(Millions of dollars, except per share data) Year Ended December 31 1996 1995 1994 1993 1992
Total revenue ----------------- 6,721.3 6,633.3 6,179.9 7,392.8 7,267.7 Income before cumulative effect of accounting change(1) ------ 513.6 482.2 349.9 415.3 359.2 Net income(1) ----------------- 513.6 482.2 349.9 318.9 359.2 Per Share Information: Income before cumulative effect of accounting change(1) ------------------ $4.91 $4.63 $3.37 $4.06 $3.86 Net income(1) --------------- 4.91 4.63 3.37 3.12 3.86 Common stock dividend(1) ---- 1.87 1.75 1.66 1.55 1.475
(1) Factors affecting the comparability of income before cumulative effect of accounting change and net income for the 1992-1996 period are shown below (see "Supplemental Data"). Assets and shareholders' equity as of December 31, 1996, 1995, 1994 and 1993 include the effect of carrying securities available-for-sale at their fair values. At the end of 1992, the bulk of the securities owned by LNC were carried at amortized cost. Per share amounts were affected by the issuance in February 1993 of 9,200,000 shares of common stock and the retirement of 500,000 and 694,582 shares of common stock in November 1994 and the fourth quarter of 1996, respectively. For other factors affecting comparability see the review of operations for each segment.
(2) Also known as "Company-Obligated Mandatorily Redeemable Preferred Securities of Subsidiary Trusts Holding Solely Junior Subordinated Deferrable Interest Debentures of Company."
Year Ended December 31 (in millions) 1996 1995 1994 1993 1992
(1) Income from operations is defined as "Net Income" less realized gain (loss) on investments, gain (loss) on sale of affiliates/operating property and cumulative effect of accounting change, all net of taxes.
On pages 11 through 21, the financial results of LNC's four business segments and other operations are presented and discussed. Within these business segment discussions, reference is made to "Income from Operations" (see definition in Item 6 above). Pages 22 through 34 discuss factors that have affected specific elements of the consolidated financial statements as well as information pertaining to LNC as a whole.
(3) Prior to 1993, all realized gain (loss) on investments was included in Other Operations. Realized gain (loss) on investments for 1993 includes an increase in the allowance for losses for mortgage loans ($42.3 million after-tax) related to a change in accounting for the impairment of mortgage loans as prescribed by Financial Accounting Standard No. 114.
Lincoln Life's wealth accumulation and wealth protection products are sold in 49 states through the approximately 1,700 career agents and 16,100 insurance brokers associated with the 38 regional offices of Lincoln Financial Group, as well as 57,100 stockbrokers and financial planners. The Lincoln Life product portfolio includes: fixed and variable annuities; term, universal and variable universal life insurance; and 401(k) retirement plans.
Lincoln Financial Group began a profound evolution in 1996. Its regional marketing offices are becoming a network of regional financial planning offices, emphasizing the value of the one-to-one, consultative, needs-based approach that such a network can offer each of its customers.
Lincoln (UK) offers life, investment and income protection and retirement planning products primarily through approximately 1,700 direct sales representatives and tied agents.
Lincoln Life, Lincoln Life & Annuity Company of New York and First Penn amassed $4.0 billion in annuity deposits in 1996, an 8% increase from 1995. The increase was tempered by increased competition from other insurers in the bank marketplace. Lincoln Life's career agents produced 50% of this business segment's annuity deposits in 1996. Stockbrokers and financial planners generated 46% and distribution through financial institutions accounted for 4%.
Term life and variable universal life insurance represent an increasing portion of new sales for this segment's U.S. based companies. First Penn introduced a new term life product in mid-1995 and since then has issued 45,000 of these policies with a total face value of $9 billion. Lincoln Life re-entered the term life market in 1996 through sales of First Penn's product. Lincoln Life's variable universal life sales, as measured by first- year premiums, increased 50% in 1996. These sales, coupled with First Penn's term life business, account for one-third of the entire segment's life insurance sales.
Lincoln Life entered into an alliance in 1996 to transfer regulatory and reporting aspects of its 401(k) servicing to a third-party administrator for nearly one-third of its 401(k) plans. The other two-thirds of Lincoln Life's 401(k) plans already obtain regulatory and reporting services through other administrators. This outsourcing of a selected portion of 401(k) plan servicing is expected to produce a meaningful reduction in expenses. Lincoln Life continues to provide fund transfer and statement services to its 401(k) plan participants.
The remainder of Lincoln Life's pension operations consist primarily of guaranteed interest contracts (GICs) and group pension annuities (GPAs). Lincoln Life ceased writing GICs and GPAs in the third quarter of 1995 because neither fit its sharper focus in the small-business retirement planning market. Lincoln Life's total pension account values, excluding the 401(k) business, declined to $4.9 billion in 1996 from $5.6 billion in 1995.
Financial Results by Source Individual Markets --------------- $49.9 $43.4 $41.4 $34.6 $33.5 Group Markets -------------------- 19.0 25.2 21.6 19.5 15.4 Financial Reinsurance ------------ 16.4 10.2 14.7 20.5 16.3 Other ---------------------------- (.2) .7 (1.9) (1.7) .4 Income from Operations, excluding Disability Income --- 85.1 79.5 75.8 72.9 65.6 Disability Income(1) ------------- (11.1) (132.2) (9.2) (54.0) (7.3) Income from Operations(1) ------ 74.0 (52.7) 66.6 18.9 58.3
Realized Gain (Loss) on Investments(2) ------------------ 11.7 10.7 .5 (1.6) --
Individual and Group Life Insurance In-Force -------------- $160.9 $142.8 $125.6 $118.0 $113.6
(2) Prior to 1993, all realized gain (loss) on investments was included in Other Operations.
Mass Customization Rather than provide a simple risk-transfer commodity, LNRC packages and distributes modular pricing, underwriting, systems, alliance resources, marketing consultation, product development and claims management components to meet the needs of client companies in a mass customized approach. More than 600 customized transactions were completed by LNRC in 1996. LNRC has a current client base of more than 1,700 U.S. and 200 international companies. Its client retention rate exceeds 95%.
Doing business in more than 50 countries, LNRC seeks to develop an even greater global presence. LNRC established new offices in London, Tel Aviv and Singapore in 1996 and plans to have an office in Buenos Aires in 1997.
LNRM's patented Life Underwriting System ("LUS"), which uses a state-of-the-art risk management technology, is licensed to more than 50 life insurance companies in the U.S. and Canada. The companies using LUS wrote approximately 20% of all the individual life insurance applications taken in the United States and Canada in 1996.
Alliance Management LNRC develops solutions that call upon the capabilities of nearly 40 alliance partners. These solutions are delivered seamlessly by LNRC and are provided through a "virtual organization" of direct marketers, medical equipment suppliers, electronic information providers and variable life and annuity administration vendors. For example, LNRC clients can quickly enter the variable life and annuity market by distributing products from alliance partners. Another example is LNRC's joint ownership of Reinsurance Marketing ("ReMark"), a direct marketing company based in the Netherlands that seeks out business opportunities with banks and insurers.
Individual Markets Superior customer service, particularly the information flow provided by LUS, differentiates LNRC in the increasingly competitive individual life markets. Operating income from individual life business has grown at a compound annual rate of 13% for the past three years. In 1996, operating income grew 15% from the previous year to $49.9 million. Favorable life mortality was an important factor. Sales volume, measured by face amount of new business, increased 17% in 1996 to $26.6 billion. Individual life sales maintained their consistent growth pattern: They have increased at a compound annual rate of 15% for the last three years.
Disability Income Lincoln Life, the largest company in LNC's Life Insurance and Annuities segment, withdrew from the difficult direct disability income market in 1996. Since the fourth quarter of 1995, LNRC has managed Lincoln Life's block of
direct disability income business as well as its own block of reinsurance disability income business. LNRC's challenge is to minimize losses on this in-force business. Losses were $11.1 million in 1996.
(1) Minority interest was recorded following the sale of 16.7% of the principal subsidiary within the Property-Casualty segment (see note 12 to the consolidated financial statements on page 67).
