LNC and the various operating businesses own or lease approximately 2.8 million square feet of office space. The governance group for LNC, the Investment Management segment, LFD and LFA lease 0.4 million square feet of office space in Philadelphia, Pennsylvania. The operating units in the Fort Wayne, Indiana area lease 0.8 million square feet. Also, businesses operating in the Chicago, Illinois metro area; Hartford, Connecticut and the United Kingdom own or lease another 0.6 million square feet of office space. An additional 1.0 million square feet of office space is owned or leased in other U.S. cities for branch offices and other operations. As shown in the notes to the consolidated financial statements (see Note 7 to the consolidated financial statements), the rental expense on operating leases for office space and equipment totaled $67.1 million for 2003. Office space rent expense accounts for $60.4 million of this total. This discussion regarding properties does not include information on investment properties.
(1) As discussed in Note 11 to the consolidated financial statements, LNC sold its reinsurance operations for approximately $2.0 billion on December 7, 2001. Revenues for 2001, 2000 and 1999 include $1.7 billion, $1.8 billion and $1.8 billion, respectively from the reinsurance operations.
(2) Per share amounts were affected by the retirement of 12,088,100; 11,278,022; 6,222,581 and 7,675,000 shares of common stock in 2002, 2001, 2000 and 1999, 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.
Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from the results contained in the forward-looking statements. These risks and uncertainties include, among others, subsequent significant changes in:
• the performance of the investment portfolios of LNC’s subsidiaries and of the portfolios which they manage (both internal and external);
• legislation (e.g., corporate, individual, estate and product taxation) including the recently enacted provisions affecting the taxation of dividends and retirement savings;
• the risk that significant accounting, fraud or corporate governance issues may adversely affect the value of certain investments in the portfolios of LNC’s companies;
• the risk that LNC could have to write off investments in certain securities if the issuers’ financial condition deteriorates;
• whether proceeds from divestitures of legal entities and blocks of business can be used as planned;
• risks associated with litigation, arbitration and other actions such as: (a) adverse decisions in significant actions including, but not limited to extra-contractual and class action damage cases; (b) new decisions which change the law; (c) unexpected trial court rulings; (d) unavailability of witnesses; (e) newly discovered evidence and (f) acts of God (e.g., hurricanes, earthquakes and storms);
• whether there will be significant charges or benefits resulting from the contingencies described in the footnotes to LNC’s consolidated financial statements;
The risks included here are not exhaustive. Other sections of this report, and LNC’s quarterly reports on Form 10-Q, current reports on Form 8-K and other documents filed with the Securities and Exchange Commission
LNC’s annuities, life insurance, money management and financial planning businesses all benefited from the improving financial markets experienced during 2003. Growth in equity markets translated into improved earnings as fee income based on account values increased, reserves for variable annuity guaranteed minimum death benefits declined, and credit losses in the investment portfolios dropped significantly. The elevated account values position LNC for earning increased ongoing fee based revenues from variable annuities, variable life insurance and asset advisory services.
Key marketplace themes of the past year against the backdrop of improving financial markets included continuing demand for variable annuity products containing guaranteed benefits, the relative safety and predictability of universal life insurance, and the desire to work with investment advisors with proven track records earned over difficult market periods. LNC’s ability to meet these needs led to the successes of 2003. Excellence in enhanced product offerings and outstanding investment management performance contributed to an acceleration of positive net cash flows into LNC’s product offerings, particularly evident in the latter half of the year.
Given the nature of LNC’s business, LNC’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 as follows:
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 (“DAC”) and the present value of acquired blocks of in-force policies (“PVIF”) are discussed within the Lincoln Retirement, Life Insurance and Lincoln UK segments. LNC’s overall accounting policy for other identified intangibles and goodwill is discussed within Results of Consolidated Operations. A key assumption affecting the accounting for DAC and PVIF is the performance of equity markets. LNC’s net income sensitivity to changes in equity market performance is discussed under the heading “First Quarter 2004 Guidance for the Effects of Equity Market Volatility “ found within LNC’s discussion of Consolidated Operating results. Additionally, LNC has goodwill resulting from various acquisitions. Refer to the “Accounting for Business Combinations and Goodwill and Other Intangible Assets” section for a discussion of the evaluation of goodwill for impairment. Within the Investment Management segment, LNC has an intangible asset for Deferred Dealer Commissions. Refer to the Investment Management Results of Operations section for further discussion of this asset.
Determining whether a decline in current fair values for invested 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 debt obligations, often represent selected levels, or tranches collateralized by underlying investments in a wide variety of underlying issuers. LNC’s accounting policies for its invested assets are discussed within Results of Consolidated Operations and Consolidated Investments. Specific discussion of LNC’s accounting policy for write-downs for securities that were determined to have declines in fair value that were other than temporary along with analysis of securities available-for-sale in an unrealized loss position can be found within Consolidated Investments.
Establishing reserves for litigation and compliance-related regulatory actions inherently involves a variety of estimates of potential 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 more fully discussed in the following section on new accounting pronouncements on page 23, net income for 2003 includes the effects of implementing Financial Accounting Standards Board (“FASB”) Derivative Implementation Group Statement No. 133 Implementation Issue No. B36 (“DIG B36”). This required LNC to recognize an embedded derivative resulting from the structure of several significant reinsurance arrangements, which was recorded as a cumulative effect of accounting change. Coincident with the recording of the embedded derivative, LNC reclassified a substantial portion of the investment securities supporting these reinsurance arrangements from available-for-sale to trading. This resulted in the recognition in earnings of the unrealized gains on these investment securities previously reported in accumulated other comprehensive income in shareholders’ equity.
A significant contributor to the decrease in net income was the effect of the poor performance of the equity markets on fee income, DAC and PVIF amortization and GMDB reserves and benefits. The equity market impact is discussed in more detail within the discussion of results of operations by segment.
(3) See Investment Management segment data starting on page 47 for additional detail.
For the other two CDOs, LNC still has the right to earn performance-based fees above the base asset management fees. These performance-based fees are considered variable fees for purposes of performing the analysis of expected residual returns. In addition, LNC also holds investment interests in these CDOs. However, in these two CDOs, LNC has determined that the expected variability in its fees and the level of other LNC interests in the CDO are currently below the level that would result in LNC being treated as the primary beneficiary. Future changes in the interest held by the third party investors in these two CDO pools, relative to LNC’s interest, will require retesting LNC’s potential status as primary beneficiary. LNC will continue to disclose its variable interests in these two CDO pools. LNC’s maximum exposure to loss is its investment in these two CDO pools, which had a carrying value of approximately $14.5 million and an estimated fair value of approximately $13.9 million, at December 31, 2003.
The effective date for implementation of DIG B36 for LNC was the October 1, 2003 start date of the fourth quarter. The following table summarizes the various effects on shareholders’ equity from the implementation of DIG B36 (in millions):
1B. In conjunction with recording the above charge in 1A., LNC also recorded an increase in Other Comprehensive Income relating to the fact that prior to the adoption of DIG B36 the net unrealized gains on the underlying available-for-sale securities supporting these reinsurance agreements had been accounted for as gains benefiting the reinsurance companies assuming the risks under these Modco and CFW reinsurance agreements.
Other Products and Riders. LNC continues to review the features and characteristics of other products and riders offered within its Retirement, Life Insurance, and Lincoln UK segments, and to evaluate the potential applicability of the SOP to these other products and riders. With respect to the other products and riders that are the subject of this ongoing review, LNC does not currently expect that the adoption of the SOP should have a material effect on LNC’s financial statements.
In December 2003, the Medicare Prescription Drug Improvement and Modernization Act of 2003 (“the Medicare Act”) became law. Beginning in 2006, the Medicare Act provides various alternatives that could result in an offset to some portion of the costs of prescription drug benefits provided to retirees. In January 2004, the staff of the FASB issued Financial Staff Position No. FAS 106-1 (“FSP 106-1”), which permits a sponsor of a post-retirement health care plan that provides retiree prescription drug benefits to make a one-time election to defer accounting for the effects of the Medicare Act.
There are several uncertainties that exist as to the eventual effects of the Medicare Act on the cost of the prescription drug benefits currently included in LNC’s retiree medical benefit plan. These uncertainties include various administrative components related to the Medicare Act that have yet to be developed, the potential for significant legislative changes to the Medicare Act prior to its implementation in 2006, and the interrelated effects that the existence of various cost containment measures currently included within LNC’s retiree medical benefit plans may have under the new legislation. However, regardless of the outcome of these various uncertainties, LNC does not currently expect that the Medicare Act would have a material affect on future net income due to the cost containment measures already in place under LNC’s retiree medical benefit plans.
In 2002, the FASB issued Statement of Financial Accounting Standards No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“FAS 146”), which addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Action (including Certain Costs Incurred in a Restructuring)” (“Issue 94-3”). The principal difference between FAS 146 and Issue 94-3 is that FAS 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred, rather than at the date of an entity’s commitment to an exit plan. FAS 146 is effective for exit or disposal activities after December 31, 2002. LNC adopted FAS 146 on January 1, 2003 and the adoption of FAS 146 affects the timing of when an expense is recognized for restructuring activities.
In June 2001, the FASB 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 and indefinite lived intangible assets are no longer amortized, but are subject to impairment tests conducted at least annually in accordance with the new standards. Intangible assets that do not have indefinite lives continue to be amortized over their estimated useful lives. LNC adopted FAS 142 on January 1, 2002. After consideration of the provisions of the new standards regarding proper classification of goodwill and other intangible assets on the consolidated balance sheet, LNC did not reclassify any goodwill or other intangible balances held as of January 1, 2002.
In compliance with the transition provision of FAS 142, LNC completed the first step of the transitional goodwill impairment test during the second quarter of 2002. The valuation techniques used by LNC to estimate the fair value of the group of assets comprising the different reporting units varied based on the characteristics of
each reporting unit’s business and operations. A discounted cash flow model was used to assess the goodwill of the reporting units within LNC’s Lincoln Retirement, Life Insurance and Lincoln UK segments. A valuation technique combining multiples of revenues, earnings before interest, taxes, depreciation and amortization (“EBITDA”) and assets under management was used to assess the goodwill in LNC’s Investment Management segment. The results of the first step of the tests indicated that LNC did not have impaired goodwill. In accordance with FAS 142, LNC has chosen October 1 as its annual review date. As such, LNC performed another valuation review during the fourth quarter of 2003 and 2002. The results of the tests performed as of October 1, 2003 and 2002 indicate that LNC did not have impaired goodwill. The valuation techniques used by LNC for each reporting unit were consistent with those used during the transitional testing.
On December 31, 2002, the FASB issued Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure” (“FAS 148”), which provides alternative methods of transition for entities that change to the fair value method of accounting for stock-based employee compensation. LNC adopted the fair value method of accounting under FAS 123 with the retroactive restatement method, as amended by FAS 148, as of January 1, 2003 and restated its financial statements for the years 2002, 2001, and 2000.
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 Lincoln Retirement segment’s 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 Lincoln Retirement and Life Insurance segments 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 and marketing office with the Philadelphia, Pennsylvania investment and marketing 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.
