(in millions, except per share data) Year Ended December 31 1999 1998 1997 1996 1995 ------------------------------------------------------------------------------------------------------ Total revenue $6,803.7 $6,087.1 $4,898.5 $4,733.6 $4,586.5
Per Share Data: (2) Shareholders' equity (Securities at market) $21.76 $26.59 $24.63 $21.50 $20.95 Shareholders' equity (Securities at cost) 24.14 23.86 22.48 19.51 17.61
The following table presents a reconciliation of "Income (Loss) from Continuing Operations" to "Net Income from Continuing Operations" determined in accordance with generally accepted accounting principles. Income (Loss) from Continuing Operations is LNC's alternative measure of operating performance which excludes the after-tax realized gain (loss) on investments and associated items, gain (loss) on sale of subsidiaries and restructuring charges.
(1) Income (loss) from continuing operations for 1999 includes changes in estimates of reserves for 1) Lincoln UK' s pension business of $126.1 million, after-tax and 2) Reinsurance's HMO excess-of-loss reinsurance programs of $25.0 million, after-tax and workers' compensation carve-out business underwritten by Unicover Managers, Inc. of $40.4 million, after-tax; and includes a tax benefit of $42.1 million relating to the decision to explore exiting the UK insurance market. Also, 1997 and 1995 include the impact of the changes in estimate of the reserve level needed for LNC's disability income business ($130.0 million and $121.6 million, after-tax, respectively). Finally, 1997 includes changes in estimates for reserves for 1) Lincoln UK's pension business of $174.9 million, after-tax and 2) Reinsurance's personal accident programs of $113.7 million, after-tax.
The pages that follow review LNC's results of operations and financial condition including liquidity and cash flows, and capital resources. Historical financial information is presented and analyzed. Where appropriate, factors that may affect future financial performance are identified and discussed. Certain statements made in this report are "forward-looking statements" within the meaning of the Securities Litigation Reform Act of 1995 (the "Act"). Forward-looking statements include, without limitation, any statement that may predict, forecast, indicate or imply future results, performance or achievements, and may contain words like: "believe", "anticipate", "expect", "estimate", "project", "will", "shall" and other words or phrases with similar meaning. Forward-looking statements involve risks and uncertainties which may cause actual results to differ materially from the forward-looking statements. These risks and uncertainties include, among others: subsequent significant changes in the company (e.g., acquisitions and divestitures), financial markets (e.g., interest rates and securities markets), legislation (e.g., taxes and product taxation), generally accepted accounting principles, regulations (e.g., insurance and securities regulations), debt and claims paying ratings issued by nationally recognized statistical rating organizations or A.M. Best Company, Inc., acts of God (e.g., hurricanes, earthquakes and storms), stability of foreign governments in countries that LNC does business, other insurance risks (e.g., policyholder mortality and morbidity) and competition.
This "Management's Discussion and Analysis" should be read in conjunction with the audited consolidated financial statements and accompanying notes presented on pages 38 through 76.
Increase (Decrease) Year Ended December 31 (in millions) 1999 1998 1997 1999 1998 ------------------------------------------------------------------------------------------------------ Continuing Operations: Life insurance and annuity premiums $ 1,183.0 $985.6 $756.2 20% 30% Health premiums 698.5 635.1 572.5 10% 11% Insurance fees 1,537.6 1,274.6 832.2 21% 53% Investment advisory fees 223.8 227.1 204.9 (1%) 11% Net investment income 2,807.5 2,681.4 2,250.8 5% 19% Equity in earnings of unconsolidated affiliates 5.8 3.3 2.1 Realized gain on investments 3.0 19.0 122.6 Other revenue and fees 344.5 261.0 157.2 32% 66% Life insurance and annuity benefits 3,145.3 2,762.0 2,358.7 14% 17% Health benefits 659.7 566.9 833.1 16% (32%) Underwriting, acquisition, insurance and other expenses 2,295.0 1,943.7 1,579.3 18% 23% Interest and debt expenses 133.7 117.1 92.5 14% 27% Federal income taxes 109.6 187.6 12.7 ----------- --------- --------- Net Income from Continuing Operations 460.4 509.8 22.2
Net income for 1999 was $460.4 million compared with $509.8 million in 1998. Excluding after-tax realized gain on investments, restructuring charges, 1999 special additions to HMO excess-of-loss and UK pension product reserves, a charge for estimated settlement costs for participation in workers' compensation carve-out business and a 1999 tax benefit related to the decision to explore exiting the UK insurance market, LNC earned $624.9 million for 1999 compared to $530.4 million in 1998. This increase was the result of increased earnings in the Life Insurance and Annuities, Reinsurance and Investment Management segments. Net income for 1998 was $509.8 million compared with $934.0 million in 1997. Excluding after-tax realized gain on investments, gain on sale of subsidiaries, restructuring charges, discontinued operations and the 1997 special additions to the disability income, personal accident programs and UK pension product reserves, LNC earned $530.4 million for 1998 compared to $368.0 million in 1997. This increase was the result of increased earnings from each of the business segments. In the fourth quarter of 1997, Other Operations benefited from earnings on proceeds from discontinued operations. This benefit did 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 11 to the consolidated financial statements). For further discussion of the results of operations, see the discussion of the results of operations by segment starting on page 10.
As a result of trends in the UK for pension and life insurance businesses, management has engaged outside advisors to explore the exit of the UK insurance market. This process will include a review of a range of strategic options including the potential sale of the Lincoln UK insurance business.
Lincoln Life, which is based in Fort Wayne, Indiana, is the 7th largest life insurer in the United States when measured by assets (Best's Review, Life/Health Edition, July 1999). First Penn, which is headquartered in Oakbrook Terrace, Illinois, markets life and annuity products through broker/dealers and banks. Lincoln Life New York, which is based in Syracuse, New York, provides group tax-qualified annuities and other insurance products in the state of New York. LFA and Sagemark, which are based in Hartford, Connecticut provide financial and estate planning services.
Year Ended December 31 1999 1998 1997 1996 1995 ------------------------------------------------------------------------------------------------------ Financial Results by Source (in millions) Annuities $312.3 $257.6 $203.0 $165.0 $149.3 Insurance 230.3 147.0 36.1 36.4 31.2 Disability Income (2) -- -- -- -- (18.3) Other (42.2) 0.6 23.4 20.4 34.5 ----------- --------- --------- --------- --------- Income from Operations 500.4 405.2 262.5 221.8 196.7 Realized Gain on Investments 4.0 2.6 44.0 37.4 78.8 Restructuring Charge -- (20.0) -- -- -- ----------- --------- --------- --------- --------- Net Income $504.4 $387.8 $306.5 $259.2 $275.5
December 31 (in billions) 1999 1998 1997 1996 1995 ------------------------------------------------------------------------------------------------------ Annuity and Insurance Account Values Annuities $59.7 $51.5 $44.6 $38.0 $30.3 Reinsurance Ceded -- Annuities (1.4) (1.6) (1.8) (1.8) (1.7) Universal and Variable Life Insurance 8.4 7.4 3.0 2.9 2.6 Interest-Sensitive Whole Life 2.0 1.8 -- -- -- ----------- --------- --------- --------- --------- Total Account Values $68.7 $59.1 $45.8 $39.1 $31.2
In Force -- Face Amount Universal Life and Other $109.9 $105.8 $32.8 $32.9 $32.2 Term Insurance 85.7 67.1 30.3 16.3 3.8
(2) Lincoln stopped writing disability income coverages on a direct basis at the end of March 1996. The administration of this business was moved to the Reinsurance segment at the end of September 1995.
The 23% increase in income from operations in 1999 was due to continued double-digit growth in earnings from both the life insurance business (57%) and annuities business (21%). The 54% increase in income from operations in 1998 was due to growth in earnings from both the life insurance business (307%) and annuities business (27%).
Life insurance first year premiums increased by $163.4 million or 40% over 1998 and deposits in the universal life, variable life and interest-sensitive life insurance products were $1.7 billion in 1999, a 42% increase over the 1998 deposits of $1.2 billion. Investment margins and insurance fee income increase proportionately with the increase in account values for universal life, variable life and interest-sensitive life products. Account values for these insurance products increased $1.2 billion or 13% over 1998 due to net deposits of $247 million and investment growth.
Life insurance results for 1998 were driven by increased sales volume of universal life and variable life insurance products which drove higher investment margins and fee income attributable to increased account values of universal life, variable life and interest-sensitive life insurance contracts. The increase in sales volume, investment margins and fee income was primarily due to the acquisitions noted above. These acquisitions enabled LNC to improve scale significantly from 1997 (see Note 11 to the consolidated financial statements for further discussion of the acquisitions). Life insurance first year premiums increased $201 million or 98% from 1997 and deposits in universal life, variable life and interest-sensitive life insurance contracts increased $824 million or 215% from 1997. It should be noted that interest-sensitive life insurance products were acquired as part of the CIGNA acquisition in 1998 and accounted for $340 million of the increase in deposits noted above.
Key to sustaining profitable future earnings growth for both fixed and variable annuity products is the ability to attract new deposits and to retain existing accounts. For 1999, total annuity deposits were $4.7 billion and withdrawals were $5.9 billion, resulting in a net cash outflow of $1.2 billion. In 1998, annuity deposits totaled $3.9 billion and withdrawals were $5.1 billion, for a net cash outflow of $1.2 billion. In 1997, deposits and withdrawals were both about $4 billion, resulting in a net cash inflow of $0.1 billion. The 21% growth rate in 1999 annuity deposits reflects LNC's strong mix of product and distribution networks; this bodes well for future profitability.
In looking at the trend of annuity withdrawals, it is important to look beyond the mere total dollar amount of withdrawals and assess how total withdrawals compare to total retained account values. These measures of account persistency are referred to as lapse rates, which are key elements to assessing underlying profitability. By comparing actual lapse rates to the rates assumed by LNC's pricing actuaries in designing the annuity product, it is possible to gauge whether performance is better or worse than expected. In the aggregate, the lapse rates for 1999, 1998 and 1997 have been more favorable than expected in pricing assumptions. This has been a contributing factor in the strong earnings growth for these years.
Another important aspect of analyzing the impact of net cash flows is to review the underlying number of new accounts compared to the number of accounts leaving. Because a typical account leaving LNC has grown over time, due to the strong performance of the financial markets, the trend in the number of annuity accounts cannot be measured by just looking at net cash flows. Here again, LNC's experience has been favorable, with the number of new annuity accounts established in 1999 significantly exceeding the number of accounts exiting.
LNC is addressing this matter on a number of fronts. To help retain existing business, LNC is providing broker/dealer compliance officers and individual brokers with enhanced persistency data for their accounts to help ensure that only suitable replacement activity occurs. LNC is also working with these firms to develop solutions to reduce the volume of replacements occurring and to identify opportunities where assets may be retained within an alternative Lincoln product.
Lincoln Life's and Lincoln Life New York's wealth accumulation and wealth protection products include fixed and variable annuities; universal, variable universal, term and whole life insurance; and employer-sponsored retirement plans. These products are sold in 50 states through the 58 regional offices of LFA and Sagemark, securities broker/dealers, and the life brokerage system. Combined, these distribution networks include more than 2,100 career agents, 35,000 life insurance brokers and 7,600 bank agents as well as 60,000 stockbrokers and financial planners. Annuity products are also sold through American Funds Distributors ("AFD") and Delaware Distributors, L.P.
As part of LFA's commitment to capitalize on opportunities in the employer-sponsored market, the Fringe Benefit Division was formed in 1999. This group consists of 240 financial planners from the LFA career system and provides a specialized marketing focus at a lower distribution cost -- two critical success factors in this evolving market.
