(2) Per share amounts were affected by the retirement of 7,611,910, 12,088,100, 11,278,022, and 6,222,581 shares of common stock in 2004, 2002, 2001, and 2000, 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.
A decline in the equity markets causing a reduction of asset fees that LNC charges on various investment and insurance products, an acceleration of amortization of deferred acquisition costs (DAC) and an increase in liabilities related to guaranteed benefit features of LNC’s variable annuity products;
Changes in accounting principles generally accepted in the United States that may result in unanticipated changes to LNC’s net income;
Changes in general economic or business conditions, both domestic and foreign, that may be less favorable than expected and may affect premium levels, claims experience, the level of pension benefit costs and funding, and investment results.
We view our business similar to a columned structure. The base of the building is made up of our employees. Building up from that is financial and risk management, which is the cornerstone of our management and business philosophy. Good employees and strong financial and risk management provide the foundation from which we operate and grow our company. With that as a base, there are three pillars that we focus on-product excellence, power of the brand and distribution reach.
Within the variable annuity arena, in June 2003, we introduced the Principal Security benefit rider, which was enhanced and renamed the Lincoln Smart SecuritySM Advantage benefit in 2004. This guaranteed minimum withdrawal benefit (“GMWB”) feature offers the contractholder a guarantee equal to the initial deposit (or contract value, if elected after issue), adjusted for any subsequent purchase payments or withdrawals. Sales of this product have helped drive our growth in variable annuities. We also have an annuity product feature, i4LIFE®, which we introduced a few years ago to meet the needs of baby boomers for retirement income as they enter the retirement phase of their life cycle. In 2004, we had $410 million of new deposits with the i4LIFE® feature, an increase of nearly $300 million over 2004. We believe that as the baby-boomer generation reaches retirement age it will present an emerging opportunity for companies like ours that offer products that allow the baby-boomers to better manage their wealth accumulation, retirement income and wealth transfer needs. We believe that this is a long-term opportunity for the industry and us.
As the third pillar, distribution is a very important part of our business. Because our products are complex and are generally purchased through broker-dealers and financial advisors, being able to distribute to these marketing channels is one key to success in our industry. During 2004, LFD, our wholesaling distribution arm, increased account penetration and the number of wholesalers. In fact, LFD’s top 25 distribution relationships across its wire/regional, financial planner and banking channels are responsible for approximately 75% of our sales. LFA, our retail distribution arm, increased sales of proprietary annuities and mutual funds, as well as other investment products, during 2004 even though the number of planners decreased.
During 2004, we were successful on several fronts, increasing deposits and net flows, improving net income, adding to our product depth and increasing our distribution capability. Further, the equity markets, as represented by the S&P 500 returned 10.9% for the full year, slightly higher than our long-term equity market growth assumption. In addition, the credit markets improved in 2004 resulting in significantly less credit related earnings charges in 2004 relative to 2003.
As discussed above, key operational measures of our success are deposits, net flows and assets under management. The table below summarizes these key measures over the last three years. These operational measures provide information necessary in understanding changes in our revenues and related expenses. Deposits are the result of sales of our products and represent the money put into our products each year. Net flows represent the deposits net of withdrawals, payments on death and surrenders. Assets under management include our investment securities as well as those assets belonging to third parties but managed by our businesses. Assets under management also include assets that are sub-advised by third parties.
(3) Consolidating adjustments represent the elimination of deposits and net flows on products affecting more than one segment.
Statement of Financial Accounting Standard No. 97, “Accounting by Insurance Companies for Certain Long-Duration Contracts and Realized Gains and Losses on Investment Sales” (“FAS 97”) requires that acquisition costs for variable annuity contracts, universal and variable universal life insurance policies be amortized over the lives of the contracts in relation to the incidence of estimated gross profits (“EGPs”) derived from the contracts. Acquisition costs are those costs that vary with and are primarily related to new or renewal business. These costs include commissions and other expenses that vary with new business volume. The costs that we defer are recorded as an asset on our balance sheet as DAC for products sold by us or PVIF for books of business acquired by us. In addition, we defer costs associated with DSI and revenues associated with DFEL. DFEL is a balance sheet liability, and when amortized, increases income. The table below presents the balances by business segment as of December 31, 2004.
Note: The above table includes DAC amortized in accordance with Statement of Financial Accounting Standards No. 60, “Accounting and Reporting by Insurance Enterprises” (“FAS 60”). Under FAS 60, acquisition costs for traditional life insurance products, which include whole life and term life insurance contracts are amortized over periods of 10 to 30 years on either a straight-line basis or as a level percent of premium of the related policies depending on the block of business. No DAC is being amortized under FAS 60 for fixed and variable payout annuities.
Because equity market movements have a significant impact on the value of variable annuity and unit-linked accounts, which are contracts written in the U.K. and are similar to U.S. produced variable life and annuity products, and the fees earned on these accounts, EGPs could increase or decrease with movements in the equity markets. Significant and sustained changes in equity markets could therefore have an impact on DAC amortization for the Retirement segment’s variable annuity block of business, the Investment Management segment’s annuity-based 401(k) business and Lincoln UK’s unit-linked business, but have significantly less impact on DAC amortization for the Life Insurance segment because approximately 82% of their account values pertain to interest-sensitive products, such as universal life and interest-sensitive whole life. Our assumption for the long-term annual gross growth rate of the equity markets used in the determination of DAC amortization is 9%, which is reduced by mortality and expense charges (“M&E”) and asset management charges.
EGPs from the stochastic modeling to that used in the DAC amortization model. A set of intervals around the mean of these scenarios are utilized to calculate two separate statistical ranges of reasonably possible EGPs. These intervals are compared to the present value of the EGPs used in the DAC amortization model. If the present value of EGP assumptions utilized in the DAC amortization model were to exceed the margin of the reasonable range of statistically calculated EGPs, a revision of the EGPs used to calculate DAC amortization would occur. If a revision is deemed necessary, future EGPs would be re-projected using the current account values at the end of the period during which the revision occurred along with a revised long-term annual equity market gross return assumption such that the re-projected EGPs would be our best estimate of EGPs.
Notwithstanding these intervals, if a severe decline or advance in equity markets were to occur or should other circumstances, including policyholder activity, suggest that the present value of future EGPs no longer represents our best estimate, we could determine that a revision of the EGPs is necessary. A severe decline or advance in equity markets would involve a sustained change from December 31, 2004 levels.
Our practice is not necessarily be to unlock immediately after exceeding the first of the two statistical ranges, but rather if we stay between the first and second statistical range for several quarters, we would likely unlock. Additionally, if we exceed the ranges as a result of a short-term market reaction, such as we saw after the events of September 11, 2001, we would not necessarily unlock. However, if the second statistical range is exceeded for more than one quarter, it is likely that we would unlock. While this approach reduces adjustments to DAC due to short-term equity market fluctuations, significant changes in the equity markets that extend beyond one or two quarters could result in a significant positive or negative unlocking.