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 Syracuse restructuring plan was completed in the first quarter of 2002 with expenditures and write-offs totaling $1.3 million. The total amount expended exceeded the original charge by $0.3 million. In addition, $0.1 million of excess reserve on the Schaumburg, Illinois restructuring plan was released during the second quarter of 2002 and $1.5 million of excess reserve on the Fort Wayne restructuring plan was released during the third quarter of 2002. The release of the reserve on the Fort Wayne restructuring plan was due to LNC’s purchase and ultimate sale of the vacant building on terms that were favorable to what was included in the original restructuring plan for rent on this abandoned office space. As of December 31, 2003, the remaining balance is expected to be utilized in the completion of the plans.
In January 2003, the Life Insurance segment announced that it was realigning its operations in Hartford, Connecticut and Schaumburg, Illinois to enhance productivity, efficiency and scalability while positioning the segment for future growth. In February 2003, Lincoln Retirement announced plans to consolidate its fixed annuity operations in Schaumburg, Illinois into Fort Wayne, Indiana. In June 2003, LNC announced that it was combining its retirement and life insurance businesses into a single operating unit focused on providing wealth accumulation and protection, income distribution and wealth transfer products. The realigned organization is expected to significantly reduce operating expenses while positioning LNC for future growth and to take advantage of the recent market recovery. In August 2003, LNC announced additional realignment activities, which impact all of LNC’s domestic operations. These realignment activities are expected to result in total charges of $127.0 million. The realignment activities are expected to be completed by the first quarter of 2006.
On August 30, 2002, LNC acquired The Administrative Management Group, Inc. (“AMG”), an employee benefits record keeping firm for $21.6 million in cash. Contingent payments up to an additional $14 million may be paid over a period of 4 years (2003-2006) if certain criteria are met. Lincoln Retirement recorded an expense of $1.2 million after-tax ($1.8 million pre-tax) for 2003 relating to such contingent payments. AMG, a strategic partner of the Lincoln Retirement segment for several years, provides record keeping services for the Lincoln Alliance Program along with approximately 200 other clients nationwide. The application of purchase accounting to this acquisition resulted in goodwill of $20.2 million.
Effective with the closing of the transaction, the former Reinsurance segment’s historical results were moved into Other Operations. During December 2001 LNC recognized in Other Operations $5.0 million ($7.9 million pre-tax) of deferred gain amortization. In addition, in December 2001, 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 December 31, 2001.
a corresponding reinsurance recoverable from Swiss Re will continue to be carried on LNC’s balance sheet during the run-off period of the underlying reinsurance business. This is particularly relevant in the case of the exited personal accident and disability income reinsurance lines of business where the underlying reserves are based upon various estimates that are subject to considerable uncertainty.
As a result of developments and information obtained during 2002 relating to personal accident and disability income matters, LNC increased these exited business reserves by $198.5 million after-tax ($305.4 million pre-tax). After giving effect to LNC’s $100 million indemnification obligation, LNC recorded a $133.5 after-tax ($205.4 million pre-tax) increase in reinsurance recoverable from Swiss Re with a corresponding increase in the deferred gain.
As a result of developments and information received in the third quarter of 2003 relating to personal accident matters, LNC increased reserves on this exited business by $20.9 million after-tax ($32.1 million pre-tax) with a corresponding increase in reinsurance recoverable from Swiss Re and in the deferred gain. During 2003, LNC amortized $49.3 million after-tax ($75.8 million pre-tax) of deferred gain.
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 the value of variable annuity accounts and the fees earned on these accounts, estimated future profits increase or decrease with movements in the equity markets. Movements in equity markets also have an impact on reserves and payments for the guaranteed minimum death benefit feature within certain annuity contracts. The Lincoln Retirement segment’s assumption for the long-term 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” for 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.
The use of a reversion to the mean assumption is common within the industry; however, the parameters used in the methodology are subject to judgment and vary within the industry. An important aspect of LNC’s application of the reversion to the mean is the use of caps and floors on the equity market growth rate assumption, which limits the gross growth rate assumption to reasonable levels above and below the long-term assumption. In the fourth quarter 2002, LNC adjusted its reversion to the mean gross equity market growth rate assumption to 9%. Going forward, as the growth rate of the equity market varies from LNC’s growth rate assumption, the period over which the reversion to the mean gross growth rate needs to occur will be four years. The Lincoln Retirement segment has incorporated a cap of 15% and a floor of 0% into the reversion to the mean methodology. At December 31, 2003, Lincoln Retirement’s reversion to the mean gross growth rate assumption for equity markets was 4.20%. If a flat 9% equity market growth rate had been used instead of the reversion to the mean rate, the December 31, 2003 DAC and PVIF balance would have been $33.8 million higher on a pre-tax basis and net income would have been $22.0 million higher on an after-tax basis. On a quarterly basis, LNC reviews the assumptions of its DAC amortization model and records a retrospective adjustment to the amount expensed, (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, PVIF.
In evaluating the GMBD exposures that exist within LNC’s variable annuity business relative to industry peers, it is important to distinguish between the various types of GMDB structures, and other factors such as average account values, average amounts of NAR, and the age of contractholders. The following table and discussion provides this information for LNC’s variable annuity business as of December 31, 2003:
LNC average 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. LNC’s average non-qualified contract holder’s attained age is just over 64 with 32% over age 73 compared to the industry average attained age of 65 with 35% over age 72.
The Lincoln Retirement segment’s net income has been significantly affected by volatility in the equity markets. Changes in the equity markets impact the segment’s earnings through the level of variable annuity account values and the effect on fees that the segment earns, unlocking of deferred acquisition costs (“DAC”) and the present value of in-force intangible (“PVIF”), and changes to reserves and benefit payments for GMDB. DAC unlocking, PVIF unlocking and GMDB reserve adjustments that result from changes in equity market volatility are based upon end of period equity market values and are immediately reflected in LNC’s earnings. However, variable annuity account values are valued on a daily basis with LNC’s fees earned on those daily balances, rather than end of period values. As a result, the point to point changes in equity market indexes do not affect the Retirement segment’s variable annuity fee income in the immediate period as much as does the timing of when the changes in the equity markets occurred during the period. These effects are highlighted in the discussion of Lincoln Retirement’s results of operations. Refer to the Results of Operations discussion provided below for information relating to variable annuity account values and an analysis of the comparative effects that movements in the equity markets have had on Lincoln Retirement’s earnings.
termination of reinsurance coverage for new business from the fixed annuity reinsurer. Starting January 1, 2004, LNC is retaining all the new fixed annuity business written. Fixed annuity business written prior to December 31, 2003 will continue to be covered by the reinsurance agreements under which they were written.
Net income increased significantly in 2003, reflecting improving equity markets and the decrease in realized losses on investments and derivative instruments. The significant realized losses on investments and derivative instruments in 2002 were the result of the decline in value and the sale and write-downs of fixed maturity securities. Net income for 2003 also includes the effects of fourth quarter implementation of DIG B36, which required the recording of an embedded derivative related to the Modco reinsurance arrangements supporting the segment’s fixed annuity business. Investment securities supporting these arrangements were reclassified at the beginning of the fourth quarter from available-for-sale to trading resulting in an increase to net income. Additional details on the Retirement segment’s reinsurance arrangements are provided in the section on Reinsurance.
The increase in variable annuity account values for the year resulted from net positive cash flows, the overall improvement in the equity markets in 2003, and shifts from the fixed portion of variable annuity products into the variable portion of variable annuity products. However, average daily variable annuity account values, a key driver of fee income for the segment, were below last year, reflecting the timing of equity market movements over the two year period, and resulted in reduced fee income in 2003 relative to 2002. As indicated in the above tables, variable annuities account values stood at $34.6 billion at December 31, 2001, declined to $27.4 billion at December 31, 2002 and recovered to $35.8 billion at December 31, 2003. Over this same timeframe, average variable account values were $35.6 billion during 2001, $30.8 billion during 2002 and $30.4 billion during 2003. The timing of when the equity markets declined and increased during these three years is a primary reason for the decline in fee revenues as reported on an annual basis. Within these annual periods, on a quarterly basis the equity markets were generally declining from the first quarter of 2002 through the first quarter of 2003. Until the fourth quarter 2003 market improvement occurred, the 2003 daily average variable annuity account values were
Investment margins on fixed annuity products contributed to the improvement in net income in 2003. The table below presents the improvement in the investment rate margin. Although the net investment income yield declined year over year, LNC was able to reduce crediting rates to offset this decrease. In addition, during 2003 the investment margins were positively impacted by $3.5 million from increases in mortgage loan prepayments and make-wholes. Annuity product investment rate margins represent the excess of the yield on earning assets over the average crediting rate. The yield on earning assets is calculated as net investment income on fixed product investment portfolios divided by average earning assets. The average crediting rate is calculated using interest credited on annuity products less bonus credits and excess dollar cost averaging (“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 in Item 7A, Quantitative and Qualitative Disclosures About Market Risk on page 81.)
Investment income on investment partnerships was below expected levels in 2003 and 2002. However, the performance of these partnerships did improve in 2003 over 2002. This improvement resulted in $6.8 million of additional income.
The income improvement from the increase in average fixed annuity account values resulted from net flows in 2003.
The decline in the equity markets in 2002 resulted in average daily variable annuity account values and ending variable annuity account values for 2002 being significantly lower than for 2001. The decrease in variable annuity account values reduced fees and lowered net income. The lower equity markets resulted in negative retrospective unlocking of DAC and PVIF and changes in the rate of amortization. The negative unlocking in 2002 was due to actual equity market performance lagging the expected market performance used in LNC’s DAC assumptions. Increases in GMDB reserves and benefit payments also significantly decreased net income in
2002. In addition, in 2002 the segment had negative prospective unlocking of various assumptions underlying DAC, PVIF and GMDB calculations, including the reversion to the mean net equity market growth assumption.
(1) Incremental Deposits represent gross deposits reduced by transfers from other Lincoln Annuity products.
LNC has been following a two-pronged approach to improving net flows over the last few years. Attracting new deposits and retaining existing accounts are key drivers of the Retirement segment’s ability to achieve profitable future earnings growth. Variable product sales were up six percent in 2003 over 2002 while fixed product sales were down from the prior year. Through the fourth quarter of 2003, the Retirement segment has experienced ten consecutive quarters of positive net flows.
New deposits are an important component of LNC’s effort to grow the annuity business. In the past several years, this effort has concentrated on both product and distribution breadth. Although overall annuity deposits were down in 2003 compared to 2002, LNC maintained deposit levels in the individual variable annuity business and saw growth in the employer-sponsored business. The overall decline was a result of a 37% reduction in individual fixed annuities, as interest rates remained at low levels in 2003.
In addition to the introduction of the Lincoln Principal SecuritySM feature, Lincoln Financial Distributors (“LFD”) added wholesalers in the latter part of 2003, and more are expected to be added in the near future. The increase in wholesalers is expected to increase sales.
Lincoln Retirement’s living benefit product, Principal Securitysm, was rolled out in June of 2003 and resulted in an immediate increase in sales in the second half of the year. While LNC expects this sales momentum to continue, history has shown that competitive pressures and new product innovations can have a short-term impact on market share.
