Per share amounts were affected by the retirement of 12,088,100; 11,278,022; 6,222,581; 7,675,000 and 1,246,562 shares of common stock in 2002, 2001, 2000, 1999 and 1998, respectively. In addition, 4,630,318 shares of common stock were issued in 2001 related to the settlement of purchase contracts issued in conjunction with FELINE PRIDES financing.
Other risks and uncertainties include: the risk that significant accounting, fraud or corporate governance issues may adversely affect the value of certain investments; whether necessary regulatory approvals are obtained (e.g., insurance department, Hart-Scott-Rodino, etc.) and, if obtained, whether they are obtained on a timely basis; whether proceeds from divestitures of legal entities and blocks of business can be used as planned; litigation, arbitration and other actions (e.g., (a) adverse decisions in significant actions including, but not limited to extra contractual and class action damage cases, (b) new decisions which change the law, (c) unexpected trial court rulings, (d) unavailability of witnesses and (e) newly discovered evidence); acts of God (e.g., hurricanes, earthquakes and storms); whether there will be any significant charges or benefits resulting from the contingencies described in the footnotes to LNC’s consolidated financial statements; acts of terrorism or war; the stability of governments in countries in which LNC’s subsidiaries do business; and other insurance risks (e.g., policyholder mortality and morbidity).
The risks included here are not exhaustive. Other sections of this report, and LNC’s quarterly reports on Form 10-Q, current reports on Form 8-K and other documents filed with the Securities and Exchange Commission include additional factors which could impact LNC’s business and financial performance. Moreover, LNC operates in a rapidly changing and competitive environment. New risk factors emerge from time to time and it is not possible for management to predict all such risk factors. Further, it is not possible to assess the impact of all risk factors on LNC’s business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements. Given these risks and uncertainties, investors should not place undo reliance on forward-looking statements as a prediction of actual results. In addition, LNC disclaims any obligation to update any forward-looking statements to reflect events or circumstances that occur after the date of this report.
Given the nature of LNC’s business, the Company’s accounting policies require the use of judgments relating to a variety of assumptions and estimates. Because of the inherent uncertainty in the assumptions and estimates underlying these accounting policies, under different conditions or assumptions the amounts reported in LNC’s financial statements could be materially different. Throughout Management’s Discussion and Analysis, the application of these various critical accounting policies is addressed along with the effect of changes in estimates and assumptions.
Accounting for intangible assets requires numerous assumptions, such as estimates of expected future profitability for various LNC operations and LNC’s ability to retain its existing blocks of life and annuity business in force. LNC’s accounting policies for the intangible assets of deferred acquisition costs (“DAC”) and the present value of acquired blocks of in-force policies (“PVIF”) are discussed within the Lincoln Retirement, Life Insurance and Lincoln UK segments. LNC’s overall accounting policy for other identified intangibles and goodwill is discussed within Results of Consolidated Operations. A key assumption affecting the accounting for DAC and PVIF is the performance of equity markets. Sensitivity to changes in equity market performance upon LNC’s net income is discussed under the heading “First Quarter 2003 Guidance for the Effects of Equity Market Volatility on Fee Income, DAC and GMDB” found within LNC’s discussion of Consolidated Operating results. Additionally, LNC has goodwill resulting from various acquisitions. Refer to the “Accounting for Business Combinations and Goodwill and Other Intangible Assets” section for discussion of the evaluation of goodwill for impairment. Within the Investment Management segment, LNC has an
intangible asset for Deferred Dealer Commissions. A significant decrease in the equity markets could affect the carrying value of this asset. Refer to the Investment Management Results of Operations section for future discussion of this asset.
Continued access to capital markets and maintenance of favorable debt and claims paying ratings are critical to LNC’s future success. LNC’s accounting, in a wide variety of areas, is inherently dependant upon continued access to capital and maintaining adequate ratings. Detailed discussion of LNC’s access to capital markets, liquidity status and ratings are contained within Review of Consolidated Financial Condition.
Net income decreased $498.6 million or 84%. The decrease in net income included an increase in realized losses on investments and derivatives of $102.8 million and expenses totaling $199.1 million recorded in 2002 related to increases in reserves for the business sold through indemnity reinsurance to Swiss Re. The realized losses on investments resulted from declines in value and the sale and write-downs of fixed maturity securities. See the Consolidated Investment section for further discussion of this matter.
Consolidated revenue decreased primarily due to the reduction of revenue of $1,699.4 million (pre-tax), excluding realized losses on investments, from the former Reinsurance segment in 2001. Another contributor to the decline in revenue was the increase in realized losses on investments noted above. Included in 2002 revenue was $74.4 million (pre-tax) for the amortization of the deferred gain on indemnity reinsurance compared to $20.4 million in 2001. The Lincoln Retirement and Lincoln UK segments experienced decreased fee income due to the negative impact that 2001 and 2002 equity market declines had on average variable annuity (Retirement) and unit-linked (Lincoln UK) account values. The Investment Management segment had decreased investment advisory fees and other revenue and fees as a result of lower retail and institutional assets under management during 2002. The decrease in assets under management was primarily a result of the declining equity markets.
For 2002, LNC reported a tax benefit of $90.0 million on $1.6 million of pre-tax earnings. This unusual relationship between tax benefit and pre-tax earnings results from the fact that LNC has tax-preferred investment income that does not change proportionately with the change in consolidated pre-tax earnings. LNC’s tax-preferred investment income is primarily the result of dividend received deductions attributable to LNC’s allocable share of dividend income generated by equity securities held within the Lincoln Retirement segments’ separate accounts. See note 4, Federal Income Taxes, to the consolidated financial statements for more details.
Total revenue, excluding realized gains and losses on investments and derivative instruments and gain on sale of subsidiaries, decreased by $395.7 million or 6% in 2001 due primarily to lower fee income in the Lincoln Retirement segment and lower investment advisory fees in the Investment Management segment resulting from the depressed equity markets in 2001 and to a lesser extent to net outflows in annuities and investment products. In addition, Lincoln UK had a decrease in operating revenue due to lower business volume along with lower fee income resulting from a downturn in the United Kingdom equity markets over
the last half of 2001. The former Reinsurance segment’s operating revenue was down in 2001 as its results only included eleven months of activity. Finally, LFA and LFD included in Other Operations had lower sales revenue largely attributable to the volatile equity markets. Partially offsetting these negative variances, the Life Insurance segment had increased operating revenue due to growth in life insurance in-force.
Total expenses, exclusive of restructuring charges and Federal income taxes, decreased by $329.9 million or 6% in 2001 due primarily to decreased expenses in the Lincoln UK segment as a result of the decrease in business volume along with effective expense management. The former Reinsurance segment had a decrease due to only eleven months of expenses being reported for its operations. However, included in 2001 expenses for the former Reinsurance segment were losses recorded for the events of September 11. The Lincoln Retirement segment had a decrease in expenses due primarily to less amortization of deferred acquisition costs and other intangible assets partially offset by increased operating and administrative expenses and benefits expenses. The Investment Management segment also experienced decreased expenses due to effective expense management and lower amortization of other intangibles assets. Partially offsetting these positive variances were increases in expenses in the Life Insurance segment, as well as LFD and LFA. Expenses increased in the Life Insurance segment primarily as a result of the growth in in-force, which drove interest credited to policyholders higher. LFD had higher expenses primarily as a result of its investment in new wholesalers during 2001 and LFA experienced an increase in general and administrative expenses partially offset by a decrease in commissions and other volume-related expenses. These expenses fell as a direct result of lower sales volume in 2001. For further discussion of the results of operations, see the discussion of the results of operations by segment.
For additional detail of deposit and net flow information see the discussion of the Results of Operations by Segment.
detail below, the effects on LNC’s results of significant volatility in equity markets are complex and are not expected to be proportional for market increases and market decreases. The first quarter 2003 information provided below is based upon market conditions and LNC’s mix of business as of the beginning of the year. This guidance can be expected to change as actual circumstances change. Although LNC believes this guidance provides reasonable estimates based upon conditions as of January 1, 2003, LNC claims no responsibility for updating this forward-looking information.
It is important to understand that the actual effect on fee income of market changes in the current quarter of an equity market change and the effect in the immediately following quarter will not be equal to a pro-rata 25% of the estimated annualized effect of the market change. This is due to the fact that the actual change in fee income in the immediate quarter during which the market changes is measured by the change in actual variable account values from the beginning of the quarter compared to the average balance of variable account values for the quarter. The change in fee income due to the change from average account values to ending account values does not occur in the immediate quarter of the market change; rather, that change in fee income will occur in the quarter following the market change. LNC estimates that this lagging effect for the fourth quarter 2002 equity markets change will create a decrease of $0.5 million in fee income in the first quarter of 2003, because average account values for the fourth quarter of 2002 exceeded the level of ending account values at December 31, 2002.
Additional market indices are used in measuring the effects of the market on the results of LNC’s Investment Management segment. All of the relevant equity market indices (S&P, NASDAQ and MSCI EAFE) declined during the third quarter, ranging from a 19.9% NASDAQ decline to a 19.7% decline in the MSCI EAFE index. The fourth quarter increases were a 13.9% increase in the NASDAQ and a 6.5% increase in the MSCI EAFE index. The ongoing effect of the fourth quarter equity markets increase is expected to be a $0.1 million increase in the first quarter of 2003.
The third scenario assumes that from December 31, 2002 through the end of the first quarter of 2003 equity markets decline smoothly by 2.5%.
However, in all following quarters, the ongoing effect of changes in the market occurring in the current quarter will be determined by the difference in beginning of quarter to end of quarter variable account balances. For purposes of this guidance, the change in account values is assumed to correlate with the change in the relevant index.
2.5% decline in equity markets from December 31, 2002 to March 31, 2003
As the above table indicates, the annual effect of a one percent change in equity markets varies depending upon the severity of the change. Presented below are estimated one million dollar effects for various market changes that are currently used by LNC in modeling the Lincoln Retirement segment. These estimated
The following table provides the annual effect for changes in equity markets for the Lincoln Retirement segment related to fee income and other:
The estimated annual effects indicated in the table above are applicable for the first quarter of 2003. For example, assume an estimate is being computed for the quarterly effect on Lincoln Retirement’s fee income due to a 2.5% increase in the markets occurring in the first quarter of 2003. In this example, the expected quarterly effect of a first quarter 2.5% increase is estimated as: ($2.0*1.25/4) = $0.625 million.
The table provided below contains information for use in estimating the first quarter 2003 effect for changes in equity markets for the Lincoln Retirement segment related to GMDB and DAC. For GMDB, quarterly results will include a reserve adjustment. This is due to the fact that LNC has established the GMDB reserves net of anticipated future GMDB fee revenues. As a result, an adjustment will be required to increase GMDB reserves during periods where a GMDB Net Amount At Risk exists.
Based upon the Net Amount At Risk for GMDB at December 31, 2002, the first quarter 2003 GMDB reserve adjustment is estimated at $5.9 million (included in the no change column in the table below).
The estimated quarterly effects indicated in the table above are applicable for the first quarter of 2003. For example, assume an estimate is being computed for the quarterly effect on Lincoln Retirement’s GMDB reserve due to a 2.5% increase in the equity markets occurring in the first quarter of 2003. The estimated quarterly effect is calculated as follows: $(5.9) + 0.8*2.5 = $(3.9) million.
ment segment. The results of the first step of the tests indicated that LNC did not have impaired goodwill. LNC has chosen October 1 as its annual review date. As such, LNC performed another valuation review during the fourth quarter of 2002. The results of the first step of the tests performed as of October 1, 2002 indicated that LNC did not have impaired goodwill. The valuation techniques used by LNC for each reporting unit were consistent with those used during the transitional testing.
In August 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“FAS 144”), which supersedes Statement of Financial Accounting Standards No. 121, and the accounting and reporting provisions of APB Opinion No. 30. FAS 144 is effective for fiscal years beginning after December 15, 2001. LNC adopted FAS 144 on January 1, 2002 and the adoption of the Statement did not have a material impact on the consolidated financial position and results of operations of LNC.
In June 2002, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“FAS 146”), which addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)” (“Issue 94-3”). The principal difference between FAS 146 and Issue 94-3 is that FAS 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred, rather than at the date of an entity’s commitment to an exit plan. FAS 146 is effective for exit or disposal activities after December 31, 2002. Adoption of FAS 146 by LNC will result in a change in timing of when expense is recognized for restructuring activities after December 31, 2002.
The three transition methods provided under FAS 148 are the prospective, the modified prospective and the retroactive restatement methods. LNC will adopt the retroactive restatement method, which requires that companies restate all periods presented to reflect stock-based employee compensation cost under the fair value accounting method in FAS 123 for all employee awards granted, modified or settled in fiscal years beginning after December 15, 1994. FAS 148’s amendment of the transition and annual disclosure requirements of FAS 123 is effective for fiscal years ending after December 15, 2002. LNC will adopt the fair value method of accounting under FAS 123, as amended by FAS 148, as of January 1, 2003 and will present restated financial statements for the years 2002, 2001 and 2000 in its first quarter 2003 filing on Form 10-Q (see Note 1 for pro forma net income and pro forma basic and diluted earnings per share amounts for 2002, 2001 and 2000 and Note 6 for discussion of stock-based employee compensation cost.).
Effective January 1, 2003, LNC’s stock option employee compensation plan and long-term cash incentive compensation plan were revised and combined to provide for performance vesting, and to provide for awards that may be paid out in a combination of stock options, performance shares of LNC stock and cash. The
In January 2003, the Financial Accounting Standards Board issued Financial Accounting Standards Board Interpretation No. 46, “Consolidation of Variable Interest Entities” (“Interpretation 46”), which requires the consolidation of variable interest entities (“VIE”) by an enterprise if that enterprise has a variable interest that will absorb a majority of the VIE’s expected losses if they occur, receive a majority of the entity’s expected residual returns if they occur, or both. If one enterprise will absorb a majority of a VIE’s expected losses and another enterprise will receive a majority of that VIE’s expected residual returns, the enterprise absorbing a majority of the losses shall consolidate the VIE. VIE refers to an entity in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. This Interpretation applies in the third quarter of 2003 to VIEs in which an enterprise holds a variable interest that is acquired before February 1, 2003. This Interpretation may be applied prospectively with a cumulative-effect adjustment as of the date on which it is first applied or by restating previously issued financial statements for one or more years with a cumulative-effect adjustment as of the beginning of the first year restated.
the original charge recorded for the Vantage restructuring plan was reversed as a reduction of restructuring costs due primarily to changes in estimates associated with severance and abandoned leased office space costs. All expenditures and write-offs for the Lincoln Investment Management restructuring plan were completed in the third quarter of 2002 and $0.4 million of the original reserve was released. The release of the reserve was primarily due to LNC’s purchase and ultimate sale of the vacant office space on terms, which were favorable to what was included in the original restructuring plan for rent on this office space. In the fourth quarter of 2002, $1.7 million of the Lincoln UK restructuring reserve was released as a result of new tenants being contracted for several of the abandoned office facilities on terms that were better than originally expected. Actual pre-tax costs totaling $95.0 million have been expended or written off for these plans through December 31, 2002. As of December 31, 2002, a balance of $9.7 million remains in the restructuring reserve for the Lincoln UK plan and is expected to be utilized in the completion of the plan. Additional details of each of the three restructuring plans are discussed in Note 12 to the consolidated financial statements.