At December 31, 2002, we completed a RTM unlocking and reset our long-term equity market growth assumption rate to 9%. We also established a range of zero to 15% for equity market returns over a subsequent 48-month period. As a result of favorable equity market returns since that date, we are more likely to unlock DAC, under our enhanced RTM process, from a positive equity market movement rather than negative equity market performance from December 31, 2004. Under the RTM process at September 30, 2004, our 48-month assumed gross equity market return was 5.11% for the Retirement segment. Given where our best estimate of EGPs for the Retirement segment was positioned in the range at December 31, 2004, if we were to reset the RTM to a 9% long-term gross equity market growth assumption from December 31, 2004, it would result in a cumulative positive DAC unlocking of approximately $78.7 million, pre-tax ($51.1 million after-tax). To further illustrate the position in the range of our best estimate of EGPs at December 31, 2004 for the Retirement segment, an immediate equity market movement of positive 15% would bring us to the first of the two statistical ranges while an immediate movement of positive 30% would bring us to the second of the two ranges for the Retirement segment. Subsequent equity market performance that would keep us at or move us beyond the first statistical range would likely result in positive unlocking. Negative equity market performance would have to be significantly greater than the above percentages for us to exceed the lower end of the two statistical ranges.
The valuation techniques we use to estimate the fair value of the group of assets comprising the different reporting units varies based on the characteristics of each reporting unit’s business and operations. A market-based valuation technique that focuses on price-to-earnings (“P/E”) multiplier and the segment-level operating income is used for the Lincoln Retirement and Life Insurance reporting units. For the Lincoln UK segment, a discounted cash flow model is utilized to determine the fair value. A valuation technique combining multiples of revenues, earnings before interest, taxes, depreciation and amortization and assets under management are used to assess the goodwill in our Investment Management segment. We use October 1 as the annual review date for impairment. As such, we performed valuation reviews during the fourth quarter of 2004, 2003 and 2002. The
results of the tests performed as of October 1, 2004, 2003 and 2002 indicated that we did not have impaired goodwill. The valuation techniques used for the Lincoln UK and the Investment Management segments are consistent with the methods used in previous periods. In 2003, the Life Insurance and Retirement segments began using market-based valuation techniques in estimating the fair value for impairment testing. The P/E multiplier valuation method replaced the previous discounted cash flow analysis that was followed in 2002.
Our primary investments are in fixed maturity securities, including corporate and government bonds, asset and mortgage-backed securities and redeemable preferred stock, and equity securities, mortgage loans and policy loans. All our fixed maturity and equity securities are classified as available-for-sale as defined in Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (“FAS 115”), except for those securities supporting certain reinsurance transactions which are classified as trading securities as defined in FAS 115. See “Accounting Pronouncements-Accounting for Modified Coinsurance” for additional information on our trading securities. Available-for-sale securities are carried at fair value with the difference from amortized cost included in shareholders’ equity as a component of accumulated other comprehensive income. The difference is net of related DAC and amounts that would be credited to policyholders, if realized, and taxes.
Fair values for fixed maturity securities are based on quoted market prices, where available. For fixed maturity securities that are not actively traded, fair values are estimated using values obtained from independent pricing services. In the case of private placements, fair values are estimated by discounting expected future cash flows using a current market rate applicable to the coupon rate, credit quality and maturity of the investments. The fair values for equity securities are based on quoted market prices. 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 the fair value based upon prices of public or non-public securities of similarly situated issuers.
For certain securitized fixed maturity securities with contractual cash flows, including asset-backed securities, we use our best estimate of cash flows for the life of the security to determine whether there is an
Based on our evaluation of securities with an unrealized loss at December 31, 2004, we do not believe that any additional other-than-temporary-impairment losses, other than those already reflected in the financial statements, is necessary at the Balance Sheet date. At December 31, 2004, there were available-for-sale securities with unrealized losses totaling $135.3 million, pre-tax, and prior to the impact on DAC.
Write-downs and allowances for losses on select mortgage loans on real estate, real estate and other investments are established when the underlying value of the property is deemed to be less than the carrying value. All mortgage loans that are impaired have an established allowance for credit loss. Changing economic conditions impact our valuation of mortgage loans. Increasing vacancies, declining rents and the like are incorporated into the discounted cash flow analysis that we perform for monitored loans and may contribute to the establishment of (or an increase in) an allowance for credit losses. In addition, we continue to monitor the entire commercial mortgage loan portfolio to identify risk. Areas of current emphasis are the hotel mortgage loan portfolio and retail, office and industrial properties that have deteriorating credits or have experienced debt coverage reduction. Where warranted, we have established or increased loss reserves based upon this analysis.
Management is responsible for establishing and maintaining adequate internal control over financial reporting for LNC to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of our assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on the financial statements.
We have audited management’s assessment, included in the accompanying Management Report on Internal Control Over Financial Reporting, that Lincoln National Corporation maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Lincoln National Corporation’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.
In our opinion, management’s assessment that Lincoln National Corporation maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Lincoln National Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on the COSO criteria.
As discussed in Notes 1 and 2 to the consolidated financial statements, in 2004 the Corporation changed its method of accounting for certain non-traditional long-duration contracts and for separate accounts. Also, as discussed in Note 2 to the consolidated financial statements, in 2003 the Corporation changed its method of accounting for stock compensation costs, certain reinsurance arrangements and costs associated with exit or disposal activities.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Lincoln National Corporation’s internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 8, 2005 expressed an unqualified opinion thereon.
Consolidated Statements of Income-Years Ended December 31, 2004, 2003 and 2002
See Notes to the Consolidated Financial Statements on pages 120 through 184.
Basis of Presentation. The accompanying Consolidated Financial Statements include Lincoln National Corporation (“LNC”) and its majority-owned subsidiaries. Through subsidiary companies, LNC operates multiple insurance and investment management businesses divided into four business segments (see Note 10). The collective group of companies uses “Lincoln Financial Group” as its marketing identity. Less than majority-owned entities in which LNC has at least a 20% interest are reported on the equity basis. These Consolidated Financial Statements have been prepared in conformity with accounting principles generally accepted in the United States.
Investments. Securities available-for-sale consist of fixed maturity and equity securities, which are carried at fair value. The cost of available-for-sale fixed maturity securities is adjusted for amortization of premiums and discounts. The cost of available-for-sale 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.
Realized gain (loss) on investments includes realized gains and (losses) from the sale of investments, derivative gains (losses), gains on sale of subsidiaries/business, and net gain on reinsurance embedded derivative/trading securities. See Note 3 for additional detail. Realized gain (loss) on investments is recognized in net income, net of associated amortization of deferred acquisition costs and investment expenses, using the specific identification method. Changes in the fair values of available-for-sale securities carried at fair value are reported as a component of accumulated other comprehensive income, after deductions for related adjustments for deferred acquisition costs and amounts required to satisfy policyholder commitments that would have been recorded had these securities been sold at their fair value, and after deferred taxes or credits to the extent deemed recoverable.
Derivative Instruments. LNC hedges certain portions of its exposure to interest rate risk, credit risk, foreign exchange risk and equity risk fluctuations by entering into derivative transactions. A description of LNC’s accounting for its hedging of such risks is discussed in the following paragraphs.
LNC recognizes all derivative instruments as either assets or liabilities in the Consolidated Balance Sheet at fair value. 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, 2004 and 2003, LNC had derivative instruments that were designated and qualified as cash flow hedges and fair value hedges and, as of December 31, 2003, hedges of a net investment in a foreign operation. In addition, LNC had derivative instruments that were economic hedges, but were not designated as hedging instruments under Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“FAS 133”).
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 non-mutual fund 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, or the average of the market values at the beginning and end of the monthly or quarterly period. Investment management and advisory contracts typically are renewable annually by the fund’s board. Contracts with non-mutual fund clients normally continue until terminated by either party or at the end of a specified term and often have cancellation clauses ranging up to 30 to 180 days. Investment advisory fees include amounts that are ultimately paid to sub-advisors for managing the sub-advised assets.
