirement
Pension Benefits Benefits
----------------- -----------------
Year Ended December 31 (in millions) 2001 2000 2001 2000
- ------------------------------------------------------------------------------------------------
Change in plan assets:
Fair value of plan assets at beginning-of-year $385.5 $390.0 $-- $--
Actual return on plan assets (17.7) 3.8 -- --
Company contributions 38.3 6.7 -- --
Administrative expenses (0.9) (0.3) -- --
Benefits paid (15.5) (14.7) -- --
- ------------------------------------------------------------------------------------------------
Fair value of plan assets at end-of-year $389.7 $385.5 $-- $--
Change in benefit obligation:
Benefit obligation at beginning-of-year $469.3 $434.7 $108.3 $108.0
Plan amendments (27.8) (5.4) -- 0.3
Service cost 14.3 14.2 2.7 2.3
Interest cost 34.0 32.1 7.2 6.9
Plan participants' contributions -- -- 2.1 0.5
Sale of business segment -- -- (6.0) --
Plan curtailment gain (16.0) (2.4) (11.8) --
Actuarial (gains) losses 19.1 13.5 3.8 (8.0)
Benefits paid (18.2) (17.4) (9.5) (1.7)
- ------------------------------------------------------------------------------------------------
Benefit obligation at end-of-year $474.7 $469.3 $96.8 $108.3
Underfunded status of the plans $(85.0) $(83.8) $(96.8) $(108.3)
Unrecognized net actuarial gains 44.9 (8.9) -- (3.9)
Unrecognized prior service cost (25.8) 2.5 -- --
- ------------------------------------------------------------------------------------------------
Accrued benefit cost $(65.9) $(90.2) $(96.8) $(112.2)
Weighted-average assumptions as of December 31:
Weighted-average discount rate 7.00% 7.50% 7.00% 7.50%
Expected return on plan assets 9.00% 9.00% -- --
Rate of increase in compensation:
Salary continuation plan 5.00% 5.50% -- --
All other plans 4.00% 4.50% 4.00% 4.50%
=================================================================================================
The funded status amounts in the pension benefits columns above combine
plans with projected benefit obligations in excess of plan assets and plans
with plan assets in excess of projected benefit obligations. For plans that
have projected benefit obligations in excess of plan assets, the aggregate
projected benefit obligations were $400.1 million and $397.2 million at
December 31, 2001 and 2000, respectively, the aggregate accumulated benefit
obligations were $373.0 million and $322.2 million at December 31, 2001 and
2000, respectively, and the aggregate fair value of plan assets was $314.9
million and $303.4 million at December 31, 2001 and 2000, respectively.
Plan assets for both the funded employees and agents plans consist
principally of listed equity securities, corporate obligations and
government bonds.
The components of net defined benefit pension plan and postretirement benefit
plan costs are as follows:
Other Postretirement
Pension Benefits Benefits
------------------------------ ------------------------------
Year Ended December 31 (in millions) 2001 2000 1999 2001 2000 1999
- -----------------------------------------------------------------------------------------------------------------
Service cost $14.8 $14.6 $19.5 $2.7 $2.3 $3.6
Interest cost 34.0 32.1 30.2 7.2 7.0 6.6
Expected return on plan assets (34.0) (34.5) (32.6) -- -- --
Amortization of prior service cost 0.4 0.4 1.0 -- -- --
Recognized net actuarial (gains) losses 0.3 (2.2) 1.6 (0.5) (0.9) 0.3
- -----------------------------------------------------------------------------------------------------------------
Net periodic benefit cost $15.5 $10.4 $19.7 $9.4 $8.4 $10.5
==================================================================================================================
The calculation of the accumulated postretirement benefits obligation
assumes a weighted-average annual rate of increase in the per capital cost
of covered benefits (i.e. health care cost trend rate) of 10.0% for 2001.
It further assumes the rate will gradually decrease to 5.0% by 2012 and
remain at that level. The health care cost trend rate assumption has a
significant effect on the amounts reported. For example, increasing the
assumed health care cost trend rates by one percentage point each year
would increase the accumulated postretirement benefits obligation as of
December 31, 2001 and 2000 by $6.8 million and $8.6 million, respectively.
The aggregate of the estimated service and interest cost components of net
periodic postretirement benefits cost for the year ended December 31, 2001
and 2000 would increase by $0.8 million.
LNC maintains a defined contribution plan for its U.S. insurance agents.
Contributions to this plan are based on a percentage of the agents' annual
compensation as defined in the plan. Effective January 1, 1998, LNC assumed
the liabilities for a non-contributory defined contribution plan covering
certain highly compensated former CIGNA agents and employees. Contributions
for this plan are made annually based upon varying percentages of annual
eligible earnings as defined in the plan. Contributions to this plan are in
lieu of any contributions to the qualified agent defined contribution plan.
Effective January 1, 2000, this plan was expanded to include certain highly
compensated Lincoln agents. The combined pre-tax expenses for these plans
amounted to $2.8 million, $4.2 million and $3.8 million in 2001, 2000 and
1999, respectively. These expenses reflect both LNC's contribution as well
as changes in the measurement of LNC's liabilities under these plans.
Pension Plan - Non U.S. The employees of LNC's primary foreign subsidiary
are covered by a defined benefit pension plan. The plan provides death and
pension benefits based on final pensionable salary. At December 31, 2001
and 2000, the projected benefit obligation exceeded plan assets by $47.0
million and $6.5 million, respectively, and was included in other
liabilities in LNC's consolidated balance sheet. As a result of the
accumulated benefit obligation being in excess of plan assets at December
31, 2001, a minimum pension liability adjustment of $36.0 million was
recorded through Other Comprehensive Income in equity. Net pension costs
for the foreign plan were $7.4 million, $4.4 million and $3.6 million for
2001, 2000 and 1999, respectively.
401(k), Money Purchase Plan and Profit Sharing Plans. LNC also sponsors
contributory defined contribution plans for eligible U.S. employees and
agents. These plans include 401(k) plans and effective April 1, 2001, a
defined contribution money purchase plan for eligible employees of Delaware
Management Holdings, Inc. ("Delaware"). Prior to April 1, 2001, the defined
contribution money purchase plan was structured as a profit sharing plan.
LNC's contributions to the 401(k) plans are equal to participant's pre-tax
contribution, not to exceed 6% of base pay, multiplied by a percentage,
ranging from 50% to 150%, which varies according to certain incentive
criteria as determined by LNC's Board of Directors. As a result of LNC
attaining the goals established under the three-year long-term incentive
plan for 1998 through 2000, an additional match was made on a participant's
2000 pre-tax contribution.
LNC's contribution to the defined contribution money purchase plan is equal
to 7.5% per annum of a participant's eligible compensation, while its
contribution to the previous profit sharing plan of Delaware was equal to
an amount, if any, determined in accordance with a resolution of the Board
of Directors. Each plan year's contribution is allocated in the proportion
that the plan compensation of each eligible participant bears to the total
plan compensation of all eligible participants for such plan year.
Compensation is defined as all of an eligible participant's plan year
earnings and is subject to the limitation of Section 401 (a) of the
Internal Revenue Code of 1986, as amended. For 2001, the contribution to
the defined contribution money purchase plan was based on 7.5% of the
eligible compensation for the nine month period ended December 31, 2001.
For the profit sharing plan's fiscal years ended March 31, 2001, 2000 and
1999, the Board issued a resolution authorizing a 15% per annum
contribution to the plan. Expense for the 401(k) and profit sharing plans
amounted to $27.0 million, $43.5 million and $27.8 million in 2001, 2000
and 1999, respectively.
Deferred Compensation Plans. LNC sponsors contributory deferred
compensation plans for certain U.S. employees and agents. Plan participants
may elect to defer payment of a portion of their compensation, as defined
by the plans. At this point, LNC has not chosen to fund these plans. Plan
participants may select from a variety of alternative measures for purposes
of calculating the investment return considered attributable to their
deferral. Under the terms of these plans, LNC agrees to pay out amounts
based upon the alternative measure selected by the participant. Plan
participants who are also participants in an LNC 401(k) plan and who have
reached the contribution limit for that plan may also elect to defer the
additional amounts into the deferred compensation plan. LNC makes matching
contributions to these plans based upon amounts placed into the deferred
compensation plans by individuals who have reached the contribution limit
under the 401(k) plan. The amount of LNC's contribution is calculated in a
manner similar to the employer match calculation described in the 401(k)
plans section above. Expense for these plans amounted to $0.6 million, $4.2
million and $10.6 million in 2001, 2000 and 1999, respectively. These
expenses reflect both LNC's employer matching contributions, as well as
changes in the measurement of LNC's liabilities under these plans.
In the fourth quarter of 1999, LNC modified the terms of the deferred
compensation plans to provide that plan participants who selected LNC stock
as the measure for their investment return would receive shares of LNC
stock in satisfaction of this portion of their deferral. In addition,
participants were precluded from diversifying any portion of their deferred
compensation plan account that is measured by LNC's stock performance. As a
result of these modifications to the plans, ongoing changes in value of
LNC's stock no longer affect the expenses associated with this portion of
the deferred compensation plans.
In connection with the acquisition of the block of individual life
insurance and annuity business from CIGNA, LNC assumed the liability for an
unfunded contributory deferred compensation plan covering certain former
CIGNA employees and agents. These participants became immediately eligible
for the LNC contributory deferred compensation plans, and therefore this
plan was frozen as to future deferrals as of January 1, 1998. Effective
January 1, 2001, this frozen plan was merged into the LNC contributory
deferred compensation plans and the associated expenses for 2001, 2000 and
1999 are now included in those plan expenses disclosed above.
The total liabilities associated with these plans were $149.5 million and
$138.4 million at December 31, 2001 and 2000, respectively.
Incentive Plans. LNC has various incentive plans for employees, agents and
directors of LNC and its subsidiaries that provide for the issuance of
stock options, stock appreciation rights, restricted stock awards and stock
incentive awards. These plans are comprised primarily of stock option
incentive plans. Stock options awarded under the stock option incentive
plans are granted with an exercise price equal to the market value of LNC
stock at the date of grant and, subject to termination of employment,
expire 10 years from the date of grant. Such options are transferable only
upon death. Options granted prior to 1992 are exercisable one year after
the date of grant and options issued subsequent to 1991 become exercisable
in 25% increments over the four-year period following the option grant
anniversary date. A "reload option" feature was added on May 14, 1997. In
most cases, persons exercising an option after that date have been granted
new options in an amount equal to the number of matured shares tendered to
exercise the original option award. The reload options are granted for the
remaining term of the related original option and have an exercise price
equal to the market value of LNC stock at the date of the reload award.
Reload options can be exercised two years after the grant date if the value
of the new option has appreciated by at least 25%.
In 2000, as a result of changes in the interpretation of the existing
accounting rules for stock options, LNC decided not to continue issuing
stock options to agents that do not meet the stringent definition of a
common law employee. In the first quarter of 2000, LNC adopted a stock
appreciation right ("SAR") program as a replacement to the agent stock
option program. The first awards under this program were also made in the
first quarter of 2000. The SARs under this program are rights on LNC stock
that are cash settled and become exercisable in 25% increments over the
four year period following the SAR grant date. SARs are granted with an
exercise price equal to the market value of LNC stock at the date of grant
and, subject to termination of employment, expire five years from the date
of grant. Such SARs are transferable only upon death.
LNC recognizes compensation expense for the SAR program based on the fair
value method using an option-pricing model. Compensation expense and the
related liability are recognized on a straight-line basis over the vesting
period of the SARs. The SAR liability is marked-to-market through net
income. This accounting treatment causes volatility in net income as a
result of changes in the market value of LNC stock. LNC hedges this
volatility by purchasing call options on LNC stock. Call options hedging
vested SARs are also marked-to-market through net income.
Information with respect to incentive plan stock options outstanding at
December 31, 2001 is as follows:
Options Outstanding Options Exercisable
- ----------------------------------------------------------------------- -----------------------------------
Weighted-Average
Range of Number Remaining Number
Exercise Outstanding at Contractual Life Weighted-Average Exercisable at Average Exercise
Prices Dec 31, 2001 (Years) Exercise Price Dec 31, 2001 Price
- --------------------------------------------------------------------------------------------------------------
$10 - $20 364,160 1.51 $18.42 364,160 $18.42
21 - 30 7,545,023 5.99 25.14 3,324,178 25.68
31 - 40 2,755,677 7.93 33.46 532,450 33.97
41 - 50 6,953,078 6.61 44.24 3,282,089 44.66
51 - 60 3,396,636 6.54 50.87 2,037,714 50.86
- --------------------------------------------------------------------------------------------------------------
$10 - $60 21,014,574 9,540,591
==============================================================================================================
LNC recognizes compensation expense for its stock option incentive plans
using the intrinsic value based method of accounting (see Note 1) and
provides the required pro forma information for stock options granted after
December 31, 1994. Accordingly, no compensation expense has been recognized
for stock option incentive plans. Had compensation expense for LNC's stock
option incentive plans been determined based on the estimated fair value at
the grant dates for awards under those plans, LNC's pro forma net income
and earnings per share for the last three years (2001, 2000 and 1999) would
have been $540.4 million ($2.79 per diluted share); $589.6 million ($3.03
per diluted share) and $443.0 million ($2.21 per diluted share),
respectively (a decrease of $49.8 million or $0.26 per diluted share; $31.8
million or $0.16 per diluted share and $17.4 million or $0.09 per diluted
share, respectively). These effects on pro forma net income and earnings
per share of expensing the estimated fair value of stock options are not
necessarily representative of the effects on reported net income for future
years due to factors such as the vesting period of the stock options and
the potential for issuance of additional stock options in future years.