LNC's Property-Casualty segment reported income from operations of $123.1 million in 1996, compared with previous year's earnings of $152.6 million. This decline is attributable to LNC's reduced ownership of American States Financial Corporation ("American States") -- 83% since the initial public offering in May -- and higher natural peril losses. Natural peril losses in 1996, after minority interest and taxes, were $98.4 million, compared with
The Property-Casualty segment's net written premium decreased 4.2% in 1996 to $1.6 billion. Net investment income contributed $200.6 million to 1996 income from operations, essentially flat compared with 1995.
Initial Public Offering LNC's property-casualty operating earnings were reduced $18.1 million in 1996 as a result of its decreased ownership percentage of American States. Seventeen percent of American States was sold in an initial public offering in May. LNC retains the remaining 83%. While proceeds from the offering remained at American States, a special dividend of $300 million was paid to LNC before the offering and American States will make $300 million in debt repayments to LNC over the next few years.
Realignment In November 1995, American States announced a realignment of its field structure designed to reduce expenses and enhance growth. By 1998, American States will have consolidated most of the underwriting and certain administrative operations of 20 division offices into four regional offices. American States continues to provide sales, claims and technology support services for agencies and policyholders from more than 200 locations. Additionally, the company created 24 field executive positions to build even stronger working relationships with its agencies. Realignment produced nearly $9 million in 1996 expense savings, after-tax, compared to 1995. By 1998, this effort appears on target to produce annual expense savings of approximately $30 million, after-tax.
Personal Lines Personal lines business represented 43% of the Property-Casualty segment's total net written premium for 1996. The personal lines underwriting loss was $39.8 million in 1996, compared with a $21.2 million loss in 1995. The combined ratio in personal lines was 109.3% in 1996, compared with 104.8% in 1995. Natural peril losses contributed 13.9 points to the personal lines combined ratio in 1996, compared with 10.0 points in 1995. American States' personal lines business is predominantly private passenger auto and homeowners' coverage.
Private passenger auto represents 68% of American State's personal lines business, nearly all of it in the preferred market. American States will continue to focus on writing more private passenger auto policies, especially for small-business owners with commercial lines accounts. Homeowners' insurance earnings deteriorated in 1996 due to higher storm losses. American
Outlook Fourth-quarter net written premium at American States grew slightly from the same period in 1995. This gives a clear signal that the market impact of field office realignment is behind the company and may signify the end of a period of declining premiums. American States is positioned to renew both unit and premium growth in 1997. A key element of this growth strategy is to leverage the company's strength in the commercial lines market. Personal lines products, such as life and private passenger auto insurance, will be marketed along with commercial lines coverage to owners of small-to medium - -sized businesses. American States, which operates in more than 40 states, seeks to increase market share in its eight "core" states. Concurrently, it is concentrating additional resources to increase both market share and agency representation in 10 states where the company believes its market position and favorable regulatory environments offer the potential for profitable growth.
LNC's Investment Management segment, conducted through Lincoln National Investments Inc. ("LNI"), reported income from operations of $11.7 million in 1996, compared with $14.7 million in 1995. The decrease was primarily caused by an increase in expenses related to retail mutual fund growth initiatives. This segment's 1996 operating income, excluding amortization of goodwill and other intangibles, was $35.4 million.
Complementary Approaches Delaware, Lynch & Mayer, Vantage and Lincoln Investment Management operate autonomously and are encouraged to preserve their distinctive cultures and investment styles. Their breadth of complementary styles and strengths is a prudent way to diversify risks, especially in today's sometimes uncertain and volatile investment markets.
Lincoln Investment Management is the investment advisor for LNC's insurance operations and is best known as a manager of fixed-income assets for insurance and pension clients. Effective January 1, 1997, this operation was moved from the Investment Management segment to Other Operations. This move allows Lincoln Investment Management to concentrate its resources on its advisory role to LNC.
Assets Under Management Of the $105.1 billion in assets managed by LNC as of December 31, 1996, LNI managed $82.0 billion. The remainder includes $6.9 billion managed by Lincoln (UK) and $16.2 billion subcontracted to outside investment managers. Domestic institutional assets represent $61.6 billion of LNI's total assets under management. Domestic retail assets represent $15.6 billion of the total. International equity and global bond assets managed by Delaware's London operations account for $4.8 billion.
Retail Mutual Funds LNI's retail mutual fund and wrap fee assets totaled $16.1 billion at December 31, 1996. Delaware, which houses LNI's retail mutual fund operations, offers 38 open-end retail mutual funds and two closed-end funds. These funds had assets under management of $10.2 billion. The remaining $5.9 billion was wrap-fee business and retail mutual funds managed by Lynch & Mayer and Vantage. Internal growth initiatives begun in mid-1996 at Delaware are designed to add wholesalers, broaden retail mutual fund options and upgrade service. Expenses related to these ongoing initiatives in 1996 were $2.3 million, after-tax.
Institutional Investment Management LNI's institutional investment management business had assets under management of $65.9 billion at December 31, 1996. The 1995 acquisition of Delaware enhanced the strong position already held by Lynch & Mayer and Vantage in this mature but still growing business.
Investment Performance Delaware's mutual funds experienced several ranking upgrades in 1996. As of December 31, 1996, seven Delaware Mutual Funds had rankings of four or five stars from Morningstar, Inc., a service that assigns rankings from one star at the lowest to five stars at the highest. These funds are: Decatur Income Fund, Delchester Fund, Decatur Total Return Fund, Tax-Free USA Fund, Tax-Free USA Intermediate Fund, Tax-Free Pennsylvania Fund and Devon Fund. The Vantage Social Awareness Fund's return was 27.96% in 1996, well ahead of the 20.27% return for the top quartile variable annuity in the Morningstar Growth Universe. This performance earned Vantage a 15th-place ranking among 691 variable annuity funds in that category.
Outlook The rapid growth of LNI's retail mutual fund business, both through internal efforts and selective acquisitions, is an essential component of LNC's long- term strategy. Delaware's marketing initiatives are at the heart of LNC's commitment to the growth of its retail-mutual fund business.
Corporate interest expense included within the LNC financing line above was greater for 1996 and 1995 than years prior to 1995 as the result of additions to long-term debt and minority interest-preferred securities of subsidiary companies (see liquidity and cash flow discussion on page 33). The reduction in LNC financing in 1996 compared to 1995 was the result of increased investment income following a special dividend from its major company within the Property-Casualty segment (see page 33).
Net income (loss) shown above for "Other Operations" includes the items described above under loss from operations plus the cumulative effect of the 1993 accounting change for the consolidated group of companies related to postretirement benefits, the gain (loss) on sale of affiliates/operating property (see note 12 to the consolidated financial statements on page 67) and realized gain (loss) on sale of certain investments.
Insurance Fees Insurance fees from universal life, other interest-sensitive life insurance contracts and variable life insurance contracts increased $105.0 million or 20% in 1996 and $73.6 million or 16% in 1995. These increases are the result of an increase in the volume of transactions and a market-driven increase in the value of existing customer accounts upon which some of the fees are based in the Life Insurance and Annuities segment. The growth in fees from this business is expected to continue in 1997.
Investment Advisory Fees This line was added to the statements of income in the second quarter of 1995 following LNC's purchase of Delaware Management Holdings, Inc. (see note 12 to the consolidated financial statements on page 67). On an annualized basis, investment advisory fees increased 8.0% as the result of increased volumes and an increase in the fair value of customer accounts.
Securities available-for-sale, mortgage loans on real estate and real estate that were deemed to have declines in fair value that were other than temporary were written down. The fixed maturity securities to which these write-downs apply were generally of investment grade quality at the time of purchase but
Underwriting, Acquisition, Insurance and Other Expenses These expenses increased $182.0 million or 10% in 1996 as the result of increased business volumes in the Reinsurance, Investment Management and Life Insurance and Annuities segments. Excluding the impact of the subsidiary sold in 1994 (see note 12 to the consolidated financial statements on page 67), these expenses increased $349.8 million or 23.5% in 1995. The primary drivers behind this increase beyond the general inflation rate were: 1) the write-off of deferred acquisition costs associated with special additions to disability reserves and; 2) higher expenses related to increased business volumes in the Reinsurance segment and Life Insurance and Annuities segment. Also, 1995's Property-Casualty segment results included $21.0 million of expenses, primarily severance compensation, related to the consolidation of 20 divisional operations into four regional operations. Other than this special 1995 expense item, 1995 and 1996 expenses for the Property-Casualty segment
Interest and Debt Expense Interest and debt expense increased $12.2 million or 17% in 1996 and $23.0 million in 1995. These increases were the result of increases in the average debt outstanding and the impact of changes in the composition of debt outstanding (see page 33). The higher outstanding debt relates to the acquisitions of companies during 1995 (see note 12 to the consolidated financial statements on page 67). During 1996 Standard and Poor's and Moody's re-affirmed LNC's debt ratings as A ("Excellent") and A2 ("Very Good, Strong or High"), respectively.