During 2001, LNC implemented restructuring plans relating to 1) the consolidation of the Syracuse operations of Lincoln Life & Annuity Company of New York into the Lincoln Retirement segment’s operations in Fort Wayne, Indiana and Portland, Maine; 2) the elimination of duplicative functions in the Schaumburg, Illinois operations of First Penn-Pacific, and the absorption of these functions into the Lincoln Retirement and Life Insurance segments operations in Fort Wayne, Indiana and Hartford, Connecticut; 3) the reorganization of the life wholesaling function within the independent planner distribution channel, consolidation of retirement wholesaling territories, and streamlining of the marketing and communications functions in LFD; 4) the reorganization and consolidation of the life insurance operations in Hartford, Connecticut related to the streamlining of underwriting and new business processes and the completion of outsourcing of administration of certain closed blocks of business; 5) the consolidation of the Boston, Massachusetts investment and marketing office with the Philadelphia, Pennsylvania investment and marketing operations in order to eliminate redundant facilities and functions within the Investment Management segment 6) the combination of LFD channel oversight, positioning of LFD to take better advantage of ongoing “marketplace consolidation” and expansion of the customer base of wholesalers in certain territories and 7) the consolidation of operations and space in LNC’s Fort Wayne, Indiana operations.
The Syracuse restructuring charge was recorded in the first quarter of 2001, the Schaumburg, Illinois restructuring charge was recorded in the second quarter of 2001, the LFD restructuring charges were recorded in the second and fourth quarters of 2001, and the remaining restructuring charges were all recorded in the fourth quarter of 2001. The aggregate charges associated with all restructuring plans entered into during 2001 totaled $24.6 million after-tax ($38.0 million pre-tax). The component elements of these aggregate pre-tax costs include employee severance and termination benefits of $12.2 million, write-off of impaired assets of $3.3 million and other exit costs of $22.5 million primarily related to the termination of equipment leases ($1.4 million) and rent on abandoned office space ($20.0 million). The Syracuse restructuring plan was completed in the first quarter of 2002 with expenditures and write-offs totaling $1.3 million. The total amount expended exceeded the original charge by $0.3 million. The LFD restructuring plan that was initiated in the second quarter of 2001 was completed in the fourth quarter of 2002. Actual pre-tax costs totaling $1.8 million were expended or written off, which was equal to the original reserve. The Life Insurance segment restructuring plan that was initiated in the fourth quarter of 2001 was completed in the fourth quarter of 2002. Actual pre-tax costs totaling $2.3 million dollars were expended or written-off. The amount expended for this plan was in excess of the original reserve by less than $0.1 million. In addition, $0.1 million of excess reserve on the FPP restructuring plan was released during the second quarter of 2002 and $1.5 million of excess reserve on the Fort Wayne restructuring plan was released during the third quarter of 2002. The release of the reserve on the Fort Wayne restructuring plan was due to LNC’s purchase and ultimate sale of the vacant building on terms which were favorable to what was included in the original restructuring plan for rent on this abandoned office space. Actual pre-tax costs totaling $34.0 million have been expended or written off for the four remaining plans through December 31, 2002. As of December 31, 2002, a balance of $1.4 million remains in the restructuring reserves for these plans and is expected to be utilized in the completion of the plans. Additional details of each of these restructuring plans are discussed in Note 12 to the consolidated financial statements.
During the second quarter of 2002, Lincoln Retirement completed a review of its entire internal information technology organization. As a result of that review, Lincoln Retirement decided in the second quarter of 2002 to reorganize its IT organization in order to better align the activities and functions conducted within its own organization and its IT service providers. This change was made in order to focus Lincoln Retirement on its goal of achieving a common administrative platform for its annuities products, to better position the organization and its service providers to respond to changing market conditions, and to reduce overall costs in response to increased competitive pressures. The restructuring plan implemented to achieve these objectives included aggregate pre-tax costs of $1.6 million, composed of $1.4 million for employee severance and $0.2 million for employee outplacement. Actual pre-tax costs expended through December 31, 2002 were $0.9 million. As of December 31, 2002, a balance of $0.7 million remains in the restructuring reserve for this plan and is expected to be utilized in the completion of the plan. Additional details of this restructuring plan are discussed in Note 12 to the consolidated financial statements.
In January 2003, the Life Insurance segment announced that it was realigning its operations in Hartford, Connecticut and Schaumburg, Illinois to enhance productivity, efficiency and scalability while positioning the segment for future growth. The financial impact of the realignment will result in the Life Insurance segment incurring costs of approximately $15-$17 million after-tax during 2003. While some savings may materialize in the second half of 2003, the majority of the savings will be realized in 2004, at which time the run-rate for operating and administrative expenses should be reduced by $15-$20 million pre-tax.
Effective with the closing of the transaction, the former Reinsurance segment’s historical results were moved into “Other Operations.” During December 2001 LNC recognized in Other Operations $5.0 million ($7.9 million pre-tax) of deferred gain amortization. In addition, in December 2001, LNC recognized $7.9 million ($12.5 million pre-tax) of accelerated deferred gain amortization relating to the fact that certain Canadian indemnity reinsurance contracts were novated after the sale, but prior to December 31, 2001.
Also during 2002, LNC exercised a contractual right to “put” its interest in a subsidiary company containing LNC’s disability income reinsurance business to Swiss Re for $10 million. The $10 million sale price was approximately equal to LNC’s book basis in the subsidiary.
Because of ongoing uncertainty related to personal accident and disability income businesses, the reserves related to these exited business lines carried on LNC’s balance sheet at December 31, 2002 may ultimately prove to be either excessive or deficient. For instance, in the event that future developments indicate that these reserves should be increased, under FAS 113 LNC would record a current period non-cash charge to record the increase in reserves. Because Swiss Re is responsible for paying the underlying claims to the ceding companies, LNC would record a corresponding increase in reinsurance recoverable from Swiss Re. However, FAS 113 does not permit LNC to take the full benefit in earnings for the recording of the increase in the reinsurance recoverable in the period of the change. Rather, LNC would increase the deferred gain recognized upon the closing of the indemnity reinsurance transaction with Swiss Re and would report a cumulative amortization “catch-up” adjustment to the deferred gain balance as increased earnings recognized in the period of change. Any amount of additional increase to the deferred gain above the cumulative amortization “catch-up” adjustment must continue to be deferred and will be amortized into income in future periods over
The Lincoln Retirement segment (formerly known as the Annuities segment), headquartered in Fort Wayne, Indiana, provides tax-deferred investment growth and lifetime income opportunities for its clients through the manufacture and sale of fixed and variable annuities. Through a broad-based distribution network, Lincoln Retirement provides an array of annuity products to individuals and employer-sponsored groups in all 50 states of the United States. Lincoln Retirement distributes some of its products through LNC’s wholesaling unit, LFD, as well as LNC’s retail unit, LFA. In addition, group fixed and variable annuity products and the Alliance program are distributed to the employer-sponsored retirement market through Lincoln Retirement’s Fringe Benefit Division dedicated sales force.
In 2002, the S&P 500 index declined 23.4%. The significant decline in the equity markets negatively affected the segment’s earnings through lower fees from lower average variable account values, negative unlocking of deferred acquisition costs (“DAC”) and the present value of in-force (“PVIF”) intangible assets and increases in reserves and benefit payments for guaranteed minimum death benefits (“GMDB”).
The use of a reversion to the mean assumption is common within the industry; however, the parameters used in the methodology are subject to judgment and vary within the industry. An important aspect of LNC’s application of the reversion to the mean is the use of caps and floors on the growth rate assumption, which limit the gross growth rate assumption to reasonable levels above and below the long-term assumption. In the fourth quarter 2002, LNC adjusted its reversion to the mean gross growth rate assumption to 9%. This change along with changes to assumptions for variable annuity persistency and revisions to amortization periods resulted in DAC and PVIF adjustments reducing income by $8.8 million. Going forward, as the growth rate of the equity market varies from LNC’s growth rate assumption, the period over which the reversion to the mean gross growth rate assumption needs to be earned will be four years. The segment is reviewing the appropriate cap or floor levels and will incorporate this into the methodology. On a quarterly basis, LNC reviews the assumptions of its DAC amortization model and records a retrospective adjustment to the amount expensed, (i.e. unlocks the DAC). On an annual basis, LNC reviews and adjusts as necessary its assumptions for prospective amortization of DAC, as well as its other intangible asset, present value of in-force (“PVIF”).
The GMDB reserves are a function of the net amount at risk (“NAR”), mortality, persistency, and incremental death benefit M&E expected to be incurred over the period of time for which the NAR is positive. At any given point in time, the NAR is the difference between the potential death benefit payable and the total account balance, with a floor value of zero (when account values exceed the potential death benefit there is no amount at risk). As part of the estimate of future NAR, gross equity growth rates which are consistent with those used in the DAC valuation process are utilized. On average, the current gross equity growth rate would project to a zero NAR over roughly four years from the balance sheet date. The fourth quarter of 2002 change to the reversion to the mean assumption resulted in an increase to GMDB reserves and reduced income by $21.5 million. Projections of account values and NAR followed by computation of the present value of expected NAR death claims using product pricing mortality assumptions less expected GMDB M&E revenue during the period for which the death benefit options are assumed to be in the money are made each valuation date for every variable annuity contract with a GMDB benefit feature. If equity market returns exactly match LNC’s reversion to the mean rate and actual mortality and lapse experience is as assumed, the GAAP reserve plus interest and GMDB M&E revenue would exactly cover the future expected GMDB payments as they arise.
such as average account values, average amounts of NAR, and the age of contractholders. The following discussion provides this information for LNC’s variable annuity business.
At December 31, 2002 LNC had $9.1 billion of variable annuity account value, about 25% of LNC’s total, that is subject to a high water mark type GMDB benefit. LNC’s average variable annuity with a high water mark feature has an average account value of $58,400 and average NAR of $19,800. The average attained age of these contract holders is just over 60 with 24% over age 70. The GAAP GMDB reserve on these accounts was $56.9 million on a total NAR of $2.8 billion.
At December 31, 2002 only $262 million of variable account value, less than 1% of LNC’s total, was subject to roll-up type GMDB benefit. LNC’s average variable annuity with a roll-up feature has an average account value of $91,000 and average NAR of $17,700. The average attained age of these contract holders is just under 63 with 28% over age 70. The GAAP GMDB reserve on these accounts was $0.4 million on a total NAR of $40 million.
At December 31, 2002 LNC had $8.5 billion of variable annuity account value, about 23%, that was not subject to any GMDB benefit. These accounts average $45,800 in account value. The average attained age of these contract holders is 58 with 20% over 70.
LNC has variable annuity contracts containing GMDB’s which have a dollar for dollar withdrawal feature. Under such a feature, withdrawals reduce both current account value and the GMDB amount on a dollar for dollar basis. For contracts containing this dollar for dollar feature, the account holder could withdraw a substantial portion of their account value resulting in a GMDB which is multiples of the current account value. LNC’s exposure to this dollar for dollar risk is somewhat mitigated by the fact that LNC does not allow for partial 1035 exchanges on non-qualified contracts. To take advantage of the dollar for dollar feature, the contract holder must take constructive receipt of the withdrawal and pay any applicable surrender charges. LNC will report the appropriate amount of the withdrawal that is taxable to the IRS, as well as indicating whether or not tax penalties apply under the premature distribution tax rules. LNC closely monitors its dollar for dollar withdrawal GMDB exposure and works with key broker dealers that distribute LNC’s variable annuity products. As of December 31, 2002, there were 276 contracts for which the death benefit to account value ratio was greater than ten to one. The net amount at risk on these contracts was $19.3 million. Effective May of 2003, the GMDB feature offered on new sales will be a pro-rata GMDB feature whereby each dollar of withdrawal will reduce the GMDB benefit in proportion to the current GMDB to account value ratio.
The $89.4 million or 25% decrease in net income was due in part to an increase in realized loss on investments and derivative instruments of $39.1 million. These investment losses were due primarily to losses
Weak performance of the equity markets in 2001 caused variable annuity account values to be depressed throughout 2001. Fee income, which is calculated daily based on the ending variable annuity account values, decreased $48.9 million between years as a result of market depreciation experienced in the last quarter of 2000 and overall in 2001 and to a lesser extent, net outflows for variable annuities in 2000. Average variable annuity account values decreased by $6.2 billion or 15% in 2001 from 2000. Variable annuity net flows (including the fixed portion of variable contracts) were essentially zero for 2001 due to a strong second half of the year. Partially offsetting the decrease in fee income was a $6.2 million positive fee income rate variance related to a change in mix of the variable annuity business. The downturn in the equity markets also contributed to an increase of $7.3 million in benefit payments and reserve requirements for guaranteed minimum death benefits. Average fixed annuity account values decreased by $331 million or 1.9% in 2001 from the average in 2000 due to net outflows in 2000. This decreased earnings by $1.4 million between years. As a result of improved retention and lower account values in 2001, surrender charges decreased $6.9 million between years.
Net investment income decreased between years due primarily to reduced earnings of $5.2 million on investment partnerships. Overall investment spreads on fixed annuity products (excluding the impact of investment income earned on surplus supporting the segment which includes investment partnerships) decreased between years: 2.05% in 2001 versus 2.14% in 2000.
The Lincoln Retirement segment experienced negative DAC unlocking in the first and third quarters of 2001 and positive unlocking in the second and fourth quarters of 2001 due to movements in the market. DAC unlocking created a negative variance in earnings of $4.0 million compared to 2000. Due to changes in assumptions for prospective DAC amortization made at the beginning of 2001, the segment experienced a decrease in DAC amortization expense of $37.8 million relative to 2000. This unlocking created a positive variance of $4.5 million between years, which was caused by improved persistency in 2001 and lower expense projections.
Incremental Deposits represent gross deposits reduced by transfers from other Lincoln Annuity products.