The fair value of options used as a basis for the proforma disclosures,
shown above, was estimated as of the date of grant using a Black-Scholes
option pricing model.
The option price assumptions used were as follows:
Year Ended December 31 2001 2000 1999
- ----------------------------------------------------------------------------------
Dividend yield 2.8% 4.4% 2.7%
Expected volatility 40.0% 39.2% 29.7%
Risk-free interest rate 4.6% 6.6% 5.4%
Expected life (in years) 4.2 4.9 5.5
Weighted-average fair value per option granted $13.44 $8.33 $14.31
==================================================================================
Restricted stock (non-vested stock) awarded from 1999 through 2001 was as
follows:
Year Ended December 31 2001 2000 1999
- ----------------------------------------------------------------------------------
Restricted stock (number of shares) 72,155 237,358 57,012
Weighted-average price per share at time of grant $46.60 $38.10 $43.91
==================================================================================
Information with respect to the incentive plans involving stock options is as
follows:
Options Outstanding Options Exercisable
--------------------- ------------------------
Weighted- Weighted-
Average Average
Shares Exercise Price Shares Exercise Price
- ---------------------------------------------------------------------------------------------------
Balance at January 1, 1999 10,784,852 33.61 3,596,946 21.63
Granted-original 4,445,316 50.51
Granted-reloads 104,422 49.32
Exercised (includes shares tendered) (1,216,263) 48.68
Forfeited (453,892) 44.90
- ---------------------------------------------------------------------------------------------------
Balance at December 31, 1999 13,664,435 39.59 5,141,438 29.21
Granted - original 10,756,413 27.62
Granted - reloads 100,544 46.13
Exercised (includes shares tendered) (1,558,639) 46.38
Forfeited (1,264,463) 43.14
- ---------------------------------------------------------------------------------------------------
Balance at December 31, 2000 21,698,290 34.35 6,797,855 34.92
Granted - original 3,236,217 43.70
Granted - reloads 130,129 48.19
Exercised (includes shares tendered) (3,238,931) 27.13
Forfeited (811,131) 43.70
- ---------------------------------------------------------------------------------------------------
Balance at December 31, 2001 21,014,574 36.59 9,540,591 37.77
===================================================================================================
7. Restrictions, Commitments and Contingencies
Statutory Information and Restrictions
Net income as determined in accordance with statutory accounting practices
for LNC's insurance subsidiaries was $0.195 billion, $0.597 billion and
$0.579 billion for 2001, 2000 and 1999, respectively. The 2001 amount only
includes the statutory net income for LNC's reinsurance subsidiaries from
January 1, 2001 through November 30, 2001. On December 7, 2001, Swiss Re
acquired LNC's reinsurance operations. The transaction structure involved a
series of indemnity reinsurance transactions combined with the sale of
certain stock companies that comprised LNC's reinsurance operation. See
Note 11 for further discussion of Swiss Re's acquisition of LNC's
reinsurance operations. Statutory net income for 2001, 2000 and 1999,
excluding LNC's foreign life reinsurance companies, was $0.168 billion,
$0.603 billion and $0.447 billion, respectively. All of LNC's foreign life
reinsurance companies were sold to Swiss Re on December 7, 2001 except
Lincoln National Reinsurance Company (Barbados) and Lincoln Re (Ireland)
Limited.
Shareholders' equity as determined in accordance with statutory accounting
practices for LNC's insurance subsidiaries was $3.517 billion and $3.454
billion for December 31, 2001 and 2000, respectively.
The National Association of Insurance Commissioners revised the Accounting
Practices and Procedures Manual in a process referred to as Codification.
The revised manual became effective January 1, 2001. The domiciliary states
of LNC's U.S. insurance subsidiaries have adopted the provisions of the
revised manual. The revised manual has changed, to some extent, prescribed
statutory accounting practices and has resulted in changes to the
accounting practices that LNC's U.S. insurance subsidiaries use to prepare
their statutory-basis financial statements. The impact of these changes to
LNC and its U.S. insurance subsidiaries' statutory-based capital and
surplus as of January 1, 2001 was not significant.
LNC's primary insurance subsidiary, Lincoln National Life Insurance Company
("LNL") acquired a block of individual life insurance and annuity business
from CIGNA in January 1998 and a block of individual life insurance from
Aetna Inc. in October 1998. These acquisitions were structured as indemnity
reinsurance transactions. The statutory accounting regulations do not allow
goodwill to be recognized on indemnity reinsurance transactions and
therefore, the related statutory ceding commission flows through the
statement of operations as an expense resulting in a reduction of statutory
earned surplus. As a result of these acquisitions, LNL's statutory earned
surplus was negative.
LNC's insurance subsidiaries are subject to certain insurance department
regulatory restrictions as to the transfer of funds and payment of
dividends to the holding company. Generally, these restrictions pose no
short-term liquidity concerns for the holding company. As a result of
negative statutory earned surplus, LNL was required to obtain the prior
approval of the Indiana Insurance Commissioner ("Commissioner") before paying
any dividends to LNC until its statutory earned surplus became positive. LNL
recently received approval from the Commissioner to reclassify total
dividends of $495 million paid to LNC in 2001 from LNL's earned surplus to
paid-in-capital. This change plus the increase in statutory earned surplus
from the indemnity reinsurance transaction with Swiss Re resulted in
positive statutory earned surplus for LNL at December 31, 2001. As long as
LNL's earned surplus remains positive, future dividends not in excess of
earned surplus will be deemed ordinary, not requiring prior approval from
the Commissioner.
LNL is recognized as an accredited reinsurer in the state of New York,
which effectively enables it to conduct reinsurance business with unrelated
insurance companies that are domiciled within the state of New York. As a
result, in addition to regulatory restrictions imposed by the state of
Indiana, LNL is also subject to the regulatory requirements that the State
of New York imposes upon accredited reinsurers.
Reinsurance Contingencies
Swiss Re acquired LNC's reinsurance operations on December 7, 2001. The
transaction structure involved a series of indemnity reinsurance
transactions combined with the sale of certain stock companies that
comprised LNC's reinsurance operation. Under the indemnity reinsurance
agreements, Swiss Re reinsured certain liabilities and obligations of
LNC. Because LNC is not relieved of its legal liability to the ceding
companies, in accordance with Statement of Financial Accounting
Standards No. 113, "Accounting and Reporting for Reinsurance of
Short-Duration and Long-Duration Contracts" ("FAS 113"), the liabilities
and obligations associated with the reinsured contracts remain on the
consolidated balance sheets of LNC with a corresponding reinsurance
receivable from Swiss Re.
LNC and Swiss Re have not agreed upon the final closing financial
statements associated with the December 7, 2001 transactions. There are
currently disputed matters of approximately $500 million, which relate
primarily to personal accident business reserves and recoverables.
LNC's ongoing indemnification to Swiss Re on the underlying reinsurance
business is limited to the personal accident business. Pursuant to the
purchase agreement, LNC's exposure is capped at $100 million ($65
million after-tax) for net future payments under the personal accident
programs in excess of $148 million, which represents the personal
accident liabilities net of the assets held for reinsurance recoverable
at December 31, 2000. Up to $200 million of net payments in excess of
the net liabilities will be shared on a 50/50 basis between LNC and
Swiss Re. LNC has no continuing indemnification risk to Swiss Re on
other reinsurance lines of business including disability income, HMO
excess-of-loss, group carrier medical and property and casualty
reinsurance lines.
Under the timeframe provided for within the acquisition agreement for
dispute resolution, it is probable that the earliest point that these
matters will be agreed upon would be the second quarter of 2002. If the
parties are unable to reach agreement, and these matters go to
arbitration, an ultimate resolution of these matters may take several
additional months.
Upon reaching agreement as to the final closing financial statements, it is
possible that LNC could record adjustments to realized gain or loss on the
sale of subsidiaries, to net income, or to the amount of deferred gain
associated with the Swiss Re transaction. Another aspect of a potential
dispute resolution could result in LNC agreeing to transfer assets to Swiss
Re until the adequacy of certain reserves and related recoverables can be
determined. In that event, LNC's future investment income would be reduced
to the extent that any such dispute resolution would result in Swiss Re's
retention of the related investment income during the time frame that Swiss
Re would hold the invested assets. While uncertainty exists as to how these
disputed matters will finally be resolved, at the present time LNC believes
the amounts reported within LNC's consolidated financial statements as of
and for the year ended December 31, 2001 represent the best estimate of the
ultimate outcome of Swiss Re's acquisition of LNC's reinsurance business.
While LNC has limited its indemnification to Swiss Re, as previously
noted, under FAS 113 LNC will continue to report the reserves subject to
the indemnity reinsurance agreements with Swiss Re on LNC's consolidated
balance sheet with an offsetting reinsurance recoverable from Swiss Re.
In the event that future developments indicate that the reserves related
to certain businesses should be adjusted, LNC would be required under
FAS 113 to recognize the changes in reserves in earnings in the period
of change. Any change to the reinsurance recoverable from Swiss Re would
be recorded as an adjustment to the amount of deferred gain.
In addition to the transactions completed on December 7, 2001, LNC has
the right to "put" its interest in a subsidiary company containing LNC's
disability income reinsurance business to Swiss Re during May 2002 for
$10 million. Developments on the underlying disability income
reinsurance business will not affect the price at which LNC may put
the subsidiary company to Swiss Re. LNC is free to market this company
to other buyers. If, prior to May 31, 2002, LNC is unable to sell this
company to other bidders for more than $10 million, LNC intends to
exercise the Swiss Re put. The $10 million exercise price is
approximately equal to LNC's book basis in the subsidiary.
United Kingdom Selling Practices
Various selling practices of the Lincoln UK operations have come under
scrutiny by the UK regulators in recent years. These selling practices
include the sale and administration of individual pension products,
mortgage endowments and the selling practices of City Financial Partners
Limited ("CFPL"), a subsidiary company purchased in December 1997.
Regarding the sale and administration of pension products to individuals,
regulatory agencies have raised questions as to what constitutes
appropriate advice to individuals who bought pension products as an
alternative to participation in an employer sponsored plan. In cases of
inappropriate advice, an extensive investigation may have to be done and
the individual put in a position similar to what would have been attained
if the individual had remained in the employer-sponsored plan.
With regard to mortgage endowments, on November 30, 2000, UK regulators
issued a paper containing draft guidelines explaining how mortgage
endowment policyholders would be compensated in instances where it is
determined that mis-selling occurred. This release also indicated that an
extensive analysis is underway of mortgage endowment products offered by
insurance companies in the UK marketplace since 1988. Where the results of
this analysis indicate that products are designed in a way that could lead
to potential mis-selling, UK regulators are contacting companies to review
sales practices.
Lincoln UK received a letter from UK regulators on February 8, 2001,
raising concerns with certain mortgage endowment products sold by British
National Life Assurance Company ("BNLA"). The specific policies at issue
were sold between the period of July 1988 through March 1994. Lincoln UK
acquired BNLA from Citibank in August of 1993. Less than 6,000 of these
BNLA policies remain in force.
In their letter and in subsequent discussions, UK regulators are contending
that BNLA's sales literature was written in a manner that provides a
contractual warranty that, if certain assumptions are achieved, the
mortgage endowment would grow to a balance sufficient to repay the
contractholder's mortgage. LNC strongly disagrees that any contractual
warranties were made in the sale of these mortgage endowment policies. In
August of 2001, LNC reaffirmed its position in a letter to the UK
regulators and is awaiting their response. LNC is prepared to proceed with
all available means of resolution, including pursuing regulatory,
administrative and legal means of concluding this matter.
Following allegations made by the UK Consumers' Association (an
organization which acts on behalf of consumers of goods and services
provided in the UK) concerning various selling practices of CFPL, LNC
has completed an internal review of 5,000 ten-year savings plans sold by
CFPL during the period September 1, 1998 to August 31, 2000. The results
of LNC's internal review are currently being discussed with the
regulator. At this stage of discussion, it appears that the regulator
will require LNC to complete additional review procedures before it will
approve a resolution of these matters. The timetable and specific
actions that may be involved in these additional review procedures are
under current discussion with the regulator.
At December 31, 2001 and 2000, the aggregate liability associated with
Lincoln UK selling practices was $164.3 million and $284.0 million,
respectively. The reserves for these issues are based on various estimates
that are subject to considerable uncertainty. Accordingly, the aggregate
liability may prove to be deficient or excessive. However, it is
management's opinion that future developments regarding Lincoln UK selling
practices will not materially affect the consolidated financial position of
LNC.
Marketing and Compliance Issues
Regulators continue to focus on market conduct and compliance issues. Under
certain circumstances, companies operating in the insurance and financial
services markets have been held responsible for providing incomplete or
misleading sales materials and for replacing existing policies with
policies that were less advantageous to the policyholder. LNC's management
continues to monitor the company's sales materials and compliance
procedures and is making an extensive effort to minimize any potential
liability. Due to the uncertainty surrounding such matters, it is not
possible to provide a meaningful estimate of the range of potential
outcomes at this time; however, it is management's opinion that such future
developments will not materially affect the consolidated financial position
of LNC.
Euro Conversion
LNC owns operating companies in the UK and previously conducted business
with companies located within Europe. LNC has modified its systems,
financial activities and currency risk exposures to align with the first
phase of the European Union's conversion to a new common currency (the
Euro) that was adopted January 1, 1999. On January 1, 2002, the Euro
banknotes and coins were put into circulation. It is management's opinion
that the conversion of the physical currency along with the additional
phases of this conversion, which will be implemented during the next few
years, will not materially affect the consolidated financial position of
LNC.
Leases
Certain of LNC's subsidiaries lease their home office properties through
sale-leaseback agreements. The agreements provide for a 25 year lease
period with options to renew for six additional terms of five years each.
