(1) Factors affecting the comparability of net income from continuing operations before cumulative effect of accounting change and net income from continuing operations for the 1993-1997 period are shown on page 8 (see "Supplemental Data"). Other factors affecting comparability are shown within the review of operations for each segment (see pages 9-17).
(2) Per share amounts were also affected by the issuance of 9,200,000 and 1,398,112 shares of common stock in 1993 and 1997, respectively, and the retirement of 500,000; 694,582 and 4,948,900 shares of common stock in 1994, 1996 and 1997, respectively. The per share amounts for prior years have been restated to conform to the provisions of Financial Accounting Standard No. 128 (see note 2 to the consolidated financial statement on page 43).
The following table presents a reconciliation of "Income (Loss) from Continuing Operations" to "Net Income (Loss) from Continuing Operations" determined in accordance with generally accepted accounting principles. Income (Loss) from Continuing Operations is LNC's alternative measure of operating performance which excludes the after-tax realized gain (loss) on investments and associated items, gain (loss) on sale of subsidiaries, restructuring charges and non-recurring accounting changes.
On pages 9 through 17, the financial results of LNC's four business segments and other operations are presented and discussed. Within these business segment discussions, reference is made to "Income from Operations". This alternative measure of earnings is defined as "Net income less realized gain (loss) on sale of investments, gain (loss) on sale of subsidiaries, restructuring charges and cumulative effect of accounting change, all net of taxes." Page 18 discusses factors affecting LNC's consolidated investment performance. Pages 19 through 33 discuss factors that have affected specific elements of the consolidated financial statements as well as information pertaining to LNC as a whole.
(2) Income from operations and net income of the annuities and pension sub- segments for 1993 include an increase in the estimate of net investment income ($26.0 million after-tax) related to a refinement in the method used to calculate the estimated effective yields on mortgage-backed securities.
(3) Realized gain (loss) on investments for 1993 includes an increase in the allowance for losses for mortgage loans ($42.3 million after-tax) related to a change in accounting for the impairment of mortgage loans as prescribed by Financial Accounting Standard No. 114.
Lincoln Life, which is based in Fort Wayne, Ind., is the 12th largest life insurer in the United States when measured by assets (Best's Review, Life/Health Edition, October 1997). First Penn, which has its headquarters in Oakbrook Terrace, Ill., is recognized for its product innovations. One recent introduction is MoneyGuard, a life insurance policy that incorporates long-term care benefits. LLANY, which is based in Syracuse, N.Y., provides group tax-sheltered annuities and other insurance products in New York State.
LFA is a new corporation that includes a network of regional financial planning offices that serve as the preferred distributor of Lincoln Life products. LFA offers a full range of financial planning services and investments, and is a securities broker/dealer and registered investment advisor.
Lincoln Life Technology: Lincoln Life has invested $70 million over the past three years to provide the infrastructure that improves customer service, adds products and lowers expense levels. The objective, realized through voice response technology and other developments, is to serve the customer from a single platform, rather than from multiple product platforms. In addition to better service, a single platform offers greater opportunities to cross-sell products to existing customers. Also during 1997 came the decision to enter into a relationship with IBM for providing information technology services for the Fort Wayne operation. This decision stemmed from the rapid acceleration of the technology industry and the realization that top technology people, whether experienced or recently graduated, are going to work for technology companies. The relationship with IBM will enable Lincoln Life to leverage that technological expertise. A seven-year contract was signed with IBM in February 1998 (see note 7 to the consolidated financial statements on page 54).
Lincoln Life is a leading writer of annuities in the United States (National Underwriter, July 1997).
Life Insurance: Operating income from life insurance was $36.1 million, about even with 1996. Combined universal life and variable universal life insurance account values increased 6 percent in 1997 to $3.0 billion. Individual life insurance sales increased 15% for the year to $18.7 billion.
The remainder of this segment's pension business consists primarily of guaranteed interest contracts ("GICs") and group pension annuities ("GPAs"), both of which Lincoln Life stopped writing in 1995 as it focused its operations on the small business retirement market. Account values in this portion of the pension business declined to $4.4 billion at year-end.
Alliances: As Lincoln Life has exited small lines of business that were outside its primary operating focus, it has entered into alliances in order to provide its distribution force with access to products. Among these lines have been long-term care, disability income insurance, pension plan termination annuities and GICs. In 1997, Lincoln Life exited the employer-sponsored life insurance market and entered into an alliance with Colonial Life & Accident for the servicing and re-enrollment of Lincoln Life's block of business.
Outlook: The acquisition and integration of the individual life and annuity business from CIGNA Corporation will add breadth to Lincoln Life's distribution structure and product portfolio. The transaction brings approximately 600 financial planners along with products to serve higher net-worth individuals seeking wealth accumulation and protection. It also will add a new, more competitive, multiple manager variable annuity to market through the various distribution channels. In addition, changes in the American Legacy annuity and distribution should improve deposits from this source.
In connection with the completion of the acquisition mentioned above, LNC expects to record a charge to its Life Insurance & Annuities segment during the first quarter of 1998 of approximately $20 million, after-tax. This charge will cover certain costs of integrating the existing operations with the new block of business.
(2) Income (loss) from operations and net income (loss) for 1997 include a charge of $174.9 million ($199.4 million pre-tax) for a change in estimate of the cost of settling pension mis-selling liabilities (see note 2 to the consolidated financial statements on page 43).
(3) Net Initial Commissions is a measure used by Lincoln UK to measure sales progress and future profitability.
LNC's Lincoln UK segment, conducted through Lincoln National (UK) and its operating subsidiaries reported income from operations of $66.6 million in 1997, excluding a charge of $174.9 million, after-tax, to strengthen reserves for future liabilities concerning past sales of pension products to individuals. Including the special charge, Lincoln UK had a loss from operations of $108.3 million. Income from operations in 1996 was $66.1 million.
Markets: Account values in the unit-linked asset business were $5.6 billion as of December 31, 1997, an increase of 11% over the year before (15% calculated using pounds sterling). Net initial commission values increased $8.2 million or 17% in 1997(12% using pounds sterling). Individual life insurance in-force as of December 31, 1997, was $25.0 billion.
Exchange Rates: LNC's subsidiary in the United Kingdom, as with subsidiaries in other foreign countries, has its balance sheet accounts and income statements translated at the current exchange and average exchange rates for the year, respectively. The average exchange rate for 1997 was $1.644 per British pound sterling. This was 5% higher than the 1996 average exchange rate of $1.567 per British pound.
Acquisition: In December 1997, City Financial Partners Ltd. ("CFPL"), Lincoln UK's largest tied agent, was acquired and is now a wholly-owned subsidiary. Founded in 1992 as a tied agent of Citibank Life, which was acquired by LNC in 1993, CFPL had a contract with Lincoln UK. It offers the full range of Lincoln UK pensions, life assurance and unit trust products.
A subsidiary of Lincoln UK incurred a small fine in 1997 in one of these actions. Lincoln UK has expressed its commitment to complete its review as quickly as possible so that appropriate action can be taken. The timetable has proved challenging, however, especially since 75% of the priority cases to be reviewed relate to companies Lincoln UK recently acquired. Considerable staff has been added to undertake the review and outside consultants have been retained to expedite the process. Lincoln UK achieved its target of completing 90% of the top-priority cases by December 1997 and is making a strong effort to meet the regulatory target of having all remaining priority cases reviewed by the end of 1998.
As of December 31, 1997, and December 31, 1996, liabilities of $291.0 million and $86.7 million had been established for this issue. These liabilities, which are net of expected recoveries, were established for the estimated cost of this issue following regulatory guidance as to activities to be undertaken. These liabilities were booked net of expected recoveries of $113.0 million and $31.4 million, respectively, from previous owners of companies acquired over the last few years as specified in the indemnification clauses of the purchase agreements.
LNC's Reinsurance segment, conducted through the Lincoln National Reinsurance companies ("Lincoln Re"), reported income from operations, excluding special charges, of $92.1 million in 1997. The two charges were $130 million for disability income reserve strengthening and $113.7 million for certain personal accident reinsurance business. As of December 31, 1997, Lincoln Re's individual and group life business in-force was $183.5 billion, an increase of 14% for the year.
Profile: One of the leading life-health reinsurers in the world, Lincoln Re reported consolidated, worldwide net premium income of $1.7 billion in 1997. This compares with $2.1 billion net premium income reported in 1996. Lincoln Re opened an office in Buenos Aires in 1997 to better serve clients in Argentina and Chile and has offices in Toronto, Brussels, London, Mexico City, Manila and Singapore. Lincoln Re does business in more than 50 countries.