Deferred Acquisition Costs, Deferred Front End Loads, Deferred Sales Inducements. Commissions and other costs of acquiring universal life insurance, variable universal life insurance, unit-linked products, traditional life insurance, annuities and other investment contracts, which vary with and are primarily related to the production of new business, have been deferred to the extent recoverable. The methodology for determining the amortization of acquisition costs varies by product type based on two different accounting pronouncements: Statement of Financial Accounting Standards No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments” (“FAS 97”) and Statement of Financial Accounting Standards No. 60, “Accounting and Reporting by Insurance Enterprises” (“FAS 60”). Under FAS 97, acquisition costs for universal life and variable universal life insurance and investment-type products, which include unit-linked products and fixed and variable deferred annuities, are amortized over the lives of the policies in relation to the incidence of estimated gross profits from surrender charges, investment, mortality net of reinsurance ceded and expense margins, and actual realized gain (loss) on investments. 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 14 to 20 years for the traditional, long surrender charge period products and 8 to 10 years for the more recent short-term, or no surrender charge variable products. The front-end load annuity product has an assumed life of 25 years. Longer lives are assigned to those blocks that have demonstrated favorable experience.
Goodwill and Other Intangible Assets. Goodwill, as measured by the excess of the cost of acquired subsidiaries or businesses over the fair value of net assets acquired, is not amortized, but is subject to impairment tests conducted at least annually.
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 (“PVIF”) 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, variable universal life and investment-type products acquired, (i.e., unit-linked products and variable deferred annuities) 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. PVIF is amortized in a manner consistent with DAC.
Insurance and Investment Contract Liabilities. The liabilities for future policy benefits and claim reserves for universal and variable universal life insurance policies consist of policy account balances that accrue to the benefit of the policyholders, excluding surrender charges. The liabilities for future insurance policy benefits and claim reserves for traditional life policies are computed using assumptions for investment yields, mortality and withdrawals based principally on generally accepted actuarial methods and assumptions at the time of policy issue. Interest assumptions for traditional direct individual life reserves for all policies range from 2.25% to 7.00% depending on the time of policy issue. The interest assumptions for immediate and deferred paid-up annuities range from 0.75% to 13.50%.
Beginning January 1, 2004, the liabilities for future claim reserves for variable annuity products containing GMDB features are calculated by multiplying the benefit ratio (present value of total expected GMDB payments over the life of the contract divided by the present value of total expected assessments over the life of the contract) by the cumulative assessments recorded from the contract inception through the balance sheet date less the cumulative GMDB payments plus interest. The change in the reserve for a period is then the benefit ratio multiplied by the assessments recorded for the period less GMDB claims paid in the period plus interest. If experience or assumption changes result in a new benefit ratio, the reserves are unlocked to reflect the changes in a manner similar to DAC. Prior to January 1, 2004, the liabilities for future claim reserves for the GMDB feature were 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 was positive.
Reinsurance. LNC’s insurance companies enter into reinsurance agreements with other companies in the normal course of their business. Prior to the acquisition of LNC’s reinsurance operations by Swiss Re in 2001, LNC’s insurance subsidiaries assumed reinsurance from unaffiliated companies. The transaction with Swiss Re involved a series of indemnity reinsurance transactions combined with the sale of certain stock companies that comprised LNC’s reinsurance operations. Assets/Liabilities and premiums/benefits from certain reinsurance contracts that grant statutory surplus relief to other insurance companies are netted on the 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, with the exception of Modco agreements for which the right of offset also exists.
Stock Based Compensation. Effective January 1, 2003 LNC implemented the provisions of Statement of Financial Accounting Standard No. 123, “Accounting for Stock-Based Compensation,” (“FAS 123”) to expense the fair value of stock options granted to employees. On December 31, 2002, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure” (“FAS 148”), which provides alternative methods of transition for entities that change to the fair value method of accounting for stock-based employee compensation.
Reclassifications. Certain amounts reported in prior years’ Consolidated Financial Statements have been reclassified to conform with the presentation adopted in the current year. These reclassifications have no effect on net income or shareholders’ equity of the prior years.
Under the SOP, the reserve is calculated by multiplying the benefit ratio (present value of total expected GMDB payments over the life of the contract divided by the present value of total expected assessments over the life of the contract) by the cumulative assessments recorded from the contract inception through the balance sheet date less the cumulative GMDB payments plus interest. The change in the reserve for a period is then the benefit ratio multiplied by the assessments recorded for the period less GMDB claims paid in the period plus interest. If experience or assumption changes result in a new benefit ratio, the reserves are unlocked to reflect the changes in a manner similar to DAC.
Application of the SOP impacts estimated gross profits (“EGPs”) used to calculate amortization of DAC, the present value of acquired blocks of in-force policies (“ PVIF”), deferred sales inducements (“DSI”), and the liability for deferred front-end loads (“DFEL”). The benefit ratio approach under the SOP results in a portion of future GMDB fees being accrued as a liability for future GMDB reserves. As a result, the EGPs used in LNC’s determination of DAC amortization are lower under the SOP. Therefore upon adoption of the SOP LNC reported an unfavorable DAC/PVIF/DSI/DFEL unlocking as a negative cumulative effect adjustment of $43.2 million, pre-tax, in 2004.
Universal Life Contracts. LNC’s Life Insurance segment offers an array of individual and survivor-life universal life insurance products that contain features for which the SOP might apply. A review of the products and their features for possible SOP implications concluded that no additional reserves would be necessary with the exception of the MoneyGuardSM product. MoneyGuardSM is a universal life insurance product with an acceleration of death benefit feature that provides convalescent care benefit payments when the insured becomes chronically ill. There is an optional extension of benefit rider available that will provide continuation of the convalescent care benefit payments once the total benefits from the base policy have been exhausted. The optional extended benefit payments can be for 2 years, 4 years, or the remaining life of the insured. Charges for the extension rider are deducted from the base policy account value and vary by the length of extension period selected. The adoption of the SOP resulted in a charge recorded as a cumulative effect of accounting change of $2.7 million, after-tax, for the extension of benefit feature in MoneyGuardSM.
Accounting for Share-Based Payment. In December 2004, the FASB issued Statement No. 123 (revised 2004), Share-Based Payment (“FAS 123(r)”), which is a revision of FASB Statement No. 123, “Accounting for
On December 31, 2002, the FASB issued Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation- Transition and Disclosure” (“FAS 148”), which provides alternative methods of transition for entities that change to the fair value method of accounting for stock-based employee compensation. LNC adopted the fair value method of accounting under FAS 123 with the retroactive restatement method, as amended by FAS 148, as of January 1, 2003 and restated its financial statements for the years 2002, 2001, and 2000.
Due to these uncertainties and expected immaterial impact, LNC elected to defer accounting for the effects of the Medicare Act in 2003. In May 2004, the staff of the FASB issued Financial Staff Position No. FAS 106-2 (“FSP 106-2”), which requires sponsors of a post-retirement health care plan that provides retiree prescription drug benefits to reflect the provisions of the Medicare Prescription Drug Improvement and Modernization Act of 2003 (“the Medicare Act”) in determining post-retirement benefit cost for the first annual or interim period starting after June 15, 2004.