LNC maintains a high-quality fixed maturity securities portfolio. As of December 31, 1996, $12.0 billion or 42.8% of its fixed maturity securities portfolio had ratings of AA or better. Only $1.7 billion or 6.1% had ratings below-investment-grade (BB or less) (see note 3 to the consolidated financial statements on page 47). The below-investment-grade fixed maturity securities represent only 5.0% of LNC's total investment portfolio. The interest rates available on these below-investment-grade securities are significantly higher than are available on other corporate debt securities. Also, the risk of loss due to default by the borrower is significantly greater with respect to such below investment grade securities because these securities are generally unsecured, often subordinated to other creditors of the issuer and issued by companies that usually have high levels of indebtedness. LNC attempts to minimize the risks associated with these below investment grade securities by limiting the exposure to any one issuer and by closely monitoring the credit worthiness of such issuers. For the year ended December 31, 1996, the aggregate cost of such investments purchased was $1.2 billion. Aggregate proceeds from such investments sold were $1.1 billion, resulting in a realized pre-tax gain at the time of sale of $31.5 million.
As of December 31, 1996, mortgage loans on real estate and investments in real estate represented 9.6% and 1.9% of the total investment portfolio. As of December 31, 1996, the underlying properties supporting the mortgage loans on real estate consisted of 20.5% in commercial office buildings, 27.9% in retail stores, 22.0% in apartments, 14.9% in industrial buildings, 5.7% in hotels/motels and 9.0% in other. In addition to the dispersion by type of property, the mortgage loan portfolio is geographically diversified throughout the United States.
Premiums and Fees Receivable Premiums and fees receivable increased $112.8 million in 1996 as the result of increased volume of business in the Reinsurance segment.
Amounts Recoverable from Reinsurers The increase of $49.0 million in amounts recoverable from reinsurers was the result of an increased volume of business ceded in the Life Insurance and Annuities segment.
Other Intangible Assets The $179.5 million increase in this balance sheet account in 1996 is the net increase of additional amounts in intangible assets associated with LNC's purchase of a block of tax-qualified annuity business (see note 12 to the consolidated financial statements on page 67), and the impact of the change in foreign currency adjustment less the impact of the amortization of existing amounts in 1996.
Other Assets The decrease in other assets of $176.4 million is the result of having a lower receivable related to investment securities sold in the last few days of 1996 versus the end of 1995.
Total Liabilities Total liabilities increased by $8.0 billion in 1996. This increase reflects: 1) an increase in business activity as evidenced by an increase in policy liabilities and accruals of $359.8 million (this increase was partially offset by the reclassification discussed above under the deferred acquisition cost heading), an increase of $2.4 billion in contractholder funds and an increase of $6.0 billion in the liabilities related to separate accounts and; 2) an increase in minority interest in consolidated subsidiaries of $223.6 million (see note 12 to the consolidated financial statements on page 67), being partially offset by decreases in debt of $270.9 million and a net decrease in all other liabilities of $696.2 million.
The percentages and amounts referenced above are at these levels due to LNC's concentration on writing coverages for small to medium-size companies rather than the larger companies that tend to incur most of the environmental and product liability claims. LNC's management challenges environmental claims in cases of questionable liability and reviews the level of the environmental liabilities on an on-going basis to help ensure that the liability maintained is adequate. Nonetheless, establishing liabilities for environmental claims is subject to significant uncertainties because of the long reporting delays, lack of historical data and the complexity of unresolved legal and regulatory issues (see note 7 to the consolidated financial statements on page 56). While it is management's judgment that, based on available information, the appropriate level of liabilities have been recorded, it is reasonably possible that a change in the estimate of the liability required could occur in the near term.
Minority Interest - Preferred Securities of Subsidiary Companies This line was added to the balance sheet following the financing activity described within the Liquidity and Cash Flow section on page 33.
Both realized and unrealized gains or losses on investments that support long- term life insurance, pension and annuity contracts are expected to be applied to contract benefits. These realized and unrealized gains or losses are included in net income and shareholders' equity, respectively. Current accounting standards do not require or permit adjustment of policyholder reserves to recognize the full effect of these realized and unrealized gains or losses on future benefit payments in the absence of a contractual obligation requiring their attribution to policyholders.
Market Risk Exposures of Financial Instruments LNC analyzes and manages the risks arising from market exposures of financial instruments, as well as other risks, in an integrated asset-liability management process that takes diversification into account. By aggregating the potential effect of market and other risks of the entire enterprise, LNC estimates and manages the risk to its earnings and shareholder value. The risks of market exposures of financial instruments, and the related risk management processes, are most important in the Life Insurance and Annuities segment. This segment is where most of the invested assets support accumulation and investment oriented insurance products. As an important element of its integrated asset-liability management process, LNC uses derivatives to minimize the effects of changes in interest rate levels and the shape of the yield curve. In this context, derivatives are designated as a hedge and serve to reduce interest rate risk by mitigating the effect of interest rate changes on LNC's stream of earnings. Additional market exposures exist in LNC's other general account insurance products and in its debt structure and derivatives positions. The primary sources of market risk are: 1) substantial, relatively rapid and sustained increases or decreases in interest rates; 2) a period of greater than normal default experience and; 3) a sharp drop in equity market values, as discussed below. Specific market risk exposures as they relate to derivatives are included in the Derivatives section of Management's Discussion and Analysis on page 31.
Accumulation and Investment Oriented Insurance Products. General account assets supporting accumulation and investment oriented insurance products total $22.8 billion or 67% of total invested assets. With respect to these products, LNC seeks to earn a stable and profitable spread between investment income and interest credited to account values. If LNC has adverse experience on investments that cannot be passed through to customers, its spreads are reduced. The interest rate scenarios of concern are those in which there is a substantial, relatively rapid increase or decrease in interest rates that is then sustained over a long period.
LNC also has assets totaling $4.8 billion that support guaranteed interest contracts, pension buy-out annuities and immediate annuities. Generally, the cash flows expected on these liabilities do not vary with fluctuations in market interest rates and are not adjustable by LNC. Accordingly, if experience on the assets supporting these products is more adverse than the assumptions used in pricing the products, spreads will tend to be below expectations. LNC limits exposure to interest rate risk by managing the duration and maturity structure of each investment portfolio in relation to the liabilities it supports.
Interest Rate Risk--Falling Rates. After rising in 1994, interest rates fell in 1995 and rose again in 1996. For example, the five-year Treasury yield rose from 5.2% to 7.8% during 1994 and fell back to 5.4% at the end of 1995 and increased to 6.2% by the end of 1996. Under scenarios in which interest rates fall and remain at levels significantly lower than those prevailing at December 31, 1996, minimum guarantees on annuity and universal life insurance policies could cause spreads to deteriorate. Select contracts that specify these minimum guarantees can be amended periodically to reflect current
interest rate conditions. The earned rate on the annuity and universal life insurance portfolios averaged 7.8% and 7.9%, respectively, for the year ended December 31, 1996, providing a cushion for further decline before the earned rates would be insufficient to cover minimum guaranteed rates plus the target spread. The maturity structure and call provisions of the related portfolios are structured to afford protection against erosion of this cushion for a period of time. However, spreads would be at risk if interest rates continued to fall and remained lower for a long period. LNC manages these exposures by maintaining a suitable maturity structure and by limiting its exposure to call risk in each respective investment portfolio.