Foremost among these systems is LNRM's patented Life Underwriting System, a state-of-the-art risk management technology now licensed to more than 50 insurers. Other proprietary systems assist health insurers, claims processors and agents. Datalliance [registered trademark] is an electronic data interchange that can link agents, insurers, information sources, medical labs and reinsurers.
Group Markets: Income from operations in 1997 in group markets was $10.4 million, excluding the special charge for personal accident programs. This compares with $19.0 million in 1996. Total annualized premium of $202.2 million represents an increase of 5% over the $193.3 million in 1996.
In the fourth quarter of 1995, LNC took a $121.6 million after-tax charge against earnings to strengthen reserves for the direct and reinsurance disability income business. These reserves were established assuming that the current experience would continue. In the second quarter of 1997, LNC took an additional charge of $130 million against earnings when it obtained new information indicating that experience had deteriorated further.
Personal Accident Programs: Certain excess-of-loss personal accident reinsurance programs created in the London market in which Lincoln Re participated from 1993 to 1996 have produced unexpectedly heavy losses. Investigations and audits of ceding companies conducted in late 1997 led LNC to conclude that many more claims will be reported than previously estimated. As a result, LNC took a charge of $113.7 million against earnings. LNC is investigating the manner in which the programs were designed and intends to pursue negotiated settlements or other remedies.
Financial Results Fees: Investment Advisory Fees . . . . . . . $219.6 $190.4 130.1 Other Revenue and Fees . . . . . . . . 38.1 24.6 18.7 Income: Income from Operations . . . . . . . . . $ 4.5 $ 10.2 $ 13.3 Realized Gain on Investments . . . . . . 3.3 5.2 4.3
Net Income . . . . . . . . . . . . . $ 7.8 $ 15.4 $ 17.6 Income from Operations-Excluding Amortization of Intangibles. . . . . . $ 31.6 $ 34.1 $ 28.1
Institutional-Fixed . . . . . . . . . 5.7 3.6 3.0 Institutional-Equity . . . . . . . . 25.8 3.5 22.1 Total Institutional . . . . . . . . 31.5 27.1 25.1 Total Assets Under Management . . . $ 54.0 $ 43.2 $ 38.7
(1) Data is not shown for this segment for 1993 and 1994 as this segment was added in April 1995 following the acquisition of Delaware Management Holdings, Inc. (see note 11 to the consolidated financial statements on page 64).
LNC's Investment Management segment reported income from operations of $4.5 million in 1997, compared with $10.2 million in 1996. The segment's 1997 operating income, excluding amortization of goodwill and other intangible assets, was $31.6 million.
Profile: Although investment management has long been an area of expertise within LNC, the addition of Delaware in 1995 signaled LNC's intention to expand its role as a money manager and meet its objective of becoming a top-tier company in the financial services industry. Particular emphasis is being given to accelerating the growth of Delaware's retail mutual funds operation.
The operating companies that comprise this segment are: Delaware; Lynch & Mayer, Inc. ("Lynch & Mayer"); and Vantage Global Advisors, Inc ("Vantage"). Delaware has its headquarters in Philadelphia, with offices also in London and Minneapolis. Lynch & Mayer and Vantage each maintain headquarters in New York.
Lynch & Mayer, founded in 1976 and acquired by LNC in 1985, is primarily an institutional investment firm with an equity growth focus. It manages equities and convertible securities as separate accounts, commingled funds and mutual funds and is now sub-advising a growth equity fund in Delaware's retail mutual fund family. Vantage founded in 1979 and also acquired in 1985, invests in undervalued companies that have strong potential for above-average growth. Employing a disciplined, systematic, risk-controlled investment approach, Vantage primarily manages part of Lincoln Life's variable U.S. life and annuity products. It also sub-advises on two of Delaware's retail mutual funds.
Assets Under Management: As shown above, the Investment Management segment has assets of $54.0 billion under management as of December 31, 1997. Domestic institutional assets represent $24.4 billion of the Investment Management's total assets under management. Domestic retail assets represent $21.8 billion of the total. International equity and global bond assets managed by Delaware International Advisors account for $7.8 billion.
Distribution: Multiple distribution channels enable the businesses in the Investment Management segment to deliver their broad range of products to an expanding community of retail and institutional investors. Retail mutual funds are marketed through regional and national broker/dealers; financial planners; insurance agents, including those associated with the regional marketing offices of Lincoln Life and banks. Institutional products are marketed primarily by an employed sales force in conjunction with pension consultants. They also are offered to defined benefit and defined contribution plan sponsors, endowments, foundations and insurance companies.
Retail Mutual Funds: The Investment Management segment's retail mutual fund and wrap fee assets totaled $22.5 billion at December 31, 1997, which is a 40% increase from the $16.1 billion at December 31, 1996. Delaware, which operates the retail mutual funds, offers 63 open-end retail mutual funds and eight closed-end funds. These funds had assets under management of $12.3 billion. The remaining $10.2 billion was from wrap-fee business and retail mutual funds managed by Lynch & Mayer and Vantage.
The retail mutual fund operations experienced both internal and external growth during the year. The external growth occurred with the acquisition and integration of the tax-free bond specialist, Voyageur Fund Managers. This added a family of 32 open end bond funds and six closed end funds and a total of $2.6 billion in assets. On the internal side, the number of wholesalers was increased to 37 as of December 31, 1997 from 31 as of December 31, 1996. Delaware strengthened its service quality foundation in order to consistently achieve exceptional customer service. As a result of enhancing service quality measurement techniques, improving training and automating business processes, Delaware's Dalbar National Rankings improved in substantially all of the Main Office - Operations categories. An impressive climb in the Overall Operations Service category from a ranking of 16th in 1996 to a ranking of 8th in 1997; illustrated Delaware's commitment to exceed customer expectations. The tracking and measuring was done by two independent outside vendors, National Quality Review, and Technical Assistance Research Programs.
Delaware undertook several strategic initiatives in its retail operation during the year, increasing the number of wholesalers and products. These efforts, combined with improved performance and service, contributed to Delaware increasing its retail non-money market sales to $2.0 billion in 1997, up 63% in comparison with $1.2 billion for 1996.
Institutional Investments: The institutional investment management business had assets under management of $31.5 billion as of December 31, 1997, compared with $27.1 billion at December 31, 1996. The 1995 acquisition of Delaware Management Holdings complemented the position already held by Lynch & Mayer and Vantage in this mature, but still growing, business. Delaware International Advisors, Ltd's institutional investment management business is experiencing exceptional growth as evidenced by assets increasing to $7.1 billion as of December 31, 1997 from $4.4 billion on December 31, 1996.
Investment Performance: In terms of performance, the number of Delaware funds ranked as four- and five-star funds by Morningstar, Inc., (a service that assigns rankings to mutual funds according to their investment styles with one star as the lowest to five stars as the highest) was 21 as of December 31, 1997, compared with seven as of December 31, 1996. High ratings are significant: Across the mutual fund industry, nearly 75% of net new fund flows in 1996 were into funds with four- or five-star ratings from Morningstar. The 21 funds represented 69% of the company's mutual fund assets under management. The largest five of these funds were: Decatur Income, Delchester, Decatur Total Return, Tax Free PA and Tax Free USA.
The income (loss) from operations shown above includes the earnings from Lincoln Investment Management, certain other operations that are not directly related to the business segments and unallocated corporate revenues and expenses, such as corporate investment income, interest expense on short-term and long-term borrowings, and corporate overhead expenses. Other operations also included LNC's investment in an unconsolidated affiliate engaged in the employee life- health benefits business prior to the sale of this holding in October 1995.
(1) See Investment Management segment data on page 15 for additional detail.
The following discussion covers select general investment matters. The review of consolidated operations, which begins on page 19, includes the fact that LNC's net investment income for the year ended December 31, 1997 was $2.3 billion, an increase of 8% over 1996. Also, this discussion indicates that during 1997 net gains on investments totaling $122.6 million were realized. The review of consolidation financial condition begins on page 22 and discusses the composition and quality of the LNC portfolio.
Fixed Maturity Performance: In 1997, the LNC fixed maturity portfolio produced a return of 10.56%, compared to the Lehman Brothers Government/Corporate index which produced 9.76%.
As the result of the purchase of a block of individual life insurance and annuity business in January of 1998, select income statement accounts listed above are expected to increase in future periods (see note 12 to the consolidated financial statements on page 65).
