The above examples are based upon the estimated annual effect on earnings for each one-percentage point change in relevant equity market indices. Taking one-fourth of this annual estimate would generate the expected effect of the equity market change on quarterly results, with the exception of DAC unlocking and GMDB incurred cost calculations where the effect is fully reflected in one quarter. The estimated annual effect in millions of dollars per one-percentage change and the changes in each of the relevant market indices used in the above examples, are listed in the following table.
Decreased earnings from investment partnerships resulted in a negative variance of $21.7 million compared to 2001. Partially offsetting the negative variances were $17.6 million from higher investment margins. Overall investment spreads on fixed annuity products was relatively flat between years: 2.04% in 2002 versus 2.05% in 2001. For annuity products spread, the yield on earning assets is calculated as net investment income on fixed product investment portfolios divided by the average earning assets, the average crediting rate is calculated using interest credited on annuity products less bonus credits and excess dollar cost averaging (“DCA”) interest, divided by the average fixed account values net of coinsured account values. Fixed account values reinsured under modified coinsurance agreements are included in account values for this calculation. (See discussion on investment margins and the interest rate risk due to falling interest rates within Item 7A, Quantitative and Qualitative Disclosures About Market Risk.)
annual gross growth rate of the equity markets used in the determination of DAC amortization and GMDB benefits is 9%, which is reduced by mortality and expense charges (“M&E”) and asset management charges resulting in a net variable account growth assumption of less than 9%. As equity markets do not move in a systematic manner, LNC uses a methodology referred to as “reversion to the mean” to maintain its long-term gross growth rate assumption while also giving consideration to the effect of short-term swings in the equity markets. The application of this methodology results in the use of a higher or lower future gross equity market growth assumption for a period of four years subsequent to the valuation date which, together with actual historical gross equity growth, is expected to produce a 9% gross return.
LNC’s contract holders overall average attained age is just over 53 with only 13% over age 70. LNC average attained ages are lower than industry average (per The Gallup Organization’s 2001 Survey) due to the mix of business that includes significant amounts of qualified and employer sponsored business.
To date, the impact on LNC’s life insurance sales of the recent changes in estate tax laws has not been significant to overall sales for the Life Insurance segment. Total survivorship sales as a percent of overall retail sales dropped from 29% of the total first year premiums in 2001 to 22% of the total in 2002. If estate taxes are permanently repealed, LNC believes there will continue to be a demand for survivorship products to meet a variety of tax, business and family needs. The Life Insurance segment’s survivorship wealth transfer products support a wide variety of financial planning needs such as business succession and charitable giving, not just management of estate tax exposure.
Net income for 2002 included releases of $0.3 million related to restructuring charges reported in the fourth quarter of 2000 to combine the investment management operations for fixed income products of Lincoln Investment Management and Delaware in Philadelphia.
However, continued declines in the financial markets or Net Asset Values (“NAVs”) of the underlying retail mutual funds may trigger the recognition of a write-down of the deferred dealer commission asset. For instance, a review of the deferred dealer commission asset was performed as of March 10, 2003. Based on information currently available, it is estimated that a decline of approximately 3% in the equity markets from March 10, 2003 levels may trigger a loss, which would range from approximately $7.4 million to $11.4 million after-tax with the application of assumed discount rates ranging between 10% to 18% for purposes of measuring the fair value of the deferred dealer commission asset. The estimated balance of the deferred dealer commission asset as of March 10, 2003 was approximately $50 million.
The determination of any impairment of the deferred dealer commission asset is performed at quarter end when complete information is available. The determination of any impairment includes both the fixed income and equity mutual funds. Once an impairment loss is recognized, no write-up of the value of the deferred dealer commission asset is permitted even if there are subsequent increases in the NAVs of the underlying retail mutual funds from favorable financial markets.
Income (loss) from operations and net income (loss) for 1999 include a charge of $126.1 million ($194.0 million pre-tax) for a change in estimate of the cost of settling pension misselling liabilities and 1999 also includes a tax benefit of $42.1 million relating to the decision to explore exiting the UK insurance market.
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 15 years. 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 included eleven months of Reinsurance segment operations through the period ended November 30, 2001.