In order to achieve profitable future earnings growth for both fixed and variable annuity products the ability to attract new deposits and to retain existing accounts is crucial. In 2002, the Lincoln Retirement segment experienced a continuation of the trend of positive net flows that began in the third quarter of 2001. For the year, total annuity deposits were $6.4 billion, flat with 2001. However, withdrawals were $5.9 billion, an improvement of $0.5 billion resulting in positive net flows of $0.5 billion.
The improvement in net flows is reflective of LNC’s goal of maintaining positive net flows by growing deposits and retaining existing accounts. LNC has experienced six consecutive quarters of positive net flows. This improvement is largely attributable to LNC’s balanced array of products and distribution breadth.
At December 31, 2002, 52% of Lincoln Retirement’s account values contained the most conservative type of GMDB which is return of premium. There are two other primary types of GMDB’s in the portfolio, the high-water mark and the 5% step-up. The 5% step-up product accounts for less than 1 percent of Lincoln Retirement’s variable annuity account values. LNC is currently reviewing this feature and other guarantees. In the future they may be changed or discontinued.
LNC’s efforts to grow deposits by introducing innovative products that meet the changing needs of its customers and to retain existing accounts through targeted conservation efforts and by offering better replacement alternatives for current customers have yielded positive results. In addition, Lincoln Retirement’s improvement in flows is even more powerful when looking at current industry activity. Aggressive pricing strategies aimed at increasing market share which are prevalent in the marketplace, but counter to LNC’s strategy, include significant commission specials that are 100-200 basis points above LNC’s; aggressive living benefit riders that give the customer the opportunity to transfer market risk to the company at their discretion and could ultimately spell disaster for either client or company; and combination high bonus and high commission products that could promote inappropriate sales behavior. LNC has been able to grow new deposits without employing, to any significant extent, the various aggressive strategies listed above. This progress can be attributed to not only its strong product line-up and distribution breadth, but also the implementation of more stringent standards and controls on internal transfers.
In looking at annuity withdrawals and the overall profitability of the business, 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 in designing the annuity product, it is possible to gauge whether performance is better or worse than pricing. Overall lapse rates were 10.47% in 2002, 9.72% in 2001 and 11.95% in 2000. In all three years, overall lapse rates have been more favorable than expected in pricing assumptions. The improvement in persistency over the three year period has partially countered the reduction in fee income resulting from lower average variable annuity account values caused by market depreciation.
To sustain and further improve overall retention levels, LNC is utilizing targeted conservation efforts and is exploring other retention initiatives. In addition, LNC believes that maintaining a strong and balanced portfolio of fixed and variable annuities provides a platform for maintaining positive net flows. If equity markets continue to decline, LNC may see increased exchange activity in 2003, particularly if consumers move funds to products that provide an account value floor (i.e. living benefits).
changes intended to mitigate the double taxation of dividends. At this point, the potential impact of this developing legislative proposal on annuities products is uncertain. Concerns expressed in this regard by the industry have been favorably received by key Bush administration officials, with indications that these matters are being given careful consideration during the ongoing drafting of the legislative proposal. Also unknown at this time is the impact, if any, that the proposed legislation may have on the Lincoln Retirement segment future corporate tax burden, including how corporate dividends would be treated under the proposed new approach to corporate taxation. At this point, LNC is unable to predict, with any degree of certainty, the likelihood or final form in which this proposed legislation might become law.
Tax legislation, along with current economic and market conditions continue to be very uncertain which may adversely affect annuity sales for the industry and Lincoln Retirement. Although LNC is committed to its two-pronged approach of growing new deposits and retaining existing assets to manage its net flows; achieving positive net flows in 2003 may be difficult for the industry and Lincoln Retirement. LNC expects to continue to strengthen its distribution breadth and emphasize expense management as key profitability drivers in an increasingly challenging market.
Cumulative Effect of Accounting Changes relates to the transition adjustment of $(0.2) million recorded in the first quarter of 2001 upon adoption of FAS No. 133 and the adjustment of $(5.3) million recorded in the second quarter of 2001 upon adoption of EITF 99-20.
Net income decreased $24.1 million or 10% in 2002 from the prior year. Excluding the amortization of goodwill in 2001, net income decreased $47.8 million or 19%. A significant contributor to the decrease in net income between periods was an increase in realized losses on investments of $26.0 million primarily resulting from the write-down of fixed maturity securities in 2002. In 2001, the Life Segment reported two restructuring charges which reduced 2001 net income by $3.5 million. There were no restructuring charges for the segment in 2002. Also, in 2001 net income was negatively affected by $5.5 million to due the cumulative effect of the adopting FAS. No. 133 and EITF 99-20. There were no accounting principles adopted in 2002 requiring a cumulative adjustment.
Mortality experience (mortality assessments less net death benefits and negative DAC unlocking) in 2002 was less favorable relative to 2001 and resulted in a $13.1 million reduction in income. Volatility is expected from mortality risk, but LNC attempts to lessen the impact of volatility on earnings by reinsuring approximately 90% of the new business written by the Life Insurance segment. Investment yields declined at a faster pace than reductions in crediting rates which reduced investment margins $10.5 million. (See discussion on investment margins and the interest rate risk due to falling interest rates within Item 7A, Quantitative and Qualitative Disclosures About Market Risk.) In addition, decreased earnings from investment partnerships resulted in a negative variance of $6.7 million.
Life insurance in-force, increased 8% from December 31, 2001 due to strong sales growth over the last year and continued favorable persistency. Total sales as measured by first year premiums were up $154.8 million or 25% and retail sales were up $113.9 million or 20% in 2002. Sales of universal life (“UL”), whole life and term life insurance products improved by 69%, 15% and 5%, respectively. Due to the volatile equity markets experienced over the last several quarters, there has been a sustained flight to interest-sensitive products from variable universal life insurance (“VUL”). As a result, sales of VUL products were down 41% from the prior year period.
Account values of $12.1 billion at December 31, 2002 increased $0.7 billion or 6% from December 31, 2001. The drivers of this increase were positive cash flows, net of policyholder assessments, of approximately $0.3 billion across all products during the last twelve months, the transfer of the Legacy Life block of business ($0.15 billion) from the Lincoln Retirement segment in the first quarter of 2002 and interest earned on the
Partially offsetting the increased retail UL/ UVL sales levels noted above was a decrease in term life sales of $11.1 million or 26% between years. Term life sales for the first six months of 2001 lagged the prior year period largely due to strong first half of 2000 sales that were bolstered by the impending enactment of the Valuation of Life Insurance Model Regulation (“Regulation XXX”). Regulation XXX required companies to increase reserves relative to certain term life and permanent insurance policies with secondary guarantees as of January 1, 2000. There was a rush of term business in anticipation of the related price increases for implementation of Regulation XXX with sales up in the first half of 2000 due to a back log of business at December 31, 1999. Term sales increased incrementally each quarter in 2001 and for the fourth quarter were 20% higher compared to the same quarter in 2000.
To reflect the financial requirements of AXXX, Lincoln is repricing single life and survivorship products that offer secondary guarantees using shadow accounts. The products are scheduled to be released in the latter part of first quarter 2003. Lincoln also markets universal life products that do not offer secondary guarantees, which will not be impacted by AXXX. LNC believes that secondary guarantees are going to continue to be critical to LNC’s target affluent market and that the repriced versions of these products should remain competitive. However, LNC may lose market share if competitors are slow to replace their secondary guarantees for AXXX.
A variety of legislative proposals are being considered that would effect corporate owned life insurance. LNC believes that life insurance remains a legitimate method of corporate funding of anticipated future commitments as well as protection from unpredictable events such as the loss of key business executives. The Life Insurance segment continues to approach COLI as an opportunistic market strategy. LNC’s COLI product is only marketed to organizations for coverage of officers and require the prospective permission of officers to be covered under the COLI policy. Given the continuing legislative debates over corporate owned life insurance LNC management is not currently able to determine what impact this environment will have on product design or sales. At December 31, 2002, Life Insurance had $684 million of account values for COLI, representing less than 6% of total segment account values.
The Life Insurance segment experienced strong retail sales growth in 2002. Sales trends over the next year for both UL and VUL products will likely continue to be heavily influenced by the equity markets performance and the uncertainty of the regulatory environment as well as the continued competitive environment. There should continue to be a demand among the affluent for sophisticated life products to meet a variety of tax, business and family needs. LNC’s balanced portfolio of products is nicely positioned to take advantage of this demand. The Life Insurance segment expects to continue to hold firm its operating fundamentals of: strong distribution relationships, solid underwriting, mortality and investment management and strong expense controls as it strives to be among the top five generators of new premiums in the life insurance industry. The Life Insurance segment’s earnings can be expected to reflect some volatility due to short-term effects of swings in mortality and morbidity.
The Investment Management segment, headquartered in Philadelphia, Pennsylvania, offers a variety of asset management services to retail and institutional clients located throughout the United States and certain foreign countries. Its product offerings include mutual funds and managed accounts. It also provides investment management and account administration services for variable annuity products, 401(k) plans, “529” college savings plans, pension, endowment, and trust and other institutional accounts. The primary operating companies within this segment are the subsidiaries of Delaware Management Holdings, Inc. (“Delaware”). Retail products are primarily marketed by LFD and Delaware Distributors, L.P. through financial intermediaries including LFA. Institutional products, including large case 401(k) plans, are marketed by a separate sales force within Delaware working closely with pension consultants.
Diversity of investment styles, as well as diversity of clients served, are prudent ways to manage risk in varying market environments. Delaware, historically known for a conservative, “value” equity investment style has now evolved into an investment manager with strong and diversified offerings across all major asset classes including value and growth equity investment styles; high-grade, high-yield and municipal fixed income investment styles; balanced and quantitative investment styles; and international and global equity and fixed income investment styles.
Cumulative Effect of Accounting Change relates to the second quarter 2001 adoption of EITF 99-20.
The primary driver of the decrease in external assets under management between years was net cash outflows of $7.2 billion in 2000 that caused the 2001 beginning of year external assets under management to be much lower than the prior year beginning balance and to a lesser extent, market depreciation of $4.3 billion. Total net outflows in 2001 of $0.6 billion also had a slight negative impact on investment advisory fees.
The change in net income for 2001 compared to 2000 also included the impact of restructuring charges. The Investment Management segment incurred a restructuring charge in the fourth quarter of 2001 of $0.4 million related to the consolidation of the Boston, Massachusetts investment and marketing office with the Philadelphia, Pennsylvania investment and marketing operations in order to eliminate redundant facilities and functions within this business segment. In 2000, the Investment Management segment incurred two restructuring charges of $2.7 million and $2.5 million in the second and fourth quarters, respectively. The objectives of the $2.7 million charge recorded in the second quarter of 2000 were to combine the structured product teams of Delaware and Vantage in Philadelphia and to consolidate the back office operations of
The Investment Management segment’s net flows turned positive for 2002, a significant improvement over the net outflows in prior years. Total net flows improved $3.5 billion over 2001. The improvement in net flows in 2002 was the result of a $1.4 billion increase in institutional inflows and improvement in retention of institutional assets. In addition, higher retail sales offset increased redemptions and transfers.
Positive investment performance has been a key driver of the improvement in net flows. On the institutional side, for the year ended December 31, 2002, 4 of the 8 largest product composites met or outperformed their respective indices and these 4 composites accounted for 74% of institutional assets under management. However, this relative performance is below the results experienced for the year ended December 31, 2001, in which 6 of the 8 largest composites outperformed their respective indices. On the retail side, for the year ended December 31, 2002, 17 of 25 or 68% of the largest retail funds in Delaware Investments Family of Funds (the Delaware Investments Family of Funds does not include mutual funds managed by Delaware for certain LNC affiliates) performed in the top half of their respective Lipper universes; 76% of the 25 largest retail funds performed in the top half of their respective Lipper universes for the year ended December 31, 2001. These 17 funds represented 63% of assets under management of the largest 25 retail funds at December 31, 2002. In addition, Delaware had 15 funds labeled Lipper Leaders for “Consistent Return,” 8 funds named Lipper Leaders for “Capital Preservation,” 10 funds labeled Lipper Leaders for “Total Return,” 7 funds labeled Lipper Leaders for “Expense” and 22 funds labeled Lipper Leaders for “Tax Efficiency.” For the year, 41 of Delaware’s 52 retail funds have been labeled a Lipper Leader in at least one category and 17 funds have been selected in multiple categories.
programs should have a favorable impact on retail sales, positive earnings impact is not expected to occur until at least 2005 because of significant start-up and distribution costs.
Lincoln UK is headquartered in Barnwood, Gloucester, England, and is licensed to do business throughout the United Kingdom (“UK”). Although Lincoln UK transferred its sales force to Inter-Alliance Group PLC in the third quarter of 2000, it continues to manage, administer and accept new deposits on its current block of business and accept new business for certain products. Lincoln UK’s product portfolio principally consists of unit-linked life and pension products, which are similar to variable life and annuity products sold in the U.S.
decline also resulted in increased amortization from retrospective unlocking of DAC and PVIF assets and the liability, deferred front-end loads revenue (“DFEL”). There was negative unlocking of $22.8 million in 2002 compared to negative unlocking of $8.4 million in 2001. As required under FAS 97, acquisition costs for unit-linked contracts are amortized over the lives of the contracts in relation to the incidence of estimated gross profits. Estimated gross profits on unit-linked contracts vary based on surrenders, fee income, expenses and realized gains/losses on investments. The amortization is adjusted retrospectively when estimates of current or future gross profits to be realized from unit-linked contracts are revised. Because market movement has such a significant impact on fee income, estimated future profits will go up or down accordingly. On a quarterly basis, Lincoln UK reviews the assumptions of its DAC amortization model and records a retrospective adjustment to the amount expensed, (i.e. unlocks the DAC). On an annual basis, Lincoln UK reviews and adjusts as necessary its assumptions for prospective amortization of DAC, PVIF and DFEL.
In 2001, Lincoln UK consolidated its home office operations into the Barnwood office. In 2002, Lincoln UK sold its former Uxbridge home office and recognized a realized gain on the transaction of $5.5 million ($7.9 million pre-tax) which is included in realized gain on investments. Excluding this gain, Lincoln UK’s realized gains (losses) decreased $12.9 million from 2001. The impact of realized gain (losses) in both years was a result of sales relating to the realignment of the investment portfolio in order to better match invested assets with the liabilities they support.
Net income for 2002 included releases of $1.7 million related to restructuring charges reported in 2000 for the restructuring plan to exit all direct sales and sales support operations and to consolidate the Uxbridge home office with the Barnwood home office.