Due to uncertainties about how participants in LNC’s post-retirement plan will elect to participate in the Medicare Act’s benefits, and the various uncertainties created by the current lack of guidelines for applying the Medicare Act’s provisions, LNC’s assessment of the effects of the provisions of the Medicare Act could change. Any change would be included in the financial statements in the period the change occurs. Any change is not expected to have a material effect on LNC.
For the other three CDOs, LNC still has the right to earn performance-based fees above the base asset management fees. These performance-based fees are considered variable fees for purposes of performing the analysis of expected residual returns. In addition, LNC also holds investment interests in these CDOs. However, in these three CDOs, LNC has determined that the expected variability in its fees and the level of other LNC interests in the CDO, are currently below the level that would result in LNC being treated as the primary beneficiary. Future changes in the interest held by the third party investors in these three CDO pools, relative to
LNC’s interest, require ongoing retesting of LNC’s potential status as primary beneficiary. LNC’s maximum exposure to loss is its investment in these three CDO pools, which had a carrying value of approximately $11.0 million, and an estimated fair value of approximately $10.8 million, at December 31, 2004.
2A. Concurrent with the initial recording of the embedded derivative associated with these reinsurance arrangements, LNC reclassified related available-for-sale securities to trading securities classification.
The portion of market adjustment for trading securities and the corresponding market adjustment for the reinsurance embedded derivative related to trading securities at December 31, 2004 and 2003 was $22.1 million and $334.7 million, respectively.
For total publicly traded and private securities held by LNC at December 31, 2004 and 2003 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 balance sheet captions, “Real Estate” and “Property and Equipment,” include allowances for depreciation as follows:
As of December 31, 2004, LNC’s investment commitments for fixed maturity securities (primarily private placements), mortgage loans on real estate and real estate were $478.9 million. This includes $181.8 million of standby commitments to purchase real estate upon completion and leasing.
The carrying value of fixed maturity securities available-for-sale, mortgage loans on real estate and real estate investments which were non-income producing totaled $147.4 million and $133.0 million at December 31, 2004 and 2003, respectively.
LNC is required to establish a valuation allowance for any gross deferred tax assets that are unlikely to reduce taxes payable in future years’ tax returns. At December 31, 2004, LNC believes that it is more likely than not that all gross deferred tax assets will reduce taxes payable in future years except for the deferred tax asset relating to the net operating losses of its foreign life reinsurance subsidiary domiciled in Barbados. In 2001, LNC established a valuation allowance of $51.2 million for the gross deferred tax asset relating to these net operating losses. This valuation allowance was reduced to $46.8 million as of December 31, 2004. The net operating losses of this subsidiary are subject to Federal income tax limitations that only allow the net operating losses to be used to offset future taxable income of the subsidiary. LNC believes that it is more likely than not that all of the tax benefits associated with this subsidiary’s net operating losses will not be realized.
At December 31, 2004, LNC had net operating loss carryforwards for Federal income tax purposes of $133.8 million for its foreign life reinsurance company domiciled in Barbados that expire in 2014 and 2018.
LNC is subject to annual tax examinations from the Internal Revenue Service (“IRS”). The audits for tax years through 1995 have been completed and these years are closed. The IRS has examined tax years 1996, 1997 and 1998, with assessments resulting in a payment that was not material to the consolidated results of operations. In addition to taxes assessed and interest, the payment included a deposit relating to a portion of the assessment, which the company continues to challenge. The company believes this portion of the assessment is inconsistent with existing law, and is protesting it through the established IRS appeals process. LNC is currently under audit by the IRS for years 1999-2002. LNC does not anticipate that any adjustments that might result from such audits would be material to LNC’s consolidated results of operations or financial condition.
Reinsurance transactions included in the income statement captions, “Insurance Premiums” and “Insurance Fees”, excluding amounts attributable to the indemnity reinsurance transaction with Swiss Re, are as follows:
The income statement caption, “Benefits,” is net of reinsurance recoveries of $0.6 billion for each of the years ended December 31, 2004, 2003 and 2002.
LNC recorded expense for company advertising of approximately $27.4 million, $21.2 million and $21.3 million in 2004, 2003 and 2002, respectively.
* The decline in goodwill for the Investment Management section results from the sale of its London based international investment unit. See Note 12 for additional information.
On October 1, 2004, LNC redeemed all $120.3 million of its outstanding 9.125% Debentures due October 1, 2024 for an aggregate redemption amount of $125.5 million. Interest and debt expense in the fourth quarter of 2004 includes approximately $6.3 million ($4.1 million after-tax) relating to the call premium and unamortized issue costs relating to the redemption.
In February 2004, LNC issued $200 million of 4.75% Notes due February 15, 2014 with semi-annual interest payments in February and August. The notes were priced at 99.297% and net proceeds to the company
were $197.3 million. A portion of the net proceeds was used to redeem the 9.125% notes described above with the remainder of the proceeds used for general corporate purposes and to reduce short-term debt. LNC used a treasury lock to reduce exposure to interest rate changes prior to closing. The treasury lock was closed prior to the issuance of the Notes with a gain of approximately $1 million. This gain, along with the costs of issuance, is being amortized over the life of the Notes.
In July 2003, LNC redeemed the $200 million 7.40% Trust Originated Preferred Securities (“TOPrS”) issued by Lincoln Capital III and guaranteed by LNC. A loss of $3.7 million ($5.6 million pre-tax) related to unamortized issuance costs was reported in 2003 related to the redemption. This expense is included in the income statement caption “Interest and debt expense.” In September 2003, Lincoln Capital VI, a wholly-owned affiliated trust of LNC, issued $150 million of 6.75% Trust Preferred Securities, Series F guaranteed by LNC. The debentures mature September 11, 2052 and can be redeemed for principal plus accrued interest beginning September 11, 2008.
In January 2002, LNC redeemed $100 million 8.35% TOPrS which were issued by Lincoln Capital II in August 1996. In June 2002, LNC issued $250 million 5.25% five-year senior notes. In conjunction with the $250 million debt issue, LNC executed an interest rate swap in the amount of $100 million notional that effectively converted the 5.25% fixed rate coupon on that portion of the bond into LIBOR-based floating rate debt.
LNC also has access to capital from junior subordinated debentures issued to affiliated trusts. Hybrid securities currently outstanding, which combine debt and equity characteristics, were offered through a series of trusts (Lincoln National Capital V and VI). These trusts were formed solely for the purpose of issuing preferred securities and lending the proceeds to LNC. The common securities of these trusts are owned by LNC. The only assets of Lincoln National Capital V and VI are the junior subordinated debentures issued by LNC. Distributions are paid by these trusts to the preferred security holders on a quarterly basis. The principal obligations of these trusts are irrevocably guaranteed by LNC. Upon liquidation of these trusts, the holders of the preferred securities would be entitled to a fixed amount per share plus accumulated and unpaid distributions. LNC reserves the right to: 1) redeem the preferred securities at a fixed price plus accumulated and unpaid distributions and; 2) defer the interest payments due on the subordinated debentures for up to 20 consecutive quarters, but not beyond the maturity date of the subordinated debenture. LNC has determined that the trusts are variable interest entities as defined by FIN 46. Prior to the implementation of FIN 46, LNC consolidated the trusts, which resulted in the elimination of the junior subordinated debentures issued to the affiliated trusts. Upon implementation of FIN 46, LNC no longer consolidates these trusts. The effect of the deconsolidation was not material.