Looking forward, continued low interest rates would lower portfolio earned rates and move more of LNC’s crediting rates to contractual minimum, causing a drop in investment spreads. Conversely, if interest rates were to rise rapidly it could lead to disintermediation risk. Changes in tax laws and additional regulatory scrutiny of variable annuities could have a negative impact on LNC’s ability to grow the business. To deal with these uncertainties, LNC remains committed to its two-pronged approach of growing new deposits and retaining existing assets to manage its net flows. LNC expects to continue to strengthen its distribution breadth, utilize and improve upon its balanced portfolio of fixed and variable annuities and aggressively manage expenses as key profitability drivers in the challenging annuity market.
Given the economic environment of the recent past, portfolio breadth has proven its value. The industry has experienced a dramatic shift from variable to fixed products over the last few years, driven primarily by the equity market declines in 2001 and 2002 and a flight to conservatism. Although the equity markets improved during 2003, there was not a movement back to variable from fixed products and the Life Insurance segment’s mix of business has continued to shift from VUL to UL.
The Life Insurance segment has continued to develop products that meet the changing needs of its target affluent market. During times when the consumer has less tolerance for market risk, it is important to have a competitive fixed UL product portfolio. In 2003, the segment focused its efforts on maintaining the series of products with the Lapse Protection Rider (“LPR”). These products, originally introduced in 1998, offer an innovative rider, which is designed to provide flexibility and guaranteed death benefit coverage (see “Guideline AXXX” section for a description of the guarantee feature). New single life and survivorship versions of these products were released in February 2003 and updated again in October 2003 to address continuing movement in the market by competitors. In May 2003, the segment’s Corporate Specialty Markets unit released an updated VUL product called Lincoln CV4. The segment continued to strengthen the guarantees available in its VUL portfolio to generate additional interest in this line. The response to all of these new products has been very positive. In 2004, the segment plans to continue to be aggressive in product development.
On a quarterly basis, LNC reviews the assumptions of its DAC amortization model and records a retrospective adjustment to the amount expensed, (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, PVIF. Changes in future assumptions resulted in prospective unlocking, which increased amortization by $14.5 million in the third quarter of 2003. In addition, as a result of a significant increase in the degree to which customers were utilizing their option to reduce the face amount of their policies, the Company recorded net prospective unlocking adjustments, which increased amortization by $5.3 million during 2003, most of which occurred in the first quarter of 2003.
Results of Operations: The Life Insurance segment’s financial results, first year premiums by product, account values and in-force amounts were as follows:
The increase in net income in 2003 was primarily due to the absence of realized losses on investments and derivative instruments that was experienced in 2002. The decrease to net income from restructuring charges was a result of the realignment of the Lincoln Retirement and Life Insurance segments and the realignment of operations from the Schaumburg, Illinois office to Hartford, Connecticut. The segment also experienced a minor impact from the fourth quarter implementation of DIG B36. A significant negative effect on net income in 2003 was the negative prospective DAC/PVIF/DFEL unlocking, and the resulting higher DAC amortization from the increase in the DAC amortization rate associated with these prospective assumption changes. See the discussion of the third quarter prospective unlocking presented above within the topic Critical Accounting Policy - DAC, PVIF and DFEL. The improvement in the equity markets during 2003 increased net income through higher fees and favorable retrospective DAC unlocking relative to 2002.
As presented in the table below, investment margins in the interest sensitive lines of business (UL and ISWL) improved 8 basis points in 2003 resulting in additional income of $7.9 million. Partially offsetting this improvement in margins was lower investment yields on traditional non-par lines of business, which reduced income by $5.6 million. Traditional non-par business includes term and whole life insurance. Investment margins for the interest sensitive line of business represent the excess of the yield on earning assets, calculated as net investment income on fixed product investment portfolios divided by the average earning assets, over the average crediting rate, calculated using interest credited on life products divided by the average fixed account values. Investment yield on traditional non-par products decreased to 6.99% in 2003 from 7.42% in 2002. For these products, the yield on earning assets is calculated as net investment income on non-par investment portfolios divided by average earning assets. At December 31, 2003 and 2002, interest-sensitive products represented 88%
In analyzing the impact of sales growth as a predictive measure of future earnings it is important to understand that product mix of sales affects future profitability. The MoneyGuard product, an important driver of recent sales growth, is typically sold as a single premium product. As a result, the relative profitability of MoneyGuard on a per dollar of first year premium basis is less than that of other types of permanent life insurance such as UL and VUL. However, the product’s profitability does meet LNC’s overall profitability targets.
The increase in life insurance in-force has been driven by the growth in term life insurance. An unusually high level of face amount reductions by policyholders electing to reduce their coverage dampened the growth in UL and other products in-force. Excluding the effects of face-amount reductions, the general level of policy lapsation was in line with segment expectations. It is important to view the in-force growth separately for term products versus the universal life and other products (“permanent products”) as term products by design have a lower profitability to face amount relationship than do permanent products.
Regardless of whether the policy has any cash value, the policy will not lapse as long as the shadow account is positive. A shadow account is a hypothetical account that accumulates actual premium payments and interest less fees based on the secondary guarantee assumptions. However, the shadow account does not provide any cash value to the policyholder. In addition to secondary guarantees using shadow accounts, all companies offering secondary guarantees that allow prefunding are impacted by AXXX to a greater or lesser degree depending on product design. A prefunded policy is one where premiums are paid earlier than is necessary to maintain the policy’s benefits.
LNC’s single life and survivorship UL products offer secondary guarantees using shadow accounts. Use of this design provides more flexibility to policyholders than a premium-based approach. In 2003, these products were redesigned twice to reflect both the financial requirements of AXXX and a changing competitive landscape. LNC expects secondary guarantees to be critical to LNC’s target affluent market and expects that the AXXX version of these products will continue to be competitive. LNC also markets many life insurance products that do not offer secondary guarantees and which were not impacted by AXXX.
Accounting reforms under Sarbanes-Oxley, which prohibit publicly traded companies from extending credit to their directors or executives, affect some split dollar programs. However, most of the products sold by LNC for use in split dollar arrangements are sold to closely held companies, limited partnerships and family owned businesses, not publicly traded companies. Given LNC’s target market, and the fact that the amount of LNC’s split dollar sales in relationship to the level of total first year life premium sold is insignificant, these changes are expected to have minimal overall effect on LNC’s sales.
LNC’s COLI products are only marketed to organizations for coverage of officers and require the prospective permission of the officers to be covered under the COLI policy. In February 2004, the Senate Finance Committee approved a COLI provision which provides that the death benefits from a COLI contract are not taxable if the deceased individual was an employee within 12 months of death; or the death benefits are payable to the employee’s family, beneficiary, estate, or are used to purchase an equity interest in the employer (buy-sell agreement); or the employee is a key person - defined as either a “highly compensated employee” (currently income over $90K), or is a “highly compensated individual” (salary in the top 35% for employer); or is a director. In all cases, the employee must receive notice of coverage and provide written consent. Passage of this legislation is uncertain, but the recent action of the Senate Finance Committee, which has shown the most interest in the issue, should provide more certainty to the market. If the existing proposal becomes law, it is not expected to have a detrimental effect on COLI markets in which LNC participates.
Despite this difficult operating environment, LNC believes the segment has sustainable competitive advantages to continue to grow profitably into the future. LNC’s balanced portfolio of products should be positioned to take advantage of the demand among the affluent for sophisticated life products to meet a variety of tax, business and family needs. In addition, the segment has taken the necessary rate actions to manage investment margins, has aggressively managed expenses, and expects to maintain a strong in-force management discipline to maintain favorable persistency. LNC believes the segment’s underwriting capabilities are well respected in the reinsurance marketplace, which should enable LNC to remain well positioned relative to the competition.
The Investment Management segment, with principal operations 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, 401(k), “529” college savings plans, pension, endowment, trust and other institutional accounts. The primary operating companies within this segment are the subsidiaries of Delaware Management Holdings, Inc. (“Delaware”). The segment employs the services of The Lincoln National Life Insurance Company for its 401(k) Director product. Retail products are primarily marketed by LFD through financial intermediaries, including LFA. Institutional asset management products are marketed by a separate sales force within Delaware, which works closely 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 has 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 international and global equity and fixed income investment styles.
The Investment Management segment’s net income is significantly affected by volatility in the equity markets. Changes in the equity markets impact the segment’s earnings through the level of assets managed and their effect on fees that the segment earns. Refer to the Results of Operations discussion provided below for an analysis of the comparative effects that movements in the equity markets have had on the Investment Management’s segment earnings.
Results of Operations: The Investment Management segment’s financial results were as follows:
The favorable equity market performance combined with positive net flows during 2003 resulted in a significant improvement in earnings for the Investment Management segment primarily due to the increased fees generated from higher assets under management.
The segment benefited from a change in tax laws in the United Kingdom permitting a deduction for stock compensation expense. The tax benefit recognized in the fourth quarter of 2003 reflects a deduction for the fair value of options granted in current and prior years that remained outstanding at the beginning of the year.
The increase in assets under management reflects market value gains in the retail and institutional equity assets under management. Market value gains in 2003 were $5.3 billion in retail and $7.3 billion in institutional. Positive net flows across equity and fixed accounts for both institutional and retail assets under management also
contributed to the growth. Retail net flows reflect favorable retention partially offset by lower sales. The combined sales of retail and institutional were the second highest since LNC acquired Delaware in 1995. Net flows for the segment have been positive for two consecutive years.
Sales of Delaware’s mutual funds by LFA improved during 2003 to approximately 8% of LFA’s total mutual fund sales compared to 4% in 2002. Sales of mutual funds, managed accounts, 401(k) products and “529” plans through LFD increased 15% in 2003 over 2002.
Investment performance is a key driver of Delaware’s ability to attract new sales, retain existing assets and improve net flows. On the institutional side, for the 12 months ended December 31, 2003, 4 of the 8 largest product composites met or outperformed their respective indices, which was consistent with performance for the 12 months ended December 31, 2002.
Over the last few years, the Investment Management segment has been focused on five key areas for improving the performance of the business; attracting and retaining a strong team of investment and research professionals, improving the investment process, improving and sustaining strong investment performance, achieving positive net flows and improving profitability. The Investment Management segment has made significant progress on these initiatives, and will continue to focus on sustaining and improving the results. The Investment Management segment may also be affected by legislative or regulatory changes made in response to current industry-wide matters of concern, such as market timing, late trading, access payments and soft-dollar arrangements.
The amortization of the Lincoln UK segment’s DAC and PVIF assets, and deferred revenue, DFEL, is impacted by the change in the market value of unit-linked contracts. 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 equity 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 expensed (i.e.,unlocks the DAC and PVIF), or earned (i.e.,unlocks the DFEL). On an annual basis, Lincoln UK reviews and adjusts as necessary its assumptions for prospective amortization of DAC, PVIF and DFEL.
* The above table excludes the effects of equity markets on realized gains (losses) on investments and derivative investments.
Net income for 2003 benefited from the increase in the FTSE 100 index during 2003. The market improvement drove a net improvement in earnings for the combined effects on DAC/PVIF/DFEL amortization. However, average equity-linked account values and the related fee revenue earned by the segment, were lower in 2003 than in 2002, reflecting the timing of equity market movements over the two year period. Offsetting the favorable effects from the market was the recording of U.S. Federal income taxes in 2003. Prior to 2003, the segment was able to utilize excess foreign tax credits to offset the U.S. Federal tax liability. These tax credits were fully utilized in 2002, resulting in an effective tax rate of approximately 35% for 2003. The segment also benefited from a change in tax laws in the United Kingdom permitting a deduction for stock options exercised after January 1, 2003. The tax benefit recognized in the fourth quarter of 2003 reflects a deduction for the fair value of options granted in current and prior years that vested in prior periods and were outstanding as of January 1, 2003.