Life Insurance and Annuity Premiums Life insurance and annuity premiums increased $27.5 million or 4% in 1997 and $21.7 million or 3% in 1996 as the result of increases in volumes of business in the Lincoln UK and Reinsurance segments being partially offset by decreases in premium in the Life Insurance and Annuities segment. Barring the passage of unfavorable tax legislation that would eliminate the tax-advantages for some of LNC's life and annuity products, LNC expects growth in life insurance and annuity premium in 1998.
Health Premiums Health premiums decreased $218.0 million or 28% in 1997 as a result of decreased volume in the Reinsurance segment. Health premiums decreased $16.5 million or 2% in 1996 as a result of increased volumes of business in the Reinsurance segment being more than offset by decreases in the Life Insurance and Annuities segment due to the withdrawal from the disability income business.
Insurance Fees Insurance fees from universal life, other interest-sensitive life insurance contracts and variable life insurance contracts increased $118.7 million or 17% in 1997 and $113.2 million or 19% in 1996. These increases are the result of an increase in the volume of transactions and a market-driven increase in the value of existing customer accounts upon which some of the fees are based in the Life Insurance & Annuities and Lincoln UK segments. The growth in fees from this business is expected to continue in 1998.
Investment Advisory Fees This line was added to the consolidated statements of income in the second quarter of 1995 following LNC's purchase of Delaware Management Holdings, Inc. (see note 11 to the consolidated financial statements on page 64). Investment advisory fees increased $24.1 million or 13% in 1997 and on an annualized basis increased 8% in 1996. These increases were the result of increased volumes of business and an increase in the market value of customer accounts.
Realized Gain on Investments The pre-tax realized gain on investments, net of related amortization and expenses was $122.6 million, $92.5 million and $157.6 million in 1997, 1996 and 1995, respectively. The after-tax gain in 1997, 1996 and 1995 was $72.9 million, $57.6 million and $102.2 million, respectively. These gains were primarily the result of the sale of investments. Some modest write-downs and provisions for losses offset a portion of the realized gains. During 1996, LNC completed a bulk sale of performing and non-performing mortgage loans and real estate holdings through a sealed bid process. The selling price for these holdings was $6.1 million in excess of the carrying value, resulting in a gain on sale.
Securities available-for-sale, mortgage loans on real estate and real estate that were deemed to have declines in fair value that were other than temporary were written down. The fixed maturity securities to which these write-downs apply were generally of investment grade quality at the time of purchase but were classified as "below-investment-grade" at the time of the write-downs. Also, write-downs and allowances for losses on select mortgage loans on real estate, real estate and other investments were established when the underlying value of the property was deemed to be less than the carrying value. These write-downs and provisions for losses are disclosed within the notes to the accompanying financial state ments (see note 3 to the consolidated financial statements on page 44).
Other Revenue and Fees Other revenue and fees increased $21.0 million or 16% in 1997 and $25.4 million or 22% in 1996 as the result of increases in the volume of transactions in the Reinsurance and Investment Management segments.
increased volumes of business in the Reinsurance and Lincoln UK segments. In 1998, the increase in life insurance and annuity benefits are expected to parallel the growth in life insurance and annuity premiums.
Health Benefits Health benefits increased $159.5 million in 1997 as the net result of decreased volumes of business being more than offset by additions to the reserves for disability income business and personal accident programs within the Reinsurance segment. Health benefits increased $40.5 million or 6% in 1996 compared to 1995 health benefits after excluding the special addition to the disability income reserve in 1995. See note 2 to the consolidated financial statements on page 43.
Interest and Debt Expense Interest and debt expense increased $7.8 million or 9% in 1997 and $12.2 million or 17% in 1996. These increases were the result of increases in the average debt outstanding and the impact of changes in the composition of debt outstanding (see page 31). During 1997, Standard and Poor's, Moody's, and Duff & Phelps re-affirmed LNC's debt ratings as A ("Excellent"), A2 ("Very Good, Strong or High") and AA- ("Excellent"), respectively.
Summary Net income for 1997 was $934.0 million compared with $513.6 million in 1996. Excluding realized gain (loss) on investments, gain (loss) on sale of subsidiaries, discontinued operations and the special 1997 additions to the disability income, personal accident programs and UK pension product reserves, all net of taxes, LNC earned $368.0 million for 1997 compared to $298.8 million in 1996. This increase is the result of increased earnings in the Life Insurance & Annuities, Lincoln UK and Reinsurance segments. In the fourth quarter of 1997 the Corporate and Other unit benefited from earnings on proceeds from discontinued operations. This benefit will not continue into 1998 as most of these funds were used to purchase a block of individual life and annuity business on January 2, 1998 (see note 12 to the consolidated financial statements on page 65). Net income for 1996 was $513.6 million compared with $482.2 million in 1995. Excluding realized gain (loss) on investments, gain on sale of subsidiaries, discontinued operations and the special 1995 addition to the disability income reserve, LNC earned $298.8 million for 1996 compared to $262.2 million in 1995. This increase is the result of increased earnings in the Life Insurance & Annuities, Lincoln UK and Reinsurance segments.
communications with critical parties that interface with LNC's systems to gain an understanding of their progress in addressing year 2000 issues. While LNC is making every effort to address its own systems and the systems with which it interfaces, it is not possible to provide assurance that operational problems will not occur. LNC presently believes that, with the modification of existing computer systems, updates by vendors and conversion to new software and hardware, the year 2000 issue will not pose significant operational problems for its computer systems. In addition, LNC is developing contingency plans in the event that, despite its best efforts, there are unresolved year 2000 problems. If the remediation efforts noted above are not completed timely or properly, the year 2000 issue could have a material adverse impact on the operation of LNC's businesses.
Investments The investment portfolio, excluding cash and invested cash, is comprised of fixed maturity securities; equities; mortgage loans on real estate; real estate, either wholly owned or joint ventures; and other long-term investments. LNC purchases investments for its segmented portfolios with yield, duration and other characteristics that take into account the liabilities of the products being supported. The total investment portfolio increased $88.9 million in 1997. This minimal increase was the net result of increases from 1) the fair value of securities available-for-sale and 2) the new purchases of investments from cash flow generated by the business units being mostly offset by 1) the sale of select investments to raise cash for the January 2, 1998 purchase of a block of individual life insurance and annuity business and 2) the continuation of fixed annuity contractholders opting to transfer funds to variable annuity contracts.
LNC maintains a high-quality fixed maturity securities portfolio. As of December 31, 1997, $8.4 billion or 35.1% of its fixed maturity securities portfolio had ratings of AA or better. Fixed maturity securities with below-investment-grade ratings (BB or less) were $1.7 billion or 7.3% of the total fixed maturity securities portfolio (see note 3 to the consolidated financial statements on page 46). The below-investment-grade fixed maturity securities represent 5.9% of LNC's total investment portfolio. The interest rates available on these below-investment-grade securities are significantly higher than are available on other corporate debt securities. Also, the risk of loss due to default by the borrower is significantly greater with respect to such below investment grade securities because these securities are generally unsecured, often subordinated to other creditors of the issuer and issued by companies that usually have high levels of indebtedness. LNC attempts to minimize the risks associated with these below investment grade securities by limiting the exposure to any one issuer and by closely monitoring the credit worthiness of such issuers. For the year ended December 31, 1997, the aggregate cost of below investment grade securities purchased was $1.8 billion. Aggregate proceeds from such investments sold were $1.6 billion, resulting in a realized pre-tax gain at the time of sale of $81.9 million.
LNC limits the extent of its risk on mortgage-backed securities by generally avoiding the purchase of securities with a cost that significantly exceeds par, by purchasing securities backed by stable collateral, and by concentrating on securities with enhanced priority in their trust structure. Such securities with reduced risk typically have a lower yield (but higher liquidity) than higher- risk mortgage-backed securities. At selected times, higher-risk securities may be purchased if they do not compromise the safety of the general portfolio. At December 31, 1997, LNC did not have a significant amount of higher-risk mortgage-backed securities. There are negligible default risks in the mortgage- backed securities portfolio as a whole as the vast majority of the assets are either guaranteed by U.S. government-sponsored entities or are supported in the securitization structure by junior securities enabling the assets to achieve high investment grade status. Note 3 to the consolidated financial statements on page 45 shows additional detail about the underlying collateral.