The life brokerage system, a network of life insurance wholesalers, has access to targeted distribution channels through managing general agents; national broker/dealers; and independent financial planners, brokers and dealers. The life brokerage system currently has access to more than 36,000 life insurance brokers across the country. In 1999, this distribution channel generated $200 million of first year premiums which was three times the amount generated in 1998.
First Penn offers linked benefit, universal and term life insurance through stockbrokers, financial planners, banks, independent agents and LFA. Life products are available for individual and work-site markets. First Penn designs, manages distribution and administers fixed annuities sold through banks for Lincoln Life.
Lincoln Life also introduced the American Legacy Shareholder's Advantage, a new "A" share product, on a limited basis in 1999. Shareholder's Advantage was specifically designed for the long-term investor who is concentrating on retirement savings. The product has one of the lowest annual expenses of any variable annuity currently sold by financial professionals.
The Delaware-Lincoln ChoicePlusSM variable annuity product was introduced in the fourth quarter of 1998 and generated sales of more than $500 million in its first year on the market. Plans for 2000 include the addition of new funds offered by the product and introducing the product in New York.
Profile: Lincoln UK offers life, investment, protection and retirement planning products primarily through 1,450 direct sales representatives and tied agents. Lincoln UK sells predominantly unit-linked products where the investment risk is borne by the policyholder. These products are similar to the variable life products sold in the United States. Home office operations are divided between Uxbridge, Middlesex and Barnwood, Gloucester, England.
(1) Income (loss) from operations and net income (loss) for 1999 and 1997 include charges of $126.1 million ($194.0 million pre-tax) and $174.9 million ($199.4 million pre-tax) for changes in estimate of the cost of settling pension mis-selling liabilities and 1999 includes a tax benefit of $42.1 million relating to the decision to explore exiting the UK insurance market (see below for discussion of these special items in 1999).
(2) Net Initial Commission Value is a measure used by Lincoln UK to measure sales progress and future profitability.
The Lincoln UK segment reported net income (loss) of $(18.2) million in 1999, $71.7 million in 1998 and $(106.8) million in 1997. Income (loss) from operations was $(13.9) million in 1999, $70.9 million in 1998 and $(108.3) million in 1997. Income from operations excluding special charges in 1999 and 1997 for changes in estimate of the cost of settling pension mis-selling liabilities and the 1999 tax benefit relating to the decision to explore exiting the UK insurance market was $70.1 million in 1999, $70.9 million in 1998 and $66.6 million in 1997.
The $0.8 million decrease in income from operations excluding above special items of $84.0 million ($126.1 million pension mis-selling costs less $42.1 million tax benefit) in 1999 was due primarily to relatively flat operating revenues and increased expenses. Operating revenues increased $5.0 million or 1% in 1999 due primarily to an increase in revenues generated by the increase in unit-linked assets of $0.9 billion or 14% between years. This was partially offset by a decrease in life insurance and annuity premiums on non-linked business caused by an industry-wide decrease in demand for pension products and product repricing. The increase in the unit-linked assets was mainly due to market appreciation. The industry-wide decrease in demand for pension products was due to the advent of the Stakeholder Pension to be launched in 2001. Benefits expense excluding the reserve strengthening noted above was flat between years. Underwriting, acquisition, insurance and other expenses increased by $23.1 million or 13% due primarily to the costs related to the strategic review process initiated in 1999 (see below for further discussion of this item).
Restructuring Charge: During the fourth quarter of 1999, LNC recorded a restructuring charge in its Lincoln UK segment of $6.5 million after-tax ($10.0 million pre-tax). The objective of this restructuring plan is to reduce operating costs by consolidating and eliminating redundant staff functions and facilities. This charge was included in Underwriting, Acquisition, Insurance and Other Expenses on the Consolidated Statement of Income for the year ended December 31, 1999. The restructuring plan identified the following activities and associated costs to achieve the objectives of the restructuring plan: (1) severance and termination benefits of $3.9 million related to the elimination of 119 positions and (2) other costs of $6.1 million primarily related to the remaining lease payments on closed facilities. Expenditures and write-offs under the restructuring plan began in the fourth quarter of 1999 and are expected to be complete by the second quarter of 2001. As of December 31, 1999, $1.2 million (pre-tax) has been expended or written-off under this restructuring plan and 35 positions have been eliminated.
Outsourcing of Investment Management to Goldman Sachs: In October 1999, Lincoln UK announced the appointment of GSAM to manage its unit-linked and unit trust investment funds which had assets at December 31, 1999 of $5.3 billion. The transition of the management of the assets to GSAM will be completed in early 2000. GSAM is a globally recognized investment manager with over $190 billion in assets under management. GSAM will manage portfolios in UK, European and Japanese common stock and balanced products. The strength of this union lies in GSAM's strong, risk-managed investment philosophy combined with Lincoln UK's wide distribution network.
Outlook: During 2000, Lincoln UK will continue to progress towards the achievement of its strategic review initiatives. Despite the challenging regulatory environment and the uncertainty surrounding LNC's ownership of Lincoln UK, Lincoln UK's management believes that its revamped product offerings place it in a strong position versus the competition and will provide its highly trained sales force with the tools to better service their clients. Also, Lincoln UK anticipates that its outsourcing agreement with GSAM will not only enhance product performance, but will provide marketing opportunities and increased access to retail distribution channels.
Lincoln Re's market positioning strategy is to distinguish itself from competitors that pursue traditional risk-transfer commodity business by providing innovative, tailored programs to its clients. To this end, Lincoln Re uses a mass customization approach. This involves packaging and distributing modular pricing, underwriting, systems, alliance resources, marketing consultation, product development and claims management components to meet the needs of client companies.
Lincoln Re uses a knowledge-based approach to reinsurance that distinguishes it as a leader in an increasingly competitive marketplace. Systems developed by Lincoln Re are used throughout the insurance industry. This approach to deploying Lincoln Re's intellectual capital promotes customer retention and the development of new customer relationships globally.
Foremost among Lincoln Re's proprietary systems is Lincoln National Risk Management's patented Life Underwriting System, a state-of-the-art risk management technology. Direct life insurance companies who license the system represent a significant portion of the total life insurance sold in the U.S. In 1998, Lincoln Re was granted a second patent to protect its Lincoln Mortality System™ and other automated decision-making systems. Other proprietary systems assist health insurers, claims processors and agents. Datalliance™, is an electronic data interchange that can link agents, insurers, information sources, medical labs and reinsurers.
Results of Operations (1): Lincoln Re's financial results, sales and in-force were as follows:
Realized Gain (Loss) on Investments (1.4) 0.7 15.2 11.7 10.7 Restructuring Charge (3.2) -- -- -- -- ----------- --------- --------- --------- --------- Net Income (Loss) (2) $33.7 $102.2 $(136.4) $85.7 $(42.0)
Individual Life Sales -- Face Amount (in billions) $116.9 $78.1 $39.5 $26.6 $22.7
(1) The 1995-1998 data was restated from prior year to identify exited businesses including carrier medical, HMO excess-of-loss reinsurance and personal accident programs previously reported in Group Markets, Seguros Serfin Lincoln previously reported in Other and Disability Income.
The increase in income from operations (exclusive of special charges in 1997) of $9.4 million or 10% in 1998 was the result of increased sales volumes in the individual life reinsurance business offset by flat sales volumes and increased benefits payments in the group markets business. The individual life business experienced a $129.7 million or 26% increase in revenues and $11.6 million or 16% increase in earnings from 1997. The group markets business had a decrease in earnings of $1.8 million or 53% from 1997.
Individual Markets: Strong sales in recent years contributed to record income from operations for individual markets in 1999. Income from operations was $91.9 million, up nearly 10 percent over 1998. Favorable life mortality throughout the year was an integral factor in the strong performance. Sales volume, measured by face amount of new business, was a record $116.9 billion for the year, up 50 percent over 1998. Life insurance in-force reached a record $340.8 billion, a 36 percent increase over the prior year.
HMO Excess-of-Loss Reinsurance Programs: During the third quarter of 1999, reported claims experience for certain HMO excess-of-loss reinsurance programs deteriorated causing loss ratios to significantly exceed pricing assumptions. The unfavorable loss ratio development related primarily to business written in 1998 and 1997. Time lags in the reporting of claims experience to Lincoln Re by clients and larger than anticipated costs for prescription drugs were significant factors that led to losses exceeding pricing assumptions. As a result of these developments, the reserve level for these programs was deemed inadequate to meet future obligations. Consequently, Lincoln Re took a charge in the third quarter of 1999 of $25.0 million after-tax or $0.12 per share ($38.5 million pre-tax) to strengthen reserves for claims on the HMO excess-of-loss reinsurance programs.
As a result of the decision to exit the HMO excess-of-loss business, LNC recorded a charge in the Reinsurance segment of $3.2 million after-tax ($4.9 million pre-tax) for employee severance and other costs related to the discontinuance of this business. The restructuring plan identified the following activities and associated costs to achieve the objectives of the restructuring plan: (1) severance and termination benefits of $2.4 million related to the elimination of 71 positions and (2) other costs of $2.5 million. This charge was included in Underwriting, Acquisition, Insurance and Other Expenses on the Consolidated Statement of Income for the year ended December 31, 1999. Activities under the restructuring plan began in the third quarter of 1999 with expenditures expected to be paid out under this restructuring plan as the discontinuance of this line of business is completed. As of December 31, 1999, $0.9 million (pre-tax) has been expended under this restructuring plan and 16 positions have been eliminated.
Disability Income: Lincoln Life discontinued writing disability income insurance in early 1996. The block of business was subsequently transferred to Lincoln Re where it has been managed along with a block of reinsurance disability income business. In May 1999, LNC announced an agreement to transfer a block of direct individual disability income business to MetLife. The transaction, which was completed in the fourth quarter of 1999, freed up approximately $100 million in capital required to support this business. Under the agreement, MetLife will provide administrative services and assume liability under an indemnity reinsurance agreement for approximately $65 million of annual disability income premium. Lincoln Re transferred to MetLife cash of $490.4 million equal to statutory reserves, net of purchase price consideration. A gain on sale of $56.7 million was deferred and will be recognized in future periods over the premium-paying period of the business.
Seguros Serfin Lincoln: In December 1997, LNC invested $85 million for a 49% share of Seguros Serfin Lincoln ("SSL"), a Mexican bancassurance company, that sells life, auto and homeowners insurance to the customers of Banca Serfin. Grupo Financiero Serfin S.A. ("GFS") owns 51% of SSL and 100% of Banca Serfin. On July 8, 1999, the private shareholders of GFS declined to contribute additional capital to Banca Serfin as required by the Mexican Government. Accordingly, the Bank Savings Protection Institute ("IPAB"), a government agency, took control of GFS. IPAB has injected capital into Banca Serfin and has indicated its intent to place GFS up for sale.
In 1999, the Investment Management segment was reorganized as follows: 1) LNC's internal investment advisor, Lincoln Investment Management, was moved from Other Operations to this segment and 2) Lincoln Life's 401(k) business was moved from the Life Insurance and Annuities segment to this segment.The integration of the 401(k) businesses resulted in combined retirement assets of $9.8 billion at year end. This combination will result in a broader product range that is better serviced and has the potential for better long-term performance.
Vantage invests in undervalued companies that have strong potential for above-average growth. It employs a disciplined, systematic, risk-controlled investment approach, which seeks to deliver growth at a reasonable price (an investment style abbreviated as "GARP"). Vantage is especially well known for its expertise in socially responsible investing, the practice of aligning investment objectives with social concerns in one investment portfolio.