The increase in net income of $82.1 million in 2001 was due primarily to the absence of restructuring charges of $76.5 million recorded in the third and fourth quarters of 2000 as discussed above. This restructuring plan resulted from LNC’s decisions to cease writing new business in the UK through its sales force and transfer of the sales force to Inter-Alliance Group PLC. In addition, Lincoln UK had an increase in realized gains on investments of $6.4 million between years. The gains reported in 2001 relate to the realignment of the investment portfolio to better match invested assets with the liabilities they support.
In the third quarter 2002, Lincoln UK agreed to outsource its customer service and policy administration function to the Capita Group, Plc (“Capita”). The agreement involved the transfer of approximately 500 employees to Capita. The purpose of the transaction was to reduce the operational risk and variability of future costs associated with administering the business by taking advantage of Capita’s proven expertise in providing outsourcing solutions to a variety of industries including general insurance companies.
During 2003, Lincoln UK will continue to work to resolve all past misselling exposures while focusing on retaining and managing its current block of business and maximizing earnings through effective expense management.
Cumulative Effect of Accounting Changes relates to the transition adjustment of $(0.5) million recorded in the first quarter of 2001 upon adoption of FAS No. 133 and the adjustment of $(2.2) million recorded in the second quarter of 2001 upon adoption of EITF 99-20.
The net loss in 2002 was a $248.0 million higher compared to net income in 2001. The net loss includes $199.1 million related to charges required by FAS 113 for increases in personal accident and disability income reserves for the business sold through indemnity reinsurance to Swiss Re. Included in the charge is $0.6 million of amortization related to the reserve increases and the settlement with Swiss Re on disputed matters. In addition, the amortization of deferred gain on indemnity reinsurance increased $36.0 million due to a full year’s amortization in 2002 compared to one month’s amortization in 2001.
LFA had an increase in net loss of $11.7 million compared to 2001. Included in LFA’s expenses are the effects of changes in the measurement of LFA’s liability for deferred compensation due to changes in fair value primarily resulting from changes in the equity markets. The declines in the equity markets during 2002, reduced LFA’s liability for deferred compensation and increased income by $6.4 million. However, in the fourth quarter 2001, LNC invested in a variable annuity contract to partially offset the impact on net income of equity market volatility associated with the liability for deferred compensation. Due to the fall of the equity markets in 2002, the annuity value decreased resulting in a loss of $8.3 million. In addition, in 2002 the Fringe Benefit operation (“FBD”) was moved from LFA to the Retirement segment. In 2001, FBD had a loss of $2.2 million which was included in LFA’s results. Excluding the net effect of the annuity and the deferred compensation liability and FBD’s income in 2001, LFA’s net loss was $25.6 million and $18.5 million in 2002 and 2001, respectively, an increase of $7.1 million between years. LFA sales during the fourth quarter 2002 did not reflect the typical seasonal fourth quarter increase over the prior three quarters of the year as had been seen during the fourth quarter of the previous four years. This deviation from the prior trend in sales resulted in a decrease in revenues for the year. In 2003, LFA expects to focus on its growth strategy to increase its financial planner base in order to expand sales while employing effective expense management.
Refer to the Acquisition and Divestiture section for discussion of the impact on income for changes in reserves for the personal accident and disability income sold to Swiss Re through indemnity reinsurance.
The loss in Financing decreased $7.0 million between years primarily due to lower short-term borrowing costs resulting from the ten Fed rate cuts that occurred in 2001 and lower long-term debt costs. The decrease in long-term debt costs resulted from several corporate finance activities in 2001 as described in the Liquidity and Cash Flow section of the Review of Consolidated Financial Conditions.
Other Corporate experienced a negative variance of $3.1 million between years. Included in the 2001 loss was the restructuring charge noted above. In 2000, there were losses of $2.6 million associated with litigation items and a $2.4 million loss related to LNC’s equity investment in AnnuityNet. In addition, there was $8.6 million in incentive compensation expense in 2000 resulting from the achievement of the three-year long-term incentive compensation goals.
The Amortization of Deferred Gain line includes the amortization of the deferred gain on the indemnity reinsurance portion of the transaction with Swiss Re for December ($5.0 million) along with the recognition of accelerated amortization of the deferred gain on Canadian reinsurance business that was novated to Swiss Re after December 7, 2001 ($7.9 million), but prior to December 31, 2001. In accordance with FAS 113, the gain associated with the indemnity reinsurance portion of the transaction with Swiss Re was recorded as a deferred gain and is being amortized into earnings over a period of 15 years. Upon novation (transfer of the legal liability), generally accepted accounting principles provide for immediate recognition in earnings of the deferred gain related to the novated business.
LFA had an increased net loss of $4.2 million between years due primarily to a decrease in sales revenue. LFA, a fee-based investment planning firm and broker/ dealer, experienced a decrease in sales across all product lines: annuities, life insurance and other investment products. The downturn in the equity markets caused a difficult sales environment for broker/ dealers. Sales in the fourth quarter of 2001 rebounded from the lower levels experienced in the first three quarters of 2001 and contributed to positive earnings for the quarter which reduced the loss for the year. This fourth quarter 2001 increase in sales was consistent with the trend experienced over the prior three years and can be explained as a seasonal improvement related to the year-end increase in tax planning and other related activities. In addition, in 2001, the events of September 11 derailed sales in the third quarter which created increased demand in the fourth quarter. In addition to lower revenues, LFA had an increase in overall expenses in 2001 as a result of increased salaries and other general and administrative expenses partially offset by reduced commissions and other volume related expenses.
During the first quarter of 2000, the appellate court upheld LNC’s position in litigation relating to the 1992 sale of the Employee Life-Health Benefit business segment. As a result of this favorable decision, LNC’s 2000 earnings increased by approximately $11.2 million ($17.2 million pre-tax).
In December 2000, LNC received a $43 million (pre-tax) cash payment in exchange for agreeing to modify certain non-compete terms included in an acquisition completed by LNC prior to 1999. In LNC’s purchase accounting for this acquisition, the non-compete terms of the acquisition agreement were believed to have only negligible value and there was no reasonable basis for estimating the additional business and profits, if any, that might result from these non-compete terms. Under these facts and circumstances, LNC concluded that no separately identifiable intangible asset should be recorded for the non-compete terms. However, events in 2000 resulted in a substantial increase in the value of these non-compete terms, culminating with the receipt of the $43 million payment. LNC does not believe that the forfeiture of its remaining non-compete rights and benefits, which would have otherwise expired in 2001, diminishes the value of goodwill recorded in the acquisition. As a result, LNC recorded the $28.0 million ($43 million pre-tax) payment in fourth quarter 2000 net income.
Investment Objective: Invested assets are an integral part of the Lincoln Retirement, Life Insurance and Lincoln UK segments’ operations. For discussion of external assets under management, i.e. retail and
Mortgaged-Backed Securities: LNC’s fixed maturity securities available-for-sale include mortgage-backed securities. The mortgage-backed securities included in LNC’s investment portfolio are subject to risks associated with variable prepayments. This may result in these securities having a different actual cash flow and maturity than expected at the time of purchase. Securities that have an amortized cost greater than par and are backed by mortgages that prepay faster than expected will incur a reduction in yield or a loss. Those securities with an amortized cost lower than par that prepay faster than expected will generate an increase in yield or a gain. In addition, LNC may incur reinvestment risks if market yields are lower than the book yields earned on the securities. Prepayments occurring slower than expected have the opposite impact. LNC may incur disinvestment risks if market yields are higher than the book yields earned on the securities and LNC is forced to sell the securities. The degree to which a security is susceptible to either gains or losses is influenced by 1) the difference between its amortized cost and par, 2) the relative sensitivity of the underlying mortgages backing the assets to prepayment in a changing interest rate environment and 3) the repayment priority of the securities in the overall securitization structure.
Mortgage Loans on Real Estate and Real Estate: As of December 31, 2002, mortgage loans on real estate and investments in real estate represented 10.5% and 0.7% of the total investment portfolio. As of December 31, 2002, the underlying properties supporting the mortgage loans on real estate consisted of 36.8% in commercial office buildings, 23.3% in retail stores, 18.1% in industrial buildings, 10.3% in apartments, 7.7% in hotels/motels and 3.8% in other. In addition to the dispersion by property type, the mortgage loan portfolio is geographically diversified throughout the United States. However, mortgage loans on real estate in California and Texas accounted for approximately 28% of the total carrying value of mortgage loans at December 31, 2002.
All mortgage loans that are impaired have an established allowance for credit loss. Changing economic conditions impact LNC’s valuation of mortgage loans. Increasing vacancies, declining rents and the like are incorporated into the discounted cash flow analysis that LNC performs for monitored loans and may contribute to the establishment of (or an increase in) an allowance for credit losses. In addition, LNC recently completed a detailed review of its entire hotel mortgage loan portfolio in light of the downturn in that sector and has done similar analysis for its portfolio of anchored retail mortgage loans. LNC also monitors and evaluates office mortgage loan exposures to troubled sectors such as telecom. Where warranted, LNC has established or increased loss reserves based upon this analysis. Impaired mortgage loans as a percentage of total mortgage loans has deteriorated over the last year as a result of increased credit losses in the sectors noted above. This percentage was 1.7%, 0.6%, 0.5%, 0.6%, 0.8%, 1.1%, 1.9% and 3.9% as of December 31, 2002, 2001, 2000, 1999, 1998, 1997, 1996 and 1995, respectively. See Note 3 to the consolidated financial statements for additional detail regarding impaired mortgage loans.
Limited Partnership Investments: As of December 31, 2002 and 2001, there were $294.2 million and $329.5 million, respectively, of limited partnership investments included in consolidated investments. These include investments in approximately 50 different partnerships that allow LNC to gain exposure to a broadly diversified portfolio of asset classes such as venture capital, hedge funds, and oil and gas. They are generally fairly large partnerships with several third party partners. These partnerships do not represent off-balance sheet financing to LNC. Select partnerships contain “capital calls” which require LNC to contribute capital
upon notification by the general partner. These capital calls are contemplated during the initial investment decision and are planned for well in advance of the call date. The capital calls are not material in size and pose no threat to LNC’s liquidity. The capital calls are included on LNC’s table of contingent commitments within Review of Consolidated Financial Condition. Limited partnership investments are accounted for using the equity method of accounting and the majority of these investments are included in “Other Investments” on the consolidated balance sheets.
Net Investment Income: Net Investment income decreased $71.3 million or 3% in 2002 due to a decrease in the yield on investments from 7.14% to 6.74% (all calculations on a cost basis). The decrease in yield was primarily due to lower interest rates on new securities purchased along with higher than historical levels of defaults due to the weak economy of 2002. In addition, 2002 net investment income generated by partnership investments was lower than the unusually favorable levels of net investment income generated by partnerships in 2001. Net investment income decreased $67.5 million or 2% in 2001 due to a decrease in the yield on investments from 7.35% to 7.14% (all calculations on a cost basis). The decrease in the yield on investments was primarily due to lower interest rates on new securities purchased along with an increase in security defaults resulting from the weak economy in 2001. In addition, LNC transferred higher yielding invested assets, and received current fair value as part of the close of the sale of the reinsurance business to Swiss Re on December 7, 2001. The proceeds of the sale were invested in lower yielding highly liquid short-term investments. Mean invested assets only increased 0.4% in 2001.
Critical Accounting Policy - Realized Gain (Loss) on Investments and Derivative Instruments: LNC had net pre-tax realized losses on investments and derivatives of $271.5 million, $114.5 million and $28.3 million in 2002, 2001 and 2000, respectively. Prior to the amortization of acquisition costs, provision for policyholder commitments and investment expenses, net pre-tax realized losses were $405.3 million, $202.8 million, and $56.4 million in 2002, 2001 and 2000, respectively. Also included in the 2002 loss was a pre-tax realized gain of $33.4 million ($21.7 million after-tax) from the sale of LNC’s investment in unconsolidated affiliate related to LNC’s former Reinsurance segment (see further discussion of this investment in the Results of Operations for “Other Operations”).
Although the realized losses that resulted from sales and impairments originated from a number of sectors, the larger losses can be attributed to collateralized debt obligations (CDOs) and the telecommunications and airline sectors.
LNC’s overall strategy of reducing exposure to CDOs was complicated by the deteriorating economy and the lack of liquidity of these instruments driven by declining economic conditions and increased corporate default rates. All these effects negatively impacted the CDO market, resulting in prolonged implementation of our strategy. As a result of sales and impairment write-downs, the CDO exposure has been reduced to approximately 1.6% of LNC’s fixed maturity securities, with 90% rated investment grade.
In addition to the aforementioned sectors, the realized losses and gains in 2002 arose from investment transactions as a result of the active management of LNC’s portfolio quality. There were several strategies that drove transactions, some of which include:
2. Portfolio exposure to certain high-risk sectors, such as bonds of issuers that have asbestos related litigation risk, was reduced.
LNC has considered economic factors and circumstances within countries and industries where recent write-downs have occurred in its assessment of the status of securities owned by LNC of similarly situated issuers. While it is possible for realized or unrealized losses on a particular investment to affect other investments, LNC’s risk management has been designed to identify correlation risks and other risks inherent in managing an investment portfolio. Once identified, strategies and procedures are developed to effectively monitor and manage these risks. The areas of risk correlation that LNC’s investment management group pays particular attention to are risks that may be correlated within specific financial and business markets, risks within specific industries and risks associated with related parties.
Fair values for private securities are estimated by (1) a matrix process that employs discounting expected future cash flows using a current market rate applicable to the coupon rate, credit quality, industry sector and maturity of the investments, (2) third party-supplied prices or secondary market transactions, and (3) applying professional judgment to arrive at fair value based upon prices of public or non-public securities of similarly situated issuers. The fair value for all private securities was $4,601.3 million and $4,537.7 million at December 31, 2002 and 2001, respectively, representing about 11.5% and 12.5% of total invested assets, respectively.
As the discussion above indicates, there are risks and uncertainties associated with determining whether declines in the fair value of investments are other than temporary. These include subsequent significant changes in general overall economic conditions as well as specific business conditions affecting particular issuers, future financial market effects such as interest rate spreads, stability of foreign governments and economies, future ratings agency actions and significant accounting, fraud or corporate governance issues that
EITF 99-20 changed the manner in which impairment on certain investments in collateralized securities is determined. The cumulative effect adjustment that LNC recorded in connection with the adoption of EITF 99-20 in the second quarter of 2001 was a net realized loss on investments of $11.3 million after-tax ($17.3 million pre-tax).