As of December 31, 1997, mortgage loans on real estate and investments in real estate represented 11% and 1.9% of the total investment portfolio. As of December 31, 1997, the underlying properties supporting the mortgage loans on real estate consisted of 20.7% in commercial office buildings, 30.4% in retail stores, 21.5% in apartments, 14.6% in industrial buildings, 4.2% in hotels/motels and 8.6% in other. In addition to the dispersion by type of property, the mortgage loan portfolio is geographically diversified throughout the United States.
Cash and Invested Cash Cash and invested cash increased by $2.6 billion in 1997. This increase is the result of accumulating funds at the end of 1997 in anticipation of the purchase of a block of individual life and annuity business on January 2, 1998 (see note 12 to the consolidated financial statements on page 65).
Assets Held in Separate Accounts This asset account, as well as the corresponding liability account, increased by $8.3 billion in 1997 as a result of increases in annuity and pension funds under management. This increase resulted from new deposits, market appreciation and the continuation of fixed annuity contractholders opting to transfer funds to variable annuity contracts.
Goodwill The increase of $106.0 million is the net result of additions related to business acquired (see note 11 to the consolidated financial statements on page 64) being more than the on-going amortization.
While it is management's judgement that, based on available information, the appropriate level of liabilities have been recorded, LNC has areas where changes in estimates of related liabilities required could occur in the near term. These areas include claims for disability income coverages, liabilities and recoveries related to inappropriate selling of pension products in the United Kingdom, liabilities for marketing and compliance issues, the reserve for the run-off of group pension annuities and liabilities for personal accident programs (see note 7 to the consolidated financial statements on page 53).
Shareholders' Equity Total shareholders' equity increased $513.0 million during the year ended December 31, 1997. Excluding the increase of $20.4 million related to an increase in the unrealized gain (loss) on securities available-for-sale, shareholders' equity increased $492.6 million. This increase in shareholders' equity was the net result of increases due to $934.0 million of net income, $74.3 million from the issuance of stock related to the purchase of subsidiary companies and $33.2 million from the issuance of common stock related to benefit plans and decreases of $203.3 million related to the declaration of dividends to shareholders, $20.3 million related to a decrease in the accumulated foreign exchange gain and $325.3 million for the retirement of common stock.
As noted above, shareholders' equity includes net unrealized gain (loss) on securities available-for-sale. At December 31, 1997, the book value of $49.27 per share included $4.31 of unrealized gains on securities and at December 31, 1996, the book value of $43.00 per share included $3.97 of unrealized gains on securities.
A significant portion of both realized and unrealized gains or losses on investments that support long-term life insurance, pension and annuity contracts are expected to be applied to contract benefits. These realized and unrealized gains or losses are included in net income and shareholders' equity, respectively. Current accounting standards do not require or permit adjustment of policyholder reserves to recognize the full effect of these realized and unrealized gains or losses on future benefit payments in the absence of a contractual obligation requiring their attribution to policyholders.
Market Risk Exposures of Financial Instruments LNC analyzes and manages the risks arising from market exposures of financial instruments, as well as other risks, in an integrated asset-liability management process that takes diversification into account. By aggregating the potential effect of market and other risks of the entire enterprise, LNC estimates, reviews and in some cases manages the risk to its earnings and shareholder value. LNC has material exposures to several market risks including interest rate, default risk, foreign currency exchange and equity price risks.
The exposures of financial instruments to market risks, and the related risk management processes, are most important in the Life Insurance and Annuities segment. This segment is where most of the invested assets support accumulation and investment oriented insurance products. As an important element of its integrated asset-liability management process, LNC uses derivatives to minimize the effects of changes in interest rate levels and the shape of the yield curve. In this context, derivatives are designated as a hedge and serve to reduce interest rate risk by mitigating the effect of large rises in interest rates on LNC's stream of earnings. Additional market exposures exist in LNC's other general account insurance products and in its debt structure and derivatives positions. The primary sources of market risk are: 1) substantial, relatively rapid and sustained increases or decreases in interest rates, 2) fluctuations in currency exchange rates 3) a sharp drop in equity market values. Each of these market risks are discussed in detail in the following pages.
Universal Life. LNC has $3.4 billion in assets supporting universal life insurance on which it has the right to adjust renewal crediting rates subject to guaranteed minimums ranging from 4% to 5% at December 31, 1997. Similar to annuities, universal life insurance customers have the right to surrender their policies at account value less a surrender charge that grades to zero over periods ranging from 5 to 10 years from policy issue date or, in some cases, the date of each premium received.
Other General Account Insurance products. LNC has $7.4 billion of assets supporting general account products, including disability income and term life insurance. For these products, the liability cash flows may have actuarial uncertainty. However, their amounts and timing do not vary significantly with interest rates. LNC limits interest rate risk by analyzing the duration of the projected cash flows and structuring investment portfolios with similar durations.
Interest Rate Risk--Falling Rates. After rising in 1994, interest rates fell in 1995, rose again in 1996 and declined in 1997. For example, the five-year Treasury yield rose from 5.2% to 7.8% during 1994 and fell back to 5.4% at the end of 1995, increased to 6.2% by the end of 1996 and decreased to 5.7 % by the end of 1997. Under scenarios in which interest rates fall and remain at levels significantly lower than those prevailing at December 31, 1997, minimum guarantees on annuity and universal life insurance policies (generally 3.0% to 4.5% or an average of approximately 4%) could cause the spread between the yield on the portfolio and the interest rate credited to policyholders to deteriorate. Select contracts that specify these minimum guarantees can be amended periodically to reflect current interest rate conditions. The earned rate on the annuity and universal life insurance portfolios averaged 7.8% and 7.9%, respectively, for the year ended December 31, 1997, providing a cushion for further decline before the earned rates would be insufficient to cover minimum guaranteed rates plus the target spread. The maturity structure and call provisions of the related portfolios are structured to afford protection against erosion of this cushion for a period of time. However, spreads would be at risk if interest rates continued to fall and remained lower for a long period. LNC manages these exposures by maintaining a suitable maturity structure and by limiting its exposure to call risk in each respective investment portfolio.
Debt. LNC has short-term debt, long-term debt, and minority interest-preferred securities of subsidiary companies totaling $1.1 billion ($835.6 million of this debt is at fixed rates and $287.6 million is at floating rates). LNC manages the timing of maturities and the mixture of fixed-rate and floating-rate debt as part of the process of integrated management of interest rate risk for the entire enterprise.
LNC uses interest rate cap agreements to hedge against the negative impact of a significant and sustained rise in interest rates. Interest rate caps are contracts that require counterparties to pay LNC at specified future dates the amount, if any, by which a specified market interest rate exceeds the cap rate stated in the agreements, applied to a notional amount. As of December 31, 1997, LNC had agreements with notional amounts of $4.9 billion with cap rates ranging from 245 to 504 basis points above prevailing interest rates. The cap rates in some contracts increase over time. These agreements expire in 1998 through 2003.
LNC also uses swaptions to hedge against the negative impact of a significant and sustained rise in interest rates. Swaptions are options to enter into a swap at a specified future date. If the option is exercised at expiration, the option is either settled in cash or exercised into a swap agreement. LNC purchases swaptions to be settled in cash. At expiration, the counterparty is required to pay LNC the amount, if any, of the present value of the difference between the fixed rate on a market rate swap and the strike rate stated in the agreement, applied to a notional amount. As of December 31, 1997, LNC had agreements with notional amounts of $1.752 billion with strike rates ranging from 224 to 350 basis points above prevailing interest rates. These agreements expire in 2002 and 2003.
LNC uses exchange-traded financial futures contracts and options on financial futures to hedge against interest rate risks and to manage duration of a portion of its fixed maturity securities. Financial futures contracts obligate LNC to buy or sell a financial instrument at a specified future date for a specified price. They may be settled in cash or through delivery of the financial instrument. Cash settlements on the change in market values of financial futures contracts are made daily. Put options on a financial futures contract give LNC the right, but not the obligation, to assume a long or short position in the underlying futures contract at a specified price during a specified time period. As of December 31, 1997, LNC did not have any open futures or options on futures.
(1) The information shown is for the fixed maturity securities and mortgage loans that support these insurance contracts. (2) Includes minority interest-preferred securities of subsidiary companies. (3) Swaptions notional is shown converted to cap equivalent. (4) The indexes are a mixture of five-year and ten-year Constant Maturity Treasury ("CMT") and Constant Maturity Swap ("CMS"). (5) The CMT curve is the five-year constant maturity treasury forward curve.