Results of Operations (1): The Investment Management segment's financial results and assets under management were as follows:
December 31 (in billions) 1999 1998 1997 1996 1995 ------------------------------------------------------------------------------------------------------ Assets Under Management Regular Operations: Retail-Equity $23.4 $22.1 $17.8 $13.1 $10.0 Retail-Fixed 7.4 8.2 8.1 5.9 6.1 ----------- --------- --------- --------- --------- Total Retail 30.8 30.3 25.9 19.0 16.1
Institutional-Equity 23.6 24.2 24.9 22.9 21.6 Institutional-Fixed 7.0 7.0 5.7 3.6 3.0 ----------- --------- --------- --------- --------- Total Institutional 30.6 31.2 30.6 26.5 24.6
(2) Data shown in the 1995 column is for a partial year, as this segment was added in April 1995 following the acquisition of Delaware Management Holdings, Inc.
The Investment Management segment reported net income of $24.6 million in 1999, $22.0 million in 1998 and $6.1 million in 1997. Income (loss) from operations was $34.6 million for 1999, $20.9 million for 1998 and $(0.8) million for 1997.
Distribution: Multiple distribution channels allow the businesses in the Investment Management segment to deliver their broad range of products to an expanding community of retail and institutional investors. Delaware markets retail mutual funds through regional and national broker/dealers, financial planners, and insurance agents, including those associated with the regional marketing offices of LFA and banks. Institutional products are marketed primarily by each company's individual 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, annuity, and wrap assets totaled $30.8 billion at December 31, 1999 and $30.3 billion at December 31, 1998. Annuity assets for the Investment Management segment were $15.5 billion and $14.3 billion at the end of 1999 and 1998, respectively. Delaware, which manages the retail mutual funds, offered 74 open-end retail mutual funds and 8 closed-end funds at the end of 1999, compared to 69 and 8, respectively, at the end of 1998. These Delaware funds had assets under management of $13.8 billion at the end of both 1999 and 1998. Delaware's wrap assets increased 43% to $1.0 billion in 1999 from $0.7 billion in 1998. The remaining retail assets were wrap assets and mutual funds totaling $0.5 billion and $1.5 billion for 1999 and 1998, respectively, managed by Lynch & Mayer and Vantage.
Lynch & Mayer Restructuring Charge: During the first quarter of 1999, LNC recorded a restructuring charge in its Investment Management segment of $12.1 million after-tax ($16.9 million pre-tax). The objective of this restructuring plan is to downsize and consolidate the back office operations of Lynch & Mayer into Delaware, in order to reduce ongoing operating costs and eliminate redundant facilities within this business segment. This charge was included in Underwriting, Acquisition, Insurance and Other Expenses on the Consolidated Statement of Income for the year ended December 31, 1999. The restructuring plan identified the following activities and associated costs to achieve the objectives of the restructuring plan: (1) severance and termination benefits of $2.8 million related to the elimination of 34 positions, (2) write-off of impaired assets of $9.8 million and (3) other costs of $4.3 million. Expenditures and write-offs under the restructuring plan began in the first quarter of 1999.
In the international equity category, Delaware's return of 17.40% for 1999 trailed the 29.96% return for its comparative Morgan Stanley Capital International Europe, Australia and Far East (EAFE) Index. For the five-year period ending December 31, 1999, Delaware's return was 14.68%, compared to 12.83% for the EAFE Index over the same period of time. This equity performance is the performance, before deduction of investment advisory fees, of one or more fully discretionary Delaware Investment Advisors Limited equity client accounts. Future returns will be reduced as a result of those advisory fees and any other expenses that may be incurred in connection with the account.
Among institutional investment managers, Delaware's All-Cap Growth Equity composite provided the firm's best performance for 1999. The All-Cap Growth product's net return of 79.4% for the year ending December 31, 1999 was significantly higher than the return of 33.82% for the benchmark Russell 3000 Index. Delaware's Large-Cap Value Equity composite in the large cap value equity category had a net return of (1.91%) for the year ending December 31, 1999. This return trailed the benchmark S&P/Barra Value Index return for 1999 of 12.73%.
Composite returns for Delaware All-Cap Growth Equity are derived from no-load, open-end mutual funds. The Large-Cap Value Equity composite consists of all fully discretionary separate accounts in this style. Performance results for these composites are shown as total returns, presented after deduction of Delaware's investment advisory fees, and are computed on a dollar-weighted rate-of-return basis. Past performance may not be indicative of future results.
Vantage manages the Lincoln Life Multi-Fund Social Awareness subaccount, which has performed exceptionally well over the long term. For the 10 years ended December 31, 1999, the Fund's annualized return was 17.34%, ahead of the 16.59% return for the top quartile variable annuity subaccount in the Morningstar Large Cap Blend category. This performance earned Vantage a 12th place ranking among 147 variable annuity subaccounts in that Morningstar category for 10 years.
Outlook: Although the Investment Management segment has experienced double-digit growth in income from operations over the last three years, this trend is not expected to continue in 2000 in part because there is uncertainty about the retention and growth of assets. The maintenance and/or growth of revenue levels depend on continued growth of the equity markets and retention and growth of assets under management. Revenues are generally a percentage of the market value of the assets under management. In a severe market decline, revenues would not only be reduced by a market reduction, but also by customer redemptions and withdrawals. In addition, expenses are expected to increase in 2000 due to LNC's intention to invest in the Investment Management segment to achieve better relative performance and better cash flows.
Results of Operations (1): Other Operations' financial results were as follows:
Investment Portfolio Composition and Diversification: Fundamental to LNC's investment policy is diversification across asset classes. LNC's investment portfolio, excluding cash and invested cash, is composed of fixed maturity securities; mortgage loans on real estate; real estate either wholly owned or in joint ventures and other long-term investments. LNC purchases investments for its segmented portfolios that have yield, duration and other characteristics that take into account the liabilities of the products being supported. The dominant investments held are fixed maturity securities, which represent approximately 78% of the investment portfolio. The total investment portfolio decreased $2.4 billion in 1999 and increased $8.1 billion in 1998. The decrease from 1998 was due to the decrease in fair value of fixed maturity securities available-for-sale due to a rising interest rate environment in 1999 and the continuation of the transfer of funds by fixed annuity contractholders to variable annuity contracts offset by the new purchases of investments from cash flow generated by the business units. The increase from 1997 was the net result of increases from 1) the addition of $8.8 billion in invested assets related to the two blocks of business acquired in 1998, 2) the increase in fair value of securities available-for-sale and 3) new purchases of investments from cash flow generated by the business units being partially offset by the continuation of the transfer of funds by fixed annuity contractholders to variable annuity contracts.
Fixed Maturity Security Ratings: LNC maintains a high-quality fixed maturity securities portfolio. As of December 31, 1999, $8.3 billion or 29.8% of its fixed maturity securities portfolio had ratings of AA or better. Fixed maturity securities with below-investment-grade ratings (BB or less) were $2.2 billion or 7.9% of the total fixed maturity securities portfolio (see Note 3 to the consolidated financial statements). The below-investment-grade fixed maturity securities represent 6.1% 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, 1999, the aggregate cost of below investment grade securities purchased was $624.5 million. Aggregate proceeds from such investments sold were $569.8 million, resulting in a realized pre-tax loss at the time of sale of $53.6 million.
Mortgage Loans on Real Estate and Real Estate: As of December 31, 1999, mortgage loans on real estate and investments in real estate represented 13.3% and 0.7% of the total investment portfolio. As of December 31, 1999, the underlying properties supporting the mortgage loans on real estate consisted of 31.0% in retail stores, 27.9% in commercial office buildings, 17.5% in apartments, 13.3% in industrial buildings, 5.4% in hotels/motels and 4.9% in other. In addition to the dispersion by type of property, the mortgage loan portfolio is geographically diversified throughout the United States.
Realized Gain on Investments: The pre-tax realized gain on investments, net of associated amortization of deferred acquisition costs and expenses, was $3.0 million, $19.0 million and $122.6 million in 1999, 1998 and 1997, respectively. The after-tax gain in 1999, 1998 and 1997 was $3.8 million, $13.7 million and $72.9 million, respectively. These gains were primarily the result of the sale of investments. Write-downs and provisions for losses offset a portion of the realized gains.
Write-Downs and Allowance for Losses: Securities available-for-sale, mortgage loans on real estate and real estate that were deemed to have declines in fair value that were other than temporary were written down. The fixed maturity securities to which these write-downs apply were generally of investment grade quality at the time of purchase, but were classified as "below-investment-grade" at the time of the write-downs. Also, write-downs and allowances for losses on select mortgage loans on real estate, real estate and other investments were established when the underlying value of the property was deemed to be less than the carrying value. These write-downs and provisions for losses are disclosed within the notes to the accompanying consolidated financial statements (see Note 3 to the consolidated financial statements).
Although LNC generates adequate cash flow to meet the needs of its normal operations, periodically LNC may issue debt or equity securities to fund internal expansion, acquisitions, investment opportunities and the retirement of LNC's debt and equity. LNC had an unused balance as of December 31, 1999 of $825 million on its existing shelf registration filed in April, 1998, that would allow LNC to issue various securities. The hybrid securities utilize six subsidiaries (Lincoln National Capital I, II, III, IV, V and VI) which were formed for the specific purpose of issuing such securities. All of these subsidiaries' common securities are owned by LNC. Cash funds are also available from LNC's revolving credit agreement, which provides for borrowing up to $750 million (see Note 5 to the consolidated financial statements).
In 1998, LNC issued $300 million of long-term debt, $200 million of Series C Trust Originated Preferred Securities and $230 million of FELINE PRIDES. Also, LNC issued 2,796,224 shares of LNC common stock for $74.4 million in 1997 to purchase subsidiary companies. Finally, LNC purchased and retired 7,675,000, 1,246,562 and 9,897,800 shares of common stock at a cost of $377.7 million, $46.9 million and $325.3 million in 1999, 1998 and 1997, respectively. In May 1999, the LNC board authorized $500 million to repurchase shares of common stock. The shares repurchased in 1999 include 4,875,600 shares at a cost of $ 236.6 million that have been purchased since the May 1999 board authorization. This leaves a Board authorization to repurchase an additional $263.4 million of LNC's common stock as of December 31, 1999.
LNC's insurance subsidiaries are subject to certain insurance department regulatory restrictions as to the transfer of funds and payment of dividends to the holding company. Generally, these restrictions pose no short-term liquidity concerns for the holding company. However, as discussed in detail within Note 7 to the consolidated financial statements, the acquisition of two blocks of business in 1998 placed further restrictions on the ability of LNC's primary insurance subsidiary, Lincoln Life, to declare and pay dividends. As a result of these acquisitions and dividends declared, Lincoln Life's statutory earned surplus is negative. It is necessary for Lincoln Life to obtain the prior approval of the Indiana Insurance Commissioner before paying any dividends to LNC until such time its statutory earned surplus is positive. The time frame for statutory earned surplus to return to a positive position is dependent upon future statutory earnings and dividends paid by Lincoln Life. Although no assurance can be given that additional dividends will be approved, during 1999, Lincoln Life received regulatory approval and paid extraordinary dividends totaling $530 million to LNC. In the event such approvals are not obtained, management believes that LNC can obtain the funds required to satisfy its obligations from its existing credit facilities and other sources.