The agreements also provide LNC with the right of the first refusal to
purchase the properties during the terms of the lease, including renewal
periods, at a price defined in the agreements. LNC also has the option to
purchase the leased properties at fair market value as defined in the
agreements on the last day of the initial 25-year lease period ending in
2009 or the last day of any of the renewal periods.
Total rental expense on operating leases in 2001, 2000 and 1999 was $83.4
million, $88.4 million and $81.5 million, respectively. Future minimum
rental commitments are as follows (in millions):
- -----------------------------------------------------------------------
2002 - $73.4 2004 - $62.3 2006 - $56.1
2003 - 65.5 2005 - 58.9 Thereafter - 142.4
=======================================================================
Information Technology Commitment
In February 1998, LNL signed a seven-year contract with IBM Global Services
for information technology services for the Fort Wayne operations. Annual
costs are dependent on usage but are expected to range from $65.0 million
to $75.0 million.
Insurance Ceded and Assumed
LNC's insurance companies cede insurance to other companies. The portion of
risks exceeding each company's retention limit is reinsured with other
insurers. LNC seeks reinsurance coverage within the businesses that sell
life insurance to limit its liabilities. As of December 31, 2001, LNC's
maximum retention was $10.0 million on a single insured. Portions of LNC's
deferred annuity business have also been co-insured with other companies to
limit LNC's exposure to interest rate risks. At December 31, 2001, the
reserves associated with these reinsurance arrangements totaled $1,513.6
million. To cover products other than life insurance, LNC acquires other
insurance coverages with retentions and limits that management believes are
appropriate for the circumstances. The accompanying financial statements
reflect premiums, benefits and deferred acquisition costs, net of insurance
ceded (see Note 5). LNC's insurance companies remain liable if their
reinsurers are unable to meet contractual obligations under applicable
reinsurance agreements.
Certain LNC insurance companies assumed insurance from other companies. At
December 31, 2001, LNC's insurance companies provided $75.3 million of
statutory surplus relief to other insurance companies under reinsurance
transactions through LNC's former Reinsurance segment. Generally, such
amounts are offset by corresponding receivables from the ceding company,
which are secured by future profits on the reinsured business. However,
LNC's insurance companies are subject to the risk that the ceding company
may become insolvent and the right of offset would not be permitted. LNC's
reinsurance operations were acquired by Swiss Re on December 7, 2001. The
transaction structure involved a series of indemnity reinsurance
transactions combined with the sale of certain stock companies that
comprised LNC's reinsurance operation. Under the indemnity reinsurance
agreements, Swiss Re reinsured certain liabilities and obligations of LNC.
Because LNC is not relieved of its legal liability to the ceding companies,
the liabilities and obligations associated with the reinsured contracts
remain on the consolidated balance sheets of LNC with a corresponding
reinsurance receivable from Swiss Re.
Letters of Credit
LNC maintains $800 million in bank agreements to issue standby letters
of credit on behalf of subsidiaries of LNC and for the benefit of third
parties. These letters of credit support LNL's reinsurance needs and
specific treaties associated with LNC's reinsurance business, which was
acquired by Swiss Re on December 7, 2001 (see Note 11 for further
discussion of this transaction). Letters of credit 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 United States. The letter of credit
allows the cedents to take credit for reinsured reserves on their
statutory balance sheets. At December 31, 2001, there was a total of
$765.7 million in outstanding bank letters of credit supporting 25
separate reinsurance treaties. In exchange for the letters of credit,
LNC paid the banks approximately $3.8 million in fees in 2001.
Vulnerability from Concentrations
At December 31, 2001, LNC did not have a material concentration of
financial instruments in a single investee, industry or geographic
location. Also at December 31, 2001, LNC did not have a concentration of:
1) business transactions with a particular customer or lender; 2) sources
of supply of labor or services used in the business or; 3) a market or
geographic area in which business is conducted that makes it vulnerable to
an event that is at least reasonably possible to occur in the near term and
which could cause a severe impact to LNC's financial position. Although LNC
does not have any significant concentration of customers, LNC's Annuities
segment has a long-standing distribution relationship with American Funds
Distributors that is significant to this segment. In 2001, the American
Legacy Variable Annuity product line sold through American Funds
Distributors accounted for about 21% of LNC's total gross annuity deposits.
The relationship with American Funds Distributors is highly valued by LNC.
Both LNC and American Funds Distributors are continuously seeking ways to
increase sales and to retain the existing business.
Other Contingency Matters
LNC and its subsidiaries are involved in various pending or threatened
legal proceedings, including purported class actions, arising from the
conduct of business. In some instances, these proceedings include claims
for unspecified or substantial punitive damages and similar types of relief
in addition to amounts for alleged contractual liability or requests for
equitable relief. After consultation with legal counsel and a review of
available facts, it is management's opinion that these proceedings
ultimately will be resolved without materially affecting the consolidated
financial position of LNC.
During the fourth quarter of 2000, LNL reached an agreement in principle to
settle all class action lawsuits alleging fraud in the sale of LNL
non-variable universal life and participating whole life insurance
policies. It requires that LNL provide benefits and a claim process to
policyholders who purchased non-variable universal life and participating
whole life policies between January 1, 1981 and December 31, 1998. The
settlement covers approximately 431,000 policies. Owners of approximately
4,300 policies have excluded themselves (opted-out) from the settlement
and, with respect to these policies, will not be bound by the settlement.
Total charges recorded during 2000 for this settlement aggregated $42.1
million after-tax ($64.7 million pre-tax). With the court's approval of the
settlement in the second quarter of 2001 and the expiration in the third
quarter of 2001 of the time to file an appeal, the case was concluded for
all policyholders not previously opting out. During the third quarter of
2001, settlement was reached with some of the owners of policies who
opted-out of the original settlement. Overall, the third quarter
developments relating to these matters were slightly favorable when
compared to the assumptions underlying the estimates made in 2000 when the
related charges were taken; however, there is continuing uncertainty as to
the ultimate costs of settling the remaining opt-out cases. It is
management's opinion that such future developments will not materially
affect the consolidated financial position of LNC.
State guaranty funds assess insurance companies to cover losses to
policyholders of insolvent or rehabilitated companies. Mandatory
assessments may be partially recovered through a reduction in future
premium taxes in some states. LNC has accrued for expected assessments net
of estimated future premium tax deductions.
Guarantees
LNC has guarantees with off-balance-sheet risks whose contractual amounts
represent credit exposure. Guarantees with off-balance sheet risks having
contractual values of $23.9 million and $35.5 million were outstanding at
December 31, 2001 and 2000, respectively.
Certain subsidiaries of LNC have invested in real estate partnerships that
use industrial revenue bonds to finance their projects. LNC has guaranteed
the repayment of principal and interest on these bonds. Certain
subsidiaries of LNC are also involved in other real estate partnerships
that use conventional mortgage loans. In some cases, the terms of these
arrangements involve guarantees by each of the partners to indemnify the
mortgagor in the event a partner is unable to pay its principal and
interest payments. In addition, certain subsidiaries of LNC have sold
commercial mortgage loans through grantor trusts, which issued pass-through
certificates. These subsidiaries have agreed to repurchase any mortgage
loans which remain delinquent for 90 days at a repurchase price
substantially equal to the outstanding principal balance plus accrued
interest thereon to the date of repurchase. It is management's opinion that
the value of the properties underlying these commitments is sufficient that
in the event of default, the impact would not be material to LNC.
Derivative Instruments
LNC maintains an overall risk management strategy that incorporates the use
of derivative instruments to minimize significant unplanned fluctuations in
earnings that are caused by interest rate risk, foreign currency risk,
equity risk, and credit risk. LNC assesses these risks by continually
identifying and monitoring changes in interest rate exposure, foreign
currency exposure, equity market exposure, and credit exposure that may
adversely impact expected future cash flows and by evaluating hedging
opportunities. Derivative instruments that are currently used as part of
LNC's interest rate risk management strategy include interest rate swaps,
interest rate caps and swaptions. Derivative instruments that are used as
part of LNC's foreign currency risk management strategy include foreign
currency swaps and foreign exchange forwards. Call options on LNC stock are
used as part of LNC's equity market risk management strategy. Call options
on the S&P 500 index were used for reinsurance programs and as a result of
the acquisition by Swiss Re of LNC's reinsurance operations, this equity
market risk management strategy was terminated. LNC also uses credit
default swaps as part of its credit risk management strategy.
By using derivative instruments, LNC is exposed to credit and market risk.
If the counterparty fails to perform, credit risk is equal to the extent of
the fair value gain in the derivative. When the fair value of a derivative
contract is positive, this generally indicates that the counterparty owes
LNC and, therefore, creates a payment risk for LNC. When the fair value of
a derivative contract is negative, LNC owes the counterparty and therefore
LNC has no payment risk. LNC minimizes the credit (or payment) risk in
derivative instruments by entering into transactions with high quality
counterparties that are reviewed periodically by LNC. LNC also maintains a
policy of requiring that all derivative contracts be governed by an
International Swaps and Derivatives Association ("ISDA") Master Agreement.
LNC and LNL are required to maintain minimum ratings as a matter of routine
practice in negotiating ISDA agreements. Under the majority of ISDA
agreements and as a matter of policy, LNL has agreed to maintain financial
strength or claims-paying ratings of S&P BBB and Moody's Baa2. A downgrade
below these levels would result in termination of the derivatives contract
at which time any amounts payable by LNC would be dependent on the market
value of the underlying derivative contract. In certain transactions, LNC
and the counterparty have entered into a collateral support agreement
requiring LNC to post collateral upon significant downgrade. LNC is
required to maintain long-term senior debt ratings of S&P BBB- and Moody's
Baa3. LNC also requires for its own protection minimum rating standards for
counterparty credit protection. LNL is required to maintain financial
strength or claims-paying ratings of S&P A- and Moody's A3 under certain
ISDA agreements which collectively do not represent material notional
exposure. LNC does not believe the inclusion of termination or
collateralization events pose any material threat to its liquidity
position.
Market risk is the adverse effect that a change in interest rates, currency
rates, implied volatility rates, or a change in certain equity indexes or
instruments has on the value of a financial instrument. LNC manages the
market risk by establishing and monitoring limits as to the types and
degree of risk that may be undertaken.
LNC's derivative instruments are monitored by its risk management committee
as part of that committee's oversight of LNC's derivative activities. LNC's
derivative instruments committee is responsible for implementing various
hedging strategies that are developed through its analysis of financial
simulation models and other internal and industry sources. The resulting
hedging strategies are then incorporated into LNC's overall risk management
strategies.
LNC has derivative instruments with off-balance-sheet risks whose notional
or contract amounts exceed the credit exposure. Outstanding derivative
instruments with off-balance-sheet risks, shown in notional or contract
amounts along with their carrying value and estimated fair values, are as
follows:
Assets (Liabilities)
----------------------------------------------
Notional or Carrying Fair Carrying Fair
Contract Amounts Value Value Value Value
----------------------- ---------------------------------------------
December 31 (in millions) 2001 2000 2001 2001 2000 2000
- --------------------------------------------------------------------------------------------------------------------
Interest rate derivative instruments:
Interest rate cap agreements 1,258.8 1,558.8 $0.6 $0.6 $2.7 $0.4
Swaptions 1,752.0 1,752.0 0.1 0.1 0.9 0.9
Interest rate swap agreements 507.6 708.2 18.1 18.1 7.2 38.1
- --------------------------------------------------------------------------------------------------------------------
Total interest rate derivative instruments 3,518.4 4,019.0 18.8 18.8 10.8 39.4
Foreign currency derivative instruments:
Foreign exchange forward contracts 67.0 124.3 (0.3) (0.3) (3.1) (3.1)
Foreign currency swaps 94.6 37.5 5.8 5.8 2.5 2.5
- --------------------------------------------------------------------------------------------------------------------
Total foreign currency derivative instruments 161.6 161.8 5.5 5.5 (0.6) (0.6)
Credit derivative instruments:
Credit default swaps 29.0 29.0 0.9 0.9 -- --
Equity indexed derivative instruments:
Call options (based on S&P) -- 183.3 -- -- 19.3 19.3
Call options (based on LNC Stock) 1.1 0.6 20.5 20.5 10.0 15.3
- --------------------------------------------------------------------------------------------------------------------
Total equity indexed derivative instruments 1.1 183.9 20.5 20.5 29.3 34.6
Embedded derivatives per FAS 133 -- -- 0.4 0.4 -- --
- --------------------------------------------------------------------------------------------------------------------
Total derivative instruments* 3,710.1 4,393.7 $46.1 $46.1 $39.5 $73.4
====================================================================================================================
* Total derivative instruments for 2001 are composed of $46.4 million and
$(0.3) million on the consolidated balance sheet in Derivative Instruments
and Other Liabilities, respectively.