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 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 is amortizing the deferred gain, and the fact that related assets and liabilities will continue to be reported within LNC’s financial statements, the historical results for the Reinsurance segment prior to the close of the transaction with Swiss Re are not reported as 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.
The reinsurance business sold to Swiss Re includes a block of personal accident and disability income business. Refer to the Acquisition and Divestiture section for discussion of this critical accounting policy and how changes in reserves for these businesses have an ongoing impact on LNC’s net income.
LNC Financing benefited in 2002 from investment income on the proceeds from the sale to Swiss Re. During 2002, the proceeds were used to repurchase stock and during the fourth quarter, the remaining proceeds were reinvested in LNC’s business segments. Excluding the investment income on the proceeds, LNC financing benefited from lower interest rates due to the changes made to LNC’s outstanding debt during 2003 as described in the liquidity and cash flow section.
Within Other Corporate in 2003, there were costs associated with LNC’s realignment activities. These costs totaled $3.4 million, including $0.9 million reported as a restructuring charge.
LFD experienced a reduction in net losses in 2003. However, included in LFD’s 2002 net loss 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 loss increased by $3.2 million in 2003. Expenses primarily associated with the expansion of the wholesaling force were the main contributor to the additional loss in 2003. Increased sales in life insurance (16% increase in retail and 43% increase in COLI), variable annuity (9% increase) and investment products (15% increase) partially offset the increase in expenses. As discussed within the Retirement Segment, LFD did experience a decrease in fixed annuity sales (32% decrease). LFD expects to continue to focus in 2004 on strengthening its strategic alliances and increasing the number and effectiveness of wholesalers across all distribution channels.
LFA’s net losses in 2003 include $6.1 million of realignment costs, of which $3.8 million were reported as restructuring charges. The significant improvement in the equity markets resulted in an increase to LFA’s deferred compensation liability and increased LFA’s loss by $9.1 million. However, this loss was more than offset by equity market related gains of $9.5 million in the variable annuity purchased in 2001 to provide an economic hedge of the deferred compensation liability. This compared to a combined loss on the deferred compensation liability and the annuity contract of $1.9 million in 2002. LFA experienced strong sales growth in all business lines in 2003. A key to LFA’s ability to reduce its net losses is related to the success of the realignment activities initiated in 2003 to enhance productivity and operational efficiencies.
The net loss in 2002 includes charges required by FAS 113 for increases in personal accident and disability income reserves for the business sold through indemnity reinsurance to Swiss Re. Amortization of the deferred gain on indemnity reinsurance increased due to a full year’s amortization in 2002 compared to one month’s amortization in 2001.
The improvement in LNC’s financing net loss from 2001 was due in part to investment income from the proceeds of the sale of LNC’s reinsurance business to Swiss Re. In addition to the investment income, there was a decrease in long-term debt expense associated with various long-term financing activities that occurred in the second half of 2001 and third quarter of 2002 as described in the Liquidity and Cash Flow section of the Review of Consolidated Financial Condition. Short-term borrowing costs were also lower due to lower interest rates and lower daily average borrowings under the commercial paper program in the U.K.
LFD experienced a reduction in net losses in 2002. However, included in LFD’s 2002 net losses were expenses of $5.0 million described in the 2003 to 2002 comparison above. Excluding this expense, LFD’s net losses improved from 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 restructuring activities occurring in 2001.
Investment Objective: Invested assets are an integral part of the Lincoln Retirement, 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 47. 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 available-for-sale, which represent approximately 77% of the investment portfolio. Trading securities, which are primarily fixed maturity securities, represent approximately 7.3% of the investment portfolio. The total investment portfolio increased $2.8 billion in 2003 and $3.9 billion in 2002. The increase in 2003 was due to the purchase of investments from cash flow generated by the business units, positive net flows for fixed annuity and life insurance portfolios and market value appreciation of fixed maturity securities resulting from overall improvements in the credit markets. The increase in 2002 was due to the purchase of investments from cash flow generated by the business units, positive net flows for fixed annuity portfolios and market value appreciation of fixed maturity securities due to the significant decline in interest rates during 2002.
The quality of LNC’s available-for-sale fixed maturity securities portfolio, as measured at fair value and by the percentage of fixed maturity securities invested in various ratings categories relative to the entire available-for-sale fixed maturity security portfolio, as of December 31, 2003 was as follows:
The ratings data listed above have been determined by using the lowest of all publicly available ratings assigned to a particular fixed maturity security. If no public ratings exist, a rating is assigned based upon LNC’s analysis of the inherent risks of the individual security.
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, 2003 and 2002.
Trading Securities: As discussed more fully in the discussion on accounting for modified coinsurance in the accounting changes section beginning on page 23, LNC reclassified fixed maturity and equity securities in designated portfolios that support Modco and CFW reinsurance arrangements from available-for-sale to trading. This was done in connection with the implementation of new accounting requirements that required the recording of an embedded derivative for these types of arrangements. Investment results for these portfolios, including gains and losses from sales, are passed directly to the reinsurers through the contractual terms of the reinsurance arrangements. Trading securities are carried at fair value and changes in fair value are recorded in net income as they occur. Offsetting these amounts are corresponding changes in the fair value of the embedded derivative liability associated with the underlying reinsurance arrangement.
Mortgage Loans on Real Estate and Real Estate: As of December 31, 2003, mortgage loans on real estate and investments in real estate represented 9.8% and 0.3% of the total investment portfolio. As of December 31, 2003, the underlying properties supporting the mortgage loans on real estate consisted of 39.3% in commercial office buildings, 22.1% in retail stores, 17.8% in industrial buildings, 10.4% in apartments, 6.7% in hotels/motels and 3.7% in other. In addition to the dispersion by property type, the mortgage loan portfolio is geographically diversified throughout the United States. However, mortgage loans on real estate in California and Texas accounted for approximately 29% of the total carrying value of mortgage loans at December 31, 2003.
All mortgage loans that are impaired have an established allowance for credit loss. Changing economic conditions impact LNC’s valuation of mortgage loans. Increasing vacancies, declining rents and the like are incorporated into the discounted cash flow analysis that LNC performs for monitored loans and may contribute to the establishment of (or an increase in) an allowance for credit losses. In addition, LNC continues to monitor the entire commercial mortgage loan portfolio to identify risk. Areas of current emphasis are the hotel mortgage loan portfolio and retail, office and industrial properties that have deteriorating credits or have experienced debt coverage reduction. Where warranted, LNC has established or increased loss reserves based upon this analysis. Impaired mortgage loans as a percentage of total mortgage loans has deteriorated over the last two years as a result of increased credit losses in the sectors noted above. This percentage was 2.9%, 1.7%, 0.6%, 0.5%, 0.6%, 0.8%, 1.1% and 1.9% as of December 31, 2003, 2002, 2001, 2000, 1999, 1998, 1997 and 1996, respectively. While the percentage of impaired mortgage loans has been increasing slightly over prior years, all commercial mortgage loans in the portfolio are current in principal and interest payments. See Note 3 to the consolidated financial statements for additional detail regarding impaired mortgage loans.
Limited Partnership Investments: As of December 31, 2003 and 2002, there were $259.8 million and $294.2 million, respectively, of limited partnership investments included in consolidated investments. These include investments in approximately 55 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 78. Limited partnership investments are accounted for using the equity method of accounting and the majority of these investments are included in “Other Investments” in the consolidated balance sheets.
Net Investment Income: Net investment income increased slightly in 2003 when compared to 2002. The favorable effects of asset growth from net flows, partnership income and prepayment and makewhole premiums were substantially offset by a declining portfolio yield, due to lower interest rates on new securities purchased as assets matured and net product sales flowed into the portfolio. Net investment income decreased 3% in 2002 compared to 2001 due to a decrease in the yield on investments and net losses on investment partnerships. The decrease in yield was primarily due to lower interest rates on new securities purchased along with higher than historical levels of defaults due to the weak economy in 2002.
The following discussion addresses LNC’s invested assets excluding trading account securities. As discussed above, investment results attributable to the trading securities are passed directly to the reinsurers under the terms of the reinsurance arrangements.
Critical Accounting Policy-Realized Gain (Loss) on Investments and Derivative Instruments: LNC had net pre-tax realized losses on investments and derivatives of $19.2 million, $271.5 million and $114.5
ABSs secured by manufactured housing receivables have experienced deterioration in value following the bankruptcy filing of a major servicer in the industry. This servicer was granted changes to the existing servicing agreements by the bankruptcy court during the first quarter of 2003. Servicing fees were increased and moved to a more senior position in the capital structure. For those securities where the subordination was not at levels high enough to withstand this increase in fees without impairing value, write-downs of $14.1 million were recorded in 2003.
Electric utility sector losses were taken on selected issuers whose securities had not recovered with the rest of the electric utility issues in the market. The deterioration of these securities, along with a lack of improvement in the underlying credit, led to the determination that the declines in value of these securities were other than temporary. Losses taken in this sector totaled $68.2 million for 2003.
LNC’s exposure to the airline sector is primarily equipment trust certificates (“ETCs”) and enhanced equipment trust certificates (“EETCs”). Aircraft owned or operated by domestic air carriers collateralize these securities. The war in Iraq, intense competition in the industry and the sale of several aircraft by a domestic carrier all put downward pressure on valuations of securities issued by domestic carriers. The sale of aircraft in the first quarter of 2003 provided a market clearing price for used aircraft at levels lower than what the market had previously anticipated. This resulted in a re-evaluation of the underlying collateral in ETC and EETC structures. The combination of these factors, along with increased concerns reflected in the market during the first quarter of 2003 relating to the potential bankruptcy filing for AMR Corporation, resulted in a write-down on AMR Corporation’s ETCs to the fair market value at that time. The change in valuation of the underlying collateral and continued economic pressures on the sector also led to an additional write-down of UAL Corporation’s ETCs of $9.0 million.
Parmalat, an Italian dairy producer, sought bankruptcy court protection in December 2003 after it was revealed that a previously reported bank account did not exist. As a result of this and other fraudulent disclosures by company management, LNC realized a gross loss of $18.8 million in December 2003 for the write down of securities issued by Parmalat. This write-down reduced LNC’s Parmalat holdings to their fair value of $4.3 million at December 31, 2003.
Critical Accounting Policy - Write-Downs and Allowance for Losses: Securities available-for-sale that were deemed to have declines in fair value that were other than temporary were written down to fair value. The fixed maturity securities to which these write-downs apply were generally of investment grade at the time of purchase, but were subsequently down graded by rating agencies to “below-investment grade.” Factors considered by LNC in determining whether declines in the fair value of fixed maturity securities are other than temporary include 1) the significance of the decline; 2) LNC’s ability and intent to retain the investment for a sufficient period of time for it to recover; 3) the time period during which there has been a significant decline in value; and 4) fundamental analysis of the liquidity, business prospects and overall financial condition of the issuer. Based upon these factors, securities that have indications of potential impairment are subject to intensive review. Where such analysis results in a conclusion that declines in fair values are other than temporary, the security is written down to fair value. See Note 8 to the consolidated financial statements (Fair Value of Financial Instruments) for a general discussion of the methodologies and assumptions used to determine estimated fair values.