2) Foreign Currency Risk Foreign Currency Denominated Investments. LNC invests in foreign currency securities for incremental return and risk diversification relative to United States Dollar-Denominated ("USD") securities. The fair value of foreign securities which are denominated in 16 different foreign currencies, as of December 31, 1997 was $519.8 million. LNC periodically uses a combination of foreign exchange forward contracts, foreign currency options, and foreign currency swaps to hedge some of the foreign exchange risk related to its investments in securities denominated in foreign currencies. The currency risk is hedged using foreign currency derivatives of the same currency as the bonds. Unhedged, a 10% adverse move in the currency would create a $52.0 million
Foreign Currency Options. A foreign currency option gives LNC the right, but not the obligation, to buy or sell a foreign currency at a specific exchange rate during a specified time period. LNC has historically used options that were slightly "out-of-the-money" resulting in a "corridor" of currency risk assumed, but limited the risk above the strike price. At December 31, 1997, LNC did not have any open positions in foreign currency options.
Foreign Currency Swaps. A foreign currency swap is a contractual agreement to exchange the currencies of two different countries pursuant to an agreement to re-exchange the two currencies at the same rate of exchange at a specified future date. As of December 31, 1997, LNC had a foreign currency swap with a notional amount of $15.0 million.
3) Equity Market Exposures LNC's revenues, assets, liabilities and derivatives are exposed to equity market risk.
Fee Revenues. The fee revenues of LNC's Investment Management segment and fees earned from variable annuities are exposed to the risk of a decline in equity market values. These fees are generally a fixed percentage of the market value of assets under management. In a severe equity market decline, fee income could be reduced by not only reduced market valuations but also by customer withdrawals. Such withdrawals from equity funds and accounts might be partially offset by transfers to LNC's fixed-income accounts and the transfer of funds to LNC by its competitors' customers.
10% Fair 10% Fair Carrying Fair Value Value December 31, 1997(in millions) Value Value Increase Decrease
Real Estate . . . . . . . . 576.0 621.3 683.4 559.2 Other Equity Interests . . . 202.1 245.5 270.1 220.9 Total . . . . . . . . $1,438.5 $1,527.2 $1,680.0 $1,374.4
Liabilities. LNC has an exposure to foreign currency equity risk with respect to unit-linked annuity policies issued in the UK. As of December 31, 1997, the aggregate U.S dollar equivalent amount of account value is $59.4 million. LNC also has a small exposure to U.S. equity markets through reinsurance contracts that reinsure equity-indexed annuities. The aggregate amount of account value of these annuities is $6.6 million. These risks are being hedged with equity derivatives as discussed below.
LNC uses OTC equity call options on the S&P 500 index to hedge against the increase in its liabilities resulting from certain reinsurance agreements which guarantee payment of the appreciation of the S&P 500 index on certain underlying annuity products. These call options require the counterparty to pay LNC at specified future expiration dates the amount, if any, of the percentage increase in the S&P 500 index over the strike price defined in the contract, applied to the notional amount. The reinsurance agreement then requires LNC to pay any appreciation on the S&P 500 index to the reinsurance client. As of December 31, 1997, LNC had agreements with notional amounts of $5.3 million. The call options expirations are matched to the liabilities and expire in 2005.
Default Risk. In assessing the risk that the rate of default losses for each category of asset may be higher than the rates assumed in pricing its products, LNC considers the entire $29.8 billion portfolio of invested assets, taking diversification into account. Of this total, $16.6 billion consists of corporate bonds and $3.3 billion consists of commercial mortgages. LNC manages the risk of adverse default experience on these investments by applying disciplined credit evaluation and underwriting standards, prudently limiting allocations to lower-quality, higher-yielding investments, and diversifying exposures by issuer, industry, region and property type. For each counterparty or borrowing entity and its affiliates, LNC's exposures from all transactions are aggregated and managed in relation to formal limits set by rating quality and industry group. LNC remains exposed to occasional adverse cyclical economic downturns during which default rates may be significantly higher than the long-term historical average used in pricing.
Although LNC generates adequate cash flow to meet the needs of its normal operations, periodically LNC may issue debt or equity securities to fund internal expansion, acquisitions, investment opportunities and the retirement of LNC's debt and equity. As of December 31, 1997, LNC had a shelf registration with an unused balance of $600 million that would allow LNC to issue debt or equity securities. In 1996, LNC filed another shelf registration for $500 million which included the right to offer various forms of hybrid securities. These securities, which have a combination of both debt and equity characteristics, are offered through a series of three newly formed trusts (Lincoln National Capital I, II and III). All of these trusts' common securities are owned by LNC. As of December 31, 1997, LNC had an unused balance of $185 million related to this hybrid security registration. Cash funds also are available from LNC's revolving credit agreement, which provides for borrowing up to $750 million (see note 5 to the consolidated financial statements on page 50).
This leaves a Board authorization to repurchase an additional $205.1 million of LNC's common stock. From January 1, 1998 through February 27, 1998 LNC purchased an additional 623,281 shares at a cost of $46.9 million. Also LNC issued 1,323,144 shares of LNC common stock in 1997 to purchase a subsidiary company (see note 12 to the consolidated financial statements on page 65).
Another transaction that occurred in 1997 that had a major impact on LNC's cash flow was the sale of a subsidiary for $2.65 billion (see note 11 to the consolidated financial statements on page 65). LNC used these proceeds to 1) repurchase $294.9 million of its own common stock, 2) retire $86.7 million in long-term debt and 3) $85.0 million to purchase 49% of Sequrous Serfin Lincoln. Also $447.6 million was set aside to pay the taxes related to the gain on sale of discontinued operations and $1.4 billion was set aside for use in purchasing a block of individual life insurance and annuity business in January 1998 (see note 12 to the consolidated financial statements on page 65). The remaining balance was applied to pay off a portion of LNC's short-term debt and invested for general corporate purposes which could include the purchase of additional subsidiary companies or blocks of business.
LNC's insurance subsidiaries are subject to certain insurance department regulatory restrictions as to the transfer of funds and payments of dividends to the holding company (see note 7 to the consolidated financial statements on page 53). However, these restrictions pose no short-term liquidity concerns for the holding company. The financial strength and stability of the subsidiaries permit ready access to short-term or long-term credit sources for the holding company.
(1) Net income (loss) from continuing operations for the second and fourth quarters of 1997 include special charges for changes in estimates on reserves. The discontinued operations amount for the fourth quarter of 1997 includes the gain on sale of the discontinued operations (see notes 2 and 11 to the consolidated financial statements on pages 43 and 64, respectively).
(2) Per share amounts for all periods shown are shown on a diluted basis in conformance with the provisions of Financial Accounting Standard No. 128 (see note 2 to the consolidated financial statements on page 43).
Consolidated Financial Statements The consolidated financial statements of Lincoln National Corporation and Subsidiaries follow on pages 34 through 66.
Securities available-for-sale, at fair value: Fixed maturity (cost: 1997-$22,626,036; 1996-$23,205,273) .... $24,066,376 $24,096,669 Equity (cost: 1997-$517,156; 1996-$434,502) ......... 660,428 557,565
Basis of Presentation. The accompanying consolidated financial statements include Lincoln National Corporation ("LNC") and its majority-owned subsidiaries. Through subsidiary companies, LNC operates multiple insurance and investment management businesses. Operations are divided into four business segments (see note 9 on page 60). Less than majority-owned entities in which LNC has at least a 20% interest are reported on the equity basis. These consolidated financial statements have been prepared in conformity with generally accepted accounting principles. Certain prior year amounts have been reclassified to conform to the current year presentation, including reclassification of amounts related to discontinued operations (see note 11 on page 64).
Realized gain (loss) on investments is recognized in net income, net of associated amortization of deferred acquisition costs and capital gains expenses, using the specific identification method. Changes in the fair values of securities carried at fair value are reflected directly in shareholders' equity, after deductions for related adjustments for deferred acquisition costs and amounts required to satisfy policyholder commitments that would have been recorded had these securities been sold at their fair value, and after deferred taxes or credits to the extent deemed recoverable.