LFD, LNC’s wholesaling distribution arm, experienced an improvement in net losses of $0.5 million in 2002. However, included in LFD’s 2002 net income were expenses of $5.0 million resulting from a decision to expense previously deferred costs related to specific initiatives to expand life insurance sales. Excluding this expense, LFD’s net losses improved as a result of a combination of increased sales in all of its product categories including life insurance, annuity and investment products and a reduction in fixed operating costs primarily due to lower expenses following two restructurings that occurred in 2001 and ongoing disciplined expense management. LFD incurred expenses of $3.7 million in 2001 for the restructuring activities. The objectives of LFD restructuring charges were to reorganize the life wholesaling function within the independent planner distribution channel; consolidate retirement wholesaling territories; streamline the marketing and communications functions in LFD; combine channel oversight; position LFD to take better advantage of ongoing “marketplace consolidation” and to expand the customer base of wholesalers in certain non-productive territories. LFD’s on-going strategy is to develop existing strategic alliances across all distribution channels. However, given the continued uncertainty of the equity markets and interest rate environment, LNC is cautious about sales expectations for 2003.
1. In addition to credit evaluations and relative value considerations, investments that do not provide adequate return relative to statutory capital requirements were liquidated and replaced with investments that are more capital efficient.
The unrealized losses for Lincoln UK Equity Securities are primarily related to participating polices in the Lincoln UK segment. Gain and losses on securities supporting this business are credited to the policyholder when incurred and do not affect net income of LNC.
The information presented above is subject to rapidly changing conditions. As such, LNC expects that the level of securities with overall unrealized losses will fluctuate, as will the level of unrealized loss securities that are subject to enhanced analysis and monitoring. The recent volatility of financial market conditions has resulted in increased recognition of both investment gains and losses, as portfolio risks are adjusted through sales and purchases. As discussed below, this is consistent with LNC’s classification of its investment portfolios as available-for-sale.
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.
The aggregate amortization expense for other intangible assets for the years ended December 31, 2002, 2001 and 2000 was $144.7 million, $125.2 million and $150.3 million, respectively.
LNC also has access to capital from minority interest in preferred securities of subsidiary companies. Hybrid securities currently outstanding, which combine debt and equity characteristics, were offered through a series of subsidiaries (Lincoln National Capital III, IV and V). 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 III, IV, and V 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 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 2002, 2001 and 2000 are included in those plan expenses disclosed above.
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 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%.
Information with respect to the LNC incentive plan SARs outstanding at December 31, 2002 is as follows:
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, The 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 and LNL have pursued claims with their liability insurance carriers for reimbursement of certain costs incurred in connection with the class action settlement and the settlement of claims and litigation brought by owners that opted out of the class action settlement. During the fourth quarter of 2002, LNC and LNL settled their claims against three liability carriers on a favorable basis. LNC and LNL continue to pursue similar claims against a fourth liability insurance carrier.
In addition, certain subsidiaries of LNC have sold commercial mortgage loans through grantor trusts, which issued pass-through certificates. These subsidiaries have agreed to repurchase any mortgage loans which remain delinquent for 90 days at a repurchase price substantially equal to the outstanding principal balance plus accrued interest thereon to the date of repurchase. In case of default by the partnerships, LNC has recourse to the underlying real estate. It is management’s opinion that the value of the properties underlying these commitments is sufficient that in the event of default, the impact would not be material to LNC. These guarantees expire in 2004 through 2009.
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 statements of income except where otherwise noted below).
As of December 31, 2002 and 2001, the carrying value of the deposit contracts and certain guaranteed contracts is net of deferred acquisition costs of $486.0 million and $338.9 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.
Reinsurance segment prior to the close of the transaction with Swiss Re are not reflected in discontinued operations, but as a separate line in Other Operations. The results for 2001 related to the former Reinsurance segment are for the eleven months ended November 30, 2001.
As noted above, effective with the closing of the transaction, the Reinsurance segment’s results for the eleven months ended November 30, 2001 and the year ended December 31, 2000 were moved into “Other Operations.”
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, 2002, actual pre-tax costs of $24.8 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