Total shareholders' equity decreased $1.1 billion during the year ended December 31, 1999. Excluding the decrease of $1.0 billion related to the decrease in the unrealized gain (loss) on securities available-for-sale, shareholders' equity decreased $106 million. This decrease in shareholders' equity was the net result of decreases of $20 million related to a decrease in the accumulated foreign exchange gain, $219 million related to the declaration of dividends to shareholders, $378 million for the retirement of common stock and $3 million for shares forefeited under benefit plans partially offset by increases due to $460 million of net income, $51 million from the issuance of common stock related to benefit plans and $3 million from the issuance of common stock related to purchase of subsidiary companies.
Capital adequacy is a primary measure used by insurance regulators to determine the financial stability of an insurance company. In the U.S., risk-based capital guidelines are used by the National Association of Insurance Commissioners to determine the amount of capital that represents minimum acceptable operating amounts related to insurance and investment risks. Regulatory action is triggered when an insurer's statutory-basis capital falls below the formula-produced capital level. At December 31, 1999, statutory-basis capital for each of LNC's U.S. insurance subsidiaries was in excess of regulatory action levels of risk-based capital required by the jurisdiction of domicile.
See Note 7 to the consolidated financial statements for information regarding claims for disability income coverages, liabilities and recoveries related to inappropriate selling of products in the UK, liabilities for personal accident reinsurance programs, liabilities for marketing and compliance issues, the reserve for the run-off of group pension annuities and other contingency matters.
The Year 2000 issue was complex and affected many aspects of LNC's businesses. LNC was particularly concerned with Year 2000 issues that related to LNC's computer systems and interfaces with the computer systems of vendors, suppliers, customers and business partners. From 1996 ­ 1999, LNC and its operating subsidiaries redirected a large portion of internal Information Technology ("IT") efforts and contracted with outside consultants to update systems to address Year 2000 issues. Experts were engaged to assist in developing work plans and cost estimates and to complete remediation activities.
The Financial Services Modernization Act was passed in November 1999 and repeals the Glass-Steagall Act of 1933 and expands the Bank Holding Company Act of 1956. This new act allows cross-ownership by banks, securities firms and insurance companies. As a result, there is speculation that there will be business combinations among banks, securities firms and insurance companies.
Tax legislation could reduce tax-advantages for some of LNC's life and annuity products. LNC continues to support reductions in the tax burden imposed on its businesses, employees and policyholders.
1998 Data Premiums and other considerations $765.7 $823.2 $794.7 $1,003.0 Net investment income 658.4 658.7 649.6 714.7 Realized gain (loss) on investments 23.9 25.5 (26.7) (3.7)
(2) The net income per diluted share amounts for 1998 and the first quarter of 1999 have been adjusted to reflect the effects of the two-for-one stock split of LNC's common stock which was effective June, 1999.
The consolidated financial statements and notes to consolidated financial statements of Lincoln National Corporation and Subsidiaries follow on pages 38 through 76.
December 31 (000s omitted) 1999 1998 -------------------------------------------------------------------------------------- ASSETS Investments: Securities available-for-sale, at fair value: Fixed maturity (cost: 1999-$28,357,057; 1998-$28,639,558) $ 27,688,613 $ 30,232,892 Equity (cost: 1999-$481,531; 1998-$436,718) 603,954 542,843
Shareholders' Equity: Series A preferred stock - 10,000,000 shares authorized (1999 liquidation value - $2,309) 948 1,083
Accumulated Other Comprehensive Income (Loss): Foreign currency translation adjustment 30,049 49,979 Net unrealized gain (loss) on securities available-for-sale (465,698) 552,369 ------------- ----------- Total Accumulated Other Comprehensive Income (Loss) (435,649) 602,348 ------------- ----------- Total Shareholders' Equity 4,263,868 5,387,941 ------------- ----------- Total Liabilities and Shareholders' Equity $103,095,733 $ 93,836,260
(000s omitted except for Year Ended December 31 per share amounts) 1999 1998 1997 ------------------------------------------------------------------------------------------------------ Revenue: Insurance premiums $1,881,515 $1,620,629 $1,328,735 Insurance fees 1,537,605 1,274,569 832,153 Investment advisory fees 223,803 227,059 204,926 Net investment income 2,807,512 2,681,406 2,250,764 Equity in earnings of unconsolidated affiliates 5,797 3,336 2,081 Realized gain on investments 2,955 19,034 122,570 Other revenue and fees 344,513 261,030 157,250 ---------- ---------- ---------- Total Revenue 6,803,700 6,087,063 4,898,479
Benefits 3,805,024 3,328,865 3,191,733 Underwriting, acquisition, insurance and other expenses 2,295,015 1,943,749 1,579,341 Interest and debt expense 133,697 117,051 92,524 ---------- ---------- ---------- Total Benefits and Expenses 6,233,736 5,389,665 4,863,598 ---------- ---------- ---------- Net Income from Continuing Operations Before Federal Income Taxes 569,964 697,398 34,881
Federal Income Taxes 109,610 187,623 12,651 ---------- ---------- ---------- Net Income from Continuing Operations 460,354 509,775 22,230
Discontinued Operations (net of income taxes): Net income prior to disposal -- -- 134,886 Gain on disposal -- -- 776,872 ---------- ---------- ---------- Net Income $ 460,354 $ 509,775 $ 933,988
Earnings Per Common Share-Diluted (1): Net Income from Continuing Operations $2.30 $2.51 $0.11 Discontinued Operations -- -- 4.38 ---------- ---------- ---------- Net Income $2.30 $2.51 $4.49
Cash Flows from Investing Activities: Securities-available-for-sale: Purchases (6,255,493) (11,780,821) (10,740,292) Sales 4,210,498 9,278,969 10,098,697 Maturities 2,279,680 1,987,506 1,461,390 Purchase of other investments (1,948,818) (2,922,984) (2,128,852) Sale or maturity of other investments 1,812,079 1,865,874 2,039,783 Sale of subsidiary/blocks of business and discontinued operations (490,381) -- 2,650,000 Purchase of affiliates/business 11,086 (2,285,081) (11,847) Cash acquired from purchase of affiliates/business -- 2,323,220 -- Increase (decrease) in cash collateral on loaned securities (485,792) 274,426 353,550 Other (271,992) (434,889) 121,065 ---------- ---------- ---------- Net Cash Provided by (Used in) Investing Activities (1,139,133) (1,693,780) 3,843,494
Cash Flows from Financing Activities: Decrease in long-term debt (includes payments and transfers to short-term debt) (476) (99,977) (116,942) Issuance of long-term debt -- 299,198 -- Net increase in short-term debt 145,543 17,402 108,248 Issuance of preferred securities of subsidiary companies -- 430,000 -- Issuance costs related to FELINE PRIDES -- (14,834) -- Universal life and investment contract deposits 1,837,769 1,314,301 986,541 Universal life and investment contract withdrawals (2,468,354) (2,655,688) (2,709,662) Common stock issued for benefit plans 48,014 48,747 33,199 Retirement of common stock (377,719) (46,871) (327,585) Dividends paid to shareholders (218,434) (209,016) (201,927) ---------- ---------- ---------- Net Cash Used in Financing Activities (1,033,657) (916,738) (2,228,128) ---------- ---------- ---------- Net Increase (Decrease) in Cash and Invested Cash (537,467) (1,361,356) 2,649,940 Cash and Invested Cash at Beginning-of-Year 2,433,350 3,794,706 1,144,766 ---------- ---------- ---------- Cash and Invested Cash at End-of-Year $1,895,883 $2,433,350 $3,794,706
Retained Earnings: Balance at beginning-of-year 3,790,038 3,533,105 3,082,368 Comprehensive income (loss) (577,643) 629,927 934,139 Less other comprehensive income (loss): Foreign currency translation gain (loss), net (19,930) 3,775 (20,250) Net unrealized gain (loss) on securities available-for-sale, net (1,018,067) 116,377 20,401 ---------- ---------- ---------- Net Income 460,354 509,775 933,988
Retirement of common stock (339,404) (40,919) (279,808) Dividends declared: Series A, preferred ($3.00 per share) (89) (100) (106) Common (1) (1999-$1.115; 1998-$1.055; 1997-$0.995) (219,429) (211,823) (203,337) ---------- ---------- ---------- Balance at End-of-Year 3,691,470 3,790,038 3,533,105
Foreign Currency Translation Adjustment: Accumulated adjustment at beginning-of-year 49,979 46,204 66,454 Change during the year (19,930) 3,775 (20,250) ---------- ---------- ---------- Balance at End-of-Year 30,049 49,979 46,204
Net Unrealized Gain (Loss) on Securities Available-for-Sale: Balance at beginning-of-year 552,369 435,992 415,591 Removal of discontinued operations -- -- (176,603) Other change during the year (1,018,067) 116,377 197,004 ---------- ---------- ---------- Balance at End-of-Year (465,698) 552,369 435,992 ---------- ---------- ---------- Total Shareholders' Equity at End-of-Year $4,263,868 $5,387,941 $4,982,915
Year Ended December 31 (Number of Shares) 1999 1998(1) 1997(1) ------------------------------------------------------------------------------------------------------ Series A Preferred Stock:
Balance at beginning-of-year 32,959 35,091 36,885 Conversion into common stock (4,102) (2,132) (1,794) ------------- ----------- --------- Balance at End-of-Year 28,857 32,959 35,091
(1) 1998 and 1997 amounts have been restated to reflect the two-for-one stock split of LNC's common stock which was effective June, 1999.
See notes to the consolidated financial statements on pages 44 through 76.
Mortgage loans on real estate are carried at the outstanding principal balances less unamortized discounts. Investment real estate is carried at cost less accumulated depreciation. The cost for both mortgage loans on real estate and investment real estate is adjusted for declines in value that are other than temporary. Also, allowances for losses are established, as appropriate, for real estate holdings that are in the process of being sold. Real estate acquired through foreclosure proceedings is recorded at fair value on the settlement date which establishes a new cost basis. If a subsequent periodic review of a foreclosed property indicates the fair value, less estimated costs to sell, is lower than the carrying value at the settlement date, the carrying value is adjusted to the lower amount. Any changes to the reserves for mortgage loans on real estate and real estate are reported as realized gain (loss) on investments.
Hedge accounting is applied as indicated above after LNC determines that the items to be hedged expose LNC to interest rate fluctuations, the widening of bond yield spreads over comparable maturity U.S. Government obligations, fluctuations in certain stock indices or foreign exchange risk. Moreover, the derivatives used to hedge these exposures are designated as hedges and reduce the indicated risk by demonstrating a high correlation between changes in the value of the derivatives and the items being hedged at both the inception of the hedge and throughout the hedge period. Should such criteria not be met or if the hedged items have been sold, terminated or matured, the change in value of the derivatives is included in net income.
Premiums and Fees. Revenue for universal life and other interest-sensitive insurance policies consists of policy charges for the cost of insurance, policy initiation and administration, and surrender charges that have been assessed. Traditional individual life-health and annuity premiums are recognized as revenue over the premium-paying period of the policies. Group health premiums are prorated over the contract term of the policies.
Assets Held in Separate Accounts/Liabilities Related to Separate Accounts. These assets and liabilities represent segregated funds administered and invested by LNC's insurance subsidiaries for the exclusive benefit of pension and variable life and annuity contractholders. Both the assets and liabilities are carried at fair value. The fees earned by LNC's insurance subsidiaries for administrative and contractholder maintenance services performed for these separate accounts are included in insurance fee revenue.
