This "Management's Discussion and Analysis of Results of Operations and Financial Condition" should be read in conjunction with the audited consolidated financial statements and accompanying notes presented on pages 36 through 67.
(1) Lincoln stopped writing disability income coverages on a direct basis at the end of March 1996. The administration of this business was moved to the Reinsurance segment at the end of September 1995.
The Life Insurance and Annuities segment reported record income from operations of $404.6 million in 1998, a 58% increase over the $255.8 million reported in 1997. Continuing double-digit growth in the annuity business, plus the added earnings from the blocks of business acquired from CIGNA and Aetna during 1998 (see note 11 to the consolidated financial statements on page 66), were the primary factors in this segment's earnings performance.
Lincoln Life, which is based in Fort Wayne, Indiana, is the 13th largest life insurer in the United States when measured by assets (Best's Review, Life/Health Edition, July 1998). First Penn, which is headquartered in Oakbrook Terrace, Illinois, is recognized for product innovations. One unique product is MoneyGuard (Registered Trade Mark), a policy that links the benefits of universal life and long-term care insurance in one. LLANY, which is based in Syracuse, New York, provides group tax-qualified annuities and other insurance products in the state of New York.
Lincoln Life, First Penn and LLANY earned charter memberships in the Insurance Marketplace Standards Association ("IMSA"), an independent, voluntary organization created by the American Council of Life Insurance. IMSA membership demonstrates a company's commitment to honesty, fairness and integrity in all customer contacts involving sales and service of individual life and annuity products.
Acquisitions/Divestitures: LNC completed the acquisition of a block of individual life insurance and annuities business on January 2, 1998, from CIGNA Corporation, adding a career agency system of 600 producers; a life brokerage operation; an annuity distribution system; and $37 billion of individual life insurance in force. The acquisition of another block of individual life insurance business on October 1, 1998, from Aetna, Inc. added 30 life brokerage managers, 30 managing general agent relationships, a corporate-owned life insurance sales force, access to more than 30,000 independent agents and a total of $42 billion of individual life insurance in force. A block of employer-sponsored life insurance business acquired in connection with the Aetna businesses was sold to Protective Life Corp. In addition, an agreement was reached with Allstate Life under which they would reinsure and administer a variable annuity portfolio acquired in connection with the CIGNA business.
Varied Distribution: Products from the companies in this segment are sold through multiple distribution channels, reflecting a marketplace where consumers increasingly want to do business on their own terms. These channels are career agents, independent agencies, insurance brokers, banks, stockbrokers, financial planners and the Internet.
Lincoln Life's and LLANY's wealth accumulation and wealth protection products include: fixed, variable and tax-deferred annuities; term, whole life, universal and variable universal life insurance; and employer sponsored retirement plans. These products are sold in 50 states through the 58 regional offices of LFA, a broker/dealer that serves approximately 2,050 career agents, 34,500 brokers and 4,500 bank agents as well as through 75,000 stockbrokers and financial planners.
Annuity deposits in 1998 were $3.9 billion. Annuity deposits sold through producers were $2.0 billion, while annuity deposits sold through stockbrokers were $1.4 billion.
As a result of restructuring its wholesaler network, AFD has broadened its distribution capabilities and its wholesalers now market both mutual funds and annuities. Today, the American Legacy product has the potential of being marketed by three times as many wholesalers as in the past. Lincoln also is supporting the wholesaler network by providing its own American Legacy sales support team to assist in sales promotion and stockbroker training programs. Product improvements, including the expansion of fund offerings, are being made to American Legacy.
All CIGNA products were duplicated within Lincoln Life within four months after the transaction closed. In addition, Lincoln introduced three new universal life products, two of which provide second-to-die coverage, for estate protection. One also offers the opportunity for equity returns on account values. All three offer lifetime death benefit guarantees, including a Survivor Variable Universal Life I and a Survivor Universal Life II product in 1998.
LNC's Lincoln UK segment, conducted through Lincoln National (UK) plc and its operating subsidiaries reported record income from operations of $70.9 million in 1998 compared with $66.6 million in 1997, excluding a special charge noted above.
Lincoln UK also participated in the sponsorship of the Rugby League Test Series between Great Britain and New Zealand, two of the top three leaders in Rugby League football in the world. The three matches were played during October and November 1998 and received wide media coverage, on television and radio, and in the national and local press.