LNC maintains two revolving credit agreements with a group of domestic and foreign banks totaling $519 million. One agreement, in the amount of $500 million, expires in December 2009. The Lincoln UK agreement was renewed in February 2005 for $19 million maturing in February 2006. Both agreements provide for interest
on borrowings based on various money market indices. Under the agreements, LNC must maintain senior unsecured long-term debt ratings of at least S&P A- and Moody’s A3 or be restricted by an adjusted debt to capitalization ratio. At December 31, 2004, LNC had no outstanding borrowings under the agreements.
Cash paid for interest related to LNC’s debt and junior subordinated debentures of affiliated subsidiary trusts for 2004, 2003 and 2002 was $93.0 million, $93.5 million and $96.6 million, respectively.
The following table provides information on the GMDB features outstanding at December 31, 2004 and 2003. (Note that LNC’s variable contracts with guarantees may offer more than one type of guarantee in each contract; therefore, the amounts listed are not mutually exclusive.) The net amount at risk is defined as the current guaranteed minimum death benefit in excess of the current account balance at the balance sheet date.
Approximately $4.2 billion and $0.8 billion of separate account values at December 31, 2004 and 2003 were attributable to variable annuities with a GMWB feature. This GMWB feature offers the contractholder a guarantee equal to the initial deposit adjusted for any subsequent purchase payments or withdrawals. There are one-year and five-year step-up options, which allow the contractholder to step up the guarantee. GMWB features are considered to be derivatives under FAS 133 resulting in the guarantees being recognized at fair value, with changes in fair value being reported in net income.
The changes to the benefit reserves amounts above are reflected in benefits in the Consolidated Statements of Income. Also included in benefits are the results of the hedging program, which included losses of $19.3 million and $3.8 million for GMDB in 2004 and 2003, respectively.
Pension and Other Post-retirement Benefit Plans-U.S. LNC maintains funded defined benefit pension plans for most of its U.S. employees and, prior to January 1, 1995, most full-time agents. Effective January 1, 2002, the employees’ pension plan was converted to a cash balance formula. Employees retiring before 2012 will have their benefits calculated under both the old final average pay formula and the cash balance formula and will receive the greater of the two calculations. Employees retiring in 2012 or after will receive benefits under the cash balance formula. Benefits under the final average pay formula are based on total years of service and the
LNC also sponsors unfunded plans that provide post-retirement medical, dental and life insurance benefits to full-time U.S. employees and agents who, depending on the plan, have worked for LNC 10 years and attained age 55 (60 for agents). Medical and dental benefits are also available to spouses and other dependents of employees and agents. For medical and dental benefits, limited contributions are required from individuals who retired prior to November 1, 1988. Contributions for later retirees, which can be adjusted annually, are based on such items as years of service at retirement and age at retirement. Effective April 1, 2004, the employees’ post-retirement plan was changed such that employees and agents not attaining age 50 by that date will not be eligible to receive life insurance benefits when they retire. This amendment to the plan resulted in the immediate recognition at the end of 2003 of a one-time curtailment gain of $2.4 million, pre-tax. Life insurance benefits for retirees are noncontributory for employees and agents that attained the age of 50 by April 1, 2004 and meet the eligibility requirements at the time they retire; however, these participants can elect supplemental contributory life benefits up to age 70. Effective July 1, 1999, the agents’ post-retirement plan was changed to require agents retiring on or after that date to pay the full medical and dental premium costs. Beginning January 1, 2002, the employees’ post-retirement plan was changed to require employees not yet age 50 with five years of service by the end of 2001 to pay the full medical and dental premium cost when they retire.
could result in an offset to some portion of the costs of prescription drug benefits provided to retirees. In January 2004, the staff of the FASB issued Financial Staff Position No. FAS 106-1 (“FSP 106-1”), which permits a sponsor of a post-retirement health care plan that provides retiree prescription drug benefits to make a one-time election to defer accounting for the effects of the Medicare Act.
LNC completed its analysis and incorporated the provisions of the Medicare Act in determining other post-retirement benefit costs and the accumulated post-retirement benefit obligation in third quarter of 2004. The implementation did not have a material effect on LNC’s results of operations.
* In 2004, other post-retirement benefits of $(98.3) million includes a $1.1 million reduction in expense recorded as the cumulative impact of adopting FSP 106-2.
The components of net defined benefit pension plan and post-retirement benefit plan expense are as follows:
LNC maintains a defined contribution plan for its U.S. insurance agents. Contributions to this plan are based on a percentage of the agents’ annual compensation as defined in the plan. Effective January 1, 1998, LNC
assumed the liabilities for a non-contributory defined contribution plan covering certain highly compensated former CIGNA agents and employees. Contributions to this plan are made annually based upon varying percentages of annual eligible earnings as defined in the plan. Contributions to this plan are in lieu of any contributions to the qualified agent defined contribution plan. Effective January 1, 2000, this plan was expanded to include certain highly compensated LNC agents. The combined pre-tax expenses for these plans amounted to $3.0 million, $3.7 million and $1.0 million in 2004, 2003 and 2002, respectively. These expenses reflect both LNC’s contribution as well as changes in the measurement of LNC’s liabilities under these plans.
LNC’s U.S. pension plan asset allocations at December 31, 2004 and 2003, by asset category are as follows:
The primary investment objective of LNC’s U.S. defined benefit pension plan is for capital appreciation and income growth, with an emphasis on avoiding undue risk. A secondary objective is for current income. Investments can be made using the following asset classes: both domestic and international equity and fixed income securities, real estate, guaranteed products, venture capital, oil and gas and other asset classes the investment managers deem prudent. A five-year time horizon is utilized as there are inevitably short-run fluctuations, which will cause variations in investment performance.
Each managed fund is expected to rank in the upper 50% of similar funds over the three and/or five-year periods. Managers not meeting these criteria will be subject to additional due diligence review and possible termination. The following short-term ranges have been established for weightings in the various asset categories:
Within the broad ranges provided above, LNC currently targets asset weightings as follows: 64% equities, 35% fixed income, including real estate, and 1% cash. The performance of the plan and the managed funds are monitored on a quarterly basis relative to the plan’s objectives. The performance of the managed fund is measured against the following indices: S&P 500, EAFE, Russell 2000, NAREIT, Lehman US Universal and Salomon (Citigroup) 90-day T-Bill. LNC reviews this investment policy on an annual basis.
LNC expects to contribute between $0 million and $20 million to its qualified U.S. defined benefit pension plans in 2005. In addition, LNC expects to fund approximately the following amounts for benefit payments for its unfunded non-qualified U.S. defined benefit plan and U.S. post-retirement benefit plans:
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, 2004 and 2003, plan assets were under the projected benefit obligations by $83.0 million and $79.0 million, respectively, and were included in other liabilities in LNC’s Consolidated Balance Sheets. Net pension costs for the foreign plan were $7.5 million, $6.8 million and $10.0 million for 2004, 2003 and 2002, respectively. See above (U.S. plans) for discussion of the minimum pension liability adjustment for the non-U.S. defined benefit pension plan.