Deferred Acquisition Costs. Commissions and other costs of acquiring universal life insurance, variable universal life insurance, unit-linked products, traditional life insurance, annuities and group health insurance which vary with and are primarily related to the production of new business, have been deferred to the extent recoverable. Acquisition costs for universal and variable universal life insurance policies and unit-linked products are amortized over the lives of the policies in relation to the incidence of estimated gross profits from surrender charges and investment, mortality, expense margins and actual realized gain (loss) on investments. That amortization is adjusted retrospectively when estimates of current or future gross profits to be realized from a group of products are revised. Traditional life acquisition costs are being 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. Annuity acquisition costs are amortized over a period of 15 years for more recently issued policies, and over the surrender charge period for all other policies. For all policies, amortization is based on assumptions consistent with those used in the development of the underlying policy form adjusted for emerging experience.
Benefits and Expenses. Benefits and expenses for universal life-type and other interest-sensitive life insurance products include interest credited to policy account balances and benefit claims incurred during the period in excess of policy account balances. Interest crediting rates associated with funds invested in the general account of LNC's insurance subsidiaries during 1997 through 1999 ranged from 4.50% to 7.50%. For traditional life, group health and disability income products, benefits and expenses, other than deferred acquisition costs, are recognized when incurred in a manner consistent with the related premium recognition policies.
Insurance businesses typically produce ongoing profit streams from expected new business generation that extend significantly beyond the maximum 40-year period allowed for goodwill amortization. Accordingly, for acquired insurance businesses where financial modeling indicates that anticipated new business benefits will extend for 40 years or longer, goodwill is amortized over a 40-year period.
Other intangible assets for acquired insurance businesses consist of the value of existing blocks of business (referred to as the "present value of future profits"). The present value of future profits is amortized over the expected lives of the block of insurance business in relation to the incidence of estimated profits expected to be generated on investment type products acquired, (i.e. variable products) and over the premium paying period for insurance products acquired, (i.e. traditional life insurance products). Amortization is based upon assumptions used in pricing the acquisition of the block of business and is adjusted for emerging experience. Accordingly, amortization periods and methods of amortization for present value of future profits vary depending upon the particular characteristics of the underlying blocks of acquired insurance business.
Goodwill relating to acquisitions of investment management subsidiaries is amortized on a straight-line method, over a 25 year period. Other intangible assets relating to these acquisitions include institutional customer relationships, covenants not to compete and mutual fund customer relationships. These assets are amortized on a straight-line basis over periods ranging from 6 to 15 years depending upon the characteristics of the particular underlying relationships for the intangible asset.
Reclassifications. Certain amounts reported in prior years' consolidated financial statements have been reclassified to conform with the presentation adopted in the current year. These reclassifications have no effect on net income or shareholders' equity of the prior years.
During the fourth quarter of 1999, LNC's Reinsurance segment conducted an in-depth review of its exposure related to its participation in workers' compensation carve-out (i.e., life and health risks associated with workers' compensation coverage) programs managed by Unicover Managers, Inc. As a result of this review as well as settlement proceedings conducted to resolve this issue, LNC took a net charge of $40.4 million after-tax or $0.20 per share ($62.2 million pre-tax) in the fourth quarter of 1999.
Accounting for Derivative Instruments and Hedging Activities. In June 1998, the Financial Accounting Standards Board ("FASB"), issued Statement of Financial Accounting Standard No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("FAS 133"). In July 1999, the FASB issued Statement of Financial Accounting Standard No. 137, "Accounting for Derivative Instruments and Hedging Activities-Deferral of the Effective Date of FASB Statement No. 133" ("FAS 137"), which delays the effective date of FAS 133 one year (i.e., adoption required no later than the first quarter of 2001). Due to the complexity of FAS 133 and the uncertainty of authoritative guidance of several issues including assessing the effectiveness of a hedge, LNC has not been able to finalize the analysis necessary to provide a reliable estimate of the effects of implementing the Standard. Management is in the process of evaluating the various hedge programs and will finalize the analysis when authoritative guidance becomes available. Because these ongoing changes to implementation guidance have required LNC to re-assess several complex implementation decisions, it is not likely that LNC will adopt the standard prior to the first quarter of 2001.
Accounting for the Costs of Computer Software Developed or Obtained for Internal Use. On January 1, 1999, LNC implemented the Statement of Position ("SOP") 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use". SOP 98-1 defines internal use software and when the costs associated with internal use software should be capitalized. The implementation did not have a material impact on LNC's consolidated financial statements.
Amortized Fair December 31 (in millions) Cost Gains Losses Value ---------------------------------------------------------------------------------------------------------------- 1999: Corporate bonds $21,760.2 $ 272.3 $ (913.0) $21,119.5 U.S. Government bonds 552.5 29.8 (44.0) 538.3 Foreign government bonds 1,383.8 88.1 (24.5) 1,447.4 Asset and mortgage-backed securities: Mortgage pass-through securities 1,043.9 6.8 (31.4) 1,019.3 Collateralized mortgage obligations 2,015.0 39.1 (46.6) 2,007.5 Other asset-backed securities 1,415.7 14.7 (53.2) 1,377.2 State and municipal bonds 15.3 -- (0.6) 14.7 Redeemable preferred stocks 170.7 2.8 (8.8) 164.7 --------- -------- --------- --------- Total fixed maturity securities 28,357.1 453.6 (1,122.1) 27,688.6 Equity securities 481.5 151.4 (28.9) 604.0 --------- -------- --------- --------- Total $28,838.6 $ 605.0 $(1,151.0) $28,292.6
1998: Corporate bonds $21,289.6 $1,350.2 $ (134.6) $22,505.2 U.S. Government bonds 1,043.9 94.3 (3.6) 1,134.6 Foreign government bonds 1,240.1 127.5 (46.4) 1,321.2 Asset and mortgage-backed securities: Mortgage pass-through securities 1,176.6 34.6 (0.9) 1,210.3 Collateralized mortgage obligations 2,532.9 120.7 (5.4) 2,648.2 Other asset-backed securities 1,170.0 54.1 (2.1) 1,222.0 State and municipal bonds 15.9 0.9 -- 16.8 Redeemable preferred stocks 170.6 7.4 (3.4) 174.6 --------- -------- --------- --------- Total fixed maturity securities 28,639.6 1,789.7 (196.4) 30,232.9 Equity securities 436.7 141.2 (35.1) 542.8 --------- -------- --------- --------- Total $29,076.3 $1,930.9 $ (231.5) $30,775.7
Par Amortized Fair December 31, 1999 (in millions) Value Cost Value ----------------------------------------------------------------------------------------------- Below 7% $890.8 $341.7 $338.8 7% - 8% 2,454.8 2,438.4 2,349.7 8% - 9% 1,117.8 1,082.0 1,082.3 Above 9% 622.6 612.5 633.2 -------- -------- --------- Total $5,086.0 $4,474.6 $4,404.0
The change in unrealized appreciation (depreciation) on investments in fixed maturity and equity securities available-for-sale is as follows:
Year Ended December 31 (in millions) 1999 1998 1997 ----------------------------------------------------------------------------------------------- Fixed maturity securities $(2,261.8) $152.9 $549.0 Equity securities 16.4 (37.1) 20.2 --------- ------ ------ Total $(2,245.4) $115.8 $569.2
December 31 (in millions) 1999 1998 ------------------------------------------------------------------------------ Real estate $40.3 $51.0 Property and equipment 238.1 222.1
The allowance for losses is maintained at a level believed adequate by management to absorb estimated probable credit losses. Management's periodic evaluation of the adequacy of the allowance for losses is based on LNC's past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower's ability to repay (including the timing of future payments), the estimated value of the underlying collateral, composition of the loan portfolio, current economic conditions and other relevant factors. This evaluation is inherently subjective, as it requires estimating the amounts and timing of future cash flows expected to be received on impaired loans that may be susceptible to significant change.
Impaired mortgage loans along with the related allowance for losses are as follows:
Impaired mortgage loans with no allowance for losses are a result of: 1) direct write-downs; or 2) collateral dependent loans where the fair value of the collateral is greater than the recorded investment in the loan.
Year Ended December 31 (in millions) 1999 1998 1997 ----------------------------------------------------------------------------------------------- Balance at beginning-of-year $4.8 $5.0 $12.4 Provisions for losses 0.8 0.7 0.8 Releases due to principal paydowns (0.9) (0.9) (4.8) Releases due to foreclosures -- -- (3.4) ---- ---- ----- Balance at end-of-year $4.7 $4.8 $ 5.0
Year Ended December 31 (in millions) 1999 1998 1997 ----------------------------------------------------------------------------------------------- Average recorded investment in impaired loans $29.6 $33.4 $74.9 Interest income recognized on impaired loans 2.9 3.5 7.0
As of December 31, 1999, LNC's investment commitments for fixed maturity securities (primarily private placements), mortgage loans on real estate and real estate were $619.9 million. This includes $175.5 million of standby commitments to purchase real estate upon completion and leasing.
The cost information for mortgage loans on real estate, real estate and other long-term investments is net of allowances for losses. The balance sheet account for other liabilities includes a reserve for guarantees of third-party debt. The amount of allowances and reserves for such items is as follows:
December 31 (in millions) 1999 1998 ------------------------------------------------------------------------------ Mortgage loans on real estate $4.7 $4.8 Real estate -- -- Guarantees 0.3 0.3
Year Ended December 31 (in millions) 1999 1998 1997 ----------------------------------------------------------------------------------------------- Current $(55.5) $(37.0) $137.4 Deferred 165.1 224.6 (124.7) ------ ------ ------ Total for continuing operations $109.6 $187.6 $ 12.7
December 31 (in millions) 1999 1998 ------------------------------------------------------------------------------ Current $ 15.4 $ (6.3) Deferred 329.6 210.4 ------ ------ Total Federal income tax asset $345.0 $204.1
Significant components of LNC's net deferred tax asset are as follows:
Cash paid for Federal income taxes in 1999, 1998 and 1997 was $70.6 million, $379.6 million and $158.0 million, respectively.
LNC is required to establish a valuation allowance for any portion of its deferred tax assets which are unlikely to be realized. At December 31, 1999, $ 232.3 million of gross deferred tax assets relating to net unrealized capital losses on fixed maturity and equity securities available-for-sale were recorded in shareholders' equity. In evaluating whether a tax valuation allowance is necessary to reduce these gross deferred tax assets to a level that is more likely than not to be realized, LNC considered the federal income tax restrictions on the use of corporate capital losses. Under the corporate income tax rules, capital losses may only be used to offset capital gains. A three-year carryback and a five-year carryforward of unused capital losses to offset capital gains generated within these years are also permitted. Due to these restrictions, LNC determined that a valuation allowance of $229 million was necessary. This valuation allowance was established in shareholders' equity at December 31, 1999. With this exception for the gross deferred tax assets relating to unrealized capital losses on available-for-sale securities, management believes it is more likely than not that LNC will realize the benefit of all other gross deferred tax assets.
Under prior Federal income tax law, one-half of the excess of a life insurance company's income from operations over its taxable investment income was not taxed, but was set aside in a special tax account designated as "Policyholders' Surplus". At December 31, 1999, LNC has approximately $196.0 million of untaxed "Policyholders' Surplus" on which no payment of Federal income taxes will be required unless it is distributed as a dividend, or under other specified conditions. Barring the passage of unfavorable tax legislation, LNC does not believe that any significant portion of the account will be taxed in the foreseeable future. Accordingly, no deferred tax liability has been recognized relating to LNC's Policyholders' Surplus balance. If the entire Policyholders' Surplus balance became taxable at the current Federal rate, the tax would be approximately $68.6 million.