A reconciliation of the notional or contract amounts for the significant
programs using derivative agreements and contracts is as follows:
Interest Rate Interest Rate
Cap Agreements Swaptions Swap Agreements
-------------------------------------------------------------------------
December 31 (in millions) 2001 2000 2001 2000 2001 2000
- ------------------------------------------------------------------------------------------------------------------
Balance at beginning-of-year 1,558.8 2,508.8 1,752.0 1,837.5 708.2 630.9
New contracts -- -- -- -- 172.5 652.2
Terminations and maturities (300.0) (950.0) -- (85.5) (373.1) (574.9)
- ------------------------------------------------------------------------------------------------------------------
Balance at end-of-year 1,258.8 1,558.8 1,752.0 1,752.0 507.6 708.2
==================================================================================================================
Spread-Lock Financial Futures
Agreements Contracts Put Options
-------------------------------------------------------------------------
December 31 (in millions) 2001 2000 2001 2000 2001 2000
- ------------------------------------------------------------------------------------------------------------------
Balance at beginning-of-year -- -- -- -- -- 21.3
New contracts -- 100.0 -- 267.2 -- --
Terminations and maturities -- (100.0) -- (267.2) -- (21.3)
- ------------------------------------------------------------------------------------------------------------------
Balance at end-of-year -- -- -- -- -- --
==================================================================================================================
Treasury Foreign Exchange Foreign Currency Swap
Locks Forward Contracts Agreements
--------------------------------------------------------------------------
December 31 (in millions) 2001 2000 2001 2000 2001 2000
- ------------------------------------------------------------------------------------------------------------------
Balance at beginning-of-year -- -- 124.3 -- 37.5 44.2
New contracts 200.0 -- 523.1 1,945.4 80.9 --
Terminations and maturities (200.0) -- (578.5) (1,822.6) (23.8) (6.7)
Foreign exchange adjustment -- -- (1.9) 1.5 -- --
- ------------------------------------------------------------------------------------------------------------------
Balance at end-of-year -- -- 67.0 124.3 94.6 37.5
==================================================================================================================
Credit Default Call Options Call Options
Swaps (Based on S&P) (Based on LNC Stock)
--------------------------------------------------------------------------
December 31 (in millions) 2001 2000 2001 2000 2001 2000
- ------------------------------------------------------------------------------------------------------------------
Balance at beginning-of-year 29.0 -- 183.3 129.6 0.6 --
New contracts -- 29.0 141.9 100.0 0.6 0.6
Terminations and maturities -- -- (325.2) (46.3) (0.1) --
- ------------------------------------------------------------------------------------------------------------------
Balance at end-of-year 29.0 29.0 -- 183.3 1.1 0.6
==================================================================================================================
Total Return
Swaps
-----------------
December 31 (in millions) 2001 2000
- ------------------------------------------------------------------------------------------------------------------
Balance at beginning-of-year -- --
New contracts 190.0 --
Terminations and maturities (190.0) --
- ------------------------------------------------------------------------------------------------------------------
Balance at end-of-year -- --
==================================================================================================================
Accounting for Derivative Instruments and Hedging Activities
As of December 31, 2001, LNC had derivative instruments that were
designated and qualified as cash flow hedges and fair value hedges and
derivative instruments that were not designated as hedging instruments. LNC
did not have derivative instruments that were designated as hedges of a net
investment in a foreign operation. See Note 1 to the consolidated financial
statements for detailed discussion of the accounting treatment for
derivative instruments. For the year ended December 31, 2001, LNC
recognized a net loss of $6.0 million after-tax in net income as a
component of realized gains and losses on investments. This loss relates to
the ineffective portion of cash flow hedges, the change in market value for
derivative instruments not designated as hedging instruments, and the gain
(loss) on swap terminations. For the year ended December 31, 2001, LNC
recognized a gain of $3.5 million after-tax in OCI related to the change in
market value on derivative instruments that are designated and qualify as
hedges. In addition, $3.5 million after-tax was reclassified from
unrealized gain (loss) on securities available-for-sale to unrealized gain
(loss) on derivative instruments, both in OCI. This reclassification
relates to derivative instruments that were marked to market through
unrealized gain (loss) on securities available-for-sale prior to the
adoption of FAS 133.
Derivative Instruments Designated in Cash Flow Hedges
Interest Rate Swap Agreements. LNC uses interest rate swap agreements to
hedge its exposure to floating rate bond coupon payments, replicating a
fixed rate bond. An interest rate swap is a contractual agreement to
exchange payments at one or more times based on the actual or expected
price level, performance or value of one or more underlying interest rates.
LNC is required to pay the counterparty the stream of variable interest
payments based on the coupon payments from the hedged bonds, and in turn,
receives a fixed payment from the counterparty, at a predetermined interest
rate. The net receipts/payments from these interest rate swaps are recorded
in net investment income. Gains (losses) on interest rate swaps hedging
interest rate exposure on floating rate bond coupon payments are
reclassified from accumulated OCI to net income as bond interest is
accrued.
LNC also uses interest rate swap agreements to hedge its exposure to
interest rate fluctuations related to the forecasted purchase of assets
for certain investment portfolios. The gains (losses) resulting from the
swap agreements are recorded in OCI. The gains (losses) are reclassified
from accumulated OCI to earnings over the life of the assets once the
assets are purchased. The forecasted purchase of assets related to
certain investment portfolios is a continuing hedge program. As of
December 31, 2001, there were no interest rate swaps hedging forecasted
asset purchases.
Foreign Currency Swaps. LNC uses foreign currency swaps, which are traded
over-the-counter, to hedge some of the foreign exchange risk of investments
in fixed maturity securities denominated in foreign currencies. 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. Gains
(losses) on foreign currency swaps hedging foreign exchange risk exposure
on foreign currency bond coupon payments are reclassified from accumulated
OCI to net income as bond interest is accrued. The foreign currency swaps
expire in 2002 through 2006.
Call Options on LNC Stock. LNC uses call options on LNC stock to hedge
the expected increase in liabilities arising from stock appreciation
rights ("SARs") granted on LNC stock. Upon option expiration, the
payment, if any, is the increase in LNC's stock price over the strike
price of the option applied to the number of contracts. Call options
hedging vested SARs are not eligible for hedge accounting and both are
marked to market through net income. Call options hedging nonvested SARs
are eligible for hedge accounting and are accounted for as cash flow
hedges of the forecasted vesting of SAR liabilities. To the extent that
the cash flow hedges are effective, changes in the fair value of the
call options are recorded in OCI. Amounts recorded in accumulated OCI
are reclassified to net income upon vesting of SARs. LNC's call option
positions will be maintained until such time the SARs are either
exercised or expire and LNC's SAR liabilities are extinguished. The SARs
expire five years from the date of grant.
Treasury Lock. LNC used a treasury lock agreement to hedge its exposure to
variability in future semi-annual interest payments, attributable to
changes in the benchmark interest rate, related to the issuance of its
10-year $250 million senior debt. A treasury lock is an agreement that
allows the holder to lock in a benchmark interest rate, so that if the
benchmark interest rate increases, the holder is entitled to receive a
payment from the counterparty to the agreement equal to the present value
of the difference in the benchmark interest rate at the determination date
and the locked-in benchmark interest rate. If the benchmark interest rate
decreases, the holder must pay the counterparty to the agreement an amount
equal to the present value of the difference in the benchmark interest rate
at the determination date and the locked-in benchmark interest rate. The
receipt (payment) from the termination of a treasury lock is recorded in
OCI and is reclassified from accumulated OCI to interest expense over the
coupon paying period of the related senior debt.
Total Return Swaps. LNC used total return swaps to hedge its exposure to
interest rate and spread risk resulting from the forecasted sale of assets
in a securitization of certain LNC mortgage loans. A total return swap is
an agreement that allows the holder to protect itself against loss of value
by effectively transferring the economic risk of asset ownership to the
counterparty. The holder pays (receives) the total return equal to interest
plus capital gains or losses on a referenced asset and receives a floating
rate of interest. As of December 31, 2001, LNC did not have any open total
return swaps.
Gains and losses on derivative contracts that are reclassified from
accumulated OCI to current period earnings are included in the line item in
which the hedged item is recorded. As of December 31, 2001, $18.2 million
of the deferred net gains on derivative instruments accumulated in OCI are
expected to be reclassified as earnings during the next twelve months. This
reclassification is primarily due to the receipt of interest payments
associated with variable rate securities and forecasted purchases, payment
of interest on LNC's senior debt, the receipt of interest payments
associated with foreign currency securities, and the periodic vesting of
SARs.
Derivative Instruments Designated in Fair Value Hedges
Interest Rate Swap Agreements. LNC uses interest rate swap agreements to
hedge the risk of paying a higher fixed rate interest on
company-obligated mandatorily redeemable preferred securities of
subsidiary trusts holding solely junior subordinated debentures than
would be paid on long-term debt based on current interest rates in the
marketplace. LNC is required to pay the counterparty a stream of
variable interest payments based on the referenced index, and in turn,
receives a fixed payment from the counterparty, at a predetermined
interest rate. The net receipts/payments from these interest rate swaps
are recorded as an adjustment to the interest expense related to the
debt being hedged. The changes in fair value of the interest rate swap
are reported in the consolidated statement of income in the period of
change along with the offsetting changes in fair value of the debt
being hedged.
All Other Derivative Instruments
LNC uses various other derivative instruments for risk management purposes
that either do not qualify for hedge accounting treatment or have not
currently been qualified by LNC for hedge accounting treatment. The gain or
loss related to the change in market value for these derivative instruments
is recognized in current income during the period of change (reported as
realized gain (loss) on investments in the consolidated statement of income
except where otherwise noted below).
Interest Rate Cap Agreements. The interest rate cap agreements, which
expire in 2002 through 2006, entitle LNC to receive quarterly payments from
the counterparties on specified future reset dates, contingent on future
interest rates. For each cap, the amount of such quarterly payments, if
any, is determined by the excess of a market interest rate over a specified
cap rate multiplied by the notional amount divided by four. The purpose of
LNC's interest rate cap agreement program is to provide a level of
protection for its annuity line of business from the effect of rising
interest rates. The interest rate cap agreements provide an economic hedge
of the annuity line of business. However, the interest rate cap agreements
are not linked to assets and liabilities on the balance sheet that meet the
significantly increased level of specificity required under FAS 133.
Therefore, the interest rate cap agreements do not qualify for hedge
accounting under FAS 133.
Swaptions. Swaptions, which expire in 2002 through 2003, entitle LNC to
receive settlement payments from the counterparties on specified expiration
dates, contingent on future interest rates. For each swaption, the amount
of such settlement payments, if any, is determined by the present value of
the difference between the fixed rate on a market rate swap and the strike
rate multiplied by the notional amount. The purpose of LNC's swaption
program is to provide a level of protection for its annuity line of
business from the effect of rising interest rates. The swaptions provide an
economic hedge of the annuity line of business. However, the swaptions are
not linked to specific assets and liabilities on the balance sheet that
meet the significantly increased level of specificity required under FAS
133. Therefore, the swaptions do not qualify for hedge accounting under FAS
133.
Foreign Exchange Forwards. LNC's foreign affiliate, Lincoln UK, uses
foreign exchange forward contracts, which are traded over-the-counter, to
hedge short-term debt issuance in currencies other than the British Pound.
The foreign currency forward contracts obligate LNC to deliver a specified
amount of currency at a future date at a specified exchange rate. The
foreign exchange forward contracts are marked to market through interest
and debt expense within the income statement.
Credit Default Swaps. LNC uses credit default swaps which expire in 2002
through 2006 to hedge against a drop in bond prices due to credit concerns
of certain bond issuers. A credit default swap allows LNC to put the bond
back to the counterparty at par upon a credit event by the bond issuer. A
credit event is defined as bankruptcy, failure to pay, or obligation
acceleration. LNC has not currently qualified credit default swaps for
hedge accounting under FAS 133 as amounts are insignificant.
Call Options on S&P 500 Index. Prior to Swiss Re's acquisition of LNC's
reinsurance operation in December 2001, LNC used S&P 500 index call options
to offset the increase in its liabilities resulting from certain
reinsurance agreements which guaranteed payment of the appreciation of the
S&P 500 index on certain underlying annuity products. The call options
provided LNC with settlement payments from the counterparties on specified
expiration dates. The payment, if any, was the percentage increase in the
index, over the strike price defined in the contract, applied to the
notional amount. The S&P 500 call options provided an economic hedge of the
reinsurance liabilities, but the hedging relationship was not eligible for
hedge accounting treatment under FAS 133.
Call Options on LNC Stock. As discussed previously in the Cash Flow Hedges
section, LNC uses call options on LNC stock to hedge the expected increase
in liabilities arising from SARs granted on LNC stock. Call options hedging
vested SARs are not eligible for hedge accounting treatment under FAS 133.
Derivative Instrument Embedded in Deferred Compensation Plan. LNC has
certain deferred compensation plans that have embedded derivative
instruments. The liability related to these plans varies based on the
investment options selected by the participants. The liability related to
certain investment options selected by the participants is marked to market
through net income. This derivative instrument is not eligible for hedge
accounting treatment under FAS 133.
Call Options on Bifurcated Remarketable Put Bonds. LNC owns various debt
securities that contain call options attached by an investment banker
before the sale to the investor. These freestanding call options are
exercisable by a party other than the issuer of the debt security to which
they are attached and are accounted for separately from the debt security.
LNC has not currently qualified call options bifurcated from remarketable
put bonds for hedge accounting treatment as amounts are insignificant.
LNC has used certain other derivative instruments in the past for hedging
purposes. Although other derivative instruments may have been used in the
past, any derivative type that was not outstanding from January 1, 2001
through December 31, 2001 is not discussed in this disclosure. Other
derivative instruments LNC has used include spread-lock agreements,
financial futures, put options, and commodity swaps. At December 31, 2001,
there are no outstanding positions in these derivative instruments.
Additional Derivative Information. Income and (expenses) for the agreements
and contracts described above amounted to $3.5 million, $(7.3) million and
$(9.9) million in 2001, 2000 and 1999, respectively. The increase in income
for 2001 was primarily because amortization of premiums for caps and
swaptions is no longer recorded through operating income. Deferred losses
of $6.2 million for the year ended December 31, 2000 were primarily the
result of terminated interest rate swaps, spread-locks, put options, and
financial futures contracts. These losses were included with the related
fixed maturity securities to which the hedge applied or as deferred assets
and were being amortized over the life of such securities until FAS 133 was
adopted as of January 1, 2001.