City Financial Partners Ltd ("CFPL"): Lincoln UK's largest tied agent, CFPL, was acquired at the end of 1997 and is now a wholly-owned subsidiary. Its integration into the organization was successfully completed in 1998, a year in which CFPL agents produced 45% of Lincoln UK's new business.
Exchange Rates: LNC's subsidiary in the United Kingdom, as with subsidiaries in other foreign countries, has its balance sheet accounts and income statements translated at the current exchange and average exchange rates for the year, respectively. The average exchange rate for 1998 was $1.658 per British pound sterling. This was 1% higher than the 1997 average exchange rate of $1.644 per British pound.
As of December 31, 1998 and December 31, 1997, the balance in the liability account established for this matter was $202.1 million and $291.0 million, respectively. These liabilities, which are net of expected recoveries, were established for the estimated cost of this issue following regulatory guidance as to activities to be undertaken. These liabilities are net of expected recoveries of $84.9 million and $113.0 million, respectively, from previous owners of companies acquired over the last few years as specified in the indemnification clauses of the purchase agreements.
Outlook: By the end of 1999, Lincoln UK will have made substantial progress in the pensions review and expects a stable earnings picture with some growth going forward. Lincoln UK anticipates growing faster than the rest of the U.K. life insurance industry through increased distribution, a superior trained sales force, improved products and investment performance.
LNC's Reinsurance segment ("Lincoln Re"), reported record income from operations of $101.5 million in 1998, exceeding its $100 million target established a few years ago. This compares with $92.1 million in 1997, excluding special charges. As of December 31, 1998, Lincoln Re's individual and group life business in force was $250.3 billion, an increase of 36% over the prior year.
Profile: One of the leading life-health reinsurers in the world, Lincoln Re reported consolidated, worldwide net premium income of $2.1 billion in 1998. This compares with $1.7 billion net premium income reported in 1997. Lincoln Re maintains offices in a number of U.S. cities and has offices in Toronto, Brussels, Buenos Aires, London, Mexico City, Manila and Singapore.
Foremost among these systems is Lincoln National Risk Management's ("LNRM") patented Life Underwriting System, a state-of-the-art risk management technology now licensed to more than 50 insurers. Further, nearly 30 % of new life business written during 1998 can be attributed to companies that have utilized the Lincoln Mortality System (Trade Mark), a system which helps design new preferred term insurance products. In 1998, Lincoln Re was granted a second patent to protect its Lincoln Mortality System and other automated decision-making systems. Other proprietary systems assist health insurers, claims processors and agents. Datalliance (Registered Trade Mark), is an electronic data interchange that can link agents, insurers, information sources, medical labs and reinsurers.
Group Markets: Income from operations in 1998 in group markets was $2.7 million. This compares with $10.4 million in 1997, excluding the special charge for personal accident programs. Total annualized premium of $248.4 million represents an increase of 23% over the $202.2 million in 1997.
In the fourth quarter of 1995, LNC took a $121.6 million after-tax charge against earnings to strengthen reserves for the direct and reinsurance disability income business. These reserves were established assuming that the current experience would continue. In the second quarter of 1997, LNC took an additional after-tax charge of $130 million against earnings when it obtained new information indicating that experience had deteriorated further.
LNIC's assets under management at December 31, 1998 were $58.8 billion, an increase of $4.8 billion or 9% from December 31, 1997 assets of $54.0 billion, primarily due to the upward trend of the market during the year. LNIC had record levels of retail sales ($4.2 billion for 1998) and institutional inflows ($6.2 billion for 1998). In addition, LNIC's net retail cash flows were $2.0 billion for the year versus $0.6 billion for 1997.
Profile: The companies that comprise this segment are: Delaware Management Holdings, Inc.; Lynch & Mayer, Inc.; and Vantage Investment Advisors. Delaware has its headquarters in Philadelphia, with affiliates in London, Denver and Minneapolis. Lynch & Mayer and Vantage each maintain separate headquarters in New York.
During 1998, two external transactions positively affected the retail business of LNIC: the acquisition of CIGNA's ACCRU business and the sale of Delaware's Unit Investment Trust business to Nike Securities. These transactions reinforced Delaware's market focus on core retail products, (i.e., mutual funds, variable annuities and participant directed retirement plans) and strengthened Delaware's retail distribution by the addition of the former CIGNA ACCRU wholesalers.