Reinsurance transactions included in the income statement captions, "Insurance Premiums" and "Insurance Fees", are as follows:
Year Ended December 31 (in millions) 1999 1998 1997 ----------------------------------------------------------------------------------------------- Commissions $ 961.0 $ 740.1 $ 575.3 Other volume related expenses 205.5 150.7 72.8 Operating and administrative expenses 1,156.9 995.8 832.5 Deferred acquisition costs net of amortization (309.3) (208.2) 1.8 Restructuring charges 27.3 52.8 -- Other 253.6 212.5 96.9 -------- -------- -------- Total $2,295.0 $1,943.7 $1,579.3
The income statement caption, "Underwriting, Acquisition, Insurance and Other Expenses", includes amortization of deferred acquisition costs of $307.3 million; $403.9 million and $388.4 million for the years ended December 31, 1999, 1998 and 1997, respectively. An additional $26.9 million; $(34.5) million and $(78.2) million of deferred acquisition costs was restored (amortized) and netted against "Realized Gain (Loss) on Investments" for the years ended December 31, 1999, 1998 and 1997, respectively.
December 31 (in millions) 1999 1998 1997 ------------------------------------------------------------------------------------------------------ Balance at beginning of year $1,753.3 $501.3 $602.4 Adjustments to balance 3.4 1,323.2 22.0 Interest accrued on unamortized balance (Interest rates range from 5% to 7%) 69.9 44.4 36.9 Balance sheet reclassifications related to Lincoln UK -- -- (94.8) Amortization (163.7) (117.4) (48.1) Foreign exchange adjustment (8.7) 1.8 (17.1) -------- -------- ------ Balance at end-of-year 1,654.2 1,753.3 501.3 Other intangible assets (non-insurance) 92.3 95.1 112.6 -------- -------- ------ Total other intangible assets at end-of-year $1,746.5 $1,848.4 $613.9
Future estimated amortization of insurance business acquired net of interest on unamortized balance for LNC's insurance subsidiaries is as follows (in millions):
December 31 (in millions) 1999 1998 ------------------------------------------------------------------------------ Premium deposit funds $19,624.1 $20,171.9 Undistributed earnings on participating business 132.0 142.8 Other 472.7 438.4 --------- --------- Total $20,228.8 $20,753.1
December 31 (in millions) 1999 1998 ------------------------------------------------------------------------------------------------------ Short-term debt: Commercial paper $ 414.0 $ 214.4 Other short-term notes 45.6 -- Current portion of long-term debt 0.5 100.2 -------- -------- Total short-term debt 460.1 314.6
Long-term debt less current portion: 7.625% notes payable, due 2002 99.9 99.8 7.250% notes payable, due 2005 191.8 191.6 6.500% notes payable, due 2008 100.2 100.2 7% notes payable, due 2018 200.3 200.3 9.125% notes payable, due 2024 119.8 119.8 Mortgages and other notes payable -- 0.5 -------- -------- Total long-term debt 712.0 712.2
The combined U.S. and U.K. commercial paper outstanding at December 31, 1999 and 1998, had a blended weighted average interest rate of approximately 5.77% and 6.67%, respectively.
2000 - $0.5 2002 - $100.0 2004 - $ -- 2001 - -- 2003 - -- Thereafter - 613.0
In July 1996, Lincoln National Capital I issued 8,600,000 shares or $215 million, 8.75% Quarterly Income Preferred Securities ("QUIPS"). In August 1996, Lincoln National Capital II issued 4,000,000 shares or $100 million, 8.35% Trust Originated Preferred Securities ("TOPrS"). Both issues mature in 2026 at $25 per share and are redeemable in whole or in part at LNC's option any time after 2001. In March 1998, LNC issued notes of 1) $100 million, 6.5% due 2008 and 2) $200 million, 7% due 2018. In July 1998, Lincoln National Capital III issued 8,000,000 shares or $200 million of 7.4% TOPrS which mature in 2028 at $25 per share and are redeemable in whole or in part at LNC's option anytime after July 2003. In August 1998, Lincoln National Capital IV issued 9,200,000 shares or $230 million of 7.75% FELINE PRIDES (service mark of Merrill Lynch & Co. Inc.). The purchasers of such securities were also provided stock purchase contract agreements that indicate they will receive a specified amount of LNC common stock on or before the August 2001 maturity date of the FELINE PRIDES. A portion of the issuance costs associated with this offering along with the present value of the payments associated with the stock purchase agreements were charged to the common stock line within shareholders' equity. In December 1998, LNC filed a shelf registration with the Securities Exchange Commission that combines unused portions of the April 1998 registration ($640 million) and the May 1996 registration ($185 million) resulting in an active shelf registration allowing LNC to sell up to an additional $825 million of securities.
The funds raised in 1998 from the various public offerings of hybrid securities described above were used to acquire a block of individual life insurance business from Aetna (see Note 11).
LNC also sponsors unfunded defined benefit plans that provide postretirement medical, dental and life insurance benefits to full-time U.S. employees and agents who, depending on the plan, have worked for LNC 10 years and attained age 55 to 60. Medical and dental benefits are also available to spouses and other dependents of employees and agents. For medical and dental benefits, limited contributions are required from individuals who retired prior to November 1, 1988. Contributions for later retirees, which can be adjusted annually, are based on such items as years of service at retirement and age at retirement. Life insurance benefits are noncontributory; however, participants can elect supplemental contributory life benefits up to age 70. Effective July 1, 1999, the agents' postretirement plan was changed to require agents retiring on or after that date to pay the full premium costs. This change in the plan resulted in a one-time curtailment gain of $10.2 million.
As a result of the acquisitions of a block of individual life insurance and annuity business from CIGNA and a block of individual life insurance business from Aetna, Inc. ("Aetna"), former CIGNA and Aetna employees became LNC employees and entered the employees' defined benefit pension and postretirement benefit plans effective January 1, 1998 and January 1, 1999, respectively. The plans were amended as of those dates to approve the entrance of these participants, to provide these participants with credit for past service for benefit purposes, and to specify that the accrued pension benefits determined by the plan benefit formula are to be offset by the benefits accrued in the CIGNA or Aetna plans, as applicable. This resulted in increases in the pension benefits obligation and the postretirement benefits obligation of $17.3 million and $8.1 million, respectively during the year ended December 31, 1998, and $5.2 million and $2.0 million, respectively during the year ended December 31, 1999.
Information with respect to defined benefit plan asset activity and defined benefit plan obligations is as follows:
Other Postretirement Pension Benefits Benefits ----------------------- ------------------------ Year Ended December 31 (in millions) 1999 1998 1999 1998 ---------------------------------------------------------------------------------------------------------------- Change in plan assets: Fair value of plan assets at beginning of year $362.4 $ 336.3 $ -- $ -- Actual return on plan assets 41.6 40.9 -- -- Company contributions -- 6.6 -- -- Administrative expenses (0.3) (0.3) -- -- Benefits paid (13.6) (21.1) -- -- ------ ------- ------- ------- Fair value of plan assets at end of year $390.1 $ 362.4 $ -- $ --
Change in benefit obligation: Benefit obligation at beginning of year $485.9 $ 390.6 $ 111.1 $ 90.0 Plan amendments -- 10.7 -- -- Acquisitions 5.2 25.7 2.0 8.1 Service cost 19.2 16.1 3.6 3.6 Interest cost 30.2 27.7 6.6 6.5 Plan participants' contributions -- -- 1.3 1.0 Plan curtailment gain -- -- (10.2) -- Actuarial (gains) losses (89.2) 38.0 0.1 6.7 Benefits paid (16.6) (22.9) (6.5) (4.8) ------ ------- ------- ------- Benefit obligation at end of year $434.7 $ 485.9 $ 108.0 $ 111.1
The funded status amounts in the pension benefits columns above combine plans with projected benefit obligations in excess of plan assets and plans with plan assets in excess of projected benefit obligations. For plans that have projected benefit obligations in excess of plan assets, the aggregate projected benefit obligations were $67.6 million and $408.6 million at December 31, 1999 and 1998, respectively, the aggregate accumulated benefit obligations were $50.1 million and $313.2 million at December 31, 1999 and 1998, respectively, and the aggregate fair value of plan assets was $0 and $283.4 million at December 31, 1999 and 1998, respectively.
Other Postretirement Pension Benefits Benefits --------------------------------------- --------------------------------------- Year Ended December 31 (in millions) 1999 1998 1997 1999 1998 1997 --------------------------------------------------------------------------------------------------------------------------------------- Service cost $19.5 $16.4 $11.4 $ 3.6 $3.6 $2.3 Interest cost 30.2 27.7 23.6 6.6 6.5 5.4 Actual return on plan assets (32.6) (29.3) (26.6) -- -- -- Amortization of prior service cost 1.0 1.1 0.8 -- -- -- Recognized net actuarial (gains) losses 1.6 0.6 0.4 0.3 (0.2) (0.8) ----- ----- ----- ----- ---- ---- Net periodic benefit cost $19.7 $16.5 $ 9.6 $10.5 $9.9 $6.9
The calculation of the accumulated postretirement 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 2000. It further assumes the rate will gradually decrease to 5.0% by 2010 and remain at that level. The health care cost trend rate assumption has a significant effect on the amounts reported. For example, increasing the assumed health care cost trend rates by one percentage point each year would increase the accumulated postretirement benefits obligation as of December 1999 and 1998 by $8.6 million and $9.7 million, respectively. The aggregate of the estimated service and interest cost components of net periodic postretirement benefits cost for the year ended December 31, 1999 would increase by $0.9 million.
Deferred Compensation Plans. LNC sponsors contributory deferred compensation plans for certain U.S. employees and agents. Plan participants may elect to defer payment of a portion of their compensation, as defined by the plans. At this point, LNC has not chosen to fund these plans. Plan participants may select from a variety of alternative measures for purposes of calculating the investment return considered attributable to their deferral. Under the terms of these plans, LNC agrees to pay out amounts based upon the alternative measure selected by the participant. Plan participants who are also participants in an LNC 401(k) plan and who have reached the contribution limit for that plan may also elect to defer the additional amounts into the deferred compensation plan. LNC makes matching contributions to these plans based upon amounts placed into the deferred compensation plans by individuals who have reached the contribution limit under the 401(k) plan. The amount of LNC's contribution is calculated in a manner similar to the employer match calculation described in the 401(k) plans section above. Expense for these plans amounted to $10.6 million, $11.5 million and $11.4 million in 1999, 1998 and 1997, respectively. These expenses reflect both LNC's employer matching contributions, as well as changes in the measurement of LNC's liabilities under these plans.
In 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. Expense for this plan amounted to $1.1 million and $2.0 million in 1999 and 1998, respectively.
Information with respect to incentive plan stock options outstanding at December 31, 1999 is as follows:
The fair value of options used as a basis for the proforma disclosures, shown above, was estimated as of the date of grant using a Black-Scholes option pricing model.
Information with respect to the incentive plans involving stock options is as follows:
Options Outstanding Options Exercisable ------------------------------- -------------------------- Weighted- Weighted- Average Average Exercise Exercise Shares Price Shares Price ---------------------------------------------------------------------------------------------------------------- Balance at January 1, 1997 6,310,326 $18.15 3,666,538 $15.61 Granted-original 2,094,400 30.03 Granted-reloads 94,058 34.21 Exercised (includes shares tendered) (1,806,814) 15.84 Expired (1,566) 35.54 Forfeited (88,632) 23.22 ------------- Balance at December 31, 1997 6,601,772 22.54 3,203,944 17.91
Granted-original 5,211,750 44.60 Granted-reloads 87,450 44.71 Exercised (includes shares tendered) (976,882) 18.11 Forfeited (139,238) 35.95 ------------- Balance at December 31, 1998 10,784,852 33.61 3,596,946 21.63
Granted-original 4,445,316 50.51 Granted-reloads 104,422 49.32 Exercised (includes shares tendered) (1,216,263) 48.68 Forfeited (453,892) 44.90 ------------- Balance at December 31, 1999 13,664,435 39.59 5,141,438 29.21
Net income (loss) as determined in accordance with statutory accounting practices for LNC's insurance subsidiaries was $(0.375) billion, $(1.452) billion and $0.345 billion for 1999,1998 and 1997, respectively. The 1998 amounts includes the statutory ceding commissions associated with the acquisition of two blocks of business as described below. Excluding the impact of these acquisitions, net income for 1998 would have been $0.546 billion. Statutory net income (loss) for 1999, 1998 and 1997, excluding LNC's foreign life reinsurance companies, was $0.447 billion, $(1.398) billion and $0.299 billion, respectively.