LNC is exposed to credit loss in the event of nonperformance by
counterparties on various derivative contracts. However, LNC does not
anticipate nonperformance by any of the counterparties. The credit risk
associated with such agreements is minimized by purchasing such agreements
from financial institutions with long-standing, superior performance
records. The amount of such exposure is essentially the net replacement
cost or market value less collateral held for such agreements with each
counterparty if the net market value is in LNC's favor. At December 31,
2001, the exposure was $48.9 million.
Events of September 11, 2001. In the third quarter of 2001, LNC recorded
losses totaling $33.2 million after-tax ($51.1 million pre-tax)
for claims associated with the September 11, 2001 terrorist attacks. Of the
total losses, $13.9 million after-tax was estimated for incurred but not
reported claims, $1.0 million after-tax was estimated for losses from
participation in a group life reinsurance pool and $8.2 million after-tax
was estimated for a recovery from participation in an individual life
reinsurance pool. In the fourth quarter of 2001, based upon updated
information received regarding actual claims reported, a reduction in the
estimate of losses was recorded in the amount of $8.7 million after-tax
($13.4 million pre-tax) for incurred but not reported claims related to
both reinsurance business and life insurance business. Uncertainty
regarding these estimates has diminished. Based upon currently available
information, LNC does not believe that future loss development will vary
significantly from its current estimates.
8. Fair Value of Financial Instruments
The following discussion outlines the methodologies and assumptions used to
determine the estimated fair value of LNC's financial instruments.
Considerable judgment is required to develop these fair values.
Accordingly, the estimates shown are not necessarily indicative of the
amounts that would be realized in a one-time, current market exchange of
all of LNC's financial instruments.
Fixed Maturity and Equity Securities. Fair values for fixed maturity
securities are based on quoted market prices, where available. For fixed
maturity securities not actively traded, fair values are estimated using
values obtained from independent pricing services. In the case of private
placements, fair values are estimated by discounting expected future cash
flows using a current market rate applicable to the coupon rate, credit
quality and maturity of the investments. The fair values for equity
securities are based on quoted market prices.
Mortgage Loans on Real Estate. The estimated fair value of mortgage loans
on real estate was established using a discounted cash flow method based on
credit rating, maturity and future income. The ratings for mortgages in
good standing are based on property type, location, market conditions,
occupancy, debt service coverage, loan to value, caliber of tenancy,
borrower and payment record. Fair values for impaired mortgage loans are
based on: 1) the present value of expected future cash flows discounted at
the loan's effective interest rate; 2) the loan's market price or; 3) the
fair value of the collateral if the loan is collateral dependent.
Policy Loans. The estimated fair value of investments in policy loans was
calculated on a composite discounted cash flow basis using Treasury
interest rates consistent with the maturity durations assumed. These
durations were based on historical experience.
Other Investments, and Cash and Invested Cash. The carrying value for
assets classified as other investments, and cash and invested cash in the
accompanying balance sheets approximates their fair value.
Investment Type Insurance Contracts. The balance sheet captions, "Insurance
Policy and Claim Reserves" and "Contractholder Funds," include investment
type insurance contracts (i.e. deposit contracts and certain guaranteed
interest contracts). The fair values for the deposit contracts and certain
guaranteed interest contracts are based on their approximate surrender
values. The fair values for the remaining guaranteed interest and similar
contracts are estimated using discounted cash flow calculations. These
calculations are based on interest rates currently offered on similar
contracts with maturities that are consistent with those remaining for the
contracts being valued.
The remainder of the balance sheet captions "Insurance Policy and Claim
Reserves" and "Contractholder Funds" that do not fit the definition of
"investment type insurance contracts" are considered insurance contracts.
Fair value disclosures are not required for these insurance contracts and
have not been determined by LNC. It is LNC's position that the disclosure
of the fair value of these insurance contracts is important because readers
of these financial statements could draw inappropriate conclusions about
LNC's shareholders' equity determined on a fair value basis. It could be
misleading if only the fair value of assets and liabilities defined as
financial instruments are disclosed. LNC and other companies in the
insurance industry are monitoring the related actions of the various
rule-making bodies and attempting to determine an appropriate methodology
for estimating and disclosing the "fair value" of their insurance contract
liabilities.
Short-term and Long-term Debt. Fair values for long-term debt issues are
based on quoted market prices or estimated using discounted cash flow
analysis based on LNC's current incremental borrowing rate for similar
types of borrowing arrangements where quoted prices are not available. For
short-term debt, the carrying value approximates fair value.
Company-Obligated Mandatorily Redeemable Preferred Securities of Subsidiary
Trusts Holding Solely Junior Subordinated Debentures. Fair values for
company-obligated mandatorily redeemable preferred securities of subsidiary
trusts holding solely junior subordinated debentures are based on quoted
market prices.
Guarantees. LNC's guarantees include guarantees related to industrial
revenue bonds, real estate partnerships and mortgage loan pass-through
certificates. Based on historical performance where repurchases have been
negligible and the current status of the debt, none of the loans are
delinquent and the fair value liability for the guarantees related to the
industrial revenue bonds, real estate partnerships and mortgage loan
pass-through certificates is insignificant.
Derivatives. LNC employs several different methods for determining the fair
value of its derivative instruments. Fair values for these contracts are
based on current settlement values. These values are based on: 1) quoted
market prices for foreign currency exchange contracts and financial futures
contracts; 2) industry standard models that are commercially available for
interest rate cap agreements, swaptions, spread-lock agreements, interest
rate swaps, commodity swaps, credit default swaps, total return swaps and
put options; 3) Monte Carlo techniques for the equity call options on LNC
stock. These techniques project cash flows of the derivatives using current
and implied future market conditions. The cash flows are then present
valued to arrive at the derivatives' current fair market values; and 4)
Black-Scholes pricing methodology for standard European equity call
options.
Investment Commitments. Fair values for commitments to make investments in
fixed maturity securities (primarily private placements), mortgage loans on
real estate and real estate are based on the difference between the value
of the committed investments as of the date of the accompanying balance
sheets and the commitment date. These estimates take into account changes
in interest rates, the counterparties' credit standing and the remaining
terms of the commitments.
Separate Accounts. Assets held in separate accounts are reported in the
accompanying consolidated balance sheets at fair value. The related
liabilities are also reported at fair value in amounts equal to the
separate account assets.
The carrying values and estimated fair values of LNC's financial
instruments are as follows:
Carrying Fair Carrying Fair
Value Value Value Value
----------------------------------------------
December 31 (in millions) 2001 2001 2000 2000
- -------------------------------------------------------------------------------------------------
Assets (liabilities):
Fixed maturities securities $28,345.7 $28,345.7 $27,449.8 $27,449.8
Equity securities 470.5 470.5 549.7 549.7
Mortgage loans on real estate 4,535.6 4,691.1 4,663.0 4,702.5
Policy loans 1,939.7 2,098.1 1,960.9 2,096.4
Derivative instruments* 46.1 46.1 39.5 73.4
Other investments 507.4 507.4 463.3 463.3
Cash and invested cash 3,095.5 3,095.5 1,927.4 1,927.4
Investment type insurance contracts:
Deposit contracts and certain guaranteed
interest contracts (18,142.7) (18,183.5) (16,813.2) (16,654.8)
Remaining guaranteed interest and similar contracts (205.2) (202.6) (817.3) (784.5)
Short-term debt (350.2) (350.2) (312.9) (312.9)
Long-term debt (861.7) (870.5) (712.2) (707.4)
Company-obligated mandatorily redeemable
preferred securities of subsidiary trusts
holding solely junior subordinated debentures (474.7) (478.3) (745.0) (722.7)
Guarantees (0.3) -- (0.3) --
Investment commitments -- (5.3) -- 2.8
=================================================================================================
* Derivative instruments for 2001 are composed of $46.4 million and $(0.3)
million on the consolidated balance sheet in Derivative Instruments and
Other Liabilities, respectively.
As of December 31, 2001 and 2000, the carrying value of the deposit
contracts and certain guaranteed contracts is net of deferred acquisition
costs of $338.9 million and $169.6 million, respectively, excluding
adjustments for deferred acquisition costs applicable to changes in fair
value of securities. The carrying values of these contracts are stated net
of deferred acquisition costs so that they are comparable with the fair
value basis.
9. Segment Information
LNC has four business segments: Annuities (effective March 7, 2002, this
segment will be known as Lincoln Retirement), Life Insurance, Investment
Management and Lincoln UK.
Prior to the fourth quarter of 2001, LNC had a Reinsurance segment
("Lincoln Re"). LNC's reinsurance business was acquired by Swiss Re in
December 2001. As the majority of the business acquired by Swiss Re was via
indemnity reinsurance agreements, LNC is not relieved of its legal
liability to the ceding companies for this business. This means that the
liabilities and obligations associated with the reinsured contracts remain
on the consolidated balance sheet of LNC with a corresponding reinsurance
receivable from Swiss Re. In addition, the gain resulting from the
indemnity reinsurance portion of the transaction was deferred and is being
amortized into earnings at the rate that earnings on the reinsured business
are expected to emerge, over a period of seven to 15 years on a declining
basis. After the acquisition of this business by Swiss Re, the ongoing
management of the indemnity reinsurance contracts and the reporting of the
deferred gain will be within LNC's Other Operations. Given the lengthy
period of time over which LNC will continue to amortize the deferred gain,
and the fact that related assets and liabilities will continue to be
reported on LNC's financial statements, the historical results for the
Reinsurance segment prior to the close of the transaction with Swiss Re
will not be reflected in discontinued operations, but as a separate line in
Other Operations. The results for 2001 are for the eleven months ended
November 30, 2001. Earlier periods were restated to aid comparability of
segment reporting between periods.
The Annuities segment, headquartered in Fort Wayne, Indiana, provides
tax-deferred investment growth and lifetime income opportunities for its
clients through the manufacture and sale of fixed and variable annuities.
Through a broad-based distribution network, the Annuities segment provides
an array of annuity products to individuals and employer-sponsored groups
in all 50 states of the United States. The Annuities segment distributes
some of its products through LNC's wholesaling unit, Lincoln Financial
Distributors ("LFD"), as well as LNC's retail unit, Lincoln Financial
Advisors ("LFA"). In addition, the Annuities segment has alliances with a
variety of unrelated companies where LNC provides the manufacturing
platform for annuity products and the alliance company provides investment
management, marketing and distribution.
The Life Insurance segment, headquartered in Hartford, Connecticut, focuses
on the creation and protection of wealth for its clients through the
manufacture and sale of life insurance products throughout the United
States. The Life Insurance segment offers, through its Hartford operations,
universal life, variable universal life, interest-sensitive whole life and
corporate owned life insurance. Additional offerings through its
Schaumburg, Illinois operations include universal life, linked-benefit life
(a universal life product with a long-term care benefit) and term life
insurance. All of the Life Insurance segment's products are distributed
through LFD and LFA.
The Investment Management segment, headquartered in Philadelphia,
Pennsylvania, offers a variety of asset management services to retail and
institutional clients throughout the United States and certain foreign
countries. Its product offerings include mutual funds and managed accounts.
It also provides investment management and account administration services
for variable annuity products, and 401(k), pension, endowment and trust
accounts. Retail products are distributed through both LFD and LFA.
Institutional products including large case 401(k) plans are marketed by a
separate sales force in conjunction with pension consultants. The
Investment Management segment also provides investment advisory services
for certain insurance and corporate portfolios of LNC.
Lincoln UK is headquartered in Barnwood, Gloucester, England, and is
licensed to do business throughout the United Kingdom ("UK"). Although
Lincoln UK transferred its sales force to Inter-Alliance Group PLC in the
third quarter of 2000, it continues to manage, administer and accept new
deposits on its current block of business and, as required by UK
regulation, accept new business for certain products. Lincoln UK's product
portfolio principally consists of unit-linked life and pension products,
which are similar to U.S. produced variable life and annuity products.
LNC reports operations not directly related to the business segments and
unallocated corporate items (i.e., corporate investment income, interest
expense on corporate debt, unallocated overhead expenses, and the
operations of Lincoln Financial Advisors ("LFA") and Lincoln Financial
Distributors ("LFD")) in "Other Operations". As noted above, the financial
results of the former Reinsurance segment were moved to Other Operations
upon the close of the transaction with Swiss Re in December 2001.