401(k), Money Purchase and Profit Sharing Plans. LNC also sponsors contributory defined contribution plans for eligible U.S. employees and agents. These plans include 401(k) plans and effective April 1, 2001, a defined contribution money purchase plan for eligible employees of Delaware Management Holdings, Inc. (“Delaware”). LNC’s contribution to the 401(k) plans is equal to 50% of each participant’s pre-tax contribution, not to exceed 6% of base pay, and is invested in the underlying investment election of the participant. An additional discretionary contribution of up to 100% may be made with respect to a participant’s pre-tax contribution (again up to 6% of base pay). The amount of discretionary contribution varies according to whether LNC has met certain performance-based criteria as determined by the Compensation Committee of LNC’s Board of Directors. The additional discretionary contributions are in LNC stock.
using the total return swap to mitigate the earnings effects created by the changes in value of LNC’s deferred compensation plan liability that result from changes in value of the underlying investment options.
Total compensation expense for performance vesting awards for 2004 was $2.1 million relating to stock options, $20.4 million relating to shares, and $2.5 million relating to cash awards. Total compensation expense for LNC performance vesting awards for 2003 was $0.4 million relating to stock options, $6.1 million relating to shares, and $0.8 million relating to cash awards. The amount of stock option expense for the performance vesting awards is included in the total LNC stock option expense as discussed below. All expense calculations for performance vesting stock options, shares, and cash awards that were granted in 2004 and 2003 have been based upon the fair value at date of grant and an estimate of performance achievement over the three-year performance measurement periods. The estimated cost for each award cycle is expensed over the performance period. As the three-year performance periods progress, LNC refines its estimate of the expense associated with these awards so that by the end of the three-year performance period, LNC’s cumulative expense will reflect the actual level of awards that vest.
Information with respect to LNC stock options outstanding at December 31, 2004 is as follows:
Total compensation expense for LNC incentive plans involving stock options, including the DIUS stock option incentive plans discussed below, for 2004, 2003 and 2002 was $34.0 million, $51.5 million and $59.9 million, respectively. Included in the above compensation is the acceleration of expense resulting from the 2004 and 2003 realignment activities.
At December 31, 2004, DIUS had 10,053,218 shares of common stock outstanding. Information with respect to the DIUS incentive plan involving stock options is as follows:
At December 31, 2004, the range of exercise prices for options outstanding under the DIUS incentive plan involving stock options was $98.71 to $131.48, with a weighted-average remaining contractual life of 7.8 years.
LNC recognizes compensation expense for the SAR program based on the fair value method using an option-pricing model. Compensation expense and the related liability are recognized on a straight-line basis over the vesting period of the SARs. The SAR liability is marked-to-market through net income. This accounting treatment causes volatility in net income as a result of changes in the market value of LNC stock. LNC hedges this volatility by purchasing call options on LNC stock. Call options hedging vested SARs are also marked-to-market through net income. Total compensation expense (income) recognized for the SAR program for 2004, 2003 and 2002 was $6.2 million, $6.8 million and $(0.7) million, respectively. The mark-to-market gain (loss) recognized through net income on the call options on LNC stock for 2004, 2003 and 2002 was $2.4 million, $0.3 million and $(6.7) million, respectively. The SAR liability at December 31, 2004 and 2003 was $9.4 million and $9.8 million, respectively.
In addition to the stock-based incentives discussed above, LNC has awarded restricted shares of LNC stock under the incentive compensation plan, generally subject to a three-year vesting period. The fair market value at date of grant of the restricted shares is expensed over the vesting period. Information with respect to LNC restricted stock (non-vested stock) awarded from 2002 through 2004 was as follows:
Net income (loss) as determined in accordance with statutory accounting practices for LNC’s insurance subsidiaries was $0.599 billion, $0.237 billion and $(0.159) billion for 2004, 2003 and 2002, respectively. In December 2001, Swiss Re acquired LNC’s reinsurance operations. The transaction structure involved a series of indemnity reinsurance transactions combined with the sale of certain stock companies that comprised LNC’s reinsurance operation. See Note 12 for further discussion of Swiss Re’s acquisition of LNC’s reinsurance operations. All of LNC’s foreign life reinsurance companies were sold to Swiss Re in 2001 except Lincoln National Reinsurance Company (Barbados) and Lincoln Re (Ireland) Limited. In the second quarter of 2002, LNC exercised a contractual right to “put” its interest in Lincoln Re (Ireland) Limited to Swiss Re. In September 2004, LNC incorporated Lincoln Reinsurance Company of Bermuda Limited, which is incorporated and operated in Bermuda.
LNL is recognized as an accredited reinsurer in the state of New York, which effectively enables it to conduct reinsurance business with unrelated insurance companies that are domiciled within the state of New York. As a result, in addition to regulatory restrictions imposed by the state of Indiana, LNL is also subject to the regulatory requirements that the State of New York imposes upon accredited reinsurers. These include reserve requirements, which differ from the State of Indiana and, in most cases, are more restrictive thus reducing LNL’s total adjusted capital as reported to New York.
Lincoln UK’s operations consist primarily of unit-linked life and pension products, which are similar to US produced variable life and annuity products. Lincoln UK’s insurance subsidiaries are regulated by the UK Financial Services Authority (FSA) and are subject to capital requirements as defined by the UK Required Minimum Solvency Margin (RMSM). Lincoln UK maintains approximately 1.5 to 2.0 times the required capital as prescribed by the regulatory margin. As is the case with regulated insurance companies in the U.S., changes to regulatory capital requirements can impact the dividend capacity of the UK insurance subsidiaries and cash flow to LNC.
Following allegations made by the U.K. Consumers’ Association (an organization which acts on behalf of consumers of goods and services provided in the U.K.) concerning various selling practices of CFPL, LNC conducted an internal review of 5,000 ten-year savings plans sold by CFPL during the period September 1, 1998 to August 31, 2000 and, following discussions with the U.K. regulator, LNC extended this review to all customers with a ten-year savings plan sold by CFPL to determine whether the sales of those policies were appropriate. The agreed upon redress process was concluded in September of 2003, with offers of redress to approximately 5,400 contractholders, and payment of a $762,600 fine for the mis-selling of ten-year savings plans by CFPL covering the period between September 1, 1998 and August 31, 2000.
The Treasury Select Committee published a report in the first quarter of 2004 on various issues associated with mortgage endowment contracts. In response to this report, in the second quarter of 2004, the FSA revised its rules relating to the time limits for making a complaint regarding the sale of these contracts. The heightened publicity surrounding these matters has contributed to an increase in the level of customer complaints, which were in excess of expected levels in the first six months of 2004. As a direct result of this experience and the likely impact of the FSA’s revised rules on time limits, Lincoln UK increased its reserves for these matters during the second quarter of 2004.
liability. Due to the uncertainty surrounding all of these matters, it is not possible to provide a meaningful estimate of the range of potential outcomes; however it is management’s opinion that future developments will not materially affect the consolidated financial position of LNC.
Certain of LNC’s subsidiaries lease their home office properties through sale-leaseback agreements. The agreements provide for a 25-year lease period with options to renew for six additional terms of five years each. The agreements also provide LNC with the right of first refusal to purchase the properties during the terms of the lease, including renewal periods, at a price defined in the agreements. LNC also has the option to purchase the leased properties at fair market value as defined in the agreements on the last day of the initial 25-year lease period ending in 2009 or the last day of any of the renewal periods.
Total rental expense on operating leases in 2004, 2003 and 2002 was $66.3 million, $67.1 million and $67.0 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. In February 2004, LNL completed renegotiations and extended the contract through February 2010. Annual costs are dependent on usage but are expected to range from $45.0 million to $50.0 million.