Interest Rate Risk--Rising Rates. For both annuities and universal life insurance, a rapid and sustained rise in interest rates poses risks of deteriorating spreads and high surrenders. The portfolios supporting these products have fixed-rate assets laddered over maturities generally ranging from one to 10 years or more. Accordingly, the earned rate on each portfolio lags behind changes in market yields. As rates rise, the lag may be increased by slowing MBS prepayments. The greater and faster the rise in interest rates, the more the earned rate will tend to lag behind market rates. If LNC sets renewal crediting rates to earn the desired spread, the gap between its renewal crediting rates and competitors' new money rates may be wide enough to cause increased surrenders. If LNC credits more competitive renewal rates to limit surrenders, its spreads will narrow. LNC devotes extensive effort to evaluating these risks by simulating asset and liability cash flows for a wide range of interest rate scenarios. Such analysis has led to adjustments in the target maturity structure and to hedging the risk of rising rates by buying out-of-the-money interest rate cap agreements and swaptions (see Derivatives section of Management's Discussion and Analysis on page 31). With this hedge, the potential adverse impact of a sustained rise in rates is kept within corporate risk tolerances. LNC believes that the risks of rising interest rates are also mitigated by its emphasis on periodic premium products.
Equity Market Exposures. At December 31, 1996, LNC owned equities consisting of $992.7 million of common stocks, $655.0 million of real estate and $198.9 million of other equity interests. While LNC invests in these categories with the expectation of achieving higher returns than would be available in its core fixed-income investments, the returns on, and values of, these equity investments are subject to somewhat greater market risk than its fixed income investments.
The fee revenues of LNC's Investment Management segment and fees earned from variable annuities are exposed to the risk of a decline in equity market values. Investment advisory fees are generally a fixed percentage of the market value of assets under management. In a severe equity market decline, fee income could be reduced by not only reduced market valuations but also by customer withdrawals. Such withdrawals from equity funds and accounts might be partially offset by transfers to LNC's fixed-income accounts and the transfer of funds to LNC by its competitors' customers.
1) LNC uses interest rate cap agreements to hedge against the negative impact of a significant and sustained rise in interest rates. Interest rate caps are contracts that require counterparties to pay LNC at specified future dates the amount, if any, by which a specified market interest rate exceeds the cap rate stated in the agreements, applied to a notional amount. As of December 31, 1996, LNC had agreements with notional amounts of $5.5 billion with cap rates ranging from 207 to 419 basis points above prevailing interest rates. These agreements expire in 1997 - 2003. The cap rates in some contracts increase over time.
2) LNC also uses swaptions to hedge against the negative impact of a significant and sustained rise in interest rates. Swaptions are options to enter into a swap at a specified future date. At expiration, the option is either settled in cash or exercised into a swap agreement. LNC purchases swaptions to be settled in cash. At expiration, the counterparty is required to pay LNC the amount, if any, of the present value of the difference between the fixed rate on a market rate swap and the strike, applied to a notional amount. As of December 31, 1996, LNC had agreements with notional amounts of $672 million with strike rates ranging from 178 to 241 basis points above prevailing interest rates. These agreements expire in 2002.
3) LNC periodically uses spread-lock agreements to hedge a portion of the value of its fixed maturity securities against the risk of widening in the spreads between their yields and the yields of comparable maturity U.S. Government obligations. The actual risk being hedged by these agreements is the potential widening of bond spreads that would be caused by widening swap spreads. Under these agreements, LNC assumed the right and the obligation to enter into an interest rate swap at a future date in which LNC would pay a fixed rate equal to a contractually specified spread over the yield of a specified U.S. Treasury security and receive a floating rate. As of December 31, 1996, LNC did not have any open spread-lock agreements.
5) LNC uses Over-the-Counter ("OTC") call options to hedge against the increase of the FTSE index. These call options require the counterparties to pay LNC at specified future expiration dates the amount, if any, of the percentage increase in the FTSE index over the strike price defined in the contract, applied to a notional amount. As of December 31, 1996, LNC had agreements with notional amounts of $14.7 million. These options expire in 1997 - 2001.
A foreign currency swap is a contractual agreement to exchange the currencies of two different countries pursuant to an agreement to re-exchange the two currencies at the same rate of exchange at a specified future date. As of December 31, 1996, LNC had a foreign currency swap with a notional amount of $15 million.
The values of the foreign exchange contracts, foreign currency options and foreign currency swaps, which are used to reduce the risk of reduction of the value in U.S. dollars of investments denominated in foreign currencies that might result from an adverse change in currency exchange rates, fluctuate according to the underlying level of exchange rates. At December 31, 1996, LNC had notional amounts of contracts in place of $316.8 million. If the U.S. dollar were to appreciate (depreciate) 1% in relation to each of the currencies involved in these contracts, the value of these positions would rise (fall) by $3.2 million.
7) LNC periodically uses foreign exchange forward contracts to hedge against foreign exchange risk related to LNC's investment in its British subsidiary, Lincoln National (UK). The foreign exchange forward contracts obligate LNC to deliver a specified amount of currency at a future date at a specified exchange rate.
LNC is depending on the ability of derivative product dealers and their guarantors to honor their obligations to pay the contract amounts under interest rate cap agreements and other over-the-counter derivative products such as swaptions, spread-lock agreements, foreign currency exchange contracts, foreign currency options, foreign currency swaps and call options. In order to minimize the risk of default losses, LNC diversifies its exposures among several dealers and limits the amount of exposure in accordance with the credit rating of each dealer or its guarantor. LNC generally limits its selection of counterparties that are obligated under these derivative contracts to those with an A credit rating or above.
Although LNC generates adequate cash flow to meet the needs of its normal operations, periodically LNC may issue debt or equity securities to fund internal expansion, acquisitions, investment opportunities and the retirement of LNC's debt and equity. As of December 31, 1996 LNC has a shelf registration with an unused balance of $600 million that would allow LNC to issue debt or equity securities. In 1996, LNC filed another shelf registration for $500 million which included the right to offer various forms of hybrid securities. These securities, which have a combination of both debt and equity characteristics, utilize a series of three newly formed trusts. All of these trusts' common securities are owned by LNC (Lincoln National Capital I, II and III). As of December 31, 1996, LNC had an unused balance of $185 million related to this hybrid security registration. Cash funds also are available from LNC's revolving credit agreement, which provides for borrowing up to $750 million (see note 5 to the consolidated financial statements on page 52).
Recent transactions such as those described in the preceding paragraph include LNC's purchase and retirement of 694,582 shares of common stock at a cost of $35.0 million in the fourth quarter of 1996. After deducting these shares, the current Board authorization would allow the repurchase of an additional 4,305,418 shares of common stock. Also, LNC issued $215 million, 8.75% Quarterly Income Preferred Securities ("QUIPS") in July of 1996 and $100 million, 8.35% Trust Originated Preferred Securities ("TOPrS") in August of 1996. Both issues mature in 2026 (callable in 2001). These securities are shown on the accompanying balance sheet between the liability and shareholders' equity sections. Proceeds from these transactions were used to pay down short-term debt and for general corporate purposes.
Another transaction which occurred in 1996 was the sale of 16.7% of the principal subsidiary within the Property-Casualty segment. This transaction was completed in the form of an initial public offering of common stock. The net cash proceeds after expenses from the sale of common stock in this subsidiary of $215.2 million is being used to support the capital base of the property-casualty operations and to meet working capital needs of the related holding company. In conjunction with this offering, this subsidiary issued $200 million of term debt payable to LNC plus $100 million, 7 1/8% debt due in 1999. Also, prior to closing the sale, this subsidiary made a one-time, special dividend distribution of $300 million to LNC. This dividend distribution consisted primarily of tax-exempt municipal securities that were previously in the subsidiary's investment portfolio. Following the completion of the transaction, this subsidiary adopted a policy of declaring regular quarterly cash dividends, commencing with $.21 per share in the third quarter of 1996. As of December 31, 1996, LNC owns 50,000,000 of the 60,050,515 outstanding shares of this subsidiary.
Cash and invested cash - December 31 -------------- $ 133.8 $ 466.8 $ 523.1 Other investments - December 31 ------------------- 227.2 20.3 28.7 Debt - December 31 -------------------------------- 1,251.9 1,402.1 1,227.5
The table above shows the cash flow activity for the holding company from 1994 through 1996. The line, "net tax receipts from (payments to) subsidiaries", recognizes that the holding company receives tax payments from subsidiaries, pays the consolidated tax liability and reimburses subsidiaries for the tax effect of any taxable operating and capital losses.