Financial data by segment for 1999 through 2001 is as follows:
Year Ended December 31 (in millions) 2001 2000 1999
- -----------------------------------------------------------------------------------------------
Revenue, Excluding Net Investment Income and Realized
Gain (Loss) on Investments and Derivative Instruments
and Sale of Subsidiaries:
Annuities $663.1 $745.4 $653.8
Life Insurance 987.3 964.9 922.5
Investment Management 383.8 436.5 438.7
Lincoln UK 216.1 364.7 368.3
Other Operations (includes consolidating adjustments) 1,552.3 1,621.2 1,609.9
- -----------------------------------------------------------------------------------------------
Total $3,802.6 $4,132.7 $3,993.2
Net Investment Income:
Annuities $1,370.0 $1,393.5 $1,474.2
Life Insurance 910.2 871.5 840.1
Investment Management 53.6 57.7 56.9
Lincoln UK 64.8 70.3 75.3
Other Operations (includes consolidating adjustments) 281.0 354.1 361.0
- -----------------------------------------------------------------------------------------------
Total $2,679.6 $2,747.1 $2,807.5
Realized Gain (Loss) on Investments and Derivative
Instruments
and Sale of Subsidiaries:
Annuities $(64.8) $(5.2) $(12.1)
Life Insurance (56.9) (17.4) (2.2)
Investment Management (3.7) (3.9) (0.1)
Lincoln UK 12.4 3.2 3.0
Other Operations (includes consolidating adjustments) 11.4 (5.0) 14.4
- -----------------------------------------------------------------------------------------------
Total $(101.6) $(28.3) $3.0
Income (Loss) before Federal Income Taxes and
Cumulative Effect of Accounting Changes:
Annuities $312.8 $438.0 $368.7
Life Insurance 369.8 392.7 332.2
Investment Management 19.1 58.2 82.5
Lincoln UK 61.6 (23.7) (100.1)
Other Operations (includes consolidating adjustments) 0.8 (28.9) (113.3)
- -----------------------------------------------------------------------------------------------
Total $764.1 $836.3 $570.0
Income Tax Expense (Benefit):
Annuities $36.3 $79.4 $77.2
Life Insurance 131.2 143.4 120.7
Investment Management 7.2 21.2 30.9
Lincoln UK (7.3) (10.5) (81.9)
Other Operations (includes consolidating adjustments) (9.1) (18.6) (37.3)
- -----------------------------------------------------------------------------------------------
Total $158.3 $214.9 $109.6
Cumulative Effect of Accounting Changes:
Annuities $(7.3) -- --
Life Insurance (5.5) -- --
Investment Management (0.1) -- --
Lincoln UK -- -- --
Other Operations (includes consolidating adjustments) (2.7) -- --
- -----------------------------------------------------------------------------------------------
Total $(15.6) -- --
Net Income (Loss):
Annuities $269.2 $358.6 $291.5
Life Insurance 233.1 249.3 211.5
Investment Management 11.8 37.0 51.6
Lincoln UK 68.9 (13.2) (18.2)
Other Operations (includes consolidating adjustments) 7.2 (10.3) (76.0)
- -----------------------------------------------------------------------------------------------
Total $590.2 $621.4 $460.4
===============================================================================================
December 31 (in millions) 2001 2000 1999
- -----------------------------------------------------------------------------------------------
Assets:
Annuities $56,888.2 $60,267.1 $63,921.0
Life Insurance 18,409.7 17,939.1 16,433.5
Investment Management 1,460.5 1,439.0 1,483.1
Lincoln UK 7,788.8 8,763.7 9,712.8
Other Operations (includes consolidating adjustments) 13,454.1 11,435.2 11,545.3
- -----------------------------------------------------------------------------------------------
Total $98,001.3 $99,844.1 $103,095.7
===============================================================================================
During 2000, management initiated a plan to change the operational and
management reporting structure of LNC's wholesale distribution
organization. Beginning with the quarter ended March 31, 2001, Lincoln
Financial Distributors ("LFD"), the wholesaling arm of LNC's distribution
network, was reported within Other Operations. Previously, LNC's
wholesaling efforts were conducted separately within the Annuities, Life
Insurance and Investment Management segments. Earlier periods were restated
to aid comparability of segment reporting between periods.
Also, in the fourth quarter of 2000, a decision was made to change the
management reporting and operational responsibilities for First
Penn-Pacific's Schaumburg, Illinois annuities business. Beginning with the
quarter ended March 31, 2001, the financial reporting for First
Penn-Pacific's annuities business was included in the Annuities segment.
This business was previously managed and reported in the Life Insurance
Segment. Earlier periods were restated to aid the comparability of segment
reporting between periods.
Prior to 2001, the management of general account investments performed by
the Investment Management segment for LNC's U.S. based insurance operations
was generally priced on an "at cost" basis. Effective January 1, 2001,
substantially all of these internal investment management services were
priced on an arms-length "profit" basis. Under this new internal pricing
standard, the Investment Management segment receives approximately 18.5
basis points on certain assets under management. The change in pricing of
internal investment management services impacted segment reporting results
for the Annuities, Life Insurance, Reinsurance and Investment Management
segments, along with Other Operations. Earlier periods were restated to aid
the comparability of segment reporting between periods.
Most of LNC's foreign operations are conducted by Lincoln UK, a UK
company. The data for this company is shown above under the Lincoln UK
segment heading. The other segments, except for the Annuities segment,
have non-U.S. operations. Foreign intracompany revenues are not
significant. Financial data for Lincoln UK and the other non-U.S. units*
is as follows:
Year Ended December 31 (in millions) 2001 2000 1999
- -----------------------------------------------------------------------------------------------
Revenue $395.5 $536.3 $572.4
Net Income (Loss) before Federal Income Taxes 111.9 (7.1) (60.4)
Income Tax Expense (Benefit) 9.5 (10.2) (56.6)
- -----------------------------------------------------------------------------------------------
Net Income (Loss) $102.4 $3.1 $(3.8)
Assets (at end of year) $7,889.7 $8,896.8 $9,820.0
===============================================================================================
* The financial data for other non-U.S. units includes the activity of
several former reinsurance subsidiaries for the years ended December 31,
2000 and 1999 and for the eleven months ended November 30, 2001. These
entities were sold to Swiss Re in December 2001.
10. Shareholders' Equity
LNC's common and series A preferred stock is without par value.
All of the issued and outstanding series A preferred stock is $3 cumulative
convertible and is convertible at any time into shares of common stock. The
conversion rate is sixteen shares of common stock for each share of series
A preferred stock, subject to adjustment for certain events. The series A
preferred stock is redeemable at the option of LNC at $80 per share plus
accrued and unpaid dividends. Outstanding series A preferred stock has full
voting rights, subject to adjustment if LNC is in default as to the payment
of dividends. If LNC is liquidated or dissolved, holders of series A
preferred stock will be entitled to payments of $80 per share. The
difference between the aggregate preference on liquidation value and the
financial statement balance for the series A preferred stock was $1.1
million at December 31, 2001.
LNC has outstanding one common share purchase ("Right") on each outstanding
share of LNC's common stock. A Right will also be issued with each share of
LNC's common stock that is issued before the Rights become exercisable or
expire. If a person or group announces an offer that would result in
beneficial ownership of 15% or more of LNC's common stock, the Rights will
become exercisable and each Right will entitle its holder to purchase one
share of LNC's common stock for $100. Upon the acquisition of 15% or more
of LNC's common stock, each holder of a Right (other than the person
acquiring the 15% or more) will have the right to acquire the number of
shares of LNC common stock that have a market value of two times the
exercise price of the Right. If LNC is acquired in a business combination
transaction in which LNC does not survive, each holder of a Right (other
than the acquiring person) will have the right to acquire common stock of
the acquiring person having a market value of two times the exercise price
of the Right. LNC can redeem each Right for one cent at any time prior to
the tenth day after a person or group has acquired 15% or more of LNC's
common stock. The Rights expire on November 14, 2006. As of December 31,
2001, there were 186,943,738 Rights outstanding.
During 2001, 2000 and 1999, LNC purchased and retired 11,278,022, 6,222,581
and 7,675,000 shares, respectively, of its common stock at a total cost of
$503.7 million, $210.0 million and $377.7 million, respectively. The common
stock account was reduced for these purchases in proportion to the
percentage of shares acquired. The remainder of the purchase price was
charged to retained earnings.
During May 1999, LNC's Board of Directors approved a two-for-one stock
split for its common stock. The record date for the stock split was June 4,
1999 and the additional shares were distributed to shareholders on June 21,
1999. The 1999 consolidated financial statements including per share
disclosures in these notes, have been adjusted to reflect the effects of
the common stock split for all periods presented.
Per share amounts for net income from continuing operations are shown on
the income statement using 1) an earnings per common share basic
calculation and 2) an earnings per common share-assuming dilution
calculation. A reconciliation of the factors used in the two calculations
are as follows:
Year Ended December 31 (in millions) 2001 2000 1999
- -----------------------------------------------------------------------------------------------
Numerator: [millions]
Net income as used in basic calculation $590.1 $621.3 $460.3
Dividends on convertible preferred stock 0.1 0.1 0.1
- -----------------------------------------------------------------------------------------------
$590.2 $621.4 $460.4
Denominator: [number of shares]
Weighted-average shares, as used in basic calculation 188,624,613 191,257,414 197,817,053
Shares to cover conversion of preferred stock 389,024 438,391 491,014
Shares to cover non-vested stock 31,160 10,673 347,145
Average stock options outstanding during the period 16,624,905 13,652,143 8,464,229
Assumed acquisition of shares with assumed proceeds
and benefits from exercising stock options
(at average market price for the year). (13,163,012) (11,102,355) (6,796,998)
Average deferred compensation shares 796,575 664,551 95,236
- -----------------------------------------------------------------------------------------------
Weighted-average shares, as used in diluted calculation 193,303,265 194,920,817 200,417,679
===============================================================================================
LNC has stock options outstanding which were issued at prices that are
above the current average market price of LNC common stock. In the event
the average market price of LNC's common stock exceeds the issue price of
stock options, such options would be dilutive to LNC's earnings per share
and will be shown in the table above. During 1999, LNC changed its deferred
compensation plans so that participants selecting 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.
Details underlying the balance sheet caption "Net Unrealized Gain (Loss) on
Securities Available-for-Sale," are as follows:
Year Ended December 31 (in millions) 2001 2000
- ----------------------------------------------------------------------------------
Fair value of securities available-for-sale $28,816.2 $27,999.5
Cost of securities available-for-sale 28,400.4 27,839.9
- ----------------------------------------------------------------------------------
Unrealized gain 415.8 159.6
Adjustments to deferred acquisition costs (83.1) 74.8
Amounts required to satisfy policyholder commitments (38.8) (243.4)
Deferred income credits (taxes) (98.2) 19.7
- ----------------------------------------------------------------------------------
Net unrealized gain (loss) on securities available-for-sale 195.7 10.7
Change in fair value of derivatives designated as a hedge in
2000 (classified as other investments) -- 1.3
- ----------------------------------------------------------------------------------
Net unrealized gain (loss) on securities available-for-sale $195.7 $12.0
==================================================================================
Adjustments to deferred acquisition costs and amounts required to satisfy
policyholder commitments are netted against the Deferred Acquisition Costs
asset line and included within the Insurance Policy and Claim Reserves line
on the balance sheet, respectively.
Details underlying "Unrealized Gain (Loss) on Securities
Available-for-Sale, Net of Reclassification Adjustment" shown on the
Consolidated Statements of Shareholder's Equity are as follows:
Year Ended December 31 (in millions) 2001 2000 1999
- -----------------------------------------------------------------------------------------------
Unrealized gains (losses) on securities available-for-sale
arising during the year $345.4 $317.4 $(1,202.4)
Less: reclassification adjustment for gains (losses)
included in net income (1) 43.8 (60.9) (3.0)
Less: Federal income tax expense (benefit) 117.9 (99.4) (181.3)
- -----------------------------------------------------------------------------------------------
Unrealized gain (loss) on securities available-for-sale,
net of reclassification and Federal income tax expense
(benefit) $183.7 $477.7 $(1,018.1)
===============================================================================================
(1) The reclassification adjustment for gains (losses) does not include the
impact of associated adjustments to deferred acquisition costs and amounts
required to satisfy policyholder commitments.
The "Unrealized Gain on Derivative Instruments" component of other
comprehensive income shown on the Consolidated Statements of Shareholders'
Equity for 2001 is net of Federal income tax expense of $12.6 million ($9.5
million of the tax expense relates to the transition adjustment recorded in
the first quarter of 2001 for the adoption of FAS 133) and adjustments to
deferred amortization costs of $23.8 million ($18.3 million relates to the
transition adjustment recorded for the adoption of FAS 133.)
The "Foreign Currency Translation" component of other comprehensive income
shown on the Consolidated Statements of Shareholders' Equity is net of
Federal income tax expense (benefit) of $(16.1) million, $(4.4) million and
$(10.7) million for 2001, 2000 and 1999, respectively.
11. Acquisitions and Divestitures
On November 1, 1999, LNC closed its previously announced agreement to
transfer a block of disability income business to MetLife. Under this
indemnity reinsurance agreement, LNC transferred $490.4 million of cash to
MetLife representing the statutory reserves transferred on this business,
net of $18.5 million of purchase price consideration. In accordance with
the accounting rules for indemnity reinsurance transactions, the gain on
sale was deferred. At December 31, 2001, a deferred gain of $64.8 million
related to this transaction is included in the overall deferred gain
associated with the acquisition of LNC's reinsurance operations by Swiss Re
and is being amortized at the rate that earnings are expected to emerge on
this reinsured business.
On September 13, 1999, LNC announced that it had reached an agreement to
purchase Alden Risk Management Services, the employer medical stop-loss
business of the John Alden Life Insurance Company for $41.5 million in
cash. The agreement also includes the purchase of a block of group life and
accidental death and dismemberment business. The purchase closed on
November 1, 1999. As of December 31, 1999, the application of purchase
accounting to this block of business resulted in goodwill of $34.1 million
and other intangible assets (i.e., present value of future service rights)
of $13.7 million. This business was sold as part of Swiss Re's acquisition
of LNC's reinsurance business on December 7, 2001. (See below for further
discussion of this transaction.)
On March 30, 2000, LNC transferred its 49% share of Seguros Serfin Lincoln
to its partner, Grupo Financiero Serfin S.A., for $100.5 million. The
proceeds included the recovery of LNC's investment which freed up
approximately $90.0 million of capital and included interest income of
$14.1 million ($9.2 million after-tax).
On December 7, 2001, Swiss Re acquired LNC's reinsurance operation for
$2.0 billion. In addition, LNC retained the capital supporting the
reinsurance operation. After giving affect to the increased levels of
capital needed within the Life Insurance and Annuity segments that
result from the change in the ongoing mix of business under LNC's
internal capital allocation models, the disposition of LNC's reinsurance
operation has freed-up approximately $100 million of capital. The
transaction structure involved a series of indemnity reinsurance
transactions combined with the sale of certain stock companies that
comprised LNC's reinsurance operation. An immediate gain of $15.0
million after-tax was recognized on the sale of the stock companies.