Unrealized Gains and Losses: At December 31, 2002 and 2001, gross unrealized gains on securities available-for-sale were $2,402.5 million and $1,075.4 million, respectively, and gross unrealized losses on securities available-for-sale were $735.4 million and $659.6 million, respectively. At December 31, 2002, gross unrealized gains and losses on fixed maturity securities available-for-sale were $2,357.5 million and $693.1 million, respectively, and gross unrealized gains and losses on equity securities available-for-sale were $11.2 million and $8.5 million, respectively. At December 31, 2001, gross unrealized gains and losses on fixed maturity securities available-for-sale were $1,005.6 million and $615.9 million, respectively, and gross unrealized gains and losses on equity securities available-for-sale were $69.8 million and $43.7 million, respectively. The great majority of these unrealized gains and losses can be attributed to changes in interest rates, which have created temporary price fluctuations. However, within the portfolio of securities with unrealized losses are certain securities that LNC has identified as exhibiting indications that the decline in fair value may be other than a temporary decline in value.
For traded and private securities held by LNC at December 31, 2002 that were subject to enhanced analysis and monitoring for potential changes in unrealized loss status, the fair value, amortized cost, unrealized loss and total time period that the security has been in an unrealized loss position are presented in the table below.
For total traded and private securities held by LNC at December 31, 2002 that are in unrealized loss status, the fair value, amortized cost, unrealized loss and total time period that the security has been in an unrealized loss position are presented in the table below.
Included in the amount of unrealized losses greater than one year are unrealized losses of $36.0 million related primarily to participating polices in the Lincoln UK segment. Gain and losses on securities supporting this business are credited to the policyholder when incurred and do not affect net income of LNC.
For total traded and private securities held by LNC at December 31, 2001 that are in unrealized loss status, the fair value, amortized cost, unrealized loss and total time period that the security has been in an unrealized loss position are presented in the table below.
The composition by industry categories of all securities in unrealized loss status, held by LNC at December 31, 2001 is presented in the table below.
On September 13, 2001, LNC redeemed all 8.6 million shares of the $215 million outstanding 8.75% Cumulative Quarterly Income Preferred Securities, Series A that were issued by Lincoln National Capital I and guaranteed by LNC.
On January 7, 2002, LNC redeemed $100 million 8.35% Trust Originated Preferred Securities issued by Lincoln Capital II and guaranteed by LNC. On June 3, 2002, LNC issued $250 million 5.25% five-year senior notes. The net proceeds of that offering was used for general corporate purposes, and pending such application, have been used to pay down short-term debt. In conjunction with the $250 million debt issue, LNC executed a $100 million notional amount interest rate swap that effectively converted the 5.25% fixed rate coupon on the bond into a LIBOR-based floating rate obligation for that portion of the bond.
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 resulted in negative statutory earned surplus for LNL which triggered certain approval requirements in order for LNL to declare and pay dividends to LNC. As a result of negative earned surplus, LNL was required to obtain the prior approval of the Indiana Insurance Commissioner (“Commissioner”) before paying any dividends to LNC until its statutory earned surplus became positive. During the first quarter 2002, LNL received approval from the Commissioner to reclassify total dividends of $495 million paid to LNC in 2001 from LNL’s earned
In general, dividends are not subject to prior approval from the Commissioner provided LNL’s statutory earned surplus is positive and such dividends do not exceed the standard limitation of the greater of 10% of total statutory earned surplus or the amount of statutory earnings in the prior calendar year. Dividends of $710 million were paid by LNL to LNC in the second quarter of 2002. These distributions were made in two installments. The first installment of $60 million was paid in April. The second installment of $650 million was paid in June. As both installments exceeded the standard limitation noted above, a special request was made for each payment and each was approved by the Commissioner. Both distributions represented a portion of the proceeds received from the indemnity reinsurance transaction with Swiss Re. As a result of the payment of dividends and statutory losses in 2002, LNL’s statutory earned surplus is negative as of December 31, 2002. The statutory losses resulted from realized losses on investments, the effect of the equity markets and the reserve strengthening in 2002 related to the reinsurance business sold to Swiss Re. Due to the negative statutory earned surplus as of December 31, 2002, any dividend(s) paid by LNL in 2003 will be subject to prior approval from the Commissioner. As occurred in 2001, dividends approved and paid while statutory earned surplus is negative are expected to be classified as a reduction to paid-in-capital.
As of December 31, 2002, LNC’s senior debt ratings were Moody’s at A3 (“Upper Medium Grade”), Standard and Poor’s at A- (“Strong”), Fitch at A (“Strong”) and A.M. Best at “a” (“Strong”), and LNC’s commercial paper ratings included Moody’s at P-2 (“Strong”), Standard and Poor’s at A-2 (“Satisfactory”) and Fitch at (“Very Strong”). On September 19, 2002 Fitch lowered LNC’s senior debt ratings from A+ to A and the trust preferred security ratings for Lincoln Capital III, IV, and V from A to A- both on “stable outlook.” Fitch’s action did not impact LNC’s commercial paper rating or the insurance financial strength ratings of LNC’s insurance subsidiaries. The move was part of industry-wide action on several life insurance companies given the recent market environment and, in the case of LNC, reflects Fitch’s desire to maintain a traditional three notch separation between debt and insurance financial strength ratings. The rating action is expected to have no effect on LNC’s liquidity, access to capital, or cost of capital. Although there are less investors for A-2/ P-2 commercial paper and there are periods in which there is weak investor interest in A-2/ P-2 commercial paper, through December 31, 2002, liquidity has not been adversely impacted. LNC can draw upon alternative short-term borrowing facilities such as revolving bank lines of credit.
If current debt ratings and claims paying ratings were downgraded in the future, certain covenants of various contractual obligations may be triggered which could impact overall liquidity. In addition, contractual selling agreements with intermediaries could be negatively impacted which could have an adverse impact on overall sales of annuities, life insurance and investment products.
On June 3, 2002, LNC announced an agreement with the Philadelphia Eagles to name the Eagles’ new stadium, Lincoln Financial Field. In exchange for the naming rights, LNC agreed to pay $139.6 million over a 20-year period, through annual payments to the Eagles, which average approximately $6.7 million per year. This future commitment has not been recorded as a liability on LNC’s balance sheet as it will be accounted for in a manner consistent with the accounting for operating leases.
LNC’s insurance affiliates, as well as other companies in the insurance industry, attempt to minimize the effect of inflation on their revenues and expenses by anticipating inflationary trends in the pricing of their products. Inflation, except for changes in interest rates, does not have a significant effect on LNC’s balance sheet due to the minimal amount of dollars invested in property, plant and equipment and the absence of inventories.
As noted above, shareholders’ equity includes accumulated other comprehensive income. At December 31, 2002, the book value of $29.82 per share included $3.85 of accumulated other comprehensive income. At December 31, 2001, the book value of $28.10 per share included $0.97 related to accumulated other comprehensive income.
In the 2003 Budget proposal, President Bush proposed an economic stimulus package and changes to retirement savings. The centerpiece of the stimulus proposal is the elimination of the double taxation of corporate dividends. Both the Bush Administration and Congress have expressed concerns regarding the impact of the proposal on variable annuities. The life insurance industry has proposed that dividends in equity securities held in separate accounts flow through to increase the basis in the variable annuity contract.
The overall impact of these proposals on LNC’s products and corporate tax burden cannot be accurately predicted at this time. Initial legislative language has been introduced to implement certain aspects of the President’s proposals, which is currently the subject of debate and testimony before Congress It is too early to predict the final form of the legislation that Congress will pass, if any.
Tax legislation could increase or reduce tax-advantages for some of LNC’s life insurance and annuity products. LNC continues to support reductions in the tax burden imposed on its businesses, employees and policyholders.
The consolidated financial statements and notes to consolidated financial statements of Lincoln National Corporation and Subsidiaries follow on pages 83 through 147.
Investments. LNC classifies its fixed maturity and equity securities as available-for-sale and, accordingly, such securities are carried at fair value. The cost of fixed maturity securities is adjusted for amortization of premiums and discounts. The cost of fixed maturity and equity securities is reduced to fair value with a corresponding charge to realized loss on investments for declines in value that are other than temporary.
Mortgage loans on real estate, which are primarily held in the Life Insurance and Retirement segments, are carried at the outstanding principal balances adjusted for amortization of premiums and discounts and are net of valuation allowances. Valuation allowances are established for the excess carrying value of the mortgage loan over its estimated fair value when it is probable that, based upon current information and events, LNC will be unable to collect all amounts due under the contractual terms of the loan agreement. When LNC determines that a loan is impaired, the cost is adjusted or a provision for loss is established equal to the difference between the amortized cost of the mortgage loan and the estimated value. Estimated value is based on: 1) the present value of expected future cash flows discounted at the loan’s effective interest rate; 2) the loan’s observable market price; 3) the fair value of the collateral. The provision for losses is reported as realized gain (loss) on investments. Mortgage loans deemed to be uncollectible are charged against the allowance for losses and subsequent recoveries, if any, are credited to the allowance for losses. Interest income on mortgage loans includes interest collected, the change in accrued interest, and amortization of premiums and discounts. Mortgage loan fees and costs are recorded in net investment income as they are incurred.
Realized gain (loss) on sale of subsidiaries, net of taxes, is recognized in net income.
Effective upon the adoption of Statement of Financial Accounting Standard No. 133, “Accounting for Derivative Instruments and Hedging Activities,” (“FAS 133”) on January 1, 2001, LNC recognizes all derivative instruments as either assets or liabilities in the consolidated balance sheet at fair value. FAS 133 standardized the accounting for derivative instruments, including certain derivative instruments embedded in other contracts. The accounting for changes in the fair value of a derivative instrument depends on whether it has been designated and qualifies as part of a hedging relationship and further, on the type of hedging relationship. For those derivative instruments that are designated and qualify as hedging instruments, LNC must designate the hedging instrument based upon the exposure being hedged - as a cash flow hedge, fair value hedge or a hedge of a net investment in a foreign operation. As of December 31, 2002 and 2001, LNC had derivative instruments that were designated and qualified as cash flow hedges and fair value hedges. In addition, LNC had derivative instruments that were economic hedges, but were not designated as hedging instruments under FAS 133. LNC also had derivative instruments that were designated as hedges of a portion of its net investment in a foreign operation at December 31, 2002.
For derivative instruments that are designated and qualify as a cash flow hedge, the effective portion of the gain or loss on the derivative instrument is reported as a component of other comprehensive income (“OCI”) and reclassified into net income in the same period or periods during which the hedged transaction affects net income. The remaining gain or loss on the derivative instrument in excess of the cumulative change in the present value of designated future cash flows of the hedged item (hedge ineffectiveness), if any, is recognized in current income during the period of change. For derivative instruments that are designated and qualify as a fair value hedge, the gain or loss on the derivative instrument as well as the offsetting loss or gain on the hedged item attributable to the hedged risk are recognized in current income during the period of change in fair values. For derivative instruments that are designated and qualify as a hedge of a net investment in a foreign operation, the gain or loss is reported in OCI as part of the cumulative translation adjustment to the extent it is effective. For derivative instruments not designated as hedging instruments, the gain or loss is recognized in current income during the period of change.
Prior to January 1, 2001, derivative instruments were carried in other investments. The premiums paid for interest rate caps and swaptions were deferred and amortized to net investment income on a straight-line basis over the term of the respective derivative. Interest rate caps that hedged interest credited on fixed annuity liabilities were carried at amortized cost. Any settlement received in accordance with the terms of the interest rate caps was also recorded as net investment income. Realized gain (loss) from the termination of the interest rate caps was included in net income.
Swaptions, put options, spread-lock agreements, interest rate swaps and financial futures that hedge fixed maturity securities available-for-sale were carried at fair value. The change in fair value was reflected directly in shareholders’ equity. Settlements on interest rate swaps and commodity swaps were recognized in net investment income. Realized gain (loss) from the termination of swaptions, put options, spread-lock agreements, interest rate swaps and financial futures were deferred and amortized over the life of the hedged assets as an adjustment to the yield. Forward-starting interest rate swaps were also used to hedge the forecasted purchase of investments. These interest rate swaps were carried off-balance sheet until the occurrence of the forecasted transaction at which time the interest rate swaps were terminated and any gain (loss) on termination was used to adjust the basis of the forecasted purchase. If the forecasted purchase did not occur or the interest rate swaps were terminated early, changes in the fair value of the swaps were recorded in net income.
Prior to January 1, 2001, hedge accounting was applied as indicated above after LNC determined that the items to be hedged exposed LNC to interest rate fluctuations, the widening of bond yield spreads over comparable maturity U.S. Government obligations, credit risk, foreign exchange risk or equity risk. Moreover, the derivatives used to hedge these exposures were designated as hedges and reduced the indicated risk 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. If such criteria was not met or if the hedged items were sold, terminated or matured, the change in value of the derivatives was included in net income.
Premiums and Fees on Investment Products and Universal Life and Traditional Life Insurance Products. Investment Products and Universal Life Insurance Products: Investment products consist primarily of individual and group variable and fixed deferred annuities. Universal life insurance products include universal life insurance, variable universal life insurance, corporate-owned life insurance, bank-owned life insurance and other interest-sensitive life insurance policies. Revenues for investment products and universal life insurance products consist of net investment income, asset based fees, cost of insurance charges, percent of premium charges, policy administration charges and surrender charges that have been assessed and earned against policy account balances and premiums received during the period. The timing of revenue recognition as it relates to fees assessed on investment contracts is determined based on the nature of such fees. Asset based fees, cost of insurance and policy administration charges are assessed on a daily or monthly basis and recognized as revenue when assessed and earned. Percent of premium charges are assessed at the time of premium payment and recognized as revenue when assessed and earned. Certain amounts assessed that represent compensation for services to be provided in future periods are reported as unearned revenue and recognized in income over the periods benefited. Surrender charges are recognized upon surrender of a contract in accordance with contractual terms.
Investment Advisory Fees. As specified in the investment advisory agreements with the mutual funds, fees are generally determined and recognized as revenues monthly, based on the average daily net assets of the mutual funds managed. Investment advisory contracts with other types of clients generally provide for the determination and payment of advisory fees based on market values of managed portfolios at the end of a calendar month or quarter. Investment management and advisory contracts typically are renewable annually with cancellation clauses ranging up to 90 days.
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.
Past amortization amounts are adjusted when revisions are made to the estimates of current or future gross profits expected from a group of products. Policy lives for universal and variable universal life policies are estimated to be 30 years, based on the expected lives of the policies and are variable based on the inception of each policy for unit-linked policies. Policy lives for fixed and variable deferred annuities are 13 to 18 years for the traditional, long surrender charge period products and 8 to 10 years for the more recent short-term, or no
For all FAS 97 and FAS 60 policies, amortization is based on assumptions consistent with those used in the development of the underlying policy form adjusted for emerging experience and expected trends.