LNC's primary insurance subsidiary, Lincoln National Life Insurance Company ("Lincoln Life") acquired a block of individual life insurance and annuity business from CIGNA in January 1998 and a block of individual life insurance from Aetna Inc. in October 1998. These acquisitions were structured as indemnity reinsurance transactions. The statutory accounting regulations do not allow goodwill to be recognized on indemnity reinsurance transactions and therefore, the related statutory ceding commission flows through the statement of operations as an expense resulting in a reduction of statutory earned surplus. As a result of these acquisitions, Lincoln Life's statutory earned surplus is negative. It is necessary for Lincoln Life to obtain the prior approval of the Indiana Insurance Commissioner before paying any dividends to LNC until such time as statutory earned surplus is positive. The time frame for statutory earned surplus to return to a positive position is dependent upon future statutory earnings and dividends paid by Lincoln Life. Although no assurance can be given that additional dividends to LNC will be approved, during 1999, Lincoln Life received regulatory approval and paid extraordinary dividends totaling $530 million to LNC. In the event such approvals are not obtained in the future, management believes that LNC can obtain the funds required to satisfy its obligations from its existing credit facilities and other sources.
Operations in the UK 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 has 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, 1999 and 1998, liabilities of $294.4 million and $202.1 million, respectively, had been established for this issue. The December 31, 1999 amount includes a change in estimate for this liability (see Note 2). 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. The expected recoveries from previous owners of companies acquired in past years as specified in the indemnification clauses of the purchase agreements at December 31, 1999 and 1998 were $99.7 million and $84.9 million, respectively. These liabilities and recoveries are based on various estimates that are subject to considerable uncertainty. Accordingly, these estimates may prove to be deficient or excessive. However, it is management's opinion that such future developments will not materially affect the consolidated financial position of LNC.
Trends in the UK for pension and life insurance businesses are changing rapidly, due in large part to government mandated product design changes that are expected to be imposed upon the industry within the next year or two. The ever changing regulatory environment has and is continuing to cause great volatility in the Lincoln UK segment. In anticipation of these marketplace changes, a review of strategic alternatives for Lincoln UK was initiated earlier this year. In the fourth quarter of 1999, as a result of this review and in response to this current business environment, management decided to explore the exit of the UK market. This process will include the review of a range of strategic options including the potential sale of the Lincoln UK insurance business.
Settlement activities relating to LNC's participation in workers' compensation carve-out (i.e., life and health risks associated with workers' compensation coverage) programs managed by Unicover Managers, Inc. have allowed LNC to evaluate the possibility of settlements and to estimate its potential costs to settle Unicover-related exposures. As of December 31, 1999, a liability of $62.2 million has been established for the settlement of LNC's exposure to the Unicover programs.
These amounts are based on various estimates that are subject to considerable uncertainty. Accordingly, the liabilities may prove to be deficient or excessive. However, it is management's opinion that future developments in these programs will not materially affect the consolidated financial position of LNC.
The liability for HMO claims, net of the related assets for amounts recoverable from reinsurers, was $101.9 million and $55.9 million at December 31, 1999 and 1998. LNC reviews reserve levels on an ongoing basis. The liability is based on the assumption that recent experience will continue in the future. If claims and loss ratios fluctuate significantly from the assumptions underlying the reserves, adjustments to reserves could be required in the future. Accordingly, the liability may prove to be deficient or excessive. However, it is management's opinion that such future developments will not materially affect the consolidated financial position of LNC.
In light of the continued volatility of this line of business, LNC discontinued writing new HMO excess-of-loss reinsurance programs in the third quarter of 1999. Consequently, during the third quarter of 1999, LNC recorded a charge in the Reinsurance segment of $3.2 million after-tax ($4.9 million pre-tax) for employee severance and other costs related to the discontinuance of the business (see Note 12).
A UK regulatory review of Lincoln UK selling practices outside of the pension product mis-selling investigations has been completed, with a final report issued in February of 2000. The finalization of this review had no effect on Lincoln UK's 1999 income from operations. Although some modifications of sales practices will be necessary, Lincoln UK does not expect these changes to adversely affect its future financial results.
The liabilities for guaranteed interest and group pension annuity contracts are supported by a single portfolio of assets that attempts to match the duration of these liabilities. Due to the long-term nature of group pension annuities and the resulting inability to exactly match cash flows, a risk exists that future cash flows from investments will not be reinvested at rates as high as currently earned by the portfolio. 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.
In December 1997, LNC invested $85 million for a 49% share of Seguros Serfin Lincoln ("SSL"), a Mexican bancassurance company, that sells life, auto and homeowners insurance to the customers of Banca Serfin. Grupo Financiero Serfin S.A. ("GFS") owns 51% of SSL and 100% of Banca Serfin. On July 8, 1999, the private shareholders of GFS declined to contribute additional capital to Banca Serfin as required by the Mexican Government. Accordingly, the Bank Savings Protection Institute ("IPAB"), a government agency, took control of GFS. IPAB has injected capital into Banca Serfin and has indicated its intent to place GFS up for sale.
LNC owns operating companies in Europe and conducts business with companies located within Europe. LNC has modified its systems, financial activities and currency risk exposures to align with the first phase of the European Union's conversion to a new common currency (the Euro) that was adopted January 1, 1999. It is management's opinion that the additional phases of this conversion, which will be implemented during the next few years, will not materially affect the consolidated financial position of LNC.
Certain of LNC's subsidiaries lease their home office properties through sale-leaseback agreements. The agreements provide for a 25 year lease period with options to renew for six additional terms of five years each. The agreements also provide LNC with the right of first refusal to purchase the properties during the term of the lease, including renewal periods, at a price defined in the agreements. LNC also has the option to purchase the leased properties at fair market value as defined in the agreements on the last day of the initial 25-year lease period ending in 2009 or the last day of any of the renewal periods.
2000 - $60.3 2002 - $51.1 2004 - $43.5 2001 - 58.2 2003 - 44.4 Thereafter - 221.1
LNC's insurance companies cede insurance to other companies. The portion of risks exceeding each company's retention limit is reinsured with other insurers. LNC seeks reinsurance coverage within the businesses that sell life insurance to limit its liabilities. As of December 31, 1999, LNC's maximum retention was $10.0 million on a single insured. Portions of LNC's deferred annuity business have also been co-insured with other companies to limit LNC's exposure to interest rate risks. At December 31, 1999, the reserves associated with these reinsurance arrangements totaled $1,422.8 million. To cover products other than life insurance, LNC acquires other insurance coverages with retentions and limits that management believes are appropriate for the circumstances. The accompanying financial statements reflect premiums, benefits and deferred acquisition costs, net of insurance ceded (see Note 5). LNC's insurance companies remain liable if their reinsurers are unable to meet contractual obligations under applicable reinsurance agreements.
Associated with these transactions, LNC's insurance companies have obtained letters of credit in favor of various insurance companies. 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, 1999, there was a total of $1.1 billion in outstanding bank letters of credit. In exchange for the letters of credit, LNC paid the banks approximately $1.7 million in fees in 1999.
At December 31, 1999, LNC did not have a material concentration of financial instruments in a single investee, industry or geographic location. Also at December 31, 1999, LNC did not have a concentration of: 1) business transactions with a particular customer, lender or distributor; 2) revenues from a particular product or service; 3) sources of supply of labor or services used in the business or; 4) a market or geographic area in which business is conducted that makes it vulnerable to an event that is at least reasonably possible to occur in the near term and which could cause a severe impact to LNC's financial position.
The number of insurance companies that are under regulatory supervision has resulted, and is expected to continue to result, in assessments by state guaranty funds to cover losses to policyholders of insolvent or rehabilitated companies. Mandatory assessments may be partially recovered through a reduction in future premium taxes in some states. LNC has accrued for expected assessments net of estimated future premium tax deductions.
Certain subsidiaries of LNC have invested in real estate partnerships which use industrial revenue bonds to finance their projects. LNC has guaranteed the repayment of principal and interest on these bonds. Certain subsidiaries of LNC are also involved in other real estate partnerships that use conventional mortgage loans. In some cases, the terms of these arrangements involve guarantees by each of the partners to indemnify the mortgagor in the event a partner is unable to pay its principal and interest payments. In addition, certain subsidiaries of LNC have sold commercial mortgage loans through grantor trusts which issued pass-through certificates. These subsidiaries have agreed to repurchase any mortgage loans which remain delinquent for 90 days at a repurchase price substantially equal to the outstanding principal balance plus accrued interest thereon to the date of repurchase. It is management's opinion that the value of the properties underlying these commitments is sufficient that in the event of default the impact would not be material to LNC.
LNC has derivatives with off-balance-sheet risks whose notional or contract amounts exceed the credit exposure. For the years ended December 31, 1999, 1998 and 1997, 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, credit risk, commodity risk, foreign exchange risk 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:
Foreign currency derivatives: Foreign exchange forward contracts -- 1.5 -- -- * * Foreign currency swaps 44.2 47.2 (0.4) (0.4) 0.3 0.3 -------- -------- ----- ----- ----- ----- Total foreign currency derivatives 44.2 48.7 (0.4) (0.4) 0.3 0.3
Commodity derivatives: Commodity swap -- 8.1 -- -- 2.4 2.4 Equity indexed derivatives: Call options (based on FTSE) 4.3 11.1 8.6 8.6 11.7 11.7 Call options (based on S&P) 129.6 79.9 24.8 24.8 23.1 23.1 -------- -------- ----- ----- ----- ----- Total equity indexed derivatives 133.9 91.0 33.4 33.4 34.8 34.8 -------- -------- ----- ----- ----- ----- Total derivatives $5,176.6 $6,435.7 $31.4 $29.4 $61.4 $53.0
Interest Rate Swap Agreements Put Options -------------------- -------------------- December 31 (in millions) 1999 1998 1999 1998 --------------------------------------------------------------------------------------- Balance at beginning-of-year $258.3 $ 10.0 $21.3 $ -- New contracts 482.4 2,226.6 -- 21.3 Terminations and maturities (109.8) (1,978.3) -- -- ------ -------- ----- ----- Balance at end-of-year $630.9 $ 258.3 $21.3 $21.3
Put Options. LNC uses put options, combined with various perpetual fixed-income securities and interest rate swaps to replicate fixed income, fixed maturity investments. The risk being hedged is a drop in bond prices due to credit concerns with international bond issuers. The put options allow LNC to put the bonds back to the counterparties at original par.
Foreign Currency Derivatives. LNC uses a combination of foreign exchange forward contracts, foreign currency options and foreign currency swaps, all of which are traded over-the-counter, to hedge some of the foreign exchange risk of investments in fixed maturity securities denominated in foreign currencies. The foreign currency forward contracts obligate LNC to deliver a specified amount of currency at a future date at a specified exchange rate. Foreign currency options give LNC the right, but not the obligation, to buy or sell a foreign currency at a specified exchange rate during a specified time period. Foreign currency options were terminated in 1997. A foreign currency swap is a contractual agreement to exchange the currencies of two different countries at a fixed rate of exchange in the future.