In return for agreeing to outsource its customer and policy administration functions to Capita, the agreement with Capita included payments that we could receive upon the achievement of certain contingencies. In the second quarter of 2004, we exercised our put options and recognized a gain of $10.1 million, pre-tax ($6.6 million, after-tax), in respect of the future contingent payments under this arrangement. In February 2005, we
LNC agreed to outsource its human resources administration functions, including payroll, to IBM on September 29, 2003. The contract is for a term of 10 years and the annual cost is based on per check and per employee charges. The total costs over the life of the contract are estimated to be $36.7 million and annual costs over the next five years are estimated to decline from $4.2 million to $3.5 million. The actual cost will depend on the number of active employees and the applicable inflation rate for the period concerned.
On November 1, 2004, LNC entered into a five-year procurement management arrangement with Accenture LLP. Payments under the arrangement are expected to total $25.8 million over the contract term, including a technology access fee of $3 million paid in 2004, aggregate operating fees of $13.8 million, ranging between $3.2 million and $1.9 million per year, and incentive fees aggregating $9.0 million if targeted savings over the contract period are achieved. Depending on the actual level of savings achieved over the contract period, the incentive fee could range from zero to $14.0 million.
LNC maintains $900 million in bank agreements to issue standby letters of credit on behalf of subsidiaries of LNC and for the benefit of third parties. These letters of credit support LNL’s reinsurance needs and specific treaties associated with LNC’s reinsurance business, which was acquired by Swiss Re in 2001 (see Note 12 for further discussion of this transaction). Letters of credit are primarily used to satisfy the U.S. regulatory requirements of domestic clients of the former Reinsurance segment who have contracted with the Reinsurance subsidiaries not domiciled in the United States and for the reserve credit provided by our affiliated offshore reinsurance company to our domestic insurance companies for ceded business. The letter of credit allows the cedents to take credit for reinsured reserves on their statutory balance sheets. At December 31, 2004, there was a total of $552.5 million in outstanding bank letters of credit.
Although LNC does not have any significant concentration of customers, LNC’s Retirement segment has had a long-standing distribution relationship with American Funds Distributors (“AFD”) that is significant to this segment. Prior to 2003, AFD used wholesalers who focus on both American Funds mutual funds as well as the American Legacy Variable Annuity products. In 2002, LNC and AFD agreed to transition the wholesaling of American Legacy to Lincoln Financial Distributors (“LFD”), which was completed in 2003. The American Legacy Variable Annuity product line sold through LFD accounted for about 30% and 17% of LNC’s total gross
annuity deposits in 2004 and 2003, respectively, compared with about 15% sold through AFD in 2002. In addition, the American Legacy Variable Annuity product line represents approximately 36% and 35% of LNC’s total gross annuity account values at December 31, 2004 and 2003, respectively.
LNC has guarantees with off-balance-sheet risks whose contractual amounts represent credit exposure. Guarantees with off-balance sheet risks having contractual values of $4.6 million and $14.2 million were outstanding at December 31, 2004 and 2003, respectively.
Certain subsidiaries of LNC had invested in real estate partnerships that used industrial revenue bonds to finance their projects. LNC guaranteed the repayment of principal and interest on these bonds. Certain subsidiaries of LNC were also involved in other real estate partnerships that used conventional mortgage loans. In case of default by the partnerships, LNC had recourse to the underlying real estate. In some cases, the terms of these arrangements involved guarantees by each of the partners to indemnify the mortgagor in the event a partner was unable to pay its principal and interest payments. These guarantees expired in 2004.
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 futures and interest rate caps. 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, total return swaps, put options and equity futures are used as part of LNC’s equity market risk management strategy. 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 of S&P BBB- and Moody’s Baa3. 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.
LNC’s derivative instruments are monitored by its risk management committee as part of that committee’s oversight of LNC’s derivative activities. LNC’s derivative instruments committee is responsible for implementing various hedging strategies that are developed through its analysis of financial simulation models and other internal and industry sources. The resulting hedging strategies are then incorporated into LNC’s overall risk management strategies.
As of December 31, 2004 and 2003, LNC had derivative instruments that were designated and qualified as cash flow hedges, fair value hedges, and at December 31, 2003 hedges of a net investment in a foreign operation. LNC also had derivative instruments that were not designated as hedging instruments. See Note 1 for a detailed discussion of the accounting treatment for derivative instruments. For the years ended December 31, 2004, 2003 and 2002, LNC recognized a net (loss) gain of ($7.4 million, after-tax after-DAC), ($1.6 million, after-tax after-DAC), and $0.8 million, after-tax after-DAC, respectively, in net income as a component of realized investment gains and losses. 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 years ended December 31, 2004 and 2003, LNC recognized a loss of $8.1 million, after-tax after-DAC, and $6.3 million, after-tax after-DAC, respectively, in OCI related to the change in market value on derivative instruments that are designated and qualify as cash flow hedges.
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 2005 through 2014.
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 $200 million senior debt in 2004 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.
Gains and losses on derivative contracts that qualify as cash-flow hedges are reclassified from accumulated OCI to current period earnings. As of December 31, 2004, $19.4 million of the deferred net gains on derivative instruments accumulated in OCI are expected to be reclassified to earnings during the next twelve months. This reclassification is primarily due to the receipt of interest payments associated with variable rate securities and forecasted purchases, payment of interest on LNC’s senior debt, the receipt of interest payments associated with foreign currency securities, and the periodic vesting of SARs.
Interest Rate Swap Agreements. LNC uses interest rate swap agreements to hedge the risk of paying a higher fixed rate of interest on junior subordinated debentures issued to affiliated trusts 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.
deliver a specified amount of currency at a future date at a specified exchange rate. All gains or losses on the foreign currency forward contracts are recorded in OCI and remain in accumulated OCI until such time that Lincoln UK is sold or liquidated. The foreign currency forward contracts outstanding at December 31, 2003 terminated in 2004.
Total Return Swaps. LNC uses total return swaps to hedge a portion of the liability related to its deferred compensation plans. LNC receives the total return on a portfolio of indexes and pays a floating rate of interest. Cash settlements on the change in market value of the total return swaps along with the resulting gains and losses are recorded in net income through the underwriting, acquisition, insurance and other expenses line in the Consolidated Statements of Income. The open positions at December 31, 2004 all expire in 2009.
Interest Rate Swap Agreements. LNC used a forward starting interest rate swap agreement to hedge its exposure to the forecasted sale of mortgage loans. LNC was required to pay the counterparty a predetermined fixed stream of payments, and in return, received payments based on a floating rate from the counterparty. The net receipts/payments from these interest rate swaps were recorded in realized gain (loss) on investments and derivative instruments. As of December 31, 2004, there were no forward starting interest rate swap agreements.
LNC also sells credit default swaps to offer credit protection to investors. The credit default swaps hedge the investor against a drop in bond prices due to credit concerns of certain bond issuers. A credit swap allows the investor to put the bond back to LNC at par upon a credit event by the bond issuer. A credit event is defined as bankruptcy, failure to pay, or restructuring. As of December 31, 2004, LNC had a credit swap with a notional amount of $5.0 million. The credit default swap expires in 2009.
Call Options on LNC Stock. As discussed previously in the Cash Flow Hedges section, LNC uses call options on LNC stock to hedge the expected increase in liabilities arising from SARs granted on LNC stock. Call options hedging vested SARs are not eligible for hedge accounting treatment under FAS 133. Marked to market changes are recorded in net income in underwriting, acquisition, insurance and other expenses.
