LNRC reorganized in 1996 to apply its mass customization approach on a global basis. International and domestic operations are now combined in each of LNRC's three major business categories: individual markets, group markets and financial reinsurance. Each now offers its customers a global service and knowledge base and products conceptualized for worldwide application. For domestic clients, LNRC will be able to offer deeper insights for delivering products and services in new environments. For international clients, it means increased access to LNRC's technical services and a faster processing cycle.
(3) Effective January 1, 1997 an event or series of related events must be in excess of $25 million in order to be deemed catastrophe losses.
Combined Ratio The Property-Casualty segment's combined ratio increased to 105.8% in 1996, compared with 104.9% in 1995. Natural perils contributed 10.3 points to the combined ratio in 1996, compared with 7.3 points in 1995. The Property- Casualty segment's combined ratio reached a high of 112.7% in 1992, which marked the beginning of American States' strategy to reduce market share in underperforming business lines, lower premium volume in targeted areas and focus on profitable agencies. American States' book of business has been reduced by approximately 20% since 1992. At the same time, operating income has nearly doubled. American States' goal is a combined ratio of 100%, which would result in a return on equity of approximately 15%.
Other Revenue Other revenue increased $37.8 million or 20% in 1996 as the result of increases in the volume of transactions in the Reinsurance and Investment Management segments. In 1995, other revenue increased $18.9 million or 11% as the result of increases in the volume of transactions in the Life Insurance and Annuities segment.
Minority Interest in Consolidated Subsidiaries This represents earnings applicable to minority shareholders following the sale of 16.7% of LNC's principal subsidiary within its Property-Casualty segment (see note 12 to the consolidated financial statements on page 67).
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 or delayed repayments. This may result in these securities having a different actual cash flow and maturity than planned at the time of purchase. Securities that have an amortized cost greater than par and 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. Repayments occurring slower than expected have the opposite impact. The degree to which a security is susceptible to either gains or losses is influenced by the difference between its amortized cost and par, the relative sensitivity of the underlying mortgages backing the assets to prepayment or delayed repayments in a changing interest rate environment and the repayment priority of the securities in the overall securitization structure.
LNC limits the extent of its risk on mortgage-backed securities 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, 1996, 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 on page 47 for additional detail about the underlying collateral.
Deferred Acquisition Costs Deferred acquisition costs increased $455.3 million in 1996. A portion of this increase ($215.3 million) was the result of a balance sheet reclassification between deferred acquisition costs and policy liabilities and accruals by LNC's United Kingdom subsidiary. This reclassification was made in order to more closely conform the United Kingdom classifications to those used by LNC's U.S. life operations. The remainder of the increase is the result of the growth in business and increases related to the reduction in unrealized gain on securities available-for-sale during 1996.
For future periods the fair value of LNC's interest rate caps and swaptions depends on the levels of interest rates on U.S. Treasury securities with maturities of two, five, seven and 10 years and U.S. dollar swap rates with five, seven and 10 year maturities. The table below analyzes fair value levels at December 31, 1996 and for the next five years if the rates were 1%, 2%, 3%, or 4% higher than they were at December 31, 1996. In relation to the level of these rates at December 31, 1996, the cap and swaption rates were from 1.78% to 4.19% out of the money, i.e., higher. Fair value levels of interest rate caps and swaptions under these scenarios are as follows:
No change $ 18.5 $ 11.1 $ 5.6 $ 2.3 $ .7 $ .1 Up 1% 49.8 33.7 20.8 9.4 4.1 .9 Up 2% 107.7 77.0 55.7 35.8 17.4 8.0 Up 3% 202.1 149.6 114.6 95.0 62.5 37.8 Up 4% 334.2 260.2 201.1 172.0 125.7 88.4
At December 31, 1996, LNC had long positions in the March 1997 ten year note futures with an aggregate face amount of $147.7 million. As the yields on the underlying Treasury securities rise (fall), the value of these long positions to LNC will decrease (increase) by approximately $.9 million for each 10 basis point parallel shift in the yield curve.
Premiums and other considerations --- $ 909.6 $1,000.3 $1,032.7 $1,135.2 Net investment income --------------- 530.1 583.6 567.7 604.3 Realized gain on investments -------- 44.1 62.3 68.1 41.1 Gain on sale of affiliates/ operating property ----------------- -- -- -- 54.2 Net income(1) ----------------------- 134.8 117.9 154.3 75.2
Other intangible assets includes the present value of business in-force that is recorded in connection with the acquisition of an insurance company or a block of policies. The initial value is determined actuarially by discounting estimated future gross profits as a measure of the value of business in-force purchased. The resulting asset is amortized on a constant yield basis over the expected revenue recognition period of the business acquired, with the accrual of interest added to the unamortized balance at rates ranging from 5% to 9%.
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.
Below 7% ------------------------------- $ 123.3 $ 117.4 $ 117.2 7% - 8% -------------------------------- 1,881.1 1,840.4 1,855.9 8% - 9% -------------------------------- 1,840.0 1,786.9 1,847.3 Above 9% ------------------------------- 1,573.3 1,518.7 1,625.0 Total -------------------------------- $5,417.7 $5,263.4 $5,445.4
LNC maintains a revolving credit agreement with a group of domestic and foreign banks in the aggregate amount of $750,000,000. This agreement, which expires in October 2001, provides for interest on borrowings based on various money market indices. Under the terms of this agreement, debt levels must remain below 45% of adjusted consolidated net worth if debt ratings fall below a prescribed level. LNC's current debt ratings are above this prescribed level. Also, LNC must maintain a prescribed level of adjusted consolidated net worth. At December 31, 1996, LNC had no outstanding borrowings under this agreement. During 1996, 1995 and 1994, fees paid for maintaining revolving credit agreements amounted to $715,000, $649,000, and $1,000,000, respectively.
The income statement caption, "Underwriting, Acquisition, Insurance and Other Expenses," includes amortization of deferred acquisition costs of $766,500,000, $687,300,000 and $598,300,000 for the years ended December 31, 1996, 1995 and 1994, respectively. An additional $(65,200,000), $(85,200,000) and $81,200,000 of deferred acquisition costs was restored (amortized) and netted against "Realized Gain (Loss) on Investments" for the years ended December 31, 1996, 1995 and 1994, respectively.
The status of the postretirement medical and life insurance benefit plans and the amount recognized on the balance sheet are as follows:
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 first refusal to purchase the properties during the term 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.
Foreign Exchange Forward Contracts (Foreign Subsidiary). LNC historically has used foreign exchange forward contracts, which were traded over-the-counter, to hedge the foreign exchange risk assumed with its investment in its U.K. subsidiary, Lincoln National (UK). LNC hedged its exposure to sterling in excess of $100,000,000 of its investment in Lincoln National (UK). The foreign exchange forward contracts obligated LNC to deliver a specified amount of currency at a future date at a specified exchange rate. LNC terminated these contracts in the third quarter of 1996.
Minority Interest - Preferred Securities of Subsidiary Companies. Fair values for minority interest-preferred securities of subsidiary companies are based on quoted market prices less the unamortized cost of issue.
Realized gain (loss) on investments/ affiliates/operating property: Life Insurance and Annuities ----------- $ 66.4 $124.4 $(137.2) Reinsurance ---------------------------- 18.1 16.4 1.0 Property-Casualty ---------------------- 34.4 27.4 19.7 Investment Management ------------------ 8.1 6.6 -- Employee Life-Health Benefits ---------- -- -- .4 Other Operations ----------------------- 1.1 95.0 34.1 Total -------------------------------- $128.1 $269.8 $ (82.0)
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, 1996 and 1995, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1996, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.