Delaware Investments' defined contribution area performed well in 1998, growing to $5.9 billion in assets under management as of December 31, 1998. In the first quarter of 1999, Lincoln Life's retirement area was combined under Delaware, resulting in an organization with $9.6 billion in retirement assets. This combination should result in a broader product range that is better serviced and more profitable over the long term, with consistent asset growth because retirement plans tend to be long-term relationships with continuing cash flow.
Delaware is best known for a conservative, "value" equity investment style that focuses on stocks with above average dividend yields. It is also recognized for expertise in the small-cap and mid-cap growth styles and in municipal and high-yield bonds. Delaware International Advisers, Ltd. in London provides global and international equity and fixed income investment expertise.
Delaware received excellent ratings in the 1998 Dalbar Broker/Dealer Survey that rates the quality of marketing and service of approximately 25 large mutual fund complexes. Delaware is the 4th highest ranked firm in the Main Office Operations category, up from 8th last year. In addition, financial advisors ranked Delaware 2nd in Wholesaler Support and 1st in Dedicated Marketing Support. High ratings are important because quality service is a key factor in growing and retaining assets.
Improved performance and service contributed to Delaware increasing its retail non-money market sales to $3.1 billion in 1998, up 55% in comparison with $2.0 billion for 1997. In addition, Delaware's net retail cash flows were $1.5 billion for 1998 versus $0.1 billion for 1997.
is the highest. High Morningstar ratings are significant because virtually all equity net inflows are directed into funds with high risk-adjusted ratings.
Vantage manages the Lincoln Life MultiFund (Registered Trade Mark) Social Awareness subaccount. The Fund has performed exceptionally well over the long term. For the five years ended December 31, 1998, the Fund's annualized return earned Vantage 30th place among 572 variable annuity funds.
Among U.S. institutional investment managers, Delaware produced strong results in the value equity category, with a return of 11.19% for the year ended December 31, 1998 that qualified as second quartile performance as measured by Callan's Yield Universe.
Underperformance in Lynch & Mayer's mid-cap growth product resulted in the loss of clients and a decline in institutional assets under management from $4.5 billion at December 31, 1997 to $2.8 billion at December 31, 1998. This issue was addressed during 1998 and a restructured investment team is in place with a mandate to improve performance.
Corporate interest expense reported within the LNC financing line above was greater for 1995 and 1996 than years prior to 1995 as the result of additions to long-term debt and minority interest-preferred securities of subsidiary companies. The 1997 amount was less than 1995 and 1996 due to reduced interest expense and investment earnings in the fourth quarter of 1997 that resulted from the use of proceeds from the sale of discontinued operations (see liquidity and cash flow discussion on page 34). This benefit did not continue into 1998 as most of these funds were used to purchase blocks of individual life insurance and annuity business in January and October of 1998 (see note 11 to the consolidated financial statements on page 66).
The following discussion covers select general investment matters. The review of consolidated operations, which begins on page 20, includes the fact that LNC's net investment income for the year ended December 31, 1998 was $2.7 billion, an increase of 17% over 1997. Also, this discussion indicates that during 1998 net gains on investments totaling $19 million were realized. The review of consolidated financial condition begins on page 24 and discusses the composition and quality of the LNC portfolio.
Investment Objective: LNC follows a balanced approach of investing for both current income and total return, with an emphasis on generating sufficient current income to meet LNC's obligations. This approach requires the evaluation of risk and expected return of each asset class utilized, while still meeting the income objectives of LNC. This approach also permits LNC to be more effective in its asset-liability management, since decisions can be made based upon both the economic and current investment income considerations affecting assets and liabilities.
REVIEW OF CONSOLIDATED OPERATIONS Some of the increases shown above are the result of the purchase of two blocks of individual life insurance and annuity business in January and October of 1998 (see note 11 to the consolidated financial statements on page 66).
Investment Advisory Fees Investment advisory fees increased $22.2 million or 11 % in 1998 and $24.1 million or 13% in 1997. These increases were the result of increased volumes of business and an increase in the market value of customer accounts. The increased volumes were the result of increasing the number of wholesalers and products, including the addition of wholesalers in the bank market.