Under the indemnity reinsurance agreements, Swiss Re reinsured certain
liabilities and obligations of LNC. Because LNC is not relieved of its
legal liability to the ceding companies, in accordance with FAS 113, the
liabilities and obligations associated with the reinsured contracts
remain on the consolidated balance sheets of LNC with a corresponding
reinsurance receivable from Swiss Re.
A gain of $723.1 million ($1.1 billion pre-tax) was generated under the
indemnity reinsurance agreements. This gain was recorded as a deferred
gain on LNC's consolidated balance sheet in accordance with the
requirements of FAS 113 and is being amortized into earnings at the rate
that earnings on the reinsured business are expected to emerge, over a
period of seven to 15 years on a declining basis. During 2001, LNC
recognized in Other Operations $5.0 million ($7.9 million pre-tax) of
deferred gain amortization. In addition, LNC recognized $7.9 million
($12.5 million pre-tax) of accelerated deferred gain amortization
relating to the fact that certain Canadian indemnity reinsurance
contracts were novated after the sale, but prior to year-end.
LNC and Swiss Re have not agreed upon the final closing financial
statements associated with the December 7, 2001 transactions. There are
currently disputed matters of approximately $500 million, which relate
primarily to personal accident business reserves and recoverables. LNC's
ongoing indemnification to Swiss Re on the underlying reinsurance
business is limited to the personal accident business. Pursuant to the
purchase agreement, LNC's exposure is capped at $100 million ($65
million after-tax) for net future payments under the personal accident
programs in excess of $148 million, which represents the personal
accident liabilities net of the assets held for reinsurance recoverable
at December 31, 2000. Up to $200 million of net payments in excess of
the net liabilities will be shared on a 50/50 basis between LNC and
Swiss Re. LNC has no continuing indemnification risk to Swiss Re on
other reinsurance lines of business including disability income, HMO
excess-of-loss, group carrier medical and property and casualty
reinsurance lines.
Under the timeframe provided for within the acquisition agreement for
dispute resolution, it is probable that the earliest point that these
matters will be agreed upon would be the second quarter of 2002. If the
parties are unable to reach agreement, and these matters go to
arbitration, an ultimate resolution of these matters may take several
additional months.
Upon reaching agreement as to the final closing financial statements, it is
possible that LNC could record adjustments to realized gain or loss on the
sale of subsidiaries, to net income, or to the amount of deferred gain
associated with the Swiss Re transaction. Another aspect of a potential
dispute resolution could result in LNC agreeing to transfer assets to Swiss
Re until the adequacy of certain reserves and related recoverables can be
determined. In that event, LNC's future investment income would be reduced
to the extent that any such dispute resolution would result in Swiss Re's
retention of the related investment income during the time frame that Swiss
Re would hold the invested assets. While uncertainty exists as to how these
disputed matters will finally be resolved, at the present time LNC believes
the amounts reported within LNC's consolidated financial statements as of
and for the year ended December 31, 2001 represent the best estimate of the
ultimate outcome of Swiss Re's acquisition of LNC's reinsurance business.
While LNC has limited its indemnification to Swiss Re, as previously
noted, under FAS 113 LNC will continue to report the reserves subject to
the indemnity reinsurance agreements with Swiss Re on LNC's consolidated
balance sheet with an offsetting reinsurance recoverable from Swiss Re.
In the event that future developments indicate that the reserves related
to certain businesses should be adjusted, LNC would be required under
FAS 113 to recognize the changes in reserves in earnings in the period
of change. Any change to the reinsurance recoverable from Swiss Re would
be recorded as an adjustment to the amount of deferred gain.
In addition to the transactions completed on December 7, 2001, LNC has
the right to "put" its interest in a subsidiary company containing LNC's
disability income reinsurance business to Swiss Re during May 2002 for
$10 million. Developments on the underlying disability income
reinsurance business will not affect the price at which LNC may put the
subsidiary company to Swiss Re. LNC is free to market this company to
other buyers. If, prior to May 31, 2002, LNC is unable to sell this
company to other bidders for more than $10 million, LNC intends to
exercise the Swiss Re put. The $10 million exercise price is
approximately equal to LNC's book basis in the subsidiary.
Approximately $565 million of the proceeds from the transaction will be
used to pay taxes and associated deal costs, leaving LNC with $1.4
billion of after-tax net proceeds from Swiss Re. In addition, LNC has
approximately $100 million of freed-up capital resulting from the
reinsurance disposition. Prior to December 31, 2001, LNC used $115
million to repurchase shares of LNC stock and $166.3 million was used to
reduce outstanding short-term debt. LNC may use the remainder of the
proceeds to purchase another organization or block of business within
the financial services industry or to repurchase its debt or stock. As
LNC evaluates opportunities in the financial services industry, it will
invest the proceeds in high quality, liquid investment instruments and
may retire additional portions of its debt and repurchase shares of its
common stock.
Effective with the closing of the transaction, the Reinsurance segment's
results for the eleven months ended November 30, 2001 and the years
ended December 31, 2000 and 1999 were moved into "Other Operations."
Earnings from LNC's reinsurance operations were as follows:
Eleven Months Ended Year Ended December 31
Year Ended December 31 (in millions) November 30, 2001 2000 1999
- ----------------------------------------------------------------------------------------------------------
Revenue $1,681.3 $1,769.3 $1,829.7
Benefits and Expenses 1,505.3 1,592.2 1,769.3
- ----------------------------------------------------------------------------------------------------------
Income before Federal Income Taxes and Cumulative Effect
of Accounting Changes 176.0 177.1 60.4
Federal Income Taxes 59.0 54.8 19.8
- ----------------------------------------------------------------------------------------------------------
Income before Cumulative Effect of Accounting Changes 117.0 122.3 40.6
Cumulative Effect of Accounting Changes (after-tax) (2.4) -- --
- ----------------------------------------------------------------------------------------------------------
Net Income $114.6 $122.3 $40.6
==========================================================================================================
12. Restructuring Charges
During 1998, LNC implemented a restructuring plan relating to the
integration of existing life and annuity operations with the new business
operations acquired from CIGNA, and a second restructuring plan related to
downsizing LNC's corporate center operations. The aggregate charges
associated with these two unrelated restructuring plans totaled $34.3
million after-tax ($52.8 million pre-tax) and were included in
Underwriting, Acquisition, Insurance and Other Expenses on the Consolidated
Statement of Income for the year ended December 31, 1998. These aggregate
pre-tax costs include $19.6 million for employee severance and termination
benefits, $9.9 million for asset impairments and $23.3 million for costs
relating to exiting business activities. The CIGNA restructuring plan was
completed in the first quarter of 2000. During the fourth quarter of 2000,
$0.5 million (pre-tax) of the original charge to downsize LNC's corporate
center operations was reversed. Through December 31, 2001, actual pre-tax
costs of $56.1 million have been expended or written-off under these
restructuring plans and a balance of $0.3 million pre-tax related to the
downsizing of LNC's corporate center operations remains in the
restructuring reserves for these 1998 plans. LNC anticipates that the
remaining reserves will be utilized in completing this restructuring plan.
Details of the 1998 restructuring plan related to the downsizing of LNC's
corporate center operations are provided below.
During the fourth quarter of 1998, LNC completed an organizational expense
review that centered around the size and make-up of the parent company. LNC
recorded a restructuring charge of $22 million (pre-tax) relating to the
restructuring plan that resulted from this review. The objectives of this
restructuring plan are to realign the activities and functions conducted
within the parent company, in light of the series of acquisitions and
divestitures that LNC executed in recent years, and to reduce overall costs
in response to increasing competitive pressures in the businesses that LNC
operates. To achieve these objectives, the restructuring plan includes
reductions in the number of corporate center employees along with a
reduction in the size of LNC's facilities. The following activities and
associated costs are included in this restructuring plan: (1) $8.9 million
for severance and termination benefits related to the elimination of 143
positions; (2) $9.9 million for the write-off of leasehold improvements
related to the abandoned facilities and other impaired assets; and (3) $3.2
million for rents on abandoned facilities. During the fourth quarter of
2000, $0.5 million (pre-tax) of the original restructuring charge was
reversed due primarily to changes in severance costs and outplacement
costs. More employees whose positions were eliminated under the
restructuring plan found employment in other areas of LNC that had been
originally anticipated; therefore, actual severance and outplacement costs
were less than previously estimated. All expenditures for severance and
termination benefits under the plan were completed in the fourth quarter of
2000. Expenditures for rents on abandoned facilities are expected to be
completed by early 2002. Through December 31, 2001, $21.2 million (pre-tax)
has been expended or written-off under this restructuring plan and 118
employees have been terminated.
In 1999, LNC implemented three different restructuring plans relating to 1)
the downsizing and consolidation of the operations of Lynch & Mayer, Inc.
("Lynch & Mayer"), 2) the discontinuance of HMO excess-of-loss reinsurance
programs and 3) the streamlining of Lincoln UK's operations. The aggregate
charges associated with these three unrelated restructuring plans totaled
$21.8 million after-tax ($31.8 million pre-tax) and were included in
Underwriting, Acquisition, Insurance and Other Expenses on the Consolidated
Statement of Income for the year ended December 31, 1999. These aggregate
pre-tax costs include $8.3 million for employee severance and termination
benefits, $9.8 million for asset impairments and $13.7 million for costs
relating to exiting business activities. Through December 31, 2001, actual
pre-tax costs of $24.3 million have been expended or written-off under
these restructuring plans. During the fourth quarter of 1999, $3.0 million
(pre-tax) of the original charge recorded for the Lynch & Mayer
restructuring plan was reversed due primarily to a change in estimate for
space cost. This reversal reduced the reported fourth quarter 1999
restructuring charges. In addition, during the fourth quarter of 1999, $1.5
million (pre-tax) associated with lease terminations was released into
income. During the fourth quarter of 2000, the Lynch & Mayer restructuring
plan was completed and $0.3 million (pre-tax) of the original charge for
the Lynch & Mayer was reversed. Also, during the fourth quarter of 2000,
$1.0 million (pre-tax) of the original charge for the discontinuance of HMO
excess-of-loss restructuring plan was reversed. During the fourth quarter
of 2001, the remaining restructuring reserve of $0.2 million relating to
the HMO excess-of-loss reinsurance programs was transferred to Swiss Re as
part of its acquisition of LNC's reinsurance operations. As of December 31,
2001, a balance of $3.0 million (pre-tax) remains in the restructuring
reserve for the Lincoln UK restructuring plan. LNC anticipates that the
remaining reserve for this restructuring plan will be utilized. Details of
the Lincoln UK restructuring plan are provided below.
During the fourth quarter of 1999, LNC recorded a restructuring charge in
its Lincoln UK segment of $6.5 million after-tax ($10.0 million pre-tax).
The objective of this restructuring plan is to reduce operating costs by
consolidating and eliminating redundant staff functions and facilities. The
restructuring plan identified the following activities and associated costs
to achieve the objectives of the restructuring plan: (1) severance and
termination benefits of $3.9 million related to the elimination of 119
positions, and (2) other costs of $6.1 million primarily related to the
remaining lease payments on closed facilities. Expenditures and write-offs
under the restructuring plan began in the fourth quarter of 1999 and were
completed in the 3rd quarter of 2001 except for lease payments on closed
facilities which will continue until 2016. Through December 31, 2001, $7.0
million (pre-tax) has been expended or written-off under this restructuring
plan and 112 positions have been eliminated.
During 2000, LNC implemented restructuring plans relating to 1) the
downsizing and consolidation of the operations of Vantage Global Advisors,
Inc. ("Vantage") 2) the exit of all direct sales and sales support
operations of Lincoln UK and the consolidation of its Uxbridge home office
with its Barnwood home office and 3) the downsizing and consolidation of
the investment management operations of Lincoln Investment Management. The
Vantage restructuring charge was recorded in the second quarter, the
Lincoln UK restructuring was recorded in the third and fourth quarters, and
the Lincoln Investment Management restructuring charge was recorded in the
fourth quarter of 2000. The aggregate charges associated with all of these
restructuring plans entered into during 2000 totaled $81.8 million
after-tax ($107.4 million pre-tax). These charges were included in
Underwriting, Acquisition, Insurance and Other Expenses on the Consolidated
Statement of Income for the year ended December 31, 2000. The component
elements of these aggregate pre-tax costs include employee severance and
termination benefits of $33.8 million, write-off of impaired assets of
$40.9 million and other exit costs of $32.7 million. During the fourth
quarter of 2000, $0.6 million (pre-tax) of the original charge recorded for
the Vantage restructuring plan was reversed as a reduction of restructuring
costs. Actual pre-tax costs totaling $90.6 million have been expended or
written off for these plans through December 31, 2001. As of December 31,
2001, a balance of $16.2 million (pre-tax) remains in the restructuring
reserves for the Lincoln UK and Lincoln Investment Management plans and is
expected to be utilized in the completion of the plans. Details of each of
these 2000 restructuring plans are provided below.
During the second quarter of 2000, LNC recorded a restructuring charge in
its Investment Management segment of $2.7 million after-tax ($4.1 million
pre-tax). The objective of this restructuring plan is to combine the
structured products team of Delaware Management Holdings, Inc. ("Delaware")
and Vantage in Philadelphia and consolidate the back office operations of
Vantage into Delaware, in order to reduce ongoing operating costs and
eliminate redundant facilities within this business segment. The
restructuring plan identified the following activities and associated
pre-tax to achieve the objectives of the restructuring plan: (1) severance
and termination benefits of $2.3 million related to the elimination of 15
positions, (2) write-off of impaired assets of $1.4 million and (3) other
costs of $0.4 million. Write-offs under the restructuring plan began in the
second quarter of 2000. During the fourth quarter of 2000, LNC determined
that part of rent expense related to abandoned office space included in (3)
above would not be incurred due to the landlord allowing LNC to surrender
the lease earlier than expected. In addition, Vantage determined that some
of the termination benefit payments included in (1) above would not be
required to be made. As a result, $0.6 million (pre-tax) of the original
charge was reversed. This plan was completed during the fourth quarter of
2001. Through December 31, 2001, $3.5 million (pre-tax) has been written
off under this restructuring plan and 13 positions have been eliminated
under this restructuring plan.