Other intangible assets for acquired insurance businesses consist of the value of existing blocks of business (referred to as the “present value of in-force”). The present value of in-force 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 universal life and investment-type products acquired 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 in-force vary depending upon the particular characteristics of the underlying blocks of acquired insurance business.
Prior to January 1, 2002, the carrying values of goodwill and other intangible assets were reviewed periodically for indicators of impairment in value that are other than temporary, including unexpected or adverse changes in the following: (1) the economic or competitive environments in which the company operates, (2) profitability analyses, (3) cash flow analyses, and (4) the fair value of the relevant subsidiary. If there was an indication of impairment then the cash flow method would be used to measure the impairment and the carrying value would be adjusted as necessary. However, effective January 1, 2002, goodwill is subject to impairment tests conducted at least annually. Other intangible assets will continue to be reviewed periodically for indicators of impairment consistent with the policy that was in place prior to January 1, 2002.
The liabilities for future claim reserves for the guaranteed minimum death benefit (“GMDB”) feature on certain variable annuity contracts are a function of the net amount at risk (“NAR”), mortality, persistency and incremental death benefit mortality and expense assessments (“M&E”) expected to be incurred over the period of time for which the NAR is positive. At any point in time, the NAR is the difference between the potential death benefit payable and the total variable annuity account values subject to the GMDB. At each quarterly valuation date, the GMDB reserves are calculated for every variable annuity contract with a GMDB feature based on projections of account values and NAR followed by the computation of the present value of expected NAR death claims using product pricing mortality assumptions less expected GMDB M&E revenue during the period for which the death benefit options are assumed to be in the money. As part of the estimate of future NAR, gross equity growth rates which are consistent with those used in the DAC valuation process are utilized.
Reinsurance. LNC’s insurance companies enter into reinsurance agreements with other companies in the normal course of their business. Prior to the acquisition of LNC’s reinsurance operations by Swiss Re on December 7, 2001, LNC’s insurance subsidiaries assumed reinsurance from unaffiliated companies. The transaction with Swiss Re involved a series of indemnity reinsurance transactions combined with the sale of certain stock companies that comprised LNC’s reinsurance operations. Assets/liabilities and premiums/benefits from certain reinsurance contracts that granted statutory surplus to other insurance companies are netted on the consolidated balance sheets and income statements, respectively, since there is a right of offset. All other reinsurance agreements including the Swiss Re indemnity reinsurance transaction are reported on a gross basis.
Stock Options. Through 2002, LNC recognized compensation expense for its stock option incentive plans using the intrinsic value method of accounting. Under the terms of the intrinsic value method, compensation cost is the excess, if any, of the quoted market price of the stock at the grant date, or other measurement date, over the amount an employee must pay to acquire the stock. On August 8, 2002, LNC
The three transition methods provided under FAS 148 are the prospective method, the modified prospective and the retroactive restatement method. LNC will adopt the retroactive restatement method, which requires that companies restate all periods presented to reflect stock-based employee compensation cost under the fair value accounting method in FAS 123 for all employee awards granted, modified or settled in fiscal years beginning after December 15, 1994. FAS 148’s amendment of the transition and annual disclosure requirements of FAS 123 is effective for fiscal years ending after December 15, 2002. As the recognition provisions of FAS 123 should be applied as of the beginning of the year, LNC will adopt the fair value method of accounting under FAS 123, as amended by FAS 148, as of January 1, 2003 and will present restated financial statements for the years 2002, 2001 and 2000 in its first quarter 2003 filing on Form 10-Q (see Note 6 for further discussion of stock-based employee compensation cost).
Foreign Exchange. LNC’s foreign subsidiaries’ balance sheet accounts and income statement items are translated at the current exchange and average exchange rates for the year, respectively. Resulting translation adjustments are reported as a component of shareholders’ equity. Other translation adjustments for foreign currency transactions that affect cash flows are reported in comprehensive income.
Change in Estimate of Premium Receivables on Certain Client-Administered Individual Life Reinsurance. During the first quarter of 2001, LNC’s former Reinsurance segment refined its estimate of due and unpaid premiums on its client-administered individual life reinsurance business. As a result of the significant growth in the individual life reinsurance business generated in recent years, the Reinsurance segment initiated a review of the block of business in the last half of 2000. An outgrowth of that analysis resulted in a review of the estimation of premiums receivable for due and unpaid premiums on client-administered business. During the first quarter of 2001, the Reinsurance segment completed the review of this matter, and concluded that enhanced information flows and refined actuarial techniques provided a basis for a more precise estimate of premium receivables on this business. As a result, the Reinsurance segment recorded income of $25.5 million or $0.13 per share ($39.3 million pre-tax) related to periods prior to 2001.
In compliance with the transition provision of FAS 142, LNC completed the first step of the transitional goodwill impairment test during the second quarter of 2002. The valuation techniques used by LNC to estimate the fair value of the group of assets comprising the different reporting units varied based on the characteristics of each reporting unit’s business and operations. A number of valuation approaches, including, discounted cash flow modeling, were used to assess the goodwill of the reporting units within LNC’s Lincoln Retirement, Life Insurance and Lincoln UK segments. Valuation approaches combining multiples of revenues, earnings before interest, taxes, depreciation and amortization (“EBITDA”) and assets under management were used to estimate the fair value of the reporting units within LNC’s Investment Management segment. The results of the first step of the tests indicate that LNC does not have impaired goodwill. In accordance with FAS 142, LNC has chosen October 1 as its annual review date. As such, LNC performed another valuation review during the fourth quarter of 2002. The results of the first step of the tests performed as of October 1, 2002 indicate that LNC does not have impaired goodwill. The valuation techniques used by LNC for each reporting unit were consistent with those used during the transitional testing.
The carrying amount of goodwill by reportable segment as of December 31, 2002 is as follows:
For intangible assets subject to amortization, the total gross carrying amount and accumulated amortization in total and for each major intangible asset class by segment are as follows:
Change in Estimate for Disability Income and Personal Accident Reinsurance Reserves. As a result of developments and information obtained during 2002 relating to personal accident and disability income matters, LNC increased these exited business reserves by $198.5 million after-tax or $1.07 per fully diluted share ($305.4 million pre-tax). After giving effect to LNC’s $100 million indemnification obligation to Swiss Re, LNC recorded a $133.5 after-tax ($205.4 million pre-tax) increase in reinsurance recoverable from Swiss Re with a corresponding increase in the deferred gain. (See Note 11 for further explanation of LNC’s Reinsurance transaction with Swiss Re.)
Accounting for Variable Interest Entities. In January 2003, the Financial Accounting Standards Board issued Financial Accounting Standards Board Interpretation No. 46, “Consolidation of Variable Interest Entities” (“Interpretation No. 46”), which requires the consolidation of variable interest entities (“VIE”) by an enterprise if that enterprise has a variable interest that will absorb a majority of the VIE’s expected losses if they occur, receive a majority of the entity’s expected residual returns if they occur, or both. If one enterprise will absorb a majority of a VIE’s expected losses and another enterprise will receive a majority of that VIE’s expected residual returns, the enterprise absorbing a majority of the losses shall consolidate the VIE. VIE refers to an entity in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. This Interpretation applies in the third quarter of 2003 to VIEs in which an enterprise holds a variable interest that is acquired before February 1, 2003. This Interpretation may be applied prospectively with a cumulative-effect adjustment as of the date on which it is first applied or by restating previously issued financial statements for one or more years with a cumulative-effect adjustment as of the beginning of the first year restated.
Although LNC and the industry continue to review the new rules, at the present time LNC does not believe there are other significant VIEs that would result in consolidation with LNC, beyond the managed CDOs discussed above.
The change in net unrealized appreciation (depreciation) on investments in fixed maturity and equity securities available-for-sale is as follows:
During the second quarter of 1998, LNC purchased three bonds issued with offsetting interest rate characteristics. Subsequent to the purchase of these bonds, interest rates increased and the value of one of these bonds decreased. This bond was sold at the end of the second quarter 1998 and a realized loss of $28.8 million ($18.7 million after-tax) was recorded. The other two bonds are still owned by LNC and are producing net investment income on an annual basis of $9.9 million ($6.4 million after-tax). Subsequent to these transactions being recorded, the Emerging Issues Task Force of the Financial Accounting Standards Board reached consensus with regard to accounting for this type of investment strategy. LNC is not required to apply the new accounting rules, however, if such rules were applied, the realized loss on the sale of
$28.8 million ($18.7 million after-tax) on one of these bonds recorded at the end of the second quarter of 1998 would be reduced to $8.8 million ($5.7 million after-tax) and the difference would be applied as a change in the carrying amount of the two bonds that remain in LNC’s portfolio. Also, net investment income for the year ended December 31, 2002, 2001 and 2000 would be less than reported by $2.9 million ($1.9 million after-tax), $2.7 million ($1.8 million after-tax) and $2.5 million ($1.6 million after-tax), respectively.
The balance sheet captions, “Real Estate” and “Property and Equipment,” are shown net of allowances for depreciation as follows:
The average recorded investment in impaired mortgage loans and the interest income recognized on impaired mortgage loans were as follows:
For the year ended December 31, 2002, fixed maturity securities available-for-sale, mortgage loans on real estate and real estate investments which were non-income producing were not significant. As of December 31, 2002 and 2001, the carrying value of non-income producing securities was $37.3 million and $32.4 million, respectively.
During the fourth quarter of 2001, LNC completed a second securitization of commercial mortgage loans. In the aggregate, the loans had a fair value of $209.7 million and a carrying value of $198.1 million. LNC received $209.7 million from the trust for the sale of the loans. A recourse liability was not recorded since LNC is not obligated to repurchase any loans from the trust that may later become delinquent. Servicing fees of $0.2 million and $0.03 million were received in 2002 and 2001, respectively. The transaction was hedged with total return swaps to lock in the value of the loans. LNC recorded a loss on the hedge of $10.1 million pre-tax and a realized gain on the sale of $11.6 million pre-tax resulting in a net gain of $1.5 million pre-tax. Upon securitization, LNC did not retain an interest in the securitized assets; however, LNC later invested $14.3 million of its general account assets in the certificates issued by the trust. This investment is included in fixed maturity securities on the balance sheet.
The effective tax rate is a ratio of tax expense over pre-tax income. Since the pre-tax income of $1.6 million resulted in a tax benefit of $90.0 million in 2002, an unusual effective tax rate of (5,558)% is reported.
Cash paid for Federal income taxes in 2002 and 2001 was $382.9 million and $57.6 million, respectively. Cash received for Federal income taxes in 2000 was $79.1 million due to the carry back of 1999 tax losses.
Since LNC made the decision in 1999 not to permanently reinvest Lincoln UK’s earnings in Lincoln UK, the U.S. tax rules rather than UK tax rules are the primary factor in determining the deferred taxes for the segment. In 2002, LNC established $16.4 million of deferred taxes relating to the segment.
Lincoln Life & Annuity Company of New York will expire in years 2004 through 2007. Net capital losses of $44.5 million for LNR Barbados will expire in the year 2007. In contrast to the net operating losses of LNR Barbados, the net capital losses can be used in future LNC consolidated U.S. tax returns. Accordingly, LNC believes that it is more likely than not that the capital losses will be fully utilized within the allowable carryforward period.
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, 2002, 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.
Detailed below is a breakdown of amounts included in LNC’s balance sheet related to the reinsurance business sold to Swiss Re through indemnity reinsurance. Because LNC is not relieved of its liability to the ceding companies for this business, the liabilities and obligations associated with the reinsured contracts remain on the consolidated balance sheet of LNC with a corresponding reinsurance receivable from Swiss Re. In addition, a portion of the business has been reinsured on a funds withheld basis. This means that LNC
transferred reserves for the reinsurance business to Swiss Re, but LNC continues to hold assets in support of those reserves. The payable to Swiss Re related to the assets is included in “Other Liabilities.”
Details underlying the income statement caption, “Underwriting, Acquisition, Insurance and Other Expenses,” are as follows:
In April 2002, a new shelf registration statement was declared effective by the Securities and Exchange Commission. The new shelf registration totaled $1.2 billion (including $402.5 million of registered but unissued securities from previous registration statements). After giving consideration to the $250 million 5.25% five-year senior notes issued in June 2002, LNC has $950 million remaining under the shelf registration to issue debt securities, preferred stock, common stock, warrants, stock purchase contracts and stock purchase units of LNC and trust preferred securities of four subsidiary trusts. The net proceeds from the sale of the securities offered by this shelf registration and the applicable prospectus supplement(s) are expected to be used by LNC for general corporate purposes, including repurchases of outstanding common stock, repayment or redemption of outstanding debt or preferred stock, the possible acquisition of financial services businesses or assets thereof, investment in portfolio assets and working capital needs.
Pension and Other Postretirement Benefit Plans - U.S. LNC maintains funded defined benefit pension plans for most of its U.S. employees and, prior to January 1, 1995, most full-time agents. Effective January 1, 2002, the employees’ pension plan has a cash balance formula. Employees retiring before 2012 will have their benefits calculated under both the old and new formulas and will receive the better of the two calculations. Employees retiring in 2012 or after will receive benefits under the amended plan. Benefits under the old employees’ plan are based on total years of service and the highest 60 months of compensation during the last 10 years of employment. Under the amended plan, employees have guaranteed account balances that grow with pay and interest credits each year. The amendment to the employees’ pension plan resulted in a $27.8 million pre-tax negative unrecognized prior service cost in 2001 that will be evenly recognized over future periods. All benefits applicable to the defined benefit plan for agents were frozen as of December 31, 1994. The plans are funded by contributions to tax-exempt trusts. LNC’s funding policy is consistent with the funding requirements of Federal law and regulations. Contributions are intended to provide not only the benefits attributed to service to date, but also those expected to be earned in the future.
The supplemental executive retirement plan provides defined pension benefits for certain executives who became employees of LNC as a result of the acquisition of a block of individual life insurance and annuity business from CIGNA Corporation (“CIGNA”). Effective January 1, 2000, this plan was amended to freeze benefits payable under this plan. The effect of this plan curtailment was to decrease the pension benefit obligation by $2.4 million. Effective January 1, 2000, a second supplemental executive retirement plan was established for this same group of executives to guarantee that the total benefit payable under the LNC employees’ defined benefit pension plan benefit formula will be determined using an average compensation not less than the minimum three-year average compensation as of December 31, 1999. All benefits payable from this plan are reduced by benefits payable from the LNC employees’ defined benefit pension plan.
were $400.1 million, the aggregate accumulated benefit obligations were $373.0 million and the aggregate fair value of plan assets was $314.9 million.