The premiums paid for interest rate caps, swaptions and S&P call options are deferred and amortized to net investment income on a straight-line basis over the term of the respective derivative. Any settlement received in accordance with the terms of the interest rate caps is also recorded as net investment income. Realized gain (loss) from the termination of the interest rates caps is included in net income. Settlements received on swaptions are deferred and amortized over the life of the hedged assets as an adjustment to yield. Swaptions, spread-lock agreements, interest rate swaps and financial futures that hedge fixed maturity securities available-for-sale are carried at fair value. The change in fair value is reflected directly in shareholders' equity. Realized gain (loss) from the settlement of such derivatives is deferred and amortized over the life of the hedged assets as an adjustment to the yield. Over-the-counter call options are carried at fair value. The change in fair value is reflected directly in shareholders' equity. Any gain (loss) realized upon termination of these call options is included in net income. Foreign exchange forward contracts, which hedge LNC's investment in its British subsidiary, Lincoln National (UK), are carried at fair value. The change in fair value and realized gain (loss) on such contracts is reflected directly in the foreign currency translation adjustment component of shareholders' equity. Foreign exchange forward contracts, foreign currency options and foreign currency swaps, which hedge some of the foreign exchange risk of investments in fixed maturity securities denominated in foreign currencies, are carried at fair value. The change in fair value is included in shareholders' equity. Realized gain (loss) from the settlement of such derivatives is included in net income.
Loaned Securities. Securities loaned are treated as collateralized financing transactions and a liability is recorded equal to the repurchase price. It is LNC's policy to take possession of securities with a market value at least equal to the securities loaned. Securities loaned are recorded at fair value as long as the value of the related collateral is sufficient. LNC's agreements with third parties generally contain contractual provisions to allow for additional collateral to be obtained when necessary. LNC values collateral daily and obtains additional collateral when deemed appropriate.
Property and Equipment. Property and equipment owned for company use is carried at cost less allowances for depreciation.
Goodwill and Other Intangible Assets. The cost of acquired subsidiaries or blocks of business in excess of the fair value of net assets (goodwill) is amortized using the straight-line method over periods of 20 to 40 years which corresponds with the benefits expected to be derived from the acquisitions.
Other intangible assets for the non-insurance subsidiaries (i.e., institutional customer relationships, covenants not to compete and mutual fund customer relationships) have been recorded in connection with the acquisition of asset management services companies. These assets are amortized on a straight-line basis over 6 to 15 years.
The carrying value of goodwill and other intangible assets is reviewed periodically for indicators of impairment in value.
Insurance and Investment Contract Liabilities. The liabilities for future policy 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 and claim reserves for traditional life policies and immediate and deferred paid-up annuities are computed using a net level premium method and assumptions for investment yields, mortality and withdrawals based principally on company experience projected at the time of policy issue, with provision for possible adverse deviations. Interest assumptions for traditional direct individual life reserves for all policies range from 2.6% to 8.4% graded to 5.7% after 30 years depending on time of policy issue. Interest rate assumptions for reinsurance reserves range from 5.0% to 11.0% graded to 8.0% after 20 years. The interest assumptions for immediate and deferred paid-up annuities range from 4.75% to 11.0%.
Because of continuing adverse experience and worsening projections of future experience, LNC conducted an additional in-depth review of loss experience on its disability income business during the second quarter of 1997. As a result of this study, the reserve level was deemed to be inadequate to meet future obligations if current incident levels were to continue in the future. In order to address this situation, LNC's Reinsurance segment strengthened its disability income reserve by $92,800,000, wrote-off deferred acquisition costs of $71,100,000 and reduced related assets by $36,100,000. Combined these actions reduced net income by $130,000,000 or $1.23 per share ($200,000,000 pre-tax).
Disclosures about Segments of an Enterprise and Related Information. Financial Accounting Standard No. 131 entitled "Disclosures about Segments of an Enterprise and Related Information" ("FAS 131") issued in June 1997, was adopted by LNC in the second quarter of 1997 on a retroactive basis as permitted by the standard. Under FAS 131 business segments are defined on the same basis that the company is managed versus the product or market approach previously used. For LNC this redefinition involved moving LNC's major United Kingdom operation from within the Life Insurance and Annuities segment into a separate segment entitled "Lincoln UK." Data shown for all periods has been restated to conform to the current period presentation (see note 9 on page 60).
Year Ended December 31 (in millions) 1997 1996 1995 Fixed maturity securities . . . . . . . $1,832.1 $1,690.1 $1,610.1 Equity securities . . . . . . . . . . . 19.2 14.4 11.9 Mortgage loans on real estate . . . . . 279.2 292.7 268.5 Real estate. . . . . . . . . . . . . . . 99.4 125.4 117.9 Policy loans . . . . . . . . . . . . . . 44.5 40.7 36.6 Invested cash . . . . . . . . . . . . . 102.4 69.2 31.6 Other investments . . . . . . . . . . . 20.6 14.7 52.0 Investment revenue. . . . . . . . . . 2,397.4 2,247.2 2,128.6 Investment expense . . . . . . . . . . . 146.6 159.3 148.9 Net investment income . . . . . . . . $2,250.8 $2,087.9 $1,979.7
Year Ended December 31 (in millions) 1997 1996 1995 Fixed maturity securities available-for-sale .$549.0 $(735.5) $2,138.2 Equity securities available-for-sale . . . . 20.2 (42.1) 93.3 Total . . . . . . . . . . . . . . . . . $569.2 $(777.6) $2,231.5
Future maturities of fixed maturity securities available-for-sale are as follows: Amortized Fair December 31 (in millions) Cost Value Due in one year or less . . . . . . . . . $ 650.5 $ 653.5 Due after one year through five years . . 4,001.0 4,109.0 Due after five years through ten years . 5,876.6 6,124.4 Due after ten years . . . . . . . . . . 7,794.3 8,650.2 Subtotal . . . . . . . . . . . . 18,322.4 19,537.1 Mortgage-backed securities . . . . . . . . 4,303.6 4,529.3 Total . . . . . . . . . . . . . . . . $ 22,626.0 $ 24,066.4
Below 7%. . . . . . . . . . . . . . . $ 62.5 $ 59.6 $ 61.3 7% - 8% . . . . . . . . . . . . . . 1,675.7 1,645.3 1,691.5 8% - 9% . . . . . . . . . . . . . 1,372.7 1,322.8 1,396.5 Above 9% . . . . . . . . . . . . . . 1,316.4 1,275.9 1,380.0
Total . . . . . . . . . . . . . . $ 4,427.3 $ 4,303.6 $ 4,529.3
The quality ratings of fixed maturity securities available-for-sale are as follows:
December 31 (in millions) 1997 1996 Impaired loans with allowance for losses . . . . . . $41.2 $71.9 Allowance for losses. . . . . . . . . . . . . . . . . (5.0) (12.4) Impaired loans with no allowance for losses . . . . . -- 2.3 Net impaired loans . . . . . . . . . . . . . . . $36.2 $61.8
Year Ended December 31 (in millions) 1997 1996 1995 Balance at beginning-of-year . . . . . . . . . $12.4 $ 29.6 $ 62.7 Provisions for losses . . . . . . . . . . . . .8 3.1 14.2 Releases due to write-downs . . . . . . . . . -- -- (11.9) Releases due to sales . . . . . . . . . . . . . (4.8) (19.9) (20.2) Releases due to foreclosures. . . . . . . . . . (3.4) (.4) (15.2) Balance at end-of-year . . . . . . . . . . $ 5.0 $ 12.4 $ 29.6
Year Ended December 31 (in millions) 1997 1996 1995 Average recorded investment in impaired loans . $74.9 $139.6 $189.6 Interest income recognized on impaired loans . 7.0 12.7 16.9
As of December 31, 1997 and 1996, LNC had restructured loans of $38,500,000 and $39,600,000, respectively. LNC recorded $3,800,000 and $4,000,000 of interest income on these restructured loans in 1997 and 1996, respectively. Interest income in the amount of $3,900,000 and $4,000,000 would have been recorded on these loans according to their original terms in 1997 and 1996, respectively. As of December 31, 1997 and December 31, 1996, LNC had no outstanding commitments to lend funds on restructured loans.
An investment in real estate is considered impaired when the projected undiscounted cash flow from the investment is less than the carrying value. When LNC determines that an investment in real estate is impaired, it is written-down to reduce the carrying value to the estimated value.