Net Investment Income Net investment income increased $430.6 million or 19% in 1998 as the net result of a 21% increase in mean invested assets, a decrease in the yield on investments from 7.46% to 7.36% (all calculations on a cost basis). This increase in mean invested assets is the result of increased volumes of business in all the business segments and funds held in Other Operations that were applied toward the purchase of a block of business in October of 1998 (see note 11 to the consolidated financial statements on page 66). The increase in the Life Insurance and Annuities segment includes the impact of the acquisition of the blocks of business in 1998 (see note 11 to the consolidated financial statements on page 66). Net investment income increased $162.9 million or 8% in 1997 as a net result of a 9% increase in mean invested assets, a decrease in the yield on investments from 7.52% to 7.46% (all calculations on a cost basis) and a benefit of a reduction in the recurring adjustment of discount on mortgage-backed securities. In 1997, this adjustment was a charge of $.4 million versus a charge of $7.6 million in 1996. The increase in mean invested assets in 1997 was the result of increased volumes of business in the Life Insurance and Annuities segment.
Realized Gain on Investments The pre-tax realized gain on investments, net of related amortization and expenses, was $19.0 million, $122.6 million and $92.5 million in 1998, 1997 and 1996, respectively. The after-tax gain in 1998, 1997 and 1996 was $13.7 million, $72.9 million and $57.6 million, respectively. These gains were primarily the result of the sale of investments. Write-downs and provisions for losses offset a portion of the realized gains. During 1996, LNC completed a bulk sale of performing and non-performing mortgage loans and real estate holdings through a sealed bid process. The selling price for these holdings was $6.1 million in excess of the carrying value, resulting in a gain on sale.
Securities available-for-sale, mortgage loans on real estate and real estate that were deemed to have declines in fair value that were other than temporary were written down. The fixed maturity securities to which these write-downs apply were generally of investment grade quality at the time of purchase but were classified as "below-investment-grade" at the time of the write-downs. Also, write-downs and allowances for losses on select mortgage loans on real estate, real estate and other investments were established when the underlying value of the property was deemed to be less than the carrying value. These write-downs and provisions for losses are disclosed within the notes to the accompanying financial statements (see note 3 to the consolidated financial statements on page 46).
Life Insurance and Annuity Benefits Life insurance and annuity benefits increased $403.3 million or 17% in 1998 as compared to 1997. This increase was the net result of increases of $470.8 million in the Life Insurance and Annuities segment (includes the addition of two blocks of individual life insurance and annuity business as described in note 11 to the consolidated financial statements on page 66) and increases in the Reinsurance segment of $122.5 million being partially offset by a decrease in the Lincoln UK segment of $190.0 million due to the absence of special charges in 1998. Life insurance and annuity benefits in 1997 increased $322.4 million or 16% as compared to 1996. This increase was the result of increases of $89.4 million or 6% from the Life Insurance and Annuities segment, $25.6 million or 7% from the Reinsurance segment and $207.1 million from the Lincoln UK segment. The Lincoln UK increase includes a change in estimate for its pension mis-selling liability (see note 2 to the consolidated financial statements on page 45).
Health Benefits Health benefits increased $108.8 million or 24% in 1998 compared to 1997 health benefits, excluding the 1997 special additions to the disability income and personal accident programs reserves ($130.0 million and $113.7 million, respectively) as the result of increased volumes of business. See note 2 to the consolidated financial
Federal Income Taxes Federal income taxes increased $174.9 million in 1998 as the result of an increase in the pre-tax earnings. Federal income taxes decreased from $147.7 million in 1996 to $12.7 million in 1997 as the result of a decrease in pre-tax earnings.
Summary Net income for 1998 was $509.8 million compared with $934.0 million in 1997. Excluding realized gain (loss) on investments, gain (loss) on sale of subsidiaries, restructuring charges, discontinued operations and the 1997 special additions to the disability income, personal accident programs and UK pension product reserves, all net of taxes, LNC earned $530.4 million for 1998 compared to $368.0 million in 1997. This increase is the result of increased earnings from each of the business segments. In the fourth quarter of 1997 Other Operations benefited from earnings on proceeds from discontinued operations. This benefit did not continue into 1998 as most of these funds were used to purchase a block of individual life and annuity business on January 2, 1998 (see note 11 to the consolidated financial statements on page 66). Net income for 1997 was $934.0 million compared with $513.6 million in 1996. Excluding realized gain (loss) on investments, gain on sale of subsidiaries, discontinued operations and the 1997 special additions to reserves, LNC earned $368.0 million for 1997 compared to $298.8 million in 1996. This increase is the result of increased earnings in the Life Insurance & Annuities, Lincoln UK and Reinsurance segments.