On September 28, 2000, LNC announced the transfer of the Lincoln UK sales
force to Inter-Alliance and the decision to cease writing new business in
the UK through direct sales distribution. As a result of these decisions,
Lincoln UK continues to manage, administer and accept new deposits on its
current block of business and will only accept new business for certain
products as required by UK regulations. To implement these decisions, LNC
entered into an exit plan ("restructuring plan") in the third quarter of
2000. The objective of this restructuring plan is to exit all sales and
sales support operations and consolidate the Uxbridge home office with the
Barnwood home office. Where all commitment date and liability recognition
criteria were met in the third quarter of 2000, charges for this
restructuring plan were recorded in the third quarter of 2000. The charges
associated with this restructuring plan that were recorded in the fourth
quarter of 2000 occurred as final decisions under the contract with
Inter-Alliance related to personnel and facilities were made, as regulatory
requirements related to certain employee involuntary termination benefits
were met, and as the decision to consolidate the Uxbridge home office with
the Barnwood home office was finalized.
The charges recorded in the third and fourth quarters of 2000 related to
this restructuring plan were $40.5 million after-tax ($53.5 million
pre-tax) and $36.1 million after-tax ($45.9 million pre-tax), respectively.
The components of the pre-tax costs include employee severance and
termination benefits of $29.8 million related to the elimination of 671
positions, write-off of impaired assets of $39.2 million and other costs to
exit of $30.4 million. All expenditures under this plan except for those
related to abandoned office facilities are expected to be completed by the
end of 2001. Expenditures for rents on abandoned office facilities are
expected to be completed by 2015. Through December 31, 2001, $85.4 million
(pre-tax) has been expended or written-off under this restructuring plan
and 671 positions have been eliminated. As of December 31, 2001, a balance
of $14.0 million remains in the restructuring reserve for this plan.
During the fourth quarter of 2000, LNC recorded a restructuring charge in
its Investment Management segment of $2.5 million after-tax ($3.9 million
pre-tax). The objective of this restructuring plan is to combine the
investment management operations of Lincoln Investment Management and
Delaware in Philadelphia, in order to reduce ongoing operating costs and
eliminate redundant facilities within this business segment. The
restructuring plan identified the following activities and associated
pre-tax costs to achieve the objectives of the restructuring plan: (1)
severance and termination benefits of $1.7 million related to the
elimination of 19 positions, (2) write-off of impaired assets of $0.3
million and (3) other costs of $1.9 million (primarily lease payments on
abandoned office space). Expenditures and write-offs under the
restructuring plan began in the fourth quarter of 2000. All remaining
expenditures under this restructuring plan are expected to be completed by
the end of the first quarter 2002, except for lease payments on abandoned
office space, which will continue until the end of the lease term in
November 2014. As of December 31, 2001, $1.7 million (pre-tax) has been
expended or written-off under this restructuring plan and 19 positions have
been eliminated. As of December 31, 2001, a balance of $2.2 million remains
in the restructuring reserve for this plan.
During 2001, LNC implemented restructuring plans relating to 1) the
consolidation of the Syracuse operations of Lincoln Life & Annuity Company
of New York into the Annuities segment operations in Fort Wayne, Indiana
and Portland, Maine; 2) the elimination of duplicative functions in the
Schaumburg, Illinois operations of First Penn-Pacific, and the absorption
of these functions into the Annuities and Life Insurance segment operations
in Fort Wayne, Indiana and Hartford, Connecticut; 3) the reorganization of
the life wholesaling function within the independent planner distribution
channel, consolidation of retirement wholesaling territories, and
streamlining of the marketing and communications functions in LFD; 4) the
reorganization and consolidation of the life insurance operations in
Hartford, Connecticut related to the streamlining of underwriting and new
business processes and the completion of outsourcing of administration of
certain closed blocks of business 5) the consolidation of the Boston,
Massachusetts investment office with the Philadelphia, Pennsylvania
investment operations in order to eliminate redundant facilities and
functions within the Investment Management segment 6) the combination of
LFD channel oversight, positioning of LFD to take better advantage of
ongoing "marketplace consolidation" and expansion of the customer base of
wholesalers in certain non-productive territories and 7) the consolidation
of operations and space in LNC's Fort Wayne, Indiana operations. In light
of LNC's divestiture of its reinsurance operations, which were
headquartered in Fort Wayne, excess space and printing capacity will not be
used. The Syracuse restructuring charge was recorded in the first quarter
of 2001, the Schaumburg, Illinois restructuring charge was recorded in the
second quarter of 2001, the LFD restructuring charges were recorded in the
second and fourth quarters of 2001, and the remaining restructuring charges
were all recorded in the fourth quarter of 2001. The aggregate charges
associated with all restructuring plans entered into during 2001 totaled
$24.6 million after-tax ($38.0 million pre-tax) and were included in
Underwriting, Acquisition, Insurance and Other Expenses on the Consolidated
Statement of Income for the year ended December 31, 2001. The component
elements of these aggregate pre-tax costs include employee severance and
termination benefits of $12.2 million, write-off of impaired assets of $3.3
million and other exit costs of $22.5 million primarily related to the
termination of equipment leases ($1.4 million) and rent on abandoned office
space ($20.0 million). Actual pre-tax costs totaling $6.3 million have been
expended or written off for these plans through December 31, 2001. As of
December 31, 2001, a balance of $31.9 million remains in the restructuring
reserves for these plans and is expected to be utilized in the completion
of the plans. Details of each of these 2001 restructuring plans are
provided below.
During the first quarter of 2001, LNC recorded a restructuring charge in
its Annuities segment of $0.65 million ($1.0 million pre-tax). The
objective of this restructuring plan is to consolidate the Syracuse
operations of Lincoln Life & Annuity Company of New York into the Annuities
segment operations in Fort Wayne, Indiana and Portland, Maine, in order to
reduce on-going operating costs and eliminate redundant facilities. The
restructuring plan identified the following activities and associated
pre-tax costs to achieve the objectives of the plan: (1) severance and
termination benefits of $0.8 million related to the elimination of 30
positions and (2) other costs of $0.2 million related primarily to lease
payments on abandoned office space. Actual pre-tax costs totaling $1.2
million have been expended or written-off and 30 positions have been
eliminated under this plan through December 31, 2001. The $0.2 million
expended in excess of the restructuring charge was expensed as incurred.
Expenditures under this restructuring plan are expected to be completed in
the first quarter of 2002.
During the second quarter of 2001, LNC recorded restructuring charges in
its Annuities and Life Insurance segments of $0.63 million ($0.97 million
pre-tax) and $2.03 million ($3.12 million pre-tax), respectively, related
to a restructuring plan for the Schaumburg, Illinois operations of First
Penn-Pacific. The objective of this plan is to eliminate duplicative
functions in Schaumburg, Illinois by transitioning them into the Annuities
and Life Insurance segment operations in Fort Wayne, Indiana and Hartford,
Connecticut, respectively, in order to reduce on-going operating costs. The
restructuring plan identified the following activities and associated
pre-tax costs to achieve the objectives of the plan: (1) severance and
termination benefits of $3.19 million related to the elimination of 27
positions and (2) other costs of $0.9 million. Actual pre-tax costs
totaling $2.4 million have been expended or written-off and 24 positions
have been eliminated under this plan through December 31, 2001. As of
December 31, 2001, a balance of $1.69 million remains in the restructuring
reserve for this plan. Expenditures under this plan are expected to be
completed in the first quarter of 2004.
During the second quarter of 2001, LNC recorded a restructuring charge for
LFD in "Other Operations" of $1.2 million ($1.8 million pre-tax). The
objectives of this restructuring plan are to reorganize the life
wholesaling function with the independent planner distribution channel,
consolidate retirement wholesaling territories, and streamline the
marketing and communications functions. The restructuring plan identified
severance and termination benefits of $1.8 million (pre-tax) related to the
elimination of 33 positions. Actual pre-tax costs totaling $1.3 million
have been expended and 23 positions have been eliminated under this plan
through December 31, 2001. As of December 31, 2001, a balance of $0.5
million remains in the restructuring reserve for this plan. Expenditures
under this restructuring plan are expected to be completed in the second
quarter of 2002.
During the fourth quarter of 2001, LNC recorded a restructuring charge in
its Life Insurance segment of $1.5 million ($2.3 million pre-tax). The
objectives of this restructuring plan are to reorganize and consolidate the
life insurance operations in Hartford, Connecticut related to the
streamlining of underwriting and new business processes and the completion
of outsourcing of administration of certain closed blocks of business. The
restructuring plan identified severance and termination benefits of $2.3
million (pre-tax) related to the elimination of 36 positions. Actual
pre-tax costs totaling $0.2 million have been expended and 10 positions
have been eliminated under this plan through December 31, 2001. As of
December 31, 2001, a balance of $2.1 million remains in the restructuring
reserve for this plan. Expenditures under this restructuring plan are
expected to be completed in the first quarter of 2003.
During the fourth quarter of 2001, LNC recorded a restructuring charge in
its Investment Management segment of $0.4 million ($0.6 million pre-tax).
The objectives of this restructuring plan are to consolidate the Boston,
Massachusetts investment office with the Philadelphia, Pennsylvania
investment operations in order to eliminate redundant facilities and
functions within the segment. The restructuring plan identified the
following activities and associated pre-tax costs to achieve the objectives
of the plan: (1) write-off of impaired assets of $0.1 million and (2) other
costs of $0.5 million primarily related to lease payments on abandoned
office space. No costs have been expended or written-off under this plan
through December 31, 2001. Expenditures under this plan are expected to be
completed by the fourth quarter of 2005.
During the fourth quarter of 2001, LNC recorded a restructuring charge for
LFD in "Other Operations" of $2.5 million ($3.8 million pre-tax). The
objectives of this restructuring plan are to combine channel oversight,
position LFD to take better advantage of ongoing "marketplace
consolidation" and to expand the customer base of wholesalers in certain
territories. The restructuring plan identified severance and termination
benefits of $3.8 million (pre-tax) related to the elimination of 63
positions. Actual pre-tax costs totaling $1.2 million have been expended
and 56 positions have been eliminated under this plan through December 31,
2001. As of December 31, 2001, a balance of $2.6 million remains in the
restructuring reserve for this plan. Expenditures under this restructuring
plan are expected to be completed in the fourth quarter of 2002.
During the fourth quarter of 2001, LNC recorded a restructuring charge in
"Other Operations" of $15.8 million ($24.4 million pre-tax). The objectives
of this restructuring plan are to consolidate operations and reduce excess
space in LNC's Fort Wayne, Indiana operations. In light of LNC's
divestiture of its reinsurance operations, which were headquartered in Fort
Wayne, excess space and printing capacity will not be used. The
restructuring plan identified the following activities and associated
pre-tax costs to achieve the objectives of the plan: (1) severance and
termination benefits of $0.3 million related to the elimination of 9
positions; (2) write-off of leasehold improvements of $3.2 million and (3)
other costs of $20.9 million primarily related to termination of equipment
leases ($1.4 million) and rent on abandoned office space ($19.5 million).
No costs have been expended or written-off under this plan through December
31, 2001. Expenditures under this restructuring plan are expected to be
completed in 2003, except for rent on abandoned office space, which will
continue until 2014. LNC estimates an annual reduction in future operating
expenses of $4.6 million (pre-tax) after the plan is fully implemented.
Report of Ernst & Young LLP, Independent Auditors
Board of Directors
Lincoln National Corporation
We have audited the accompanying consolidated balance sheets of Lincoln
National Corporation as of December 31, 2001 and 2000, and the related
consolidated statements of income, shareholders' equity and cash flows for
each of the three years in the period ended December 31, 2001. These
financial statements are the responsibility of the Corporation's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures
in the financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by management, as
well as evaluating the overall financial statement presentation. We believe
that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Lincoln
National Corporation at December 31, 2001 and 2000, and the consolidated
results of its operations and its cash flows for each of the three years in
the period ended December 31, 2001, in conformity with accounting
principles generally accepted in the United States.
As discussed in Notes 2 and 7 to the consoldiated financial statements,
in 2001 the Corporation changed its method of accounting for derivative
instruments and hedging activities as well as its method of accounting
for impairment of certain investments.
/S/Ernst & Young LLP
Philadelphia, Pennsylvania
February 1, 2002
Stock Market and Dividend Information
The dividend on LNC's common stock is declared each quarter by LNC's
Board of Directors. In determining dividends, the Board takes into
consideration items such as LNC's financial condition, including current
and expected earnings, projected cash flows and anticipated financing
needs. The range of market prices and cash dividends declared by
calendar quarter for the past two years are as follows:
Common Stock Data: (per share) 1st Qtr 2nd Qtr 3rd Qtr 4th Qtr
2001
High $48.250 $52.300 $52.750 $49.450
Low 38.000 41.280 41.000 40.000
Dividend Declared $ .305 $ .305 $ .305 $ .320
2000
High $41.375 $40.063 $56.375 $50.938
Low 22.625 29.000 35.625 40.875
Dividend Declared $ .290 $ .290 $ .290 $ .305
Notes:
At Dec. 31, 2001, the number of shareholders of record of LNC's common
stock was 10,609.