Year Ended December 31 (in millions) 1997 1996 1995 Current . . . . . . . . . . . . . . . . $137.4 $129.8 $173.9 Deferred . . . . . . . . . . . . . . . (124.7) 17.9 (60.9) Total for Continuing Operations . . $ 12.7 $147.7 $113.0
Year Ended December 31 (in millions) 1997 1996 1995 Tax rate times pre-tax income from continuing operations . . . . . . . . . $12.2 $176.4 $145.0 Effect of: Tax-preferred investment income . . . . . (34.8) (25.6) (21.8) Change in valuation allowance . . . . . . 43.5 -- -- Other items . . . . . . . . . . . . . . (8.2) (3.1) (10.2) Provision for income taxes . . . . . $12.7 $147.7 $113.0
Effective tax rate . . . . . . . . . 36% 29% 27%
Significant components of LNC's net deferred tax asset (liability) for continuing operations are as follows:
Deferred tax liabilities: Deferred acquisition costs ............................. 271.2 367.0 Premiums and fees receivable ........................... 3.9 55.7 Investment asset related ............................... 27.9 43.9 Net unrealized gain on securities available-for-sale ... 520.0 337.2 Present value of business in-force ..................... 211.2 220.4 Other................................................... 101.2 146.0 Total deferred tax liabilities ....................... 1,135.4 1,170.2
LNC's Lincoln UK segment has incurred losses in its pension business which under U.K. tax law can only be utilized against its future pension business earnings. At December 31, 1997 the deferred tax asset related to these pension business losses was $92,000,000. The valuation allowance shown in the table above was established as an offset to this deferred tax asset.
Cash paid for Federal income taxes in 1997, 1996 and 1995 was $158,000,000, $143,800,000 and $38,300,000 respectively. The cash paid in 1995 is net of a $147,400,000 cash refund related to the carryback of 1994 capital losses to prior years.
At December 31, 1997, LNC had net operating loss carryforwards of $99,900,000 for Federal income tax purposes related to its foreign life reinsurance companies that expire in years 2005 through 2009. Delaware Management Holdings, Inc. ("Delaware"), acquired in 1995, has net operating loss carryforwards for Federal income tax purposes of $89,400,000 at December 31, 1997, which expire in the years 2002 through 2010. These carryforwards will only be available to reduce the respective taxable income of the foreign life reinsurance companies and Delaware.
Reinsurance transactions included in the income statement caption, "Insurance Premiums," are as follows:
The income statement caption, "Underwriting, Acquisition, Insurance and Other Expenses," includes amortization of deferred acquisition costs of $468,000,000, $428,500,000 and $327,400,000 for the years ended December 31, 1997, 1996 and 1995, respectively. An additional $(78,200,000), $(65,200,000) and $(85,200,000) of deferred acquisition costs was restored (amortized) and netted against "Realized Gain (Loss) on Investments" for the years ended December 31, 1997, 1996 and 1995, respectively.
December 31 (in millions) 1997 1996 Real estate. . . . . . . . . . . . . . . . . . . $ 50.2 $ 44.1 Property and equipment. . . . . . . . . . . . . . . 155.9 147.9
Details underlying the balance sheet caption, "Contractholder Funds," are as follows:
December 31 (in millions) 1997 1996 Premium deposit funds . . . . . . . . . . . . . . . $19,803.0 $20,894.5 Undistributed earnings on participating business . . 79.8 81.9 Other . . . . . . . . . . . . . . . . . . . . . . . . 180.6 189.0 Total . . . . . . . . . . . . . . . . . . . . . $20,063.4 $21,165.4
1998 - $12.0 2000 - $14.9 2002 - $ 20.0 1999 - 14.7 2001 - 18.5 Thereafter - 421.2
The amounts shown do not include future amortization associated with the purchase of a block of individual life insurance and annuity business in January 1998 (see note 12 to the consolidated financial statements on page 65).
December 31 (in millions) 1997 1996 Short-term debt: Commercial paper . . . . . . . . . . . . . . . . $286.3 $164.5 Other short-term notes . . . . . . . . . . . . 1.3 .7 Current portion of long-term debt. . . . . . . . 9.6 23.8 Total short-term debt . . . . . . . . . . . $297.2 $189.0
The commercial paper outstanding at December 31, 1997 and 1996, had a weighted average interest rate of approximately 5.83% and 5.87%, respectively.
1998 - $ 9.6 2000 - $ .1 2002 - $100.0 1999 - 100.1 2001 - .5 Thereafter - 313.3
LNC also has access to capital from minority interest in preferred securities of subsidiary companies. In May 1996, LNC filed a shelf registration with the Securities and Exchange Commission that would allow LNC to offer and sell up to $500 million of various forms of hybrid securities. These securities, which combine debt and equity characteristics, are offered through a series of three trusts (Lincoln National Capital I, II and III). 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 I, II and III are the notes receivable from LNC for such loans. Distributions are paid by these trusts to the preferred securityholders 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.
In July 1996, Lincoln National Capital I issued 8,600,000 shares or $215,000,000, 8.75% Quarterly Income Preferred Securities ("QUIPS"). In August 1996, Lincoln National Capital II issued 4,000,000 shares or $100,000,000, 8.35% Trust Originated Preferred Securities ("TOPrS"). Both issues mature in 2026 at $25 per share and are redeemable in whole or in part at LNC's option any time after 2001. LNC may offer and sell up to an additional $185,000,000 of securities under this shelf registration.
Financial Accounting Standard No. 123 entitled "Accounting for Stock-Based Compensation" ("FAS 123") issued in October 1995, was adopted by LNC as of December 31, 1995. Pursuant to the provisions of FAS 123, LNC has elected to continue its practice of recognizing compensation expense for its stock option incentive plans using the intrinsic value based method of accounting (see note 1 on page 43) and to provide the required pro forma information for stock options granted after December 31, 1994. Accordingly, no compensation expense has been recognized for stock option incentive plans. Had compensation expense for LNC's stock option incentive plans for options granted after December 31, 1994 been determined based on the estimated fair value at the grant dates for awards under those plans, LNC's pro forma net income and earnings per share for 1997, 1996 and 1995 would have been $925,994,000 ($8.90 per share), $510,518,000 ($4.84 per share) and $479,814,000 ($4.58 per share), respectively (a decrease of $7,994,000 or $.08 per share, $3,040,000 or $.03 per share and $2,372,000 or $.02 per share, respectively). These effects on pro forma net income and earnings per share of expensing the estimated fair value of stock options are not necessarily representative of the effects on reported net income for future years due to factors such as the vesting period of the stock options and the potential for issuance of additional stock options in future years.
The fair value of options granted after December 31, 1994, used as a basis for the above pro forma disclosures, was estimated as of the date of grant using a Black-Scholes option pricing model.
Year Ended December 31 1997 1996 1995 Dividend yield . . . . . . . . . . . . . . . . . 3.8% 4.1% 4.4% Expected volatility. . . . . . . . . . . . . . . 19.0% 18.0% 22.0% Risk-Free interest rate . . . . . . . . . . . . 6.6% 6.5% 6.3% Expected life (years). . . . . . . . . . . . . . 6 5 5
Year Ended December 31 1997 1996 1995 Restricted stock (number of shares). . . . . . . . 118,836 55,538 335,126 Weighted-average price per share at time of grant . $61.98 $46.16 $41.09
Statutory Information and Restrictions Net income as determined in accordance with statutory accounting practices for LNC's insurance subsidiaries was $345,200,000, $384,600,000 and $300,300,000 for 1997, 1996 and 1995, respectively. Statutory net income for 1997, 1996 and 1995, excluding LNC's foreign life reinsurance companies, was $299,100,000, $342,700,000 and $336,700,000, respectively.
United Kingdom Pension Products Operations in the U.K. include the sale of pension products to individuals. Regulatory agencies have raised questions as to what constitutes appropriate advice to individuals who bought pension products as an alternative to participation in an employer sponsored plan. In cases of inappropriate advice, an extensive investigation may have to be done and the individual put in a position similar to what would have been attained if the individual had remained in the employer sponsored plan. At December 31, 1997 and 1996, liabilities of $291,000,000, and $86,700,000, respectively, had been established for this issue. The December 31, 1997 amount includes a change in estimate for this liability (see note 2 on page 43). These liabilities, which are net of expected recoveries, have been established for the estimated cost of this issue following regulatory guidance as to activities to be undertaken. These liabilities were booked net of expected recoveries of $113,000,000 and $31,400,000, respectively, from previous owners of companies acquired over the last few years as specified in the indemnification clauses of the purchase agreements. These liabilities and recoveries are based on various estimates that are subject to considerable uncertainty. Accordingly, these liabilities may prove to be deficient or excessive. However, it is management's opinion that such future development will not materially affect the consolidated financial position of LNC.