Plan assets for both the funded employees and agents plans are principally invested in equity and fixed income funds managed by LNC’s Investment Management segment.
Pension Plan - Non U.S. The employees of LNC’s primary foreign subsidiary are covered by a defined benefit pension plan. The plan provides death and pension benefits based on final pensionable salary. At December 31, 2002 and 2001, plan assets were under the projected benefit obligations by $62.7 million and $47.0 million, respectively, and was included in other liabilities in LNC’s balance sheet. As a result of the accumulated benefit obligation being in excess of plan assets at December 31, 2002 and 2001, a minimum pension liability adjustment of $33.0 million ($50.9 million pre-tax) and $36.0 million, respectively, was recorded in Accumulated Other Comprehensive Income in equity. There was no tax recorded on the minimum pension liability adjustment in 2001. Net pension costs for the foreign plan were $10.0 million, $7.4 million and $4.4 million for 2002, 2001 and 2000, respectively.
401(k), Money Purchase and Profit Sharing Plans. LNC also sponsors contributory defined contribution plans for eligible U.S. employees and agents. These plans include 401(k) plans and effective April 1, 2001, a defined contribution money purchase plan for eligible employees of Delaware Management Holdings, Inc. (“Holdings”). Prior to April 1, 2001, the defined contribution money purchase plan was structured as a profit sharing plan. LNC’s contributions to the 401(k) plans are equal to participant’s pre-tax contribution, not to exceed 6% of base pay, multiplied by a percentage, ranging from 50% to 150%, which varies according to certain incentive criteria as determined by LNC’s Board of Directors. As a result of LNC attaining the goals established under the three-year long-term incentive plan for 1998 through 2000, an additional match was made on a participant’s 2000 pre-tax contribution.
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 $1.7 million, $0.6 million and $4.3 million in 2002, 2001 and 2000, 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 2000, as a result of changes in the interpretation of the existing accounting rules for stock options, LNC decided not to continue issuing stock options to agents that do not meet the stringent definition of a common law employee. In the first quarter of 2000, LNC adopted a stock appreciation right (“SAR”) program as a replacement to the agent stock option program. The first awards under this program were also made in the first quarter of 2000. The SARs under this program are rights on LNC stock that are cash settled and become exercisable in 25% increments over the four year period following the SAR grant date. SARs are granted with an exercise price equal to the market value of LNC stock at the date of grant and, subject to termination of employment, expire five years from the date of grant. Such SARs are transferable only upon death.
LNC recognizes compensation expense for the SAR program based on the fair value method using an option-pricing model. Compensation expense and the related liability are recognized on a straight-line basis over the vesting period of the SARs. The SAR liability is marked-to-market through net income. This accounting treatment causes volatility in net income as a result of changes in the market value of LNC stock. LNC hedges this volatility by purchasing call options on LNC stock. Call options hedging vested SARs are also marked-to-market through net income. Total compensation expense (income) recognized for the SAR program for 2002, 2001 and 2000 was $(0.7) million, $4.8 million and $3.1 million, respectively. The mark-to-market gain (loss) recognized through net income on the call options on LNC stock for 2002, 2001 and 2000 was $(6.7) million, $0.8 million and $1.3 million, respectively. The SAR liability at December 31, 2002 and 2001 was $3.7 million and $6.5 million, respectively.
outside appraiser, and expire 10 years from the date of the grant, subject to conditions of the plan agreements. Options granted under the DIUS plan become exercisable and vest in 25% increments over the four-year period following the option grant anniversary date. Options granted under the DIAL plan also vest in 25% increments over the four-year period following the option grant anniversary date, however, such options are exercisable immediately. In the event DIAL options are exercised prior to vesting, such stock acquired is restricted from resale until vested under the option terms.
Shares acquired upon exercise, provided they have been held for more than six months and are vested, may be “put” to Holdings at the most recent determined fair market value per share, subject to the specific terms of the plan agreements. Fair market value is determined on a semi-annual basis by the outside appraiser. Additionally, shares acquired upon exercise, provided they have been held for more than six months and are vested, may be “called” by Holdings, DIUS or DIAL, as applicable, at the most recent determined fair market value per share.
If compensation expense for the DIUS and DIAL stock option incentive plans had been determined based on the estimated fair value at the grant dates for awards under those plans, LNC’s net income and earnings per share for 2002 and 2001 would have been further reduced by $8.2 million ($0.04 per diluted share) and $1.9 million ($0.01 per diluted share), respectively.
The fair value of options used as a basis for the pro forma disclosures, shown above, was estimated as of the date of grant using a Black-Scholes option-pricing model. Included in the above pro forma decrease in net income for 2001 was $6.1 million after-tax of stock option expense related to the former Reinsurance segment.
Effective January 1, 2003, LNC’s stock option employee compensation plan and long-term cash incentive compensation plan were revised and combined to provide for performance vesting, and to provide for awards that may be paid out in a combination of stock options, performance shares of LNC stock and cash. The performance measures for the initial grant under the new plan will be calculated over a three-year period from grant date and will compare LNC’s performance relative to a selected group of peer companies. Comparative performance measures will include relative growth in earnings per share, return on equity and total share
performance. Certain participants in the new plans will select from seven different combinations of stock options, performance shares and or cash in determining the form of their award. Other participants will have their award paid in performance shares. This plan will replace the current LNC stock option plan; however, the separate stock option incentive plans established by DIUS and DIAL, both wholly-owned subsidiaries of Delaware Management Holdings, Inc., will continue.
Information with respect to the LNC incentive plan stock options outstanding at December 31, 2002 is as follows:
At December 31, 2002, DIUS had 10,000,000 shares of common stock outstanding. Information with respect to the DIUS incentive plan involving stock options is as follows:
Restricted stock (non-vested stock) awarded from 2000 through 2002 was as follows:
Various selling practices of the Lincoln UK operations have come under scrutiny by the U.K. regulators at different times in the recent past. These selling practices include the sale and administration of individual pension products, mortgage endowments and the selling practices of City Financial Partners Limited (“CFPL”), a subsidiary company purchased in December 1997. Regarding the sale and administration 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 alleged inappropriate advice, an extensive investigation has been or is being carried out and the individual put in a position similar to what would have been attained if the individual had remained in an employer-sponsored plan.
On March 20, 2002, the U.K. regulator wrote to LNC expressing the opinion that Laurentian Life, Liberty Life (acquired by Lincoln UK in January and April 1995, respectively) and Lincoln UK had in some cases calculated premiums for certain endowment mortgage policies issued between July 1988 and October 2000 based upon growth rates that were, for that time, unduly optimistic, creating exceptional risks for consumers. LNC has reviewed a sample of the Liberty Life policies and based on the results of this review, LNC and the regulators have agreed that no further action is required on the Liberty Life policies unless additional information is discovered. Discussions continue on the Laurentian Life and Lincoln UK blocks of business.
At December 31, 2002 and 2001, the aggregate liability associated with Lincoln UK selling practices was $82.2 million and $164.3 million, respectively. The decrease in the aggregate liability was a result of redress payments and expenditures partially offset by exchange rate fluctuation. The reserves for these issues are based on various estimates that are subject to considerable uncertainty. Accordingly, the aggregate liability may prove to be deficient or excessive. However, it is management’s opinion that future developments regarding Lincoln UK selling practices will not materially affect the consolidated financial position of LNC.
Total rental expense on operating leases in 2002, 2001 and 2000 was $67.0 million, $79.4 million and $88.4 million, respectively. Future minimum rental commitments are as follows (in millions):
In February 1998, LNL signed a seven-year contract with IBM Global Services for information technology services for the Fort Wayne operations. Annual costs are dependent on usage but are expected to range from $60.0 million to $70.0 million.
For discussion of the resolution of legal proceedings related to LNC’s sale of its former reinsurance business to Swiss Re, refer to the discussion within Note 11, “Acquisitions and Divestitures.”
LNC has guarantees with off-balance-sheet risks whose contractual amounts represent credit exposure. Guarantees with off-balance sheet risks having contractual values of $22.4 million and $23.9 million were outstanding at December 31, 2002 and 2001, respectively.
In some cases, the terms of these arrangements involve guarantees by each of the partners to indemnify the mortgagor in the event a partner is unable to pay its principal and interest payments. These guarantees expire in 2003 through 2012.
LNC maintains an overall risk management strategy that incorporates the use of derivative instruments to minimize significant unplanned fluctuations in earnings that are caused by interest rate risk, foreign currency risk, equity risk, and credit risk. LNC assesses these risks by continually identifying and monitoring changes in interest rate exposure, foreign currency exposure, equity market exposure, and credit exposure that may adversely impact expected future cash flows and by evaluating hedging opportunities. Derivative instruments that are currently used as part of LNC’s interest rate risk management strategy include interest rate swaps, interest rate caps and swaptions. Derivative instruments that are used as part of LNC’s foreign currency risk management strategy include foreign currency swaps and foreign exchange forwards. Call options on LNC stock are used as part of LNC’s equity market risk management strategy. Call options on the S&P 500 index were used for reinsurance programs and as a result of the acquisition by Swiss Re of LNC’s reinsurance operations in December 2001, this equity market risk management strategy was terminated. LNC also uses credit default swaps as part of its credit risk management strategy.
LNC and LNL are required to maintain minimum ratings as a matter of routine practice in negotiating ISDA agreements. Under the majority of ISDA agreements and as a matter of policy, LNL has agreed to maintain financial strength or claims-paying ratings above S&P BBB and Moody’s Baa2. A downgrade below these levels would result in termination of the derivatives contract at which time any amounts payable by LNC would be dependent on the market value of the underlying derivative contract. In certain transactions, LNC and the counterparty have entered into a collateral support agreement requiring LNC to post collateral upon significant downgrade. LNC is required to maintain long-term senior debt ratings above S&P BBB and Moody’s Baa2. LNC also requires for its own protection minimum rating standards for counterparty credit protection. LNL is required to maintain financial strength or claims-paying ratings above S&P A- and Moody’s A3 under certain ISDA agreements, which collectively do not represent material notional exposure. LNC does not believe the inclusion of termination or collateralization events pose any material threat to its liquidity position.
As of December 31, 2002 and 2001, LNC had derivative instruments that were designated and qualified as cash flow hedges and fair value hedges and derivative instruments that were not designated as hedging instruments. LNC also had derivative instruments that were designated as hedges of a portion of its net investment in a foreign operation at December 31, 2002. See Note 1 to the consolidated financial statements for detailed discussion of the accounting treatment for derivative instruments. For the year ended December 31, 2002 and 2001, LNC recognized a net gain of $2.5 million after-tax and a net loss of $6.0 million after-tax, respectively, in net income as a component of realized gains and losses on investments and derivative instruments. These gains (losses) relate to the ineffective portion of cash flow hedges, the change in market value for derivative instruments not designated as hedging instruments, and the gain (loss) on swap terminations. For the year ended December 31, 2002 and 2001, LNC recognized a gain of $6.8 million after-tax and $3.5 million after-tax, respectively, in OCI related to the change in market value on derivative instruments that are designated and qualify as cash flow hedges. In addition, for the year ended December 31, 2001, $3.5 million after-tax was reclassified from unrealized gain (loss) on securities available-for-sale to unrealized gain (loss) on derivative instruments, both in OCI. This reclassification relates to derivative instruments that were marked to market through unrealized gain (loss) on securities available-for-sale prior to the adoption of FAS 133.
Interest Rate Swap Agreements. LNC uses interest rate swap agreements to hedge its exposure to floating rate bond coupon payments, replicating a fixed rate bond. An interest rate swap is a contractual agreement to exchange payments at one or more times based on the actual or expected price level, performance or value of one or more underlying interest rates. LNC is required to pay the counterparty the stream of variable interest payments based on the coupon payments from the hedged bonds, and in turn, receives a fixed payment from the counterparty, at a predetermined interest rate. The net receipts/payments from these interest rate swaps are recorded in net investment income. Gains (losses) on interest rate swaps hedging interest rate exposure on floating rate bond coupon payments are reclassified from accumulated OCI to net income as bond interest is accrued.
LNC also uses interest rate swap agreements to hedge its exposure to interest rate fluctuations related to the forecasted purchase of assets for certain investment portfolios. The gains (losses) resulting from the swap agreements are recorded in OCI. The gains (losses) are reclassified from accumulated OCI to earnings over the life of the assets once the assets are purchased. As of December 31, 2002, there were no interest rate swaps hedging forecasted asset purchases.
Foreign Currency Swaps. LNC uses foreign currency swaps, which are traded over-the-counter, to hedge some of the foreign exchange risk of investments in fixed maturity securities denominated in foreign currencies. A foreign currency swap is a contractual agreement to exchange the currencies of two different countries at a specified rate of exchange in the future. Gains (losses) on foreign currency swaps hedging foreign exchange risk exposure on foreign currency bond coupon payments are reclassified from accumulated OCI to net income as bond interest is accrued. The foreign currency swaps expire in 2003 through 2006.
Treasury Lock. LNC used treasury lock agreements to hedge its exposure to variability in future semi-annual interest payments, attributable to changes in the benchmark interest rate, related to the issuance of its 10-year $250 million senior debt in 2001 and its 5-year $250 million senior debt in 2002. A treasury lock is an agreement that allows the holder to lock in a benchmark interest rate, so that if the benchmark interest rate increases, the holder is entitled to receive a payment from the counterparty to the agreement equal to the present value of the difference in the benchmark interest rate at the determination date and the locked-in benchmark interest rate. If the benchmark interest rate decreases, the holder must pay the counterparty to the agreement an amount equal to the present value of the difference in the benchmark interest rate at the determination date and the locked-in benchmark interest rate. The receipt (payment) from the termination of a treasury lock is recorded in OCI and is reclassified from accumulated OCI to interest expense over the coupon-paying period of the related senior debt.
Total Return Swaps. LNC used total return swaps to hedge its exposure to interest rate and spread risk resulting from the forecasted sale of assets in a securitization of certain LNC mortgage loans in 2001. A total return swap is an agreement that allows the holder to protect itself against loss of value by effectively transferring the economic risk of asset ownership to the counterparty. The holder pays (receives) the total
Gains and losses on derivative contracts are reclassified from accumulated OCI to current period earnings. As of December 31, 2002, $13.6 million of the deferred net gains on derivative instruments accumulated in OCI are expected to be reclassified as earnings during the next twelve months. The amount reclassed from OCI to earnings for derivative instruments was $15.9 million and $9.7 million for the year ended December 31, 2002 and 2001, respectively. This reclassification is primarily due to the receipt of interest payments associated with variable rate securities and forecasted purchases, payment of interest on LNC’s senior debt, the receipt of interest payments associated with foreign currency securities, and the periodic vesting of SARs.