As the discussion above indicates, there are risks and uncertainties associated with determining whether declines in the fair value of investments are other than temporary. These include subsequent significant changes in general overall economic conditions, as well as specific business conditions affecting particular issuers, future financial market effects such as interest rate spreads, stability of foreign governments and economies, future rating agency actions and significant accounting, fraud or corporate governance issues that may adversely affect certain investments. In addition, there are often significant estimates and assumptions required by LNC to estimate the fair values of securities, including projections of expected future cash flows and pricing of private securities. LNC is continuously monitoring developments and updating underlying assumptions and financial models based upon new information. Provided below are additional facts concerning the potential effect upon LNC’s future earnings and financial position should management later conclude that some of the current declines in fair value of securities are other than temporary declines.
EITF 99-20 changed the manner in which impairment of 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).
The following information is applicable to unrealized loss securities that were subject to enhanced analysis and monitoring processes as of the relevant balance sheet date. In viewing this information, it is important to realize that LNC is continuously reviewing and updating the status of its investment portfolios. Accordingly, the information presented below relates to the status of securities that were being monitored at a particular point in time, and may not be indicative of the status of LNC’s investment portfolios subsequent to the balance sheet date. Further, since the timing of the recognition of realized investment gains and losses through the selection of which securities are sold is largely at management’s discretion, it is important to consider the information provided below within the context of the overall unrealized gain or loss position of LNC’s investment portfolios. These are important considerations that should be included in any evaluation of the potential impact of unrealized loss securities upon LNC’s future earnings. LNC had an overall net unrealized gain (after the amortization of acquisition costs, provision for policyholder commitments, investment expenses and taxes) on securities available-for-sale under FAS 115 of $793.1 million and $753.3 million at December 31, 2003 and 2002, respectively.
For publicly traded and private securities held by LNC at December 31, 2003 and 2002 that were subject to enhanced analysis and monitoring for potential changes in unrealized loss status, the fair value, amortized cost, unrealized loss and total time period that the security has been in an unrealized loss position are presented in the table below.
For Fixed Maturity Securities held by LNC at December 31, 2003 and 2002 that are below investment grade and in an unrealized loss position, the fair value, amortized cost, unrealized loss and the ratios of market value to amortized cost are presented in the table below (000s omitted).
At December 31, 2003 and 2002, less than 34.6% and 9.0%, respectively, of the publicly traded and private securities held that were subject to enhanced analysis and monitoring for potential changes in unrealized loss status were rated as investment grade. At December 31, 2003, the range of maturity dates for these securities varies, with about 49.2% of these securities maturing between 5 and 10 years, about 44.0% maturing in greater than 10 years and the remaining maturity dates maturing in less than 5 years. At December 31, 2003 and 2002, 84.4% and 65.3%, respectively of total publicly traded and private securities in unrealized loss status were rated as investment grade. At December 31, 2003, the range of maturity dates for total publicly traded and private securities in unrealized loss status varies, with about 26.0% maturing between 5 and 10 years, 56.3% maturing after 10 years and the remaining securities maturing in less than 5 years. At December 31, 2002, the range of maturity dates for these securities varies, with about 22% maturing between 5 and 10 years, 46% maturing after 10 years and the remaining securities maturing in less than 5 years. See Note 3 to the consolidated financial statements for ratings and maturity date information for LNC’s fixed maturity investment portfolio.
As of December 31, 2003, gross unrealized losses including assets held at Lincoln UK totaled $218.8 million, a 70% improvement over gross unrealized losses of $735.4 million at December 31, 2002. This improvement occurred, despite a rise in interest rates over the year, as a result of a sustained rally in credit spreads in 2003. As of December 31, 2003, there were gross unrealized losses of $98.1 million in the airline, ABS, electric utility and banking sectors, representing 44.8% of total unrealized losses. LNC’s view of risk factors at December 31, 2003 with respect to these industries is presented below.
Airline holdings ended 2003 with an unrealized loss of $32.4 million, an improvement of $66.9 million over year-end 2002. Airline securities issued by relatively stronger carriers improved in market value significantly throughout 2003. For those relatively stronger airlines, LNC believes the unrealized loss positions at December 31, 2003, are temporary, and LNC expects an ultimate recovery of full principal and interest as these securities mature. All of LNC’s airline holdings in an unrealized loss position are secured as either ETC or EETC structures. For the portion of the airline sector exposure that is invested in EETC structures, LNC holds securities that are enhanced through the liquidity facilities present in these securities and their relatively higher quality aircraft collateral pools.
The ABS exposure of the LNC portfolio ended 2003 with a gross unrealized loss of $29.4 million, an improvement of $41.8 million from year-end 2002. Of this amount, $12.0 million relates to CDOs and $8.2 million relates to ABS secured by manufactured housing receivables. CDOs had experienced pressure due to the nature of the assets, poor historical experience and the risk of downgrade for individual tranches held by LNC. Overall improvements in the underlying collateral pools of CDOs have driven up market pricing of these securities and helped to improve the gross unrealized loss.
The electric utility sector had $20.2 million of unrealized losses at December 31, 2003, compared with $164.7 million at December 31, 2002. During the first half of 2003, several utilities were able to complete asset sales and secure the financing needed in order to maintain operations through the energy cycle. LNC believes that as the over-capacity in the market for electricity is rectified by increased economic activity and as old, inefficient power plants are taken off-line, margins should begin to revert to mid-cycle valuations. As this cycle progresses, LNC expects to see further improvement in this sector and believes that the unrealized losses are temporary.
For fixed maturity securities available-for-sale with gross unrealized losses of $10 million held by LNC at December 31, 2003 and 2002, the fair value, amortized cost, unrealized loss and length of time in a loss position are presented in the table below.
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
During the year ended December 31, 2003 and 2002, LNC sold securities at gains and at losses. As discussed earlier, in the process of evaluating whether a security with an unrealized loss reflects an other than temporary decline, LNC considers its ability and intent to hold the security until its value recovers. However, subsequent decisions on securities sales are made within the context of overall risk monitoring, assessing value relative to other comparable securities and overall portfolio maintenance. Although LNC’s portfolio managers may, at a given point in time, believe that the preferred course of action is to hold securities with unrealized losses that are considered temporary until such losses are recovered, the dynamic nature of portfolio management may result in a subsequent decision to sell. These subsequent decisions are consistent with the classification of LNC’s investment portfolio as available-for-sale. In the future, LNC expects to continue to manage all non-trading invested assets within its portfolios in a manner that is consistent with the available-for-sale classification.
Liquidity refers to the ability of an enterprise to generate adequate amounts of cash from its normal operations to meet cash requirements with a prudent margin of safety. The consolidated statements of cash flows on page 95 indicate that operating activities provided cash of $1.0 billion, $0.3 billion and $1.3 billion in 2003, 2002 and 2001, 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.
When considering LNC’s liquidity and cash flow it is important to distinguish between the needs of LNC’s principal insurance subsidiary, The Lincoln National Life Insurance Company (“LNL”) and its insurance subsidiaries, and the needs of the holding company, LNC.
Capital considerations for LNL are impacted by factors influencing LNL’s risk-based capital and statutory earnings performance. The most common measure of risk-based capital (“RBC”) is the National Association of Insurance Commissioners (“NAIC”) RBC formula. The NAIC RBC formula requires a company to hold minimum capital against the quality and liquidity of assets, insurance risk, interest rate risk, and general business risk. LNL currently targets a NAIC RBC ratio of three-times the NAIC’s defined Company Action Level. The Company Action Level is the minimum level of capital required before necessitating a plan of action filed with the regulators. LNC believes this target to be consistent with maintaining or increasing its current financial strength ratings. LNC revisits RBC and other key financial ratio targets as the company risk profile, environmental conditions, and/or rating agency views of industry risk change. In addition, merger and acquisition activity may give rise to short-term fluctuations in RBC and other key financial ratios.
2002 LNL Dividends: Dividends of $710 million were paid by LNL to LNC in the second quarter of 2002. These distributions were made in two installments. As both installments exceeded the standard limitation noted above, a special request was made for each payment and each was approved by the Commissioner. Both distributions represented a portion of the proceeds received from the indemnity reinsurance transaction with Swiss Re. As a result of the payment of dividends and net statutory losses generated in 2002, LNL’s statutory earned surplus was negative at December 31, 2002.
LNC’s liquidity and cash flow position is driven principally by dividends and interest payments from subsidiaries augmented by holding company short-term investments, bank lines of credit, a commercial paper program, and the ongoing availability of long-term financing under a SEC shelf registration. These sources of liquidity and cash flow support the general corporate needs of the holding company including its common stock dividends, interest and debt service, funding of callable securities, securities repurchases, and acquisitions.
Although LNC generates adequate cash flow to meet the needs of its normal operations, periodically LNC may issue debt or equity securities to fund internal expansion, acquisitions, and the retirement of LNC’s debt and equity. In April 2002, a shelf registration statement was declared effective by the SEC. The new shelf registration totaled $1.2 billion (including $402.5 million of registered but unissued securities from previous registration statements).
• On January 7, 2002, LNC redeemed all 4 million shares of the $100 million 8.35% Trust Originated Preferred Securities (“TOPrS”) issued by Lincoln Capital II and guaranteed by LNC.
• In July 2003, LNC redeemed the $200 million 7.40% TOPrS issued by Lincoln Capital III and guaranteed by LNC. A loss of $3.7 million related to unamortized issuance costs was reported in 2003 related to the redemption.
• On January 28, 2004, LNC issued $200 million 4.75% ten-year senior notes.
Trust preferred securities issued through Lincoln National Capital V and VI are reported in the financial statements in the caption “Junior subordinated debentures issued to affiliated trusts.”
One of the principal liquidity and capital requirements for LNC is providing a return to its shareholders. Through dividends and stock repurchases, LNC has an established record of providing significant cash returns to its shareholders. The following table summarizes this activity over the most recent three years.
LNC has established a 20-year track record of increasing its dividend. In determining its dividend payout, LNC balances the desire to increase dividends against capital needs, rating agency considerations, and requirements for financial flexibility.
The following table summarizes the primary sources of LNC cash flow.
The following table summarizes the primary uses of LNC cash flow.
The tables below summarize LNC’s obligations and commitments to make future payments under contracts in place at December 31, 2003, as well as contingent commitments in place at December 31, 2003.
(4) Contract calls for a per employee and per paycheck charge. Estimates are based on headcount and actual number of checks processed in 2002. Cost of living adjustments are not included in the estimates.
(5) Total includes $102.8 million of capital calls on limited partnership investments, $147.0 million of real estate pre-buys and $77.5 million and $45.0 million of commitments for mortgage loans and private placement securities, respectively.