Commodity Swap. LNC used a commodity swap to hedge its exposure to fluctuations in the price of gold. A commodity swap is a contractual agreement to exchange a certain amount of a particular commodity for a fixed amount of cash. LNC owned a fixed income security that met its coupon payment obligations in gold bullion. LNC was obligated to pay to the counterparty the gold bullion, and in return receive from the counterparty a stream of fixed income payments. The fixed income payments were the product of the swap notional multiplied by the fixed rate stated in the swap agreement. The net receipts/payments from the commodity swap were recorded in net investment income. The fixed income security was called in the third quarter of 1999 and the commodity swap expired.
Call Options. LNC uses both FTSE index and S&P 500 index call options. Call options, which expire in 2000 through 2007, provide LNC with settlement payments from the counterparties on specified expiration dates. The payment, if any, is the percentage increase in the index, over the strike price defined in the contract, applied to the notional amount. The purpose of LNC's FTSE call option program is to offset the cost of increases in the liabilities of certain single premium investment contracts that are tied to the FTSE index. The purpose of LNC's S&P 500 call option program is to offset 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.
Guarantees. LNC's guarantees include guarantees related to industrial revenue bonds, real estate partnerships and mortgage loan pass-through certificates. Based on historical performance where repurchases have been negligible and the current status, which indicates none of the loans are delinquent, the fair value liability for the guarantees related to the mortgage loan pass-through certificates is insignificant.
Derivatives. LNC employs several different methods for determining the fair value of its derivative instruments. Fair values for these contracts are based on current settlement values. These values are based on: 1) quoted market prices for foreign currency exchange contracts and financial futures contracts 2) industry standard models that are commercially available for interest rate cap agreements, swaptions, spread-lock agreements, interest rate swaps, commodity swaps and put options. 3) Monte Carlo techniques are used for the exotic equity call options. These techniques project cash flows of the derivatives using current and implied future market conditions. The cash flows are then present valued to arrive at the derivatives current fair market value. 4) Black-Scholes pricing methodology for standard European equity call options.
Carrying Fair Carrying Fair Value Value Value Value ---------- ---------- ---------- ---------- December 31 (in millions) 1999 1999 1998 1998 --------------------------------------------------------------------------------------- Assets (liabilities): Fixed maturities securities $27,688.6 $27,688.6 $30,232.9 $30,232.9 Equity securities 604.0 604.0 542.8 542.8 Mortgage loans on real estate 4,735.4 4,615.4 4,393.1 4,580.4 Policy loans 1,892.4 2,024.8 1,840.0 1,938.4 Other investments 401.8 401.8 432.0 432.0 Cash and invested cash 1,895.9 1,895.9 2,433.4 2,433.4 Investment type insurance contracts: Deposit contracts and certain guaranteed interest contracts (18,601.5) (18,267.5) (18,746.3) (18,419.8) Remaining guaranteed interest and similar contracts (1,129.8) (1,091.7) (1,444.9) (1,433.8) Short-term debt (460.1) (460.1) (314.6) (314.6) Long-term debt (712.0) (690.7) (712.2) (748.7) Company-obligated mandatorily redeemable preferred securities of subsidiary trusts holding solely junior subordinated debentures (745.0) (655.7) (745.0) (744.4) Guarantees (0.3) -- (0.3) -- Derivatives 31.4 29.4 61.4 53.0 Investment commitments -- (3.5) -- 0.1
As of December 31, 1999 and 1998, the carrying value of the deposit contracts and certain guaranteed contracts is net of deferred acquisition costs of $58.0 million and $52.6 million, respectively, excluding adjustments for deferred acquisition costs applicable to changes in fair value of securities. The carrying values of these contracts are stated net of deferred acquisition costs so that they are comparable with the fair value basis.
"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).
Year Ended December 31 (in millions) 1999 1998 1997 ------------------------------------------------------------------------------------------------- Revenue, Excluding Net Investment Income and Realized Gain (Loss) on Investments and Subsidiaries: Life Insurance and Annuities $1,778.1 $1,450.2 $826.3 Lincoln UK 368.3 350.7 340.0 Reinsurance 1,509.6 1,267.5 1,073.7 Investment Management 403.2 399.5 355.0 Other Operations (includes consolidating adjustments) (66.0) (81.2) (69.9) -------- -------- -------- Total $3,993.2 $3,386.7 $2,525.1
LNC's common and series A preferred stock is without par value.
LNC has outstanding one common share purchase right ("Right") on each outstanding share of LNC's common stock. A Right will also be issued with each share of LNC's common stock that is issued before the Rights become exercisable or expire. If a person or group announces an offer that would result in beneficial ownership of 15% or more of LNC's common stock, the Rights will become exercisable and each Right will entitle its holder to purchase one share of LNC's common stock for $100. Upon the acquisition of 15% or more of LNC's common stock, each holder of a Right (other than the person acquiring the 15% or more) will have the right to acquire the number of shares of LNC common stock that have a market value of two times the exercise price of the Right. If LNC is acquired in a business combination transaction in which LNC does not survive, each holder of a Right (other than the acquiring person) will have the right to acquire common stock of the acquiring person having a market value of two times the exercise price of the Right. LNC can redeem each Right for one cent at any time prior to the tenth day after a person or group has acquired 15% or more of LNC's common stock. The Rights expire on November 14, 2006. As of December 31, 1999, there were 195,494,898 Rights outstanding.
During 1999, 1998 and 1997, LNC purchased and retired 7,675,000, 1,246,562 and 9,897,800 shares, respectively, of its common stock at a total cost of $377.7 million, $46.9 million and $325.3 million, respectively. The common stock account was reduced for these purchases in proportion to the percentage of shares acquired. The remainder of the purchase price was charged to retained earnings.
Details underlying the balance sheet caption "Net Unrealized Gain (Loss) on Securities Available-for-Sale," are as follows:
Year Ended December 31 (in millions) 1999 1998 1997 --------------------------------------------------------------------------------------- Unrealized gains (losses) on securities available-for-sale arising during the year $(1,202.4) $210.7 $426.5 Less: reclassification adjustment for gains (losses) included in net income (1) (3.0) 50.9 158.3 Less: Federal income tax expense (benefit) (181.3) 43.4 71.2 --------- ------- ------- Unrealized gains (losses) on securities available-for-sale, net of reclassification and Federal income tax expense (benefit) $(1,018.1) $116.4 $197.0
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 $(10.7) million, $2.0 million and $(10.9) million for 1999, 1998 and 1997, respectively.
On January 2, 1998, LNC acquired a block of individual life insurance and annuity business from CIGNA for $1.414 billion. Additional funds of $228.5 million were required to cover expenses associated with the purchase and to provide additional capital for the Life Insurance and Annuities segment to support this business. Funding used to complete this acquisition was from the proceeds of the sale of the property-casualty business in 1997 (see previous paragraph). This transaction was accounted for using purchase accounting and, accordingly, operating results generated by this block of business after the closing date are included in LNC's consolidated financial statements. At the time of closing, this block of business had liabilities, measured on a statutory basis, of $5.5 billion that became LNC's obligations. LNC also received assets measured on a historical statutory basis, equal to the liabilities. Subsequent to this acquisition, LNC announced that it had reached an agreement to sell the administration rights to a variable annuity portfolio that had been acquired as part of the block of business acquired on January 2, 1998. This sale closed on October 12, 1998 with an effective date of September 1, 1998. As of December 31, 1999, the application of purchase accounting to this block of business, net of the administration rights sold and amortization, resulted in goodwill and other intangible assets of $718.6 million and $433.7 million, respectively. The goodwill amount shown includes adjustments to the amount shown at December 31, 1998. These first quarter 1999 adjustments resulted from reaching final agreement with the seller as to the statutory accounting basis of the assets and liabilities transferred to LNC.
The consolidated proforma results of operations shown below assumes that the two blocks of business described in the preceding paragraphs were purchased on January 1, 1997. Approximately one-half of the funding for this acquisition came from available funds within the consolidated group. The other half was from the proceeds of the third quarter 1998 public securities offerings from available shelf registrations.
Income from continuing operations per diluted share $ 2.69 $ 0.70 Net income per diluted share 2.69 5.09
On November 1, 1999, LNC closed its previously announced agreement to transfer a block of disability income business to MetLife. Under this indemnity reinsurance agreement, LNC transferred $490.4 million of cash to MetLife representing the statutory reserves transferred on this business, net of $18.5 million of purchase price consideration. A gain on sale of $56.7 million was deferred and will be recognized in future periods over the premium-paying period of the business.
On September 13, 1999, LNC announced that it had reached an agreement to purchase Alden Risk Management Services, the employer medical stop-loss business of the John Alden Life Insurance Company for $41.5 million in cash. The agreement also includes the purchase of a block of group life and accidental death and dismemberment business. The purchase closed on November 1, 1999. As of December 31, 1999, the application of purchase accounting to this block of business resulted in goodwill of $34.1 million and other intangible assets (i.e. present value of future service rights) of $13.7 million.
During the first quarter of 1999, LNC recorded a restructuring charge in its Investment Management segment of $12.1 million after-tax ($16.9 million pre-tax). The objective of this restructuring plan is to downsize and consolidate the back office operations of Lynch & Mayer, Inc. into Delaware Management Holdings, Inc., in order to reduce ongoing operating costs and eliminate redundant facilities within this business segment. This charge was included in Underwriting, Acquisition, Insurance and Other Expenses on the Consolidated Statement of Income for the year ended December 31, 1999. The restructuring plan identified the following activities and associated costs to achieve the objectives of the restructuring plan: (1) severance and termination benefits of $2.8 million related to the elimination of 34 positions, (2) write-off of impaired assets of $9.8 million and (3) other costs of $4.3 million. Expenditures and write-offs under the restructuring plan began in the first quarter of 1999. During the fourth quarter of 1999, LNC determined that part of rent expense related to abandoned office space included in (3) above would not be incurred due to the landlord allowing Lynch & Mayer to surrender the lease, rather than to sublease the space. As a result, the original estimate was reduced by $3.0 million (pre-tax). This reduction was recorded in the fourth quarter of 1999 as a reversal to the restructuring charge and related reserve. All remaining expenditures under this restructuring charge are expected to be complete by the second quarter of 2000. As of December 31, 1999, $13.4 million (pre-tax) has been expended or written-off under this restructuring plan and all 34 positions have been eliminated under the restructuring plan. In addition, during the fourth quarter of 1999, $1.5 million (pre-tax) associated with lease terminations was released into income.
During the fourth quarter of 1999, LNC recorded a restructuring charge in its Lincoln UK segment of $6.5 million after-tax ($10.0 million pre-tax). The objective of this restructuring plan is to reduce operating costs by consolidating and eliminating redundant staff functions and facilities. This charge was included in Underwriting, Acquisition, Insurance and Other Expenses on the Consolidated Statement of Income for the year ended December 31, 1999. The restructuring plan identified the following activities and associated costs to achieve the objectives of the restructuring plan: (1) severance and termination benefits of $3.9 million related to the elimination of 119 positions and (2) other costs of $6.1 million primarily related to the remaining lease payments on closed facilities. Expenditures and write-offs under the restructuring plan began in the fourth quarter of 1999 and are expected to be complete by the second quarter of 2001. As of December 31, 1999, $1.2 million (pre-tax) has been expended or written-off under this restructuring plan and 35 positions have been eliminated.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Lincoln National Corporation at December 31, 1999 and 1998, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.