Premiums and other considerations --- $1,008.5 $1,041.7 $1,095.2 $1,081.9 Net investment income --------------- 560.7 572.7 587.9 644.6 Realized gain on investments -------- 71.3 29.5 1.8 25.5 Net income -------------------------- 140.0 111.4 119.3 142.9
The consolidated financial statements of Lincoln National Corporation and Subsidiaries follow on pages 36 through 68.
Company-Obligated Mandatorily Redeemable Preferred Securities of Subsidiary Trusts Holding Solely Junior Subordinated Deferrable Interest Debentures of Company ---- 315,000 --
Series E and F Preferred Stock: Balance at beginning-of-year ----------- -- 309,913 309,913 Conversion into common stock ----------- -- (309,913) -- Balance at End-of-Year --------------- -- -- 309,913
Balance at beginning-of-year ------------ 889,476 555,382 543,659 Conversion of series A preferred stock -- 123 85 133 Conversion of series E and F preferred stock ------------------------ -- 309,913 -- Issued for benefit plans ---------------- 7,597 26,888 30,616 Shares forfeited under benefit plans ---- (4,771) (2,792) (631) Retirement of common stock -------------- (34,975) -- (18,395) Balance at End-of-Year --------------- 857,450 889,476 555,382
Accumulated adjustment at beginning-of-year ---------------------- 13,413 6,890 (1,214) Change during the year ------------------ 53,041 6,523 8,104 Balance at End-of-Year --------------- 66,454 13,413 6,890
Balance at beginning-of-year ---------- 104,185,117 94,477,942 94,183,190 Conversion of series A preferred stock- 30,088 20,576 32,568 Conversion of series E and F preferred stock ---------------------- -- 8,835,794 -- Issued for benefit plans -------------- 250,072 905,361 778,587
Series A preferred stock -------------- $3.00 $3.00 $3.00 Series E preferred stock -------------- -- 1.89 3.79 Series F preferred stock -------------- -- 1.97 3.94 Common stock -------------------------- 1.87 1.75 1.66
Adjustments to reconcile net income to net cash provided by (used in) operating activities: Deferred acquisition costs ----------- 34,644 (44,990) (199,419) Premiums and fees receivable --------- (113,022) (15,087) (7,777) Accrued investment income ------------ (20,489) (41,268) (44,171) Policy liabilities and accruals ------ (51,556) 147,989 11,487 Contractholder funds ----------------- 1,281,535 1,631,192 1,674,888 Amounts recoverable from reinsurers -- (110,752) (435,776) (776,408) Federal income taxes ----------------- 31,335 268,338 (59,611) Equity in undistributed earnings of unconsolidated affiliates ----------- (1,428) (11,493) (12,408) Minority interest in consolidated subsidiaries ------------------------ 19,555 -- -- Provisions for depreciation ---------- 58,878 59,835 58,689 Amortization of goodwill and other intangible assets ------------------- 87,442 74,229 9,274 Realized (gain) loss on investments -- (128,052) (300,840) 212,201 (Gain) loss on sale of affiliates/ operating property ------------------ -- (54,195) (48,842) Other -------------------------------- (364,633) 160,180 14,365
Principal payments on long-term debt ---- (35,074) (14,182) (142,065) Issuance of long-term debt -------------- 2,082 197,785 199,482 Net increase (decrease) in short-term debt ------------------------ (237,888) 25,785 (59,698) Company-Obligated Mandatorily Redeemable Preferred Securities of Subsidiary Trusts Holding Solely Junior Subordinated Deferrable Interest Debentures of Company 315,000 -- -- Universal life and investment contract deposits ---------------------- 1,172,673 2,142,043 2,429,113 Universal life and investment contract withdrawals ------------------- (2,380,187) (2,158,392) (1,613,780) Common stock issued for benefit plans --- (565) 24,096 29,985 Retirement of common stock -------------- (32,716) -- (18,395) Proceeds from sale of minority interest in subsidiary ----------------- 215,182 -- -- Dividends paid to shareholders ---------- (191,223) (178,805) (172,157)
Basis of Presentation. The accompanying consolidated financial statements include Lincoln National Corporation ("LNC") and its majority-owned subsidiaries. Through subsidiary companies, LNC operates multiple insurance and investment management businesses. Operations are divided into four business segments (see note 9 on page 63). Less than majority-owned entities in which LNC has at least a 20% interest are reported on the equity basis. These consolidated financial statements have been prepared in conformity with generally accepted accounting principles.
Investments. LNC classifies its fixed maturity and equity securities (common and non-redeemable preferred stocks) 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 adjusted for declines in value that are other than temporary.
Mortgage loans on real estate are carried at the outstanding principal balances less unaccrued discounts. Investment real estate is carried at cost
Realized gain (loss) on investments is recognized in net income, net of related amortization of deferred acquisition costs and capital gains expenses, using the specific identification method. Changes in the fair values of securities carried at fair value are reflected directly in shareholders' equity, after deductions for related adjustments for deferred acquisition costs and amounts required to satisfy policyholder commitments that would have been recorded had these securities been sold at their fair value, and after deferred taxes or credits to the extent deemed recoverable.
The premiums paid for interest rate caps and swaptions are deferred and amortized to net investment income on a straight-line basis over the term of the respective derivative. Any settlement received in accordance with the terms of the interest rate caps is also recorded as net investment income. Settlements received on swaptions are deferred and amortized over the life of the hedged assets as an adjustment to yield. Swaptions, spread-lock agreements, interest rate swaps and financial futures that hedge fixed maturity securities available-for-sale are carried at fair value. The change in fair value is reflected directly in shareholders' equity. Realized gain (loss) from the settlement of such derivatives is deferred and amortized over the life of the hedged assets as an adjustment to the yield. Over-the-counter call options are carried at fair value. Foreign exchange forward contracts, which hedge LNC's investment in its British subsidiary, Lincoln National (UK), are carried at fair value. The change in fair value and realized gain (loss) on such contracts is reflected directly in the foreign currency translation adjustment component of shareholders' equity. Foreign exchange forward contracts, foreign currency options and foreign currency swaps, which hedge some of the foreign exchange risk of investments in fixed maturity securities denominated in foreign currencies, are carried at fair value. The change in fair value is reflected in earnings. Realized gain (loss) from the settlement of such derivatives is also reflected in earnings.
Deferred Acquisition Costs. Commissions and other costs of acquiring universal life insurance, variable universal life insurance, traditional life insurance, unit-linked products, annuities, group health insurance and property-casualty insurance which vary with and are primarily related to the production of new business, have been deferred to the extent recoverable. Acquisition costs for universal and variable universal life insurance policies and unit-linked products are being amortized over the lives of the policies in relation to the incidence of estimated gross profits from surrender charges and investment, mortality, and expense margins, and actual realized gain (loss) on investments. That amortization is adjusted retrospectively when estimates of current or future gross profits to be realized from a group of products are revised. Traditional life-health and annuity acquisition costs are being amortized over the premium-paying period of the related policies using assumptions consistent with those used in computing policy reserves. Deferred acquisition costs for property-casualty policies are amortized over the contract term of the policies. Property-casualty acquisition costs that are not recoverable from future premiums and related investment income are expensed.
Expenses. Expenses for universal and variable universal life insurance policies include interest credited to policy account balances and benefit claims incurred during the period in excess of policy account balances. Interest crediting rates associated with funds invested in the insurance company's general account during 1994 through 1996 ranged from 5.9% to 8.0%. Interest and debt expense includes interest on Company-Obligated Mandatorily Redeemable Preferred Securities of Subsidiary Trusts Holding Solely Junior Subordinated Deferrable Interest Debentures of Company ("Minority Interest - Preferred Securities of Subsidiary Companies").
The liability for unpaid property-casualty claims is based on estimates of payments to be made for individual claims reported and unreported claims, reduced by estimated recoveries from salvage and subrogation. With respect to its policy liabilities and accruals, LNC carries on a continuing review of its: 1) overall reserve position; 2) reserving techniques and; 3) reinsurance arrangements. As experience develops and new information becomes known, liabilities are adjusted as deemed necessary. The effects of changes in estimates are included in the operating results for the period in which such estimates occur.