In September 2002, Fitch lowered LNC’s senior debt ratings from A+ to A and the trust preferred security ratings for Lincoln Capital III, IV, and V from A to A- both on “stable outlook.” Fitch’s action did not impact LNC’s commercial paper rating or the insurance financial strength ratings of LNC’s insurance subsidiaries. The move was part of industry-wide action on several life insurance companies given the recent market environment and, in the case of LNC, reflects Fitch’s desire to maintain a traditional three notch separation between debt and insurance financial strength ratings. The rating action had no effect on LNC’s liquidity, access to capital, or cost of capital.
In September 2003, A.M. Best lowered LNC’s senior debt ratings from “a” to “a-” and the trust preferred security ratings for Lincoln Capital IV, and V from “a-” to “bbb+” with both on “stable outlook.” A.M. Best’s action did not impact LNC’s commercial paper rating or the insurance financial strength ratings of LNC’s insurance subsidiaries. The move was part of industry-wide action to address the notching practices between insurance company financial strength and senior debt. The ratings action was described as an “affirmation” of Lincoln’s ratings rather than a “downgrade,” as the adjustment was unrelated to Lincoln’s financial condition. The rating action had no effect on LNC’s liquidity, access to capital, or cost of capital.
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, 2003, LNC’s liquidity has not been adversely impacted by the lack of A-1/P-1 rating. LNC can draw upon alternative short-term borrowing facilities such as revolving bank lines of credit.
At December 31, 2003, LNC maintained three revolving credit agreements with a group of domestic and foreign banks totaling $536 million. LNC’s commercial paper is supported by two facilities, a $200 million three-year revolving credit facility maturing in February 2007 and a $300 million revolving credit facility maturing in December 2005. The UK facility was renewed in January 2004 for $18 million maturing in January 2005. At December 31, 2003, LNC did not have any loans outstanding under any of the bank lines.
Under all three 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. In addition, LNC must maintain a minimum level of capitalization. LNC completes a quarterly compliance certificate for its banks computing each financial covenant. At December 31, 2003 LNC was in compliance with all such covenants.
If current debt ratings and claims paying ratings were downgraded in the future, certain covenants of various contractual obligations may be triggered which could negatively impact overall liquidity. In addition, contractual selling agreements with intermediaries could be negatively impacted which could have an adverse impact on overall sales of annuities, life insurance and investment products. At December 31, 2003, LNC maintains adequate current financial strength and senior debt ratings and does not anticipate any ratings-based impact to future liquidity.
LNL is actively exploring strategies to lessen the burden of increased AXXX reserves. Strategies include both reinsurance and capital markets solutions that provide for risk transfer and associated reserve and surplus relief. Of the $455.7 million in outstanding letters of credit as of December 31, 2003, approximately $150 million in standby letters of credit are dedicated for this purpose. LNC and LNL are exploring alternative capital market solutions. It is likely LNL will apply a mix of letters of credit, reinsurance, and capital market strategies in addressing long-term AXXX and XXX needs.
As noted above, shareholders’ equity includes accumulated other comprehensive income. At December 31, 2003, the book value of $32.56 per share included $4.87 of accumulated other comprehensive income. At December 31, 2002, the book value of $30.10 per share included $4.13 of accumulated other comprehensive income.
See Note 7 to the consolidated financial statements for information regarding contingencies.
The Bush Administration’s 2005 budget includes various proposals, which, if enacted, could have an effect on LNC’s business. The more significant of these include the President’s proposals to make permanent recent reductions in individual tax rates, to permanently repeal the estate tax, and to reintroduce the modified proposals for the Lifetime Savings Accounts (LSAs) and the Retirement Savings Accounts (RSAs). With the increasing focus on the projections for growing federal budget deficits, and the significant tax revenue costs associated with these particular proposals, the legislative outlook for these elements of the Administration’s 2005 budget is extremely uncertain. Until such time that an indication of the likely form of what may evolve from the ongoing legislative process emerges, it will not be possible for LNC to predict the potential effects of these proposals. In the meantime, LNC continues to support reductions in the tax burden imposed on its businesses, employees and policyholders.
The consolidated financial statements and notes to consolidated financial statements of Lincoln National Corporation and Subsidiaries follow on pages 91 through 158.
See notes to the consolidated financial statements on pages 96 through 158.
Use of Estimates. The nature of the insurance and investment management businesses requires management to make numerous estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results will differ from those estimates.
Mortgage loans on real estate, which are primarily held in the Life Insurance and Lincoln Retirement segments, are carried at the outstanding principal balances adjusted for amortization of premiums and discounts and are net of valuation allowances. Valuation allowances are established for the excess carrying value of the mortgage loan over its estimated fair value when it is probable that, based upon current information and events, LNC will be unable to collect all amounts due under 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 amortized 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; 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. Interest income on mortgage loans includes interest collected, the change in accrued interest, and amortization of premiums and discounts. Mortgage loan fees and costs are recorded in net investment income as they are incurred.
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 available-for-sale 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.
Derivative Instruments. LNC hedges 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 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.
LNC’s has certain Modco and CFW reinsurance arrangements with embedded derivatives related to the funds withheld assets. These derivatives are considered total return swaps with contractual returns that are attributable to various assets and liabilities associated with these reinsurance arrangements. Changes in the fair value of these derivatives are recorded in net income as they occur. Offsetting these amounts are corresponding changes in the fair value of trading securities in portfolios that support these arrangements.
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. This liability is included within Other Liabilities within LNC’s consolidated balance sheet. 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.
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.
Under FAS 60, acquisition costs for traditional life insurance products, which include whole life and term life 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.
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
Interest and debt expense includes interest on junior subordinated debentures issued to affiliated trusts.
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 0.75% to 13.55%.
The liabilities for future claim reserves for the guaranteed minimum death benefit (“GMDB”) feature on certain variable annuity contracts are a function of the net amount at risk (“NAR”), mortality, persistency and incremental death benefit mortality and expense assessments (M&E) expected to be incurred over the period of time for which the NAR is positive. At any point in time, the NAR is the difference between the potential death
benefit payable and the total variable annuity account values subject to the GMDB. At each quarterly valuation date, the GMDB reserves are calculated for every variable annuity contract with a GMDB feature based on projections of account values and NAR followed by the computation of the present value of expected NAR death claims using product pricing mortality assumptions less expected GMDB M&E revenue during the period for which the death benefit options are assumed to be in the money.
Reinsurance. LNC’s insurance companies enter into reinsurance agreements with other companies in the normal course of their business. Prior to the acquisition of LNC’s reinsurance operations by Swiss Re in 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. All reinsurance agreements, excluding Modco agreements, are reported on a gross basis since there is a right of offset.
Stock Based Compensation. Effective January 1, 2003 LNC implemented the provisions of Statement of Financial Accounting Standard No. 123, “Accounting for Stock-Based Compensation,” (“FAS 123”) to expense the fair value of stock options granted to employees. On December 31, 2002, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation- Transition and Disclosure” (“FAS 148”), which provides alternative methods of transition for entities that change to the fair value method of accounting for stock-based employee compensation.
LNC identified certain partnership investments that required consolidation under the requirements of FIN 46. LNC consolidated these partnerships at December 31, 2003 with no material effect to either financial condition or results of operations.
FIN 46 also affected LNC’s accounting for the junior subordinated debentures issued to affiliated trusts. Previously, LNC consolidated the affiliated trusts which resulted in LNC carrying a liability equal to the trusts’ liability to the preferred shareholders. These trusts are variable interests as defined by FIN 46, and LNC will not receive a majority of expected residual returns. LNC deconsolidated its $10.0 million investment in the trusts as of December 31, 2003. The effect was a $10.0 million increase to other invested assets and a corresponding increase in the liability for junior subordinated debentures payable to affiliated trusts.
1B. In conjunction with recording the above charge in 1A. LNC also recorded an increase in Other Comprehensive Income relating to the fact that prior to the adoption of DIG B36 the net unrealized gains on the underlying available-for-sale securities supporting these reinsurance agreements had been accounted for as gains benefiting the reinsurance companies assuming the risks under these Modco and CFW reinsurance agreements.
As indicated in the above tables, the implementation of DIG B36 resulted in an initial decrease to shareholders’ equity and the ongoing accounting of DIG B36 will continue to give rise to ongoing gains and losses flowing through net income as the embedded derivative and trading account securities are continuously marked to market.
Statement of Accounting Position 03-1. In July 2003, the Accounting Standards Executive Committee (“AcSEC”) of the American Institute of Certified Public Accountants issued Statement of Position 03-1, “Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts” (“the SOP”). LNC will adopt the SOP as of January 1, 2004.
GMDB Reserves. Although there was no method prescribed under generally accepted accounting principles for GMDB reserving until the issuance of the SOP, LNC’s Retirement segment has been recording a reserve for GMDB’s. At December 31, 2003 LNC’s GMDB reserve was $46.4 million. Based upon a comparison of the requirements of the SOP to LNC’s established practice of reserving for GMDB, the adoption of the GMDB reserving methodology under the SOP is not expected to have a material effect on LNC’s financial statements.
Change in Estimate for Disability Income and Personal Accident Reinsurance Reserves. As a result of developments and information received in the third quarter of 2003 relating to personal accident matters, LNC increased reserves on this exited business by $20.9 million after-tax ($32.1 million pre-tax) with a corresponding increase in reinsurance recoverable from Swiss Re and in the deferred gain. As a result of developments and information obtained during 2002 relating to personal accident and disability income matters, LNC increased these exited business reserves by $198.5 million after-tax or $1.07 per fully diluted share ($305.4 million pre-tax). After giving effect to LNC’s $100 million indemnification obligation to Swiss Re, LNC recorded a $133.5 after-tax ($205.4 million pre-tax) increase in reinsurance recoverable from Swiss Re with a corresponding increase in the deferred gain. (See Note 11 for further explanation of LNC’s Reinsurance transaction with Swiss Re.)
Accounting for Stock-Based Compensation - Transition and Disclosure. On December 31, 2002, the FASB issued Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation- Transition and Disclosure” (“FAS 148”), which provides alternative methods of transition for entities that change to the fair value method of accounting for stock-based employee compensation. LNC adopted the fair value method of accounting under FAS 123 with the retroactive restatement method, as amended by FAS 148, as of January 1, 2003 and restated its financial statements for the years 2002, 2001, and 2000.
Accounting for Costs Associated with Exit or Disposal Activities. In June 2002, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“FAS 146”), which addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Action (including Certain Costs Incurred in a Restructuring)” (“Issue 94-3”). The principal difference between FAS 146 and Issue 94-3 is that FAS 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the
liability is incurred, rather than at the date of an entity’s commitment to an exit plan. FAS 146 is effective for exit or disposal activities after December 31, 2002. LNC adopted FAS 146 on January 1, 2003, and the adoption affects the timing of when expense is recognized for restructuring activities after December 31, 2002. See Note 12 for information on Restructuring charges.
Accounting for the Impairment or Disposal of Long-lived Assets. LNC adopted Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” on January 1, 2002. The effect of adoption was immaterial.
Accounting for Business Combinations and Goodwill and Other Intangible Assets. LNC adopted Statements of Financial Accounting Standards No. 141, “Business Combinations” (“FAS 141”), and No. 142, “Goodwill and Other Intangible Assets” (“FAS 142”) on January 1, 2002. After consideration of the provisions of the new standards regarding proper classification of goodwill and other intangible assets on the consolidated balance sheet, LNC did not reclassify any goodwill or other intangible balances held as of January 1, 2002.