LNC has completed these four phases for over two-thirds of its high priority IT systems, including those provided by software vendors. While LNC's year 2000 program for nearly all high priority IT systems is expected to be completed in the first quarter of 1999, phase four, for a small but important subset of these systems, will continue through the end of the second quarter 1999. As of December 31, 1998 the status of projects addressing readiness of IT assets is: 100% of IT assets have been inventoried (Phase 1) and assessed (Phase 2); 97% of IT projects have been through the remediation phase (Phase 3) with the last project scheduled for completion by the end of March 1999; and 71% of IT projects have completed the testing phase (Phase 4) with the last project scheduled to finish testing by the end of June 1999. A portion of the effort that extends into 1999 is dependent on outside third parties and is behind the original schedule. LNC is working with these parties to modify the completion schedule.
While LNC is working to meet the schedules outlined above, some uncertainty remains. Specific factors that give rise to this uncertainty include a possible loss of technical resources to perform the work, failure to identify all susceptible systems, non-compliance by third parties whose systems and operations impact LNC and other similar uncertainties.
process claim payments, accurately maintain policyholder information, accurately maintain accounting records, and/or perform adequate customer service. Should the worst case scenario occur, it could, depending on its duration, have a material impact on LNC's results of operations and financial position. Simple failures can be repaired and returned to production within a matter of hours with no material impact. Unanticipated failures with a longer service disruption period would have a more serious impact. For this reason, LNC is placing significant emphasis on risk management and Year 2000 contingency planning. LNC is in the process of modifying its contingency plans to address potential year 2000 issues. Where these efforts identify high risks due either to unacceptable work around procedures or significant readiness risks, appropriate risk management techniques are being defined. These techniques, such as resource shifting or use of alternate providers, will be employed to provide stronger assurances of readiness. LNC has gone through exercises to identify worst case scenario failures. At this time, LNC believes its plans are sufficient to mitigate identified worst case scenarios.
Some of the increases in the balance sheet accounts described below are a result of the purchase of two blocks of individual life insurance and annuity business in January and October of 1998 (see note 11 to the consolidated financial statements on page 66).
LNC's entire fixed maturity and equity securities portfolio is classified as "available-for-sale" and is carried at fair value. Changes in fair values, net of related deferred acquisition costs, amounts required to satisfy policyholder commitments and taxes are charged or credited directly to shareholders' equity. Note 3 to the consolidated financial statements on page 46 shows the gross unrealized gains and losses as of December 31, 1998.
LNC limits the extent of its risk on mortgage-backed securities by prudently limiting exposure to the asset class, by generally avoiding the purchase of securities with a cost that significantly exceeds par, by purchasing securities backed by stable collateral, and by concentrating on securities with enhanced priority in their trust structure. Such securities with reduced risk typically have a lower yield (but higher liquidity) than higher-risk mortgage-backed securities. At selected times, higher-risk securities may be purchased if they do not compromise the safety of the general portfolio. At December 31, 1998, LNC did not have a significant amount of higher-risk mortgage-backed securities. There are negligible default risks in the mortgage-backed securities portfolio as a whole as the vast majority of the assets are either guaranteed by U.S. government- sponsored entities or are supported in the securitization structure by junior securities enabling the assets to achieve high investment grade status. Note 3 to the consolidated financial statements on page 48 shows additional detail about the underlying collateral.
As of December 31, 1998, mortgage loans on real estate and investments in real estate represented 11.5% and 1.3% of the total investment portfolio. As of December 31, 1998, the underlying properties supporting the mortgage loans on real estate consisted of 25.4% in commercial office buildings, 33.5% in retail stores, 18.8% in apartments, 12.6% in industrial buildings, 4.0% in hotels/motels and 5.7% 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 $48.7 million in 1998 as the result of increased volumes of business in the Life Insurance & Annuities and Reinsurance segments.
Other Assets The decrease in other assets of $76.8 million is the result of having a lower receivable related to investment securities sold in the last few days of 1998 versus the end of 1997.