Interest Rate Swap Agreements. LNC uses interest rate swap agreements to hedge the risk of paying a higher fixed rate interest on company-obligated mandatorily redeemable preferred securities of subsidiary trusts holding solely junior subordinated debentures and on senior debt than would be paid on long-term debt based on current interest rates in the marketplace. LNC is required to pay the counterparty a stream of variable interest payments based on the referenced index, and in turn, receives a fixed payment from the counterparty, at a predetermined interest rate. The net receipts/payments from these interest rate swaps are recorded as an adjustment to the interest expense related to the debt being hedged. The changes in fair value of the interest rate swap are reported in the consolidated statement of income in the period of change along with the offsetting changes in fair value of the debt being hedged.
Swaptions. Swaptions, which expire in 2003, entitle LNC to receive settlement payments from the counterparties on specified expiration dates, contingent on future interest rates. For each swaption, the amount of such settlement payments, if any, is determined by the present value of the difference between the fixed rate on a market rate swap and the strike rate multiplied by the notional amount. The purpose of LNC’s swaption program is to provide a level of protection for its annuity line of business from the effect of rising interest rates. The swaptions provide an economic hedge of the annuity line of business. However, the swaptions are not linked to specific assets and liabilities on the balance sheet that meet the significantly increased level of specificity required under FAS 133. Therefore, the swaptions do not qualify for hedge accounting under FAS 133.
Foreign Exchange Forwards. LNC’s foreign affiliate, Lincoln UK, used foreign exchange forward contracts, which are traded over-the-counter, to hedge short-term debt issuance in currencies other than the British Pound until Lincoln UK terminated their commercial paper program in the second quarter of 2002. The foreign currency forward contracts obligate LNC to deliver a specified amount of currency at a future date at a specified exchange rate. The foreign exchange forward contracts were marked to market through interest and debt expense within the income statement.
Credit Default Swaps. LNC uses credit default swaps which expire in 2003 through 2006 to hedge against a drop in bond prices due to credit concerns of certain bond issuers. A credit swap allows LNC to put the bond back to the counterparty at par upon a credit event by the bond issuer. A credit event is defined as bankruptcy, failure to pay, or obligation acceleration. LNC has not currently qualified credit default swaps for hedge accounting under FAS 133 as amounts are insignificant.
Call Options on S&P 500 Index. Prior to Swiss Re’s acquisition of LNC’s reinsurance operation in December 2001, LNC used S&P 500 index call options to offset the increase in its liabilities resulting from certain reinsurance agreements which guaranteed payment of the appreciation of the S&P 500 index on certain underlying annuity products. The call options provided LNC with settlement payments from the counterparties on specified expiration dates. The payment, if any, was the percentage increase in the index, over the strike price defined in the contract, applied to the notional amount. The S&P 500 call options provided an economic hedge of the reinsurance liabilities, but the hedging relationship was not eligible for hedge accounting treatment under FAS 133.
Call Options on Bifurcated Remarketable Put Bonds. LNC owns various debt securities that contain call options attached by an investment banker before the sale to the investor. These freestanding call options are exercisable by a party other than the issuer of the debt security to which they are attached and are accounted for separately from the debt security. LNC has not currently qualified call options bifurcated from remarketable put bonds for hedge accounting treatment as amounts are insignificant.
LNC has used certain other derivative instruments in the past for hedging purposes. Although other derivative instruments may have been used in the past, any derivative type that was not outstanding from January 1, 2001 through December 31, 2002 is not discussed in this disclosure. Other derivative instruments LNC has used include spread-lock agreements, financial futures and put options. At December 31, 2002, there are no outstanding positions in these derivative instruments.
LNC is exposed to credit loss in the event of nonperformance by counterparties on various derivative contracts. However, LNC does not anticipate nonperformance by any of the counterparties. The credit risk associated with such agreements is minimized by purchasing such agreements from financial institutions with long-standing, superior performance records. The amount of such exposure is essentially the net replacement cost or market value less collateral held for such agreements with each counterparty if the net market value is in LNC’s favor. At December 31, 2002, the exposure was $85.8 million.
Policy Loans. The estimated fair value of investments in policy loans was calculated on a composite discounted cash flow basis using Treasury interest rates consistent with the maturity durations assumed. These durations were based on historical experience.
Derivative Instruments. LNC employs several different methods for determining the fair value of its derivative instruments. Fair values for these contracts are based on current settlement values. These values are 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, credit default swaps, total return swaps and put options; 3) Monte Carlo techniques for the equity call options on LNC stock. 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 values; and 4) Black-Scholes pricing methodology for standard European equity call options.
Other Investments, and Cash and Invested Cash. The carrying value for assets classified as other investments, and cash and invested cash in the accompanying balance sheets approximates their fair value. Other investments include limited partnership investments which are accounted for using the equity method of accounting.
LNC has four business segments: Lincoln Retirement (formerly known as the Annuities segment), Life Insurance, Investment Management and Lincoln UK. Prior to the fourth quarter of 2001, LNC had a Reinsurance segment. LNC’s reinsurance business was acquired by Swiss Re in December 2001. As the majority of the business acquired by Swiss Re was via indemnity reinsurance agreements, LNC is not relieved of its legal liability to the ceding companies for this business. This means that the liabilities and obligations associated with the reinsured contracts remain on the balance sheets of LNC with a corresponding reinsurance receivable from Swiss Re. In addition, the gain resulting from the indemnity reinsurance portion of the transaction was deferred and is being amortized into earnings at the rate that earnings on the reinsured business are expected to emerge over a period of 15 years. The ongoing management of the indemnity reinsurance contracts and the reporting of the deferred gain is within LNC’s Other Operations. Given the lengthy period of time over which LNC will continue to amortize the deferred gain, and the fact that related assets and liabilities will continue to be reported on LNC’s financial statements, the historical results for the
The Lincoln Retirement segment, headquartered in Fort Wayne, Indiana, provides tax-deferred investment growth and lifetime income opportunities for its clients through the manufacture and sale of fixed and variable annuities. Through a broad-based distribution network, Lincoln Retirement provides an array of annuity products to individuals and employer-sponsored groups in all 50 states of the United States. Lincoln Retirement distributes some of its products through LNC’s wholesaling unit, Lincoln Financial Distributors (“LFD”), as well as LNC’s retail unit, Lincoln Financial Advisors (“LFA”). In addition, group fixed and variable annuity products and the Alliance program are distributed to the employer-sponsored retirement market through Lincoln Retirement’s Fringe Benefit Division dedicated sales force.
The Investment Management segment, headquartered in Philadelphia, Pennsylvania, offers a variety of asset management services to retail and institutional clients throughout the United States and certain foreign countries. Its product offerings include mutual funds and managed accounts. It also provides investment management and account administration services for variable annuity products, and 401(k) plans, “529” college savings plans, pension, endowment, trust, and other institutional accounts. Retail products are primarily marketed by LFD through financial intermediaries including LFA. Institutional products, including large case 401(k) plans, are marketed by a separate sales force within Delaware working closely with manager selection consultants.
Revenues for the Investment Management segment include inter-segment revenues for asset management services provided to the other segments of LNC. These inter-segment revenues totaled $83.8 million, $87.5 million and $88.9 million for 2002, 2001 and 2000, respectively.
Prior to 2001, the management of general account investments performed by the Investment Management segment for LNC’s U.S. based insurance operations was generally priced on an “at cost” basis. Effective January 1, 2001, substantially all of these internal investment management services were priced on an arms-length “profit” basis. Under this new internal pricing standard, the Investment Management segment receives approximately 18.5 basis points on certain assets under management. The change in pricing of internal investment management services impacted segment reporting results for the Lincoln Retirement, Life Insurance, Reinsurance and Investment Management segments, along with Other Operations. Earlier periods were restated to aid the comparability of segment reporting between periods.
All of the issued and outstanding series A preferred stock is $3 cumulative convertible and is convertible at any time into shares of common stock. The conversion rate is sixteen shares of common stock for each share of series A preferred stock, subject to adjustment for certain events. The series A preferred stock is redeemable at the option of LNC at $80 per share plus accrued and unpaid dividends. Outstanding series A preferred stock has full voting rights, subject to adjustment if LNC is in default as to the payment of dividends. If LNC is liquidated or dissolved, holders of series A preferred stock will be entitled to payments of $80 per share. The difference between the aggregate preference on liquidation value and the financial statement balance for the series A preferred stock was $0.9 million at December 31, 2002.
LNC has outstanding one common share purchase (“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
stock for measuring the investment return attributable to their deferral amounts will be paid out in LNC stock. The obligation to satisfy these deferred compensation plan liabilities is dilutive and is shown in the table above.
Details underlying the change in “Net Unrealized Gain (Loss) on Securities Available-for-Sale, Net of Reclassification Adjustment” shown on the Consolidated Statements of Shareholder’s Equity are as follows:
The “Net Unrealized Gain (Loss) on Derivative Instruments” component of other comprehensive income shown on the Consolidated Statements of Shareholders’ Equity is net of Federal income tax expense of $1.2 million and $12.6 million ($9.5 million of the tax expense relates to the transition adjustment recorded in the first quarter of 2001 for the adoption of FAS 133) for 2002 and 2001, respectively, and net of adjustments to deferred amortization costs of $1.6 million and $23.8 million ($18.3 million relates to the transition adjustment recorded for the adoption of FAS 133) for 2002 and 2001, respectively.
The “Foreign Currency Translation” component of other comprehensive income shown on the Consolidated Statements of Shareholders’ Equity is net of Federal income tax expense (benefit) of $31.7 million, $(16.1) million and $(4.4) million for 2002, 2001 and 2000, respectively.
On August 30, 2002, LNC acquired The Administrative Management Group, Inc. (“AMG”), an employee benefits record keeping firm for $21.6 million in cash. Contingent payments up to an additional
$14 million will be paid over a period of 4 years (2003-2006) if certain criteria are met. Any such contingent payments will be expensed as incurred. AMG, a strategic partner of LNC’s Retirement segment for several years, provides record keeping services for the Lincoln Alliance Program along with approximately 400 other clients nationwide. As of December 31, 2002, the application of purchase accounting to this acquisition resulted in goodwill of $20.2 million.
the deferred gain. An additional $1.3 million after-tax ($2 million pre-tax) of deferred gain was recognized, due to a novation of certain Canadian business during 2002.
Accordingly, even though LNC has no continuing underwriting risk, and no cash would be transferred between LNC and Swiss Re, in the event that future developments indicate LNC’s December 31, 2002 personal accident or disability income reserves are deficient or redundant, FAS 113 requires LNC to adjust earnings in the period of change, with only a partial offset to earnings for the cumulative deferred gain amortization adjustment in the period of change. The remaining amount of increased gain would be amortized into earnings over the remaining run-off period of the underlying business.
On September 28, 2000, LNC announced the transfer of the Lincoln UK sales force to Inter-Alliance and the decision to cease writing new business in the UK through direct sales distribution. As a result of these decisions, Lincoln UK continues to manage, administer and accept new deposits on its current block of business and will only accept new business for certain products as required by UK regulations. To implement these decisions, LNC entered into an exit plan (“restructuring plan”) in the third quarter of 2000. The objective of this restructuring plan was to exit all sales and sales support operations and consolidate the Uxbridge home office with the Barnwood home office. Where all commitment date and liability recognition criteria were met in the third quarter of 2000, charges for this restructuring plan were recorded in the third quarter of 2000. The charges associated with this restructuring plan that were recorded in the fourth quarter of
2000 occurred as final decisions under the contract with Inter-Alliance related to personnel and facilities were made, as regulatory requirements related to certain employee involuntary termination benefits were met, and as the decision to consolidate the Uxbridge home office with the Barnwood home office was finalized.
The aggregate charges associated with all restructuring plans entered into during 2001 totaled $24.6 million after-tax ($38.0 million pre-tax) and were included in Underwriting, Acquisition, Insurance and Other Expenses on the Consolidated Statement of Income for the year ended December 31, 2001. The component elements of these aggregate pre-tax costs include employee severance and termination benefits of $12.2 million, write-off of impaired assets of $3.3 million and other exit costs of $22.5 million primarily related to the termination of equipment leases ($1.4 million) and rent on abandoned office space ($20.0 million). Actual pre-tax costs totaling $1.3 million were expended or written-off and 30 positions were eliminated under the Syracuse restructuring plan. The total amount expended for this plan exceeded the original restructuring reserve by $0.3 million. Actual pre-tax costs totaling $1.8 million were expended or written-off and 26 positions were eliminated under the second quarter of 2001 LFD restructuring plan. The amount expended for this plan was equal to the original reserve. Actual pre-tax costs totaling $2.3 million were expended or
written-off and 36 positions were eliminated under the fourth quarter of 2001 Life Insurance segment restructuring plan. The amount expended for this plan was in excess of the original reserve by less than $0.1 million. In addition, $0.1 million of excess reserve on the FPP restructuring plan was released during the second quarter of 2002 and $1.5 million of excess reserve on the Fort Wayne restructuring plan was released during the third quarter of 2002. The release of the reserve on the Fort Wayne restructuring plan was due to LNC’s purchase and ultimate sale of the vacant building on terms which were favorable to what was included in the original restructuring plan for rent on this abandoned office space. Actual pre-tax costs totaling $34.0 million have been expended or written-off for the remaining plans through December 31, 2002. As of December 31, 2002, a balance of $1.4 million remains in the restructuring reserves for the remaining plans and is expected to be utilized in the completion of the plans. Details of each of the remaining 2001 restructuring plans are provided below.
In January 2003, the Life Insurance segment announced that it was realigning its operations in Hartford, Connecticut and Schaumburg, Illinois to enhance productivity, efficiency and scalability while positioning the segment for future growth. The financial impact of the realignment will result in the Life Insurance segment incurring costs of approximately $15-$17 million after-tax during 2003.
In February 2003, Lincoln Retirement announced plans to consolidate its fixed annuity operations in Schaumburg, Illinois into Fort Wayne, Indiana. Restructuring costs under the plan are expected to be $3-$5 million after-tax and are expected to be incurred during 2003.
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, 2002 and 2001, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2002, 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.
As discussed in Note 2 to the consolidated financial statements, in 2002 the Corporation changed its method of accounting for goodwill and its related amortization. As discussed in Notes 2 and 7 to the consolidated financial statements, in 2001 the Corporation changed its method of accounting for derivative instruments and hedging activities as well as its method of accounting for impairment of certain investments.