The consolidated carrying value of goodwill changes as a result of acquisitions and changes in foreign currency exchange rates. The Lincoln UK segment’s carrying value changes as a result of the translation of the Lincoln UK balance from British pounds to U.S. dollars based on prevailing exchange rates as of the balance sheet date. During the 2002, goodwill for the Retirement segment increased as a result of the acquisition of The Administrative Management Group, Inc. (“AMG”). Total purchased goodwill in 2002 from the acquisition was $20.2 million. (see Note 11).
Par value, amortized cost and estimated fair value of investments in asset and mortgage-backed securities available-for-sale summarized by interest rates of the underlying collateral are as follows:
Trading securities at fair value retained in connection with Modco and CFW reinsurance arrangements, consisted of the following:
The portion of market adjustment for trading securities and the corresponding market adjustment for the reinsurance embedded derivative related to trading securities at December 31, 2003 was $334.7 million.
As of December 31, 2003, LNC had no mortgage loans on non-accrual status compared with $1.8 million at December 31, 2002. As of December 31, 2003 and 2002, LNC had no mortgage loans past due 90 days and still accruing.
Significant components of LNC’s deferred tax assets and liabilities are as follows:
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, 2003, LNC believes that it is more likely than not that all gross deferred tax assets will reduce taxes payable in future years except for the amount of the valuation allowance established in 2001. In 2001, LNC established a valuation allowance of $51.2 million for the gross deferred tax asset relating to net operating losses of its foreign life reinsurance subsidiary. The net operating losses of this subsidiary are subject to Federal income tax limitations that only allow the net operating 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 all of 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.
LNC has made the decision not to permanently reinvest earnings in Lincoln National (UK) plc and Investment Management’s UK operating subsidiary Delaware Investment Advisers, Ltd. Full U.S. deferred taxes applicable to any un-repatriated earnings have been recorded.
The income statement caption, “Benefits,” is net of reinsurance recoveries of $0.6 billion in each of the years ended December 31, 2003, 2002 and 2001.
A roll forward of the balance sheet account, “Deferred Acquisition Costs,” is as follows:
** The gross carrying amount and accumulated amortization of the present value of in-force for the Lincoln UK segment changed from December 31, 2002 to December 31, 2003 due to the translation of the balances from British pounds to U.S. dollars based on the prevailing exchange rate as of the balance sheet dates.
The aggregate amortization expense for other intangible assets for the years ended December 31, 2003, 2002 and 2001 was $88.1 million, $144.7 million and $125.2 million, respectively.
LNC also has access to capital from junior subordinated debentures issued to affiliated trusts. Hybrid securities currently outstanding, which combine debt and equity characteristics, were offered through a series of trusts (Lincoln National Capital V and VI). These trusts were formed solely for the purpose of issuing preferred securities and lending the proceeds to LNC. The common securities of these trusts are owned by LNC. The only assets of Lincoln National Capital V and VI are the junior subordinated debentures issued by LNC. Distributions are paid by these trusts to the preferred security holders on a quarterly basis. The principal obligations of these trusts are irrevocably guaranteed by LNC. Upon liquidation of these trusts, 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. LNC has determined that the trusts are variable interest entities as defined by FIN 46. Prior to the implementation of FIN 46, LNC consolidated the trusts, which resulted in the elimination of the junior subordinated debentures issued to the affiliated trusts. Upon implementation of FIN 46, LNC no longer consolidates these trusts. The effect of the deconsolidation was not material.
affiliated trust of LNC, issued $150 million of 6.75% Trust Preferred Securities, Series F guaranteed by LNC. The debentures mature September 11, 2052 and can be redeemed for principal plus accrued interest beginning September 11, 2008.
Cash paid for interest related to LNC’s debt and junior subordinated debentures of affiliated subsidiary trusts for 2003, 2002 and 2001 was $93.5 million, $96.6 million and $123.1 million, respectively.
Pension and Other Post-retirement 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 greater 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.
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. 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 post-retirement 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. Effective April 1, 2004, the employees’ post-retirement plan was changed such that employees and agents not attaining age 50 by that date will not be eligible to receive life insurance benefits when they retire. This amendment to the plan resulted in the immediate recognition at the end of 2003 of a one-time curtailment gain of $2.4 million pre-tax. Life insurance benefits for retirees are noncontributory for employees and agents that attain the age of 50 by April 1, 2004 and meet the eligibility requirements at the time they retire; however, these participants can elect supplemental contributory life benefits up to age 70. Effective July 1, 1999, the agents’ post-retirement plan was changed to require agents retiring on or after that date to pay the full medical and dental premium costs. Beginning January 1, 2002, the employees’ post-retirement plan was changed to require employees not yet age 50 with five years of service by the end of 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.
As discussed in Note 2, the Medicare Prescription Drug Improvement and Modernization Act of 2003 (“the Medicare Act”) became law. Beginning in 2006, the Medicare Act provides various alternatives that could result in an offset to some portion of the costs of prescription drug benefits provided to retirees. In January 2004, the staff of the FASB issued Financial Staff Position No. FAS 106-1 (“FSP 106-1”), which permits a sponsor of a post-retirement health care plan that provides retiree prescription drug benefits to make a one-time election to defer accounting for the effects of the Medicare Act.
Information with respect to U.S. defined benefit plan asset activity and defined benefit plan obligations is as follows:
The expected return on plan assets for 2003 and 2002 was 8.25%. This rate is initially established at the beginning of the plan year based on the historical rates of return and is reevaluated based on the actual return through an interim date during the current plan year. As there was not a significant variance between the projected actual return for both 2002 and 2003 and the expected return of 8.25%, LNC maintained the expected return at 8.25% for the actuarial valuation calculated at the end of each year.
The calculation of the accumulated post-retirement benefits obligation assumes a weighted-average annual rate of increase in the per capita cost of covered benefits (i.e. health care cost trend rate) of 10.0% for 2003. It further
assumes the rate will gradually decrease to 5.0% by 2015 and remain at that level in future periods. 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 post-retirement benefits obligation as of December 31, 2003 and 2002 by $4.8 million and $7.5 million, respectively. The aggregate of the estimated service and interest cost components of net periodic postretirement benefits cost for the year ended December 31, 2003 and 2002 would increase by $0.4 million and $0.6 million, respectively.
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 LNC agents. The combined pre-tax expenses for these plans amounted to $3.7 million, $1.0 million and $2.8 million in 2003, 2002 and 2001, respectively. These expenses reflect both LNC’s contribution as well as changes in the measurement of LNC’s liabilities under these plans.
LNC’s U.S. pension plan asset allocations at December 31, 2003 and 2002, by asset category are as follows:
The primary investment objective of LNC’s U.S. defined benefit pension plan is for capital appreciation and income growth, with an emphasis on avoiding undue risk. A secondary objective is for current income. Investments can be made using the following asset classes: both domestic and international equity and fixed income securities, real estate, guaranteed products, venture capital, oil and gas and other asset classes the investment managers deem prudent. A five-year time horizon is utilized, as there are inevitably short-run fluctuations, which will cause variations in investment performance.
Each managed fund is expected to rank in the upper 50% of similar funds over the three and/or five year periods. Managers not meeting criteria will be subject to additional due diligence review and possible termination. The following short-term ranges have been established for weightings in the various asset categories:
LNC expects to contribute between $0 million and $18 million to its qualified U.S. defined benefit pension plans in 2004. In addition, LNC expects to fund approximately $9 million and $6 million in 2004 for benefit payments for its unfunded non-qualified U.S. defined benefit plan and U.S. post-retirement benefit plans, respectively.
401(k), Money Purchase 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.
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
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 2003, 2002 and 2001 are included in those plan expenses disclosed above.
The total liabilities associated with these plans were $197.8 million and $161.3 million at December 31, 2003 and 2002, respectively.
of these 2003 awards were outstanding. The performance measures that must be met for vesting to occur are established at the beginning of the three year performance period. Certain participants in the plan will select from seven different combinations of stock options, performance shares and or cash in determining the form of their award. Other participants will have their award paid in performance shares.
Total compensation expense for LNC incentive plans involving performance vesting for 2003 was $0.4 million relating to stock options, $6.1 million relating to performance shares, and $0.8 million relating to cash awards. The amount of stock option expense for the performance vesting awards is included in the total LNC stock option expense as discussed below. All expense calculations for performance vesting stock options, performance shares, and performance vesting cash awards that were granted in 2003 have been based upon the current assumption that the actual performance achievement over the three-year performance measurement period will result in target levels of long-term incentive compensation payouts. As the three-year performance period progresses, LNC will continue to refine its estimate of the expense associated with these awards so that by the end of the three-year performance period, LNC’s cumulative expense will reflect the actual level of awards that vest.
Stock options awarded under the stock option incentive plans in effect prior to 2003 were 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%. The reload feature is not available for options granted after 2002.
Information with respect to the LNC incentive plans involving stock options is as follows:
Delaware Stock Option Incentive Plans: In 2001, Delaware Management Holdings, Inc. (“Holdings”), through its wholly-owned subsidiaries DIUS and DIAL, established separate stock option incentive plans for its domestic and international personnel, respectively. Stock options awarded under the plans are granted with an exercise price equal to the estimated fair market value per share at the date of the grant, as determined by an outside appraiser, and expire 10 years from the date of the grant, subject to conditions of the plan agreements. Options granted under the DIUS plan become exercisable and vest in 25% increments over the four-year period following the option grant anniversary date. Options granted under the DIAL plan also vest in 25% increments over the four-year period following the option grant anniversary date, however, such options are exercisable immediately. In the event DIAL options are exercised prior to vesting, such stock acquired is restricted from resale until vested under the option terms.
At December 31, 2003, DIUS had 10,000,000 shares of common stock outstanding. Information with respect to the DIUS incentive plan involving stock options is as follows:
At December 31, 2003, the range of exercise prices for options outstanding under the DIAL incentive plan involving stock options was $25.47 to $26.79, with a weighted-average remaining contractual life of 8.3 years.
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. Total compensation expense (income) recognized for the SAR program for 2003, 2002 and 2001 was $6.8 million, $(0.7) million and $4.8 million, respectively. The mark-to-market gain (loss) recognized through net income on the call options on LNC stock for 2003, 2002 and 2001 was $0.3 million, $(6.7) million and $0.8 million, respectively. The SAR liability at December 31, 2003 and 2002 was $9.8 million and $3.7 million, respectively.
Information with respect to the LNC SARs incentive plan at December 31, 2003 is as follows:
The option price assumptions used for the LNC SAR plan were as follows:
Information with respect to the LNC incentive plan involving SARs is as follows:
Net income (loss) as determined in accordance with statutory accounting practices for LNC’s insurance subsidiaries excluding the insurance subsidiaries sold to Swiss Re in 2001 was $0.237 billion, $(0.159) billion and $0.268 billion for 2003, 2002 and 2001, respectively. 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. 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. In the second quarter of 2002, LNC exercised a contractual right to “put” its interest in Lincoln Re (Ireland) Limited to Swiss Re.
Shareholders’ equity as determined in accordance with statutory accounting practices for LNC’s insurance subsidiaries was $3.1 billion and $3.0 billion for December 31, 2003 and 2002, respectively.