Total Liabilities Total liabilities increased by $16.3 billion in 1998. The primary item underlying this increase is the addition of the blocks of individual life and annuity business described above. Insurance policy reserves increased $8.9 billion as a result of the new blocks of business and increased levels of business in the Life Insurance and Annuities segment. Contractholder funds increased $689.7 million which is the net result of additions related to the block of business acquired and new deposits being partially offset by the withdrawal upon maturity of guaranteed interest contracts. Liabilities related to separate accounts increased $6.3 billion (see discussion of Assets Held in Separate Accounts above). Total debt increased $648.5 million as the result of
Shareholders' Equity Total shareholders' equity increased $405.0 million during the year ended December 31, 1998. Excluding the increase of $116.4 million related to an increase in the unrealized gain (loss) on securities available-for- sale, shareholders' equity increased $288.6 million. This increase in shareholders' equity was the net result of increases due to $509.8 million of net income, $48.7 million from the issuance of common stock related to benefit plans and $3.8 million related to an increase in the accumulated foreign exchange gain being offset by $211.8 million related to the declaration of dividends to shareholders, $14.8 million of issuance costs related to an offering of FELINE PRIDES and $46.9 million for the retirement of common stock.
Capital adequacy is a primary measure used by insurance regulators to determine the financial stability of an insurance company. In the U.S., risk-based capital guidelines are used by the National Association of Insurance Commissioners to determine the amount of capital that represents minimum acceptable operating amounts related to insurance and investment risks. Regulatory action is triggered when an insurer's statutory- basis capital falls below the formula-produced capital level. At December 31, 1998, statutory-basis capital for each of LNC's U.S. insurance subsidiaries was substantially in excess of regulatory action levels of risk- based capital required by the jurisdiction of domicile.
The consolidated statements of cash flows on page 39 indicate that operating activities provided cash of $1.3 billion, $1.1 billion and $1.4 billion in 1998, 1997 and 1996, respectively. This statement also classifies the other sources and uses of cash by investing activities and financing activities and discloses the amount of cash available at the end of the year to meet LNC's obligations.
The table above shows the cash flow activity for the holding company from 1996 through 1998. 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.
LNC's insurance subsidiaries are subject to certain insurance department regulatory restrictions as to the transfer of funds and payment of dividends to the holding company. Generally, these restrictions pose no short-term liquidity concerns for the holding company. However, as discussed in detail within note 7 on page 54, the acquisition of two blocks of business in 1998 will place further restrictions on the ability of LNC's primary insurance subsidiary, Lincoln National Life Insurance Company ("Lincoln Life"), to declare and pay dividends. As a result of these acquisitions, Lincoln Life's statutory earned surplus will be negative and it will be necessary for Lincoln Life to obtain the prior approval of the Indiana Insurance Commissioner before paying any dividends to LNC until such time its statutory earned surplus is positive. It is expected that statutory earned surplus will return to a positive position within two to three years from the closing of the Aetna transaction assuming a level of statutory earnings coinciding with recent earnings patterns. If statutory earnings are less than recent patterns due, for example, to adverse operating conditions or further indemnity reinsurance transactions of this nature, the statutory earned surplus may not return to a positive position as soon as expected. Although no assurance can be given, management believes that the approvals for the payment of dividends in amounts consistent with those paid in the past can be obtained. In the event such approvals are not obtained, management believes that LNC can obtain the funds required to satisfy its obligations from its existing credit facilities and other sources.
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. During 1998, the collective group of companies adopted "Lincoln Financial Group" as its marketing identity. Operations are divided into four business segments (see note 9 on page 62). 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.
Realized gain (loss) on sale of subsidiaries, net of taxes, is recognized in net income. Realized gain (loss) on sale of minority interests in subsidiaries is reflected directly in shareholders' equity net of deferred taxes, if any.
Hedge accounting is applied as indicated above after LNC determines that the items to be hedged expose LNC to interest rate fluctuations, the widening of bond yield spreads over comparable maturity U.S. Government obligations, fluctuations in certain stock indices, increased liabilities associated with certain reinsurance agreements and foreign exchange risk. Moreover, the derivatives used are designated as a hedge and reduce the indicated risk by having a high correlation between changes in the value of the derivatives and the items being hedged at both the inception of the hedge and throughout the hedge period. Should such criteria not be met or if the hedged items have been sold, terminated or matured, the change in value of the derivatives is included in net income.
Benefits and Expenses. Benefits 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 1996 through 1998 ranged from 5.80% to 7.05%. Interest and debt expense includes interest on Minority Interest-Preferred Securities of Subsidiary Companies.
Goodwill and Other Intangible Assets. The cost of acquired insurance subsidiaries or blocks of business in excess of the fair value of net assets (goodwill) is amortized using the straight-line method over periods of 20 to 40 years which corresponds with the benefits expected to be derived from the acquisitions.