During the fourth quarter of 1995, LNC completed an in-depth review of the experience of its disability income business. As a result of this study, and based on the assumption that recent experience will continue in the future, net income decreased by $121,600,000 or $1.17 per share ($187,000,000 pre-tax) as a result of strengthening the disability income reserve by $142,700,000 and writing-off deferred acquisition costs of $44,300,000 in the Reinsurance segment.
Fixed maturity securities --------------------- $1,937.6 $1,853.6 $1,614.9 Equity securities ----------------------------- 35.5 30.3 29.9 Mortgage loans on real estate ----------------- 295.8 272.0 277.2 Real estate ----------------------------------- 125.4 117.9 104.4 Policy loans ---------------------------------- 42.1 37.9 34.0 Invested cash --------------------------------- 54.3 49.2 39.1 Other investments ----------------------------- 36.8 43.2 54.5 Investment revenue -------------------------- 2,527.5 2,404.1 2,154.0 Investment expense ---------------------------- 161.6 152.8 159.4 Net investment income ----------------------- $2,365.9 $2,251.3 $1,994.6
Fixed maturity securities available-for-sale - $ (823.3) $2,448.9 $(2,295.1) Equity securities available-for-sale --------- (33.2) 138.2 (93.3) Total -------------------------------------- $ (856.5) $2,587.1 $(2,388.4)
1995: Corporate bonds -------------------- $14,011.4 $1,262.3 $ 31.2 $15,242.5 U.S. Government bonds -------------- 1,033.1 115.0 .1 1,148.0 Foreign governments bonds ---------- 1,273.2 98.6 9.7 1,362.1 Mortgage-backed securities: Mortgage pass-through securities - 1,175.0 45.6 3.4 1,217.2 Collateralized mortgage obligations --------------------- 4,089.0 266.9 3.8 4,352.1 Other mortgage-backed securities - 2.7 .4 .1 3.0 State and municipal bonds ---------- 2,238.1 154.0 2.0 2,390.1 Redeemable preferred stocks -------- 113.0 7.0 .5 119.5 Total fixed maturity securities -- 23,935.5 1,949.8 50.8 25,834.5 Equity securities ------------------ 936.1 232.4 3.7 1,164.8 Total ---------------------------- $24,871.6 $2,182.2 $ 54.5 $26,999.3
At December 31, 1996, the current par, amortized cost and estimated fair value of investments in mortgage-backed securities summarized by interest rates of the underlying collateral are as follows: Current Fair December 31 (in millions) Par Cost Value
Treasuries and AAA ----------------------------------- 32.8% AA --------------------------------------------------- 10.0 A ---------------------------------------------------- 28.2 BBB -------------------------------------------------- 22.9 BB --------------------------------------------------- 2.7 Less than BB ----------------------------------------- 3.4 100.0%
Impaired loans with no allowance for losses are a result of: 1) direct write-downs or; 2) collateral dependent loans where the fair value of the collateral is greater than the recorded investment in the loan.
All interest income on impaired loans was recognized on the cash basis of income recognition.
As of December 31, 1996 and 1995, LNC had restructured loans of $39,600,000 and $62,500,000, respectively. LNC recorded $4,000,000 and $6,300,000 of interest income on these restructured loans in 1996 and 1995, respectively. Interest income in the amount of $4,000,000 and $6,600,000 would have been recorded on these loans according to their original terms in 1996 and 1995, respectively. As of December 31, 1996 and December 31, 1995, LNC had no outstanding commitments to lend funds on restructured loans.
Mortgage loans on real estate ------------------------- $12.4 $29.6 Real estate ------------------------------------------- 3.0 58.0 Other long-term investments --------------------------- -- 13.6 Guarantees -------------------------------------------- 1.8 7.1
Current -------------------------------------- $158.9 $206.8 $(93.9) Deferred ------------------------------------- 20.3 (62.4) 120.3 Total -------------------------------------- $179.2 $144.4 $ 26.4
The effective tax rate on pre-tax income is lower than the prevailing corpo- rate Federal income tax rate. A reconciliation of this difference is as follows:
Tax rate times pre-tax income ----------------- $249.3 $219.3 $131.7 Effect of: Tax-exempt investment income ------------------ (66.5) (70.0) (74.0) Loss (gain) on sale of affiliates/ operating property --------------------------- -- -- (17.1) Other items ----------------------------------- (3.6) ( 4.9) (14.2) Provision for income taxes ------------------ $179.2 $144.4 $ 26.4 Effective tax rate -------------------------- 25% 23% 7%
Significant components of LNC's net deferred tax asset (liability) are as follows:
Deferred tax assets: Policy liabilities and accruals and contractholder funds --------------------------------- $ 966.1 $1,032.2 Net operating loss ------------------------------------ 90.0 120.7 Loss on investments ----------------------------------- -- 16.3 Postretirement benefits other than pensions ----------- 62.2 56.6 Other ------------------------------------------------- 108.7 91.7 Total deferred tax assets --------------------------- 1,227.0 1,317.5
Undistributed earnings of certain LNC foreign subsidiaries that are considered to be indefinitely reinvested amounted to approximately $135,000,000 at December 31, 1996. Accordingly, no provisions for U.S. income taxes have been provided on these undistributed earnings. Upon distribution of those earnings in the form of dividends or otherwise, LNC would be subject to both U.S. income taxes (with adjustments for foreign tax credits) and withholding taxes payable to the applicable foreign countries. Determination of the amount of unrecognized deferred U.S. income tax liability is not practicable because of the complexities associated with its hypothetical calculations.
Real estate (allowances for depreciation) ----------- $ 44.1 $ 58.7 Property and equipment (allowances for depreciation)- 232.5 228.5 Property and equipment (valuation allowance) -------- 26.9 28.3
Premium deposit funds ------------------------------- $20,894.7 $18,489.6 Undistributed earnings on participating business ---- 81.9 91.9 Other ----------------------------------------------- 200.4 203.0 Total --------------------------------------------- $21,177.0 $18,784.5
Future estimated amortization of the present value of business in-force net of interest on unamortized balance for LNC's insurance subsidiaries is as follows (in millions):
1997 - $22.7 1999 - $24.2 2001 - $27.9 1998 - 24.4 2000 - 25.0 Thereafter - 478.2
A reconciliation of the beginning-of-year and end-of-year liability for property-casualty claims and claim expenses is as follows:
Total liability reported at beginning-of-year -- $2,595.3 $2,702.5 $2,810.1 Reinsurance recoverable ------------------------ 189.0 203.1 225.5 Liability for claims and claim expenses at beginning-of-year, net of reinsurance --- 2,406.3 2,499.4 2,584.6
Reinsurance recoverable ------------------------ 179.8 189.0 203.1 Total liability reported at end-of-year ----- $2,485.6 $2,595.3 $2,702.5
Short-term debt: Commercial paper ------------------------------------ $164.5 $301.9 Other short-term notes ------------------------------ .7 123.4 Current portion of long-term debt ------------------- 23.8 1.5 Total short-term debt ----------------------------- $189.0 $426.8
The commercial paper outstanding at December 31, 1996 and 1995, had a weighted average interest rate of approximately 5.87% and 6.00%, respectively.
1997 - $ 23.8 1999 - $100.7 2001 - $ 1.1 1998 - 27.3 2000 - .7 Thereafter - 500.4
Insurance assumed --------------------------- $1,374.0 $1,297.6 $1,159.9 Insurance ceded ----------------------------- 376.6 448.7 482.9 Net reinsurance premiums ------------------ $ 997.4 $ 848.9 $ 677.0
The income statement caption, "Benefits and Settlement Expenses," is net of reinsurance recoveries of $292,900,000, $422,600,000 and $284,000,000 for the years ended December 31, 1996, 1995 and 1994, respectively.
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, 1996 and 1995, plan assets exceeded the projected benefit obligations by $9,076,000 and $9,020,000, respectively, and were included in other assets in LNC's balance sheet. Net pension costs for the foreign plan were $1,544,000, $1,727,000 and $633,000, for 1996, 1995 and 1994, respectively.