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.
See Note 11, “Acquisitions and Divestitures,” for discussion of contingencies surrounding Swiss Re’s acquisition of LNC’s reinsurance operations on December 7, 2001.
With regard to mortgage endowments, an agreed upon resolution with regulatory authorities in connection with a subsidiary company resulted in redress payments of about $1.8 million during 2003. Regulatory reviews of other subsidiary companies marketing mortgage endowments are currently in abeyance.
At December 31, 2003 and 2002, the aggregate liability associated with Lincoln UK selling practices was $25.0 million and $82.2 million, respectively. The decrease in the aggregate liability was a result of redress payments and expenditures partially offset by exchange rate fluctuation. These reserves are based on various assumptions, in particular, the expected level of future complaints. 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.
Regulators also continue to focus on replacement and exchange issues. Under certain circumstances companies have been held responsible for replacing existing policies with policies that were less advantageous to the policyholder. LNC’s management continues to monitor compliance procedures to minimize any potential liability. Due to the uncertainty surrounding all of these matters, it is not possible to provide a meaningful estimate of the range of potential outcomes; however it is management’s opinion that future developments will not materially affect the consolidated financial position of LNC.
Lincoln UK agreed to outsource its customer and policy administration functions to the Capita Group Plc on August 1, 2002. The contract was originally for a term of 10 years. During 2003, this agreement was converted to an evergreen contract. The annual cost is based on a per policy charge plus an amount for other services provided. The total costs over the next 10 years of the contract are estimated to be $307.5 million and annual costs over the next five years are estimated to decline from $35.2 million to $30.0 million. The amounts quoted are estimates as the actual cost will depend on the number of policies in force and the applicable inflation rate for the period concerned. Lincoln UK or Capita may terminate the contract, subject to the necessary conditions being satisfied, by serving six and 12 months notice, respectively.
LNC’s amounts recoverable from reinsurers represents receivables from and reserves ceded to reinsurers. LNC obtains reinsurance from a diverse group of reinsurers and monitors concentration as well as financial strength ratings of LNC’s principal reinsurers. LNC’s principal reinsurers are strongly rated companies, with Swiss Re representing the largest exposure. As discussed above, LNC sold its reinsurance business to Swiss Re through an indemnity reinsurance arrangement in 2001. Because LNC is not relieved of its liability to the ceding companies for this business, the liabilities and obligations associated with the reinsured contracts remain on the consolidated balance sheet of LNC with a corresponding reinsurance receivable from the business sold to Swiss Re, which totaled $5.1 billion at December 31, 2003, and is included in amounts recoverable from reinsurers. In addition to various remedies that LNC would have in the event of a default by Swiss Re, LNC continues to hold assets in support of certain of the transferred reserves. These assets consist of those reported as trading securities
Although LNC does not have any significant concentration of customers, LNC’s Retirement segment has had a long-standing distribution relationship with American Funds Distributors (“AFD”) that is significant to this segment. Prior to 2003, AFD used wholesalers who focus on both American Funds mutual funds as well as the American Legacy Variable Annuity products. In 2002, LNC and AFD agreed to transition the wholesaling of American Legacy to LFD, which was completed in 2003. The American Legacy Variable Annuity product line sold through LFD accounted for about 17% of LNC’s total gross annuity deposits in 2003, compared with about 15% sold through AFD in 2002. In addition, the American Legacy Variable Annuity product line represents approximately 35% and 31% of LNC’s total gross annuity account values at December 31, 2003 and 2002, respectively.
LNC has guarantees with off-balance-sheet risks whose contractual amounts represent credit exposure. Guarantees with off-balance sheet risks having contractual values of $14.2 million and $22.4 million were outstanding at December 31, 2003 and 2002, respectively.
Certain subsidiaries of LNC have invested in real estate partnerships that use industrial revenue bonds to finance their projects. LNC has guaranteed the repayment of principal and interest on these bonds. Certain subsidiaries of LNC are also involved in other real estate partnerships that use conventional mortgage loans. In case of default by the partnerships, LNC has recourse to the underlying real estate. In some cases, the terms of these arrangements involve guarantees by each of the partners to indemnify the mortgagor in the event a partner is unable to pay its principal and interest payments. These guarantees expire in 2005 through 2008.
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.
* Total derivative instruments for 2003 are composed of $82.5 million and $(352.3) million on the consolidated balance sheet in Derivative Instruments and Reinsurance Related Derivative Liability, respectively.
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, 2003, LNC did not have any open total return swaps.
Gains and losses on derivative contracts are reclassified from accumulated OCI to current period earnings. As of December 31, 2003, $19.3 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.
Financial Futures. LNC uses financial futures contracts to hedge the liability exposure on certain options in variable annuity products. These 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 value of financial futures contracts along with the resulting gains and losses are recorded daily in net income. The open positions at December 31, 2003, all expire in 2004.
Swaptions. Swaptions entitled 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, were 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 was to provide a level of protection for its annuity line of business from the effect of rising interest rates. The swaptions provided an economic hedge of the annuity line of business. However, the swaptions were not linked to specific assets and liabilities on the balance sheet that met the significantly increased level of specificity required under FAS 133. Therefore, the swaptions did not qualify for hedge accounting under FAS 133. At December 31, 2003, there were no outstanding swaptions.
Credit Default Swaps. LNC uses credit default swaps which expire in 2006 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. LNC has not currently qualified credit default swaps for hedge accounting under FAS 133 as amounts are insignificant.
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. Mark to market changes are recorded in net income.
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.
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, 2003, the exposure was $85.3 million.
Fixed Maturity and Equity Securities - Available-for-Sale and Trading 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.
Derivative Instruments. 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
Investment Type Insurance Contracts. The balance sheet captions, “Insurance Policy and Claims 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.
As of December 31, 2003 and 2002, the carrying value of the deposit contracts and certain guaranteed contracts is net of deferred acquisition costs of $448.6 million and $486.0 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.
LNC has four business segments: Lincoln Retirement, Life Insurance, Investment Management and Lincoln UK. Prior to the fourth quarter of 2001, LNC had a Reinsurance segment. 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 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 are within LNC’s
The Lincoln Retirement segment, with principal operations 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, Lincoln Retirement provides an array of annuity products to individuals and employer-sponsored groups in all 50 states of the United States. Lincoln Retirement 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, Lincoln Retirement 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.
LNC reports operations of LFA and LFD and the 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 amortization of the gain on the sale of reinsurance business) 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.
Most of LNC’s foreign operations are conducted by Lincoln UK. The data for this company is shown above under the Lincoln UK segment heading. The other segments, except for the Lincoln Retirement 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:
* The financial data for other non-U.S. units includes the activity of several former reinsurance subsidiaries for the eleven months ended November 30, 2001. These entities were sold to Swiss Re in December 2001.
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 $0.8 million at December 31, 2003.
During 2002 and 2001, LNC purchased and retired 12,088,100 and 11,278,022 shares, respectively, of its common stock at a total cost of $474.5 million and $503.7 million, respectively. There were no repurchases in 2003. 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.
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. Participants in LNC’s deferred compensation plans that select LNC stock for measuring the investment return attributable to their deferral amounts will be paid out in LNC stock. The obligation to satisfy these deferred compensation plan liabilities is dilutive and is shown in the table above.
The “Net Unrealized Gain on Derivative Instruments” component of other comprehensive income shown on the Consolidated Statements of Shareholders’ Equity is net of Federal income tax expense (benefit) of $(3.9) million, $1.2 million, and $12.6 million for 2003, 2002 and 2001, respectively, and net of adjustments to deferred acquisition costs of $(4.5) million, $1.6 million and $23.8 million for 2003, 2002 and 2001, respectively. The 2001 amounts for tax expense and deferred acquisition cost adjustment include $9.5 million and $18.3 million, respectively, related 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 $31.3 million, $31.7 million and $(16.1) million for 2003, 2002 and 2001, respectively.
On August 30, 2002, LNC acquired The Administrative Management Group, Inc. (“AMG”), an employee benefits record keeping firm for $21.6 million in cash. Contingent payments up to an additional $14 million will be paid over a period of 4 years (2003-2006) if certain criteria are met. Lincoln Retirement recorded an expense of $1.2 million after-tax ($1.8 million pre-tax) for 2003 relating to such contingent payments. AMG, a strategic partner of LNC’s Retirement segment for several years, provides record keeping services for the Lincoln Alliance Program along with approximately 200 other clients nationwide. The application of purchase accounting to this acquisition resulted in goodwill of $20.2 million.
The transaction structure involved a series of indemnity reinsurance transactions combined with the sale of certain stock companies that comprised LNC’s reinsurance operation. At closing, an immediate gain of $15.0 million after-tax
was recognized on the sale of the stock companies. A gain of $723.1 million after-tax ($1.1 billion pre-tax) relating to the indemnity reinsurance agreements was reported at the time of closing. 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 15 years.
As part of the dispute settlement, LNC also paid $100 million to Swiss Re in satisfaction of LNC’s $100 million indemnification obligation with respect to personal accident business. As a result of this payment, LNC has no further underwriting risk with respect to the reinsurance business sold. However, because LNC has not been relieved of it legal liabilities to the underlying ceding companies with respect to the portion of the business indemnity reinsured by Swiss Re, under FAS 113 the reserves for the underlying reinsurance contracts as well as a corresponding reinsurance recoverable from Swiss Re will continue to be carried on LNC’s balance sheet during the run-off period of the underlying reinsurance business. This is particularly relevant in the case of the exited personal accident and disability income reinsurance lines of business where the underlying reserves are based upon various estimates that are subject to considerable uncertainty.
Accordingly, even though LNC has no continuing underwriting risk, and no cash would be transferred between LNC and Swiss Re, in the event that future developments indicate LNC’s December 31, 2003 personal accident or disability income reserves are deficient or redundant, FAS 113 requires LNC to adjust earnings in the period of change, with only a partial offset to earnings for the cumulative deferred gain amortization adjustment in the period of change. The remaining amount of increased gain would be amortized into earnings over the remaining run-off period of the underlying business.
Included in the 1999 restructuring charge is $6.5 million after-tax ($10.0 million pre-tax) recorded in the Lincoln UK segment. The objective of this restructuring plan is to reduce operating costs by consolidating and eliminating redundant staff functions and 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, 2003, $8.3 million (pre-tax) has been expended or written-off under this restructuring plan and 112 positions have been eliminated.
Pre-tax restructuring charges for the June/August realignment activities for the year ended December 31, 2003 were reported in the following segments: Retirement ($15.9 million), Life Insurance ($1.7 million), Investment Management ($7.1 million), and Other Operations ($7.2 million).
In February 2004 LNC issued of $200 million 4.75% Notes due 2014 with semi-annual interest payments in February and August. The notes were priced at 99.297% and net proceeds to the company were $197.3 million, which will be used for general corporate purposes. Until the funds are needed for such purposes, the net proceeds will be used to invest in short-term investment grade securities and to pay down short-term debt. LNC used a treasury lock to reduce exposure to interest rate changes prior to closing. The treasury lock was closed prior to the issuance of the Notes with a gain of approximately $1 million. This gain, along with the costs of issuance, will be amortized over the life of the Notes.