Derivative Instrument Embedded in Deferred Compensation Plan. LNC has certain deferred compensation plans that have embedded derivative instruments. The liability related to these plans varies based on the investment options selected by the participants. The liability related to certain investment options selected by the participants is marked to market through net income in underwriting, acquisition, insurance and other expenses.
Derivative Instrument Embedded in Modified Coinsurance and Coinsurance with Funds Withheld Arrangements. LNC is involved in various Modco and CFW reinsurance arrangements that have embedded derivatives. The change in fair value of the embedded derivative, as well as the gains or losses on trading securities supporting these arrangements, flows through net income.
Derivative Instrument Embedded in Variable Annuity Products. LNC has certain variable annuity products with a GMWB feature that is an embedded derivative. The change in fair value of the embedded derivatives flow through net income through the benefits line in the Consolidated Statements of Income.
The remainder of the balance sheet captions, “Insurance Policy and Claims Reserves” and “Contractholder Funds” that do not fit the definition of “investment type insurance contracts” are considered insurance contracts. Fair value disclosures are not required for these insurance contracts and have not been determined by LNC. It is LNC’s position that the disclosure of the fair value of these insurance contracts is important because readers of these financial statements could draw inappropriate conclusions about LNC’s shareholders’ equity determined on a fair value basis. It could be misleading if only the fair value of assets and liabilities defined as financial instruments are disclosed. LNC and other companies in the insurance industry are monitoring the related actions of the various rule-making bodies and attempting to determine an appropriate methodology for estimating and disclosing the “fair value” of their insurance contract liabilities.
LNC has four business segments: Lincoln Retirement, Life Insurance, Investment Management and Lincoln UK.
Financial data by segment for 2002 through 2004 is as follows:
(1) 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 $105.8 million, $101.2 million and $97.7 million for 2004, 2003 and 2002, respectively.
(2) Includes realized losses on investments of $45.7 million, $16.7 million and $272.7 million for 2004, 2003 and 2002, respectively; realized gains (losses) on derivative instruments of $(11.5) million, $(2.5) million and $1.2 million for 2004, 2003 and 2002, respectively; gain on transfer of securities from available-for-sale to trading of $371.5 million for 2003; gain (loss) on reinsurance embedded derivative/trading securities of
(5) Includes realized losses on investments of $30.0 million, $11.0 million and $177.2 million for 2004, 2003 and 2002, respectively; realized gains (losses) on derivative instruments of $(7.5) million, $(1.6) million and $0.9 million for 2004, 2003 and 2002, respectively; gain on transfer of securities from available-for-sale to trading of $241.5 million for 2003; gain (loss) on reinsurance embedded derivative/trading securities of $(0.6) million and $2.7 million for 2004 and 2003, respectively; and gain (loss) on sale of subsidiaries/businesses of $61.9 million and $(9.4) million for 2004 and 2002, respectively.
Most of LNC’s foreign operations are conducted by Lincoln UK. The data for this company is shown above under the Lincoln UK segment heading. The other segments have limited non-U.S. operations. Foreign intracompany revenues are not significant. Financial data for Lincoln UK and the other non-U.S. units is as follows:
During 2004 and 2002, LNC purchased and retired 7,611,910 and 12,088,100 shares, respectively, of its common stock at a total cost of $350.2 million and $474.5 million, respectively. There were no repurchases in 2003. The common stock account was reduced for these purchases in proportion to the percentage of shares acquired. The remainder of the purchase price was charged to retained earnings.
The “Foreign Currency Translation” component of other comprehensive income shown on the Consolidated Statements of Shareholders’ Equity is net of Federal income tax expense of $24.4 million, $31.3 million and $31.7 million for 2004, 2003 and 2002, respectively.
As part of the dispute settlement, LNC also paid $100 million to Swiss Re in satisfaction of LNC’s $100 million indemnification obligation with respect to personal accident business. As a result of this payment, LNC has no further underwriting risk with respect to the reinsurance business sold. However, because LNC has not been relieved of legal liabilities to the underlying ceding companies with respect to the portion of the business indemnity reinsured by Swiss Re, under FAS 113 the reserves for the underlying reinsurance contracts as well as a corresponding reinsurance recoverable from Swiss Re will continue to be carried on LNC’s balance sheet during the run-off period of the underlying reinsurance business. This is particularly relevant in the case of the exited personal accident reinsurance lines of business where the underlying reserves are based upon various estimates that are subject to considerable uncertainty.
As a result of developments and information received in the third quarter of 2003 relating to personal accident matters, LNC increased reserves on this exited business by $20.9 million, after-tax ($32.1 million pre-tax) with a corresponding increase in reinsurance recoverable from Swiss Re and in the deferred gain.
During 2004, 2003 and 2002 we amortized $57.4 million, after-tax ($88.3 million, pre-tax), $49.3 million, after-tax ($75.8 million, pre-tax) and $47.0 million, after-tax ($72.4 million, pre-tax), respectively, of deferred gain on the sale of the reinsurance operation. In the third quarter of 2004, we adjusted the deferred gain up by $77 million. As a result, the amortization of the deferred gain in 2004 included an adjustment upward of $9.1 million, after-tax. The on-going impact on quarterly revenues is an increase of $1.2 million, pre-tax ($0.8 million, after-tax). The deferred gain is being amortized over a period of 15 years beginning in December 2001.
Because of ongoing uncertainty related to personal accident business, the reserves related to these exited business lines carried on LNC’s balance sheet at December 31, 2004 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 remaining period of expected run-off of the underlying business. No cash would be transferred between LNC and Swiss Re as a result of these developments.
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 charge recorded in 2002 for this plan totaled $1.6 million and 49 positions were eliminated. During 2002 and 2003, $0.9 million and $0.7 million, respectively, was expended. This plan was completed in the third quarter of 2003.
During 2000, LNC implemented three restructuring plans, with the plans relating to the 1) the exit of all direct sales and sales support operations of Lincoln UK and the consolidation of its Uxbridge home office with its Barnwood home office; and 2) the downsizing and consolidation of the investment management operations of Lincoln Investment Management (“LIM”) not completed as of December 31, 2001. The LIM plan was completed in the third quarter of 2002 and 19 positions were eliminated under this plan. In 2002, expenditures under this plan totaled $1.8 million and the remaining reserve of $0.4 million was released. The remaining restructuring reserve for the Lincoln UK plan was $14.0 million at December 31, 2001. During 2002, $1.7 million was reversed, and during 2002, 2003 and 2004, $2.6 million, $1.3 million and $1.0 million, respectively, was expended. The remaining reserve at December 31, 2004 is $7.4 million, which is for lease payments on closed sales offices that run through 2015. Positions eliminated under this plan totaled 671.
The objective of the restructuring plan is to reduce operating costs by consolidating and eliminating redundant staff functions and facilities in Lincoln UK. The remaining reserve at December 31, 2004 is $1.1 million.
In 2001, one of LNC’s subsidiaries provided non-recourse loans to three officers, one of whom became an executive officer of LNC in 2002. The terms of the loans were never amended, and the loan to the executive officer was “grandfathered” under Section 402 of the Sarbanes-Oxley Act of 2002. The amounts outstanding, including interest, at December 31, 2004 and 2003, were approximately $30,000, and $1.1 million, respectively. Under the terms of the loan agreements, all but approximately $30,000 of the loans were forgiven in January 2004. The receivables are included in other assets on the Balance Sheet. In March 2005, the loan to the executive officer was repaid in full and the balances for the other two officers were forgiven.