Service cost ------------------------------------------- $ 3.9 $ 3.1 $ 4.3 Interest cost ------------------------------------------ 9.0 9.7 10.4 Amortized cost (credit) -------------------------------- (1.8) (2.0) .3 Net periodic postretirement benefit cost ------------- $11.1 $10.8 $15.0
The calculation of the accumulated postretirement benefit obligation assumes a weighted-average annual rate of increase in the per capita cost of covered benefits (i.e. health care cost trend rate) of 8.5% for 1997. It further assumes the rate will gradually decrease to 5.0% by 2005 and remain at that level. The health care cost trend rate assumption has a significant effect on the amounts reported. For example, increasing the assumed health care cost trend rates by one percentage point each year would increase the accumulated postretirement benefit obligation as of December 1996 and 1995 by $9,900,000 and $11,100,000, respectively. The aggregate of the estimated service and interest cost components of net periodic postretirement benefit cost for the year ended December 31, 1996 would increase by $1,100,000. The calculation assumes a long-term rate of increase in compensation of 4.5% and 5.0% for December 31, 1996 and 1995, respectively. The weighted-average discount rate used in determining the accumulated postretirement benefit obligation was 7.0% for both December 31, 1996 and 1995.
Financial Accounting Standard No. 123 entitled "Accounting for Stock-Based Compensation" ("FAS 123") issued in October 1995, was adopted by LNC as of December 31, 1995. Pursuant to the provisions of FAS 123, LNC has elected to continue its practice of recognizing compensation expense for its stock option incentive plans using the intrinsic value based method of accounting (see note 1 on page 45) and to provide the required pro forma information for stock options granted after December 31, 1994. Accordingly, no compensation expense has been recognized for stock option incentive plans. Had compensation expense for LNC's stock option incentive plans for options granted after December 31, 1994 been determined based on the estimated fair value at the grant dates for awards under those plans, LNC's pro forma net income and earnings per share for 1996 and 1995 would have been $510,518,000 ($4.88 per share) and $479,814,000 ($4.61 per share), respectively (a decrease of $3,040,000 or $.03 per share and $2,372,000 or $.02 per share, respectively). The effects on 1996 and 1995 pro forma net income and earnings per share of expensing the estimated fair value of stock options are not necessarily representative of the effects on reported net income for future years due to factors such as the vesting period of the stock options and the potential for issuance of additional stock options in future years.
Granted ------------------------ (510,150) 510,150 42.57 Exercised ---------------------- -- (313,612) 25.70 Expired ------------------------ (5,273) (275) 19.97 Forfeited ---------------------- 175,446 (36,172) 34.64 Restricted stock awarded ------- (335,126) Balance at December 31, 1995 - 7,747,911 2,832,280 33.21
December 31 1996 1995 1994 Options exercisable (number of shares) ----------- 1,833,269 1,647,872 1,615,839 Weighted-average exercise price (per share) ------------ $31.22 $28.56 $26.34
Information with respect to incentive plan stock options outstanding at December 31, 1996 is as follows:
Year Ended December 31 (in millions) 1996 1995 1994 Life-health insurance --------------------- $399.7 $314.0 $411.7 Property-casualty insurance --------------- 161.4 182.0 167.9
Life-health insurance statutory net income for 1996, 1995 and 1994, excluding LNC's foreign life reinsurance companies, was $357,800,000, $350,400,000 and $411,100,000, respectively.
LNC's insurance subsidiaries are subject to certain insurance department regulatory restrictions as to the transfer of funds and payments of dividends to LNC. In 1997, LNC's insurance subsidiaries can transfer up to $584,000,000 without seeking prior approval from the insurance regulators.
1997 - $53.4 1999 - $48.0 2001 - $ 43.6 1998 - 49.3 2000 - 46.2 Thereafter - 328.8
Associated with these transactions, LNC's foreign insurance companies have obtained letters of credit in favor of various unaffiliated insurance companies from which LNC assumes business. This allows the ceding companies to take statutory reserve credit. The letters of credit issued by the banks represent a guarantee of performance under the reinsurance agreements. At December 31, 1996, there was a total of $453,000,000 in outstanding bank letters of credit. In exchange for the letters of credit, LNC paid the banks approximately $758,000 in fees in 1996.
LNC writes personal and commercial lines of property and casualty insurance throughout the United States. As a result, LNC is always at risk that there could be significant losses arising in certain geographic areas from catastrophes such as earthquakes and hurricanes. LNC seeks to protect itself from such events by purchasing catastrophe insurance. LNC's policies in-force providing earthquake, hurricane and related coverage in the Midwest, Western and Southeastern coastal areas of the United States could expose LNC to losses exceeding its reinsurance limits. Although the exposure exists, LNC has not encountered losses in excess of its reinsurance limits during any year.
The number of insurance companies that are under regulatory supervision has resulted, and is expected to continue to result, in assessments by state guaranty funds to cover losses to policyholders of insolvent or rehabilitated
companies. Mandatory assessments may be partially recovered through a reduction in future premium taxes in some states. LNC has accrued for expected assessments net of estimated future premium tax deductions.
Derivatives LNC has derivatives with off-balance-sheet risks whose notional or contract amounts exceed the credit exposure. LNC has entered into derivative transactions to reduce its exposure to fluctuations in interest rates, the widening of bond yield spreads over comparable maturity U.S. Government obligations, fluctuations in the FTSE index and foreign exchange risks. In addition, LNC is subject to the risks associated with changes in the value of its derivatives; however, such changes in the value generally are offset by changes in the value of the items being hedged by such contracts. Outstanding derivatives with off-balance-sheet risks, shown in notional or contract amounts along with their carrying value and estimated fair values, are as follows: Assets (Liabilities) Notional or Carrying Fair Carrying Fair Contract Amounts Value Value Value Value December 31 (in millions) 1996 1995 1996 1996 1995 1995
Interest rate derivatives: Interest rate cap agreements -- $5,500.0 $5,110.0 $20.8 $8.2 $22.7 $ 5.3 Swaptions --------------------- 672.0 -- 10.6 10.6 -- -- Spread-lock agreements -------- -- 600.0 -- -- (.9) (.9) Financial futures ------------- 147.7 106.7 (2.4) (2.4) 5.1 5.1 Interest rate swaps ----------- -- 5.0 -- -- .2 .2 Total interest rate derivatives ---------------- 6,319.7 5,821.7 29.0 16.4 27.1 9.7
Spread-Lock Agreements. Spread-lock agreements provide for a lump sum payment to or by LNC, depending on whether the spread between the swap rate and a specified U.S. Treasury note is larger or smaller than a contractually specified spread. Cash payments are based on the product of the notional amount, the spread between the swap rate and the yield of an equivalent maturity U.S. Treasury security, and the price sensitivity of the swap at that time. It is expressed in dollars-per-basis point. The purpose of LNC's spread-lock program is to protect a portion of its fixed maturity securities against widening spreads.
Financial Futures. LNC uses exchange-traded financial futures contracts and options on those financial futures to hedge against interest rate risks and to manage duration of a portion of its fixed maturity securities. Financial futures contracts obligate LNC to buy or sell a financial instrument at a
specified future date for a specified price. They may be settled in cash or through delivery of the financial instrument. Cash settlements on the change in market values of financial futures contracts are made daily. Options on financial futures give LNC the right, but not the obligation, to assume a long or short position in the underlying futures at a specified price during a specified time period.
Call Options. Call options which expire in 1997 through 2001, provide LNC with settlement payments from the counterparties on specified expiration dates. The payment, if any, is the percentage increase in the FTSE index over the strike price defined in the contract, applied to a notional amount. The purpose of LNC's call option program is to offset the cost of increases in the liabilities of certain single premium investment contracts which are tied to the FTSE index.
Foreign Currency Derivatives (Foreign Investments). LNC uses a combination of foreign exchange forward contracts, foreign currency options and foreign currency swaps, all of which are traded over-the-counter, to hedge some of the foreign exchange risk of investments in fixed maturity securities denominated in foreign currencies. The foreign currency forward contracts obligate LNC to deliver a specified amount of currency at a future date at a specified exchange rate. Foreign currency options give LNC the right, but not the obligation, to buy or sell a foreign currency at a specified exchange rate during a specified time period. A foreign currency swap is a contractual agreement to exchange the currencies of two different countries pursuant to an agreement to re-exchange the two currencies at the same rate of exchange at a specified future date.