1998 - $49.4 2000 - $44.6 2002 - $ 35.4 1999 - 47.6 2001 - 41.2 Thereafter - 222.6
Associated with these transactions, LNC's foreign insurance companies have obtained letters of credit in favor of various unaffiliated insurance companies from which LNC assumes business. This allows the ceding companies to take statutory reserve credit. The letters of credit issued by the banks represent a guarantee of performance under the reinsurance agreements. At December 31, 1997, there was a total of $680,700,000 in outstanding bank letters of credit. In exchange for the letters of credit, LNC paid the banks approximately $1,380,000 in fees in 1997.
Derivatives LNC has derivatives with off-balance-sheet risks whose notional or contract amounts exceed the credit exposure. LNC has entered into derivative transactions to reduce its exposure to fluctuations in interest rates, the widening of bond yield spreads over comparable maturity U.S. Government obligations, increased liabilities associated with certain reinsurance agreements, foreign exchange risks and fluctuations in the FTSE and S&P indexes. In addition, LNC is subject to the risks associated with changes in the value of its derivatives; however, such changes in value generally are offset by changes in the value of the items being hedged by such contracts. Outstanding derivatives with off-balance-sheet risks, shown in notional or contract amounts along with their carrying value and estimated fair values, are as follows:
Swaptions. Swaptions, which expire in 2002 through 2003, entitle LNC to receive settlement payments from the counterparties on specified expiration dates, contingent on future interest rates. For each swaption, the amount of such settlement payments, if any, is determined by the present value of the difference between the fixed rate on a market rate swap and the strike rate multiplied by the notional amount. The purpose of LNC's swaption program is to protect its annuity line of business from the effect of rising interest rates. The premium paid for the swaptions is included in other long-term investments (amortized cost of $20,200,000 as of December 31, 1997) and is being amortized over the terms of the agreements. This amortization is included in net investment income.
Spread-Lock Agreements. Spread-lock agreements provide for a lump sum payment to or by LNC, depending on whether the spread between the swap rate and a specified Government note is larger or smaller than a contractually specified spread. Cash payments are based on the product of the notional amount, the spread between the swap rate and the yield of an equivalent maturity Government security, and the price sensitivity of the swap at that time. The purpose of LNC's spread-lock program is to protect a portion of its fixed maturity securities against widening spreads.
Interest Rate Swaps. LNC uses interest rate swap agreements to hedge its exposure to floating rate bond coupon payments, replicating a fixed rate bond. An interest rate swap is a contractual agreement to exchange payments at one or more times based on the actual or expected price, level, performance or value of one or more underlying interests rates. LNC is required to pay the counterparty to the agreements the stream of variable coupon payments generated from the bonds, and in turn, receives a fixed payment from the counterpart, at a predetermined interest rate. The net receipts/payments from interest rate swaps are recorded in net investment income.
Foreign Exchange Forward Contracts (Foreign Subsidiary). LNC has used foreign exchange forward contracts, which are traded over-the-counter, to hedge the foreign exchange risk assumed with its investment in its U.K. subsidiary, Lincoln National (UK). The foreign exchange forward contracts obligated LNC to deliver a specified amount of currency at a future date at a specified exchange rate. LNC terminated these contracts in the third quarter of 1996.
LNC is exposed to credit loss in the event of nonperformance by counterparties on interest rate cap agreements, swaptions, spread-lock agreements, interest rate swaps, call options, foreign exchange forward contracts, foreign currency options and foreign currency swaps. 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 for such agreements with each counterparty if the net market value is in LNC's favor. At December 31, 1997, the exposure was $26,400,000.
Derivatives. LNC's derivatives include interest rate cap agreements, swaptions, spread-lock agreements, foreign currency exchange contracts, financial futures contracts, interest rate swaps, call options, foreign currency options and foreign currency swaps. Fair values for these contracts are based on current settlement values. These values are based on: 1) quoted market prices for the foreign currency exchange contracts and financial futures contracts and; 2) brokerage quotes that utilized pricing models or formulas using current assumptions for all other swaps and agreements.
The carrying values and estimated fair values of LNC's financial instruments are as follows:
As of December 31, 1997 and 1996, the carrying value of the deposit contracts and certain guaranteed contracts is net of deferred acquisition costs of $96,400,000 and $176,000,000, 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.
"Other Operations" includes operations not directly related to the business segments and unallocated corporate items (i.e., corporate investment income, interest expense on corporate debt and unallocated overhead expenses). LNC's other operations also includes data for: 1) the 29% owned unconsolidated affiliate engaged in the life-health benefit business prior to the sale of this interest in 1995 and, 2) its investment management company that services LNC's business segments.
Acquisitions and dispositions of affiliated companies during 1994 - 1996 (see note 11 on page 64) resulted in LNC's foreign operations being more significant relative to LNC's consolidated totals. Substantially all of LNC's foreign operations are conducted by Lincoln National (UK) plc, a United Kingdom company. The data for this company is shown above under the Lincoln UK segment heading.
Foreign intracompany revenue is not significant. All earnings from LNC's U.K. operations have been retained in the U.K.
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 eight 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.
On June 30, 1995, Dia-ichi Mutual Life Insurance Company, the owner of LNC's series E and F preferred stock which was 5 1/2% cumulative convertible exchangeable, converted its entire holdings to LNC common stock. Based on a conversion rate of two shares of common stock for each share of series E and F preferred stock, 2,201,443 shares of series E and 2,216,454 shares of series F were converted into 8,835,794 shares of common stock.
In April 1995, LNC completed the acquisition of Delaware Management Holdings, Inc. ("Delaware"). Delaware provides a variety of asset management services through its operating companies. The purchase price, including LNC's expenses associated with the acquisition, was $305,000,000. This acquisition also involved the assumption of $25,000,000 in short-term debt and $180,000,000 (face amount) in long-term debt. In May 1995, this debt was repaid from the proceeds of an LNC debt offering of $200,000,000 plus available cash. This acquisition, which was accounted for using purchase accounting, resulted in goodwill of $339,900,000 and other intangible assets of $131,500,000. The results of Delaware's operations are included in LNC's consolidated financial statements from April 3, 1995. The Delaware acquisition agreement included a provision for contingent payments of up to $22,500,000 based on the levels of investment management revenues from the date of acquisition through December 31, 1996, with any such additional payments to be accounted for as goodwill. Payments under this provision totaling $9,300,000 million were made during 1997.
In May 1996, 16.7% of American States Financial Corporation ("ASFC"), the holding company of LNC's principal property-casualty subsidiary, was sold to the public in the form of an initial public offering of its common stock. ASFC received net proceeds of $215,200,000 from the sale of this 16.7% minority interest and LNC recorded a non-taxable realized gain, net of expenses, directly in shareholders' equity of $15,000,000. LNC continued to fully consolidate this operation within its financial statements and tax reporting until the sale of the remaining 83.3% (see below).
In October 1996, LNC purchased a block of group tax-qualified annuity business from UNUM Corporation's affiliates. The bulk of the transaction was completed in the form of a reinsurance transaction, which resulted in a ceding commission of $71,800,000. The ceding commission, along with $67,000,000 to cover expenses associated with the purchase, represents the present value of business in-force and accordingly has been classified as an intangible asset. LNC's assets and policy liabilities and accruals increased $3,200,000,000 as a result of this transaction.
On January 2, 1998, LNC completed the purchase of a block of individual life insurance and annuity business from CIGNA Corporation for approximately $1,414,000,000. This acquisition involved additional expenditures to cover expenses associated with the purchase and to provide additional capital for the Life Insurance and Annuities segment to support this business totaling $228,500,000. This transaction is being accounted for using purchase accounting and, accordingly, the operating results generated by this block of business after the closing date will be included in LNC's consolidated financial statements from the closing date. At the time of closing this block of business had liabilities, measured on a statutory basis, of $5,500,000,000 that became LNC's obligation. LNC also received assets, measured on a historical statutory basis, equal to the liabilities. During 1997, this block produced premiums, fees and deposits of $1,181,000,000 and earnings of $98,000,000 on a basis of generally accepted accounting principles and is prior to any adjustments that will be required by purchase accounting. A preliminary application of purchase accounting to this block of business indicates that intangible assets and goodwill will be approximately $1,400,000,000. The additional analysis of this block of business that will occur during 1998 may result in a change in this amount.
In connection with the completion of this acquisition, LNC expects to record a charge to its Life Insurance and Annuities segment during the first quarter of 1998 of approximately $20,000,000 ($31,000,000 pre-tax). This charge will cover certain costs of integrating the existing operations with the new block of business.