Reinsurance. LNC's insurance companies enter into reinsurance agreements with other companies in the normal course of their business. LNC's insurance subsidiaries may assume reinsurance from unaffiliated companies and/or cede reinsurance to such companies. Assets/liabilities and premiums/benefits from certain reinsurance contracts that grant statutory surplus to other insurance companies have been netted on the balance sheets and income statements, respectively, since there is a right of offset. All other reinsurance agreements are reported on a gross basis.
Change in Estimate for United Kingdom Pension Mis-selling. During the fourth quarter of 1997, an in-depth review was completed of the United Kingdom regulatory environment, settlements to date and the remaining liability established to settle claims associated with this business. As a result of this study, the Lincoln UK segment strengthened its liability by $199,400,000 reducing net income in the fourth quarter of 1997 by $174,900,000 after-tax or $1.70 per share.
Change in Estimate for Personal Accident Programs. During the fourth quarter of 1997, an in-depth review was completed of certain excess-of-loss personal accident reinsurance programs written by LNC's Reinsurance segment. Based on a concern that these programs were generating claims substantially in excess of expectations, an investigation and audit was conducted covering all such programs. While LNC continues to investigate the manner in which these programs were designed and all legal remedies available, it has been determined that the incurred but not reported reserve liability related to this business should be strengthened. Accordingly, a charge of $175,000,000 ($113,700,000 after-tax or $1.11 per share) was taken in the fourth quarter of 1997.
Accounting for Derivative Instruments and Hedging Activities. In June 1998, the Financial Accounting Standards Board issued an accounting standard entitled "Accounting for Derivative Instruments and Hedging Activities" ("FAS 133"). This standard indicates that adoption may occur at the beginning of any fiscal quarter but no later than the first quarter of 2000. LNC has not completed the analysis necessary to provide a precise estimate of the effect of this statement or to specify the quarter in which it plans to adopt the standard.
During the second quarter of 1998, LNC purchased two bonds issued with offsetting interest rate characteristics. Subsequent to the purchase of these bonds, interest rates increased and the value of one of these bonds decreased. This bond was sold at the end of the second quarter 1998 and a realized loss of $20.0 million ($13.0 million after-tax) was recorded. The other bond is still owned by LNC and is producing net investment income on an annual basis of $10.0 million ($6.5 million after-tax). Subsequent to these transactions being recorded, the Emerging Issues Task Force of the Financial Accounting Standards Board reached consensus with regard to accounting for this type of investment strategy. LNC is not required to apply the new accounting rules, however, if such rules were applied, the realized loss on the sale of $20.0 million ($13.0 million after-tax) on one of these bonds recorded at the end of the second quarter of 1998 would be reversed and the amount would be applied as a change in the carrying amount of the bond that remains in LNC's portfolio. Also, net investment income for the year ended December 31, 1998 would be less than reported by $5.0 million ($3.3 million after-tax).
The balance sheet captions, "Real Estate" and "Property and Equipment," are shown net of allowances for depreciation as follows:
Impaired loans with allowance for losses......... $37.0 $41.2 Allowance for losses............................. (4.8) (5.0) Impaired loans with no allowance for losses...... 2.2 -- ------ ------ Net impaired loans............................... $34.4 $36.2
Year Ended December 31 (in millions) 1998 1997 1996 - -------------------------------------------------------------------------------
Year Ended December 31 (in millions) 1998 1997 1996 - --------------------------------------------------------------------------------
As of December 31, 1998 and 1997, LNC had restructured mortgage loans of $32,000,000 and $38,500,000, respectively. LNC recorded $3,100,000 and $3,800,000 of interest income on these restructured mortgage loans in 1998 and 1997, respectively. Interest income in the amount of $3,200,000 and $3,900,000 would have been recorded on these mortgage loans according to their original terms in 1998 and 1997, respectively. As of December 31, 1998 and December 31, 1997, LNC had no outstanding commitments to lend funds on restructured mortgage loans.
As of December 31, 1998, LNC's investment commitments for fixed maturity securities (primarily private placements), mortgage loans on real estate and real estate were $487,800,000.
Mortgage loans on real estate....................... $4.8 $ 5.0 Real estate......................................... -- 1.5 Guarantees.......................................... .3 .8
LNC's Lincoln UK segment has incurred losses in its pension business which