Additional Derivative Information. Expenses for the agreements and contracts described above amounted to $8,000,000 and $9,100,000 in 1996 and 1995, respectively. Deferred losses of $33,500,000 as of December 31, 1996, were the result of: 1) terminated and expired spread-lock agreements and; 2) financial futures contracts. These losses are included with the related fixed maturity securities to which the hedge applied and are being amortized over the life of such securities.
LNC is exposed to credit loss in the event of nonperformance by counterparties on interest rate cap agreements, swaptions, spread-lock agreements, interest rate swaps, call options, foreign exchange forward contracts, foreign currency options and foreign currency swaps. However, LNC does not anticipate nonperformance by any of the counterparties. The credit risk associated with such agreements is minimized by purchasing such agreements from financial institutions with long-standing, superior performance records. The amount of such exposure is essentially the net replacement cost or market value for such agreements with each counterparty if the net market value is in LNC's favor. At December 31, 1996, the exposure was $28,000,000.
Derivatives. LNC's derivatives include interest rate cap agreements, swaptions, spread-lock agreements, foreign currency exchange contracts, financial futures contracts, options on financial futures, interest rate swaps, call options, foreign currency options and foreign currency swaps. Fair values for these contracts are based on current settlement values. These values are based on: 1) quoted market prices for the foreign currency exchange contracts, financial futures contracts and options on financial futures and; 2) brokerage quotes that utilized pricing models or formulas using current assumptions for all other swaps and agreements.
"Other Operations" includes operations not directly related to the business segments and unallocated corporate items (i.e., corporate investment income, interest expense on corporate debt and unallocated overhead expenses). LNC's other operations also included: 1) the equity in the earnings of a 29% owned unconsolidated affiliate engaged in the life-health benefit business prior to the sale of this interest in 1995 and, 2) the earnings of its investment management companies prior to the formation of the Investment Management
Revenue, excluding net investment income and realized gain (loss) on investments/ affiliates/operating property: Life Insurance and Annuities ----------- $1,124.2 $1,074.8 $1,133.4 Reinsurance ---------------------------- 1,279.2 1,181.9 1,070.9 Property-Casualty ---------------------- 1,617.2 1,688.7 1,710.6 Investment Management (Regular) -------- 210.7 142.8 -- Investment Management (at Cost --------- 61.6 42.8 -- Employee Life-Health Benefits ---------- -- -- 303.7 Other Operations (includes consolidating adjustments) ------------ (65.6) (18.8) 48.5 Total -------------------------------- $4,227.3 $4,112.2 $4,267.1
Income (loss) before income taxes and minority interest: Life Insurance and Annuities ----------- $470.3 $472.4 $106.7 Reinsurance ---------------------------- 131.1 (65.6) 102.9 Property-Casualty ---------------------- 187.6 190.4 177.2 Investment Management ------------------ 34.6 36.0 -- Employee Life-Health Benefits ---------- -- -- 22.9 Other Operations (includes interest expense) ------------------------------ (111.3) (6.6) (33.4) Total -------------------------------- $712.3 $626.6 $376.3
Income taxes (credits): Life Insurance and Annuities ----------- $138.8 $138.3 $12.6 Reinsurance ---------------------------- 45.4 (23.6) 35.9 Property-Casualty ---------------------- 23.9 24.1 5.6 Investment Management ------------------ 17.7 17.0 -- Employee Life-Health Benefits ---------- -- -- 8.5 Other Operations ----------------------- (46.6) (11.4) (36.2) Total -------------------------------- $179.2 $144.4 $26.4
Acquisitions and dispositions of affiliated companies in 1994 and 1995 (see note 12 on page 67) resulted in LNC's foreign operations being more significant relative to LNC's consolidated totals. Substantially all of LNC's foreign operations are conducted by Lincoln National (UK) plc, a United Kingdom company. The data for this company included within the Life Insurance and Annuities segment above is as follows:
Revenue -------------------------------- $393.2 $351.5 $409.1 Income before income taxes-------------- 101.5 72.5 29.1 Income taxes --------------------------- 35.5 26.8 10.6 Net income ----------------------------- 66.0 45.7 18.5
In May 1996, LNC filed a shelf registration with the Securities and Exchange Commission that would allow LNC to offer and sell up to $500 million of various forms of hybrid securities. These securities, which combine debt and equity characteristics, utilize a series of three trusts (Lincoln National Capital I, II and III). These trusts were formed solely for the purpose of issuing preferred securities and lending the proceeds to LNC. The common securities of these trusts are owned by LNC. The only assets of Lincoln National Capital I, II and III are the notes receivable from LNC for such loans. Distributions are paid by these trusts to the preferred securityholders on a quarterly basis. The principal obligations of these trusts are irrevocably guaranteed by LNC. Upon liquidation of these trusts the holders of the preferred securities would be entitled to a fixed amount per share plus accumulated and unpaid distributions. LNC reserves the right to: 1) redeem the preferred securities at a fixed price plus accumulated and unpaid distributions and; 2) extend the stated redemption date up to 19 years if certain conditions are met.
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 $80.00 per share. The difference between the aggregate preference on liquidation value and the financial statement balance for the series A preferred stock was $1,700,000 at December 31, 1996.
On June 30, 1995, Mutual Life Insurance Company, Dai-ichi the owner of LNC's series E and F preferred stock which was 5 1/2% cumulative convertible exchangeable, converted its entire holdings to LNC common stock. Based on a conversion rate of two shares of common stock for each share of series E and F preferred stock, 2,201,443 shares of series E and 2,216,454 shares of series F were converted into 8,835,794 shares of common stock.
LNC has outstanding one common share purchase right ("Right") on each outstanding share of LNC's common stock. A Right will also be issued with each share of LNC's common stock that is issued before the Rights become exercisable or expire. If a person or group announces an offer that would result in beneficial ownership of 15% or more of LNC's common stock, the Rights will become exercisable and each Right will entitle its holder to purchase one share of LNC's common stock for $200. Upon the acquisition of 15% or more of LNC's common stock, each holder of a Right (other than the person acquiring the 15% or more) will have the right to acquire the number of shares of LNC common stock that have a market value of two times the exercise price of the Right. If LNC is acquired in a business combination transaction in which LNC does not survive, each holder of a Right (other than the acquiring person) will have the right to acquire common stock of the acquiring person having a market value of two times the exercise price of the Right. LNC can redeem each Right for one cent at any time prior to the tenth day after a person or group has acquired 15% or more of LNC's common stock. The Rights expire on November 14, 2006. As of December 31, 1996, there were 103,658,575 Rights outstanding.
Fair value of securities available-for-sale ------------- $28,899.1 $26,999.3 Cost of securities available-for-sale ------------------- 27,627.9 24,871.6 Unrealized Gain (Loss) -------------------------------- 1,271.2 2,127.7 Adjustments to deferred acquisition costs --------------- (286.9) (515.3) Amounts required to satisfy policyholder commitments ---- (339.0) (555.0) Deferred income credits (taxes) ------------------------- (229.7) (359.2) Net unrealized gain (loss) on securities available-for-sale ----------------------------------- $ 415.6 $ 698.2
Adjustments to deferred acquisition costs and amounts required to satisfy policyholder commitments are netted against the Deferred Acquisition Costs asset account and included with the Future Policy Benefits, Claims and Claim Expenses liability account on the balance sheet, respectively.
In October 1996, LNC purchased a block of group tax-qualified annuity business from UNUM Corporation's affiliates. The bulk of the transaction was completed in the form of a reinsurance transaction, which resulted in a ceding commission of $71,800,000. The ceding commission, along with other expenses of $67,000,000, represents the present value of business in-force and accordingly has been classified as an intangible asset. LNC's assets and policy liabilities and accruals increased $3.2 billion as a result of this transaction.
We have audited the accompanying consolidated balance sheets of Lincoln National Corporation as of December 31, 1996 and 1995, and the related consolidated statements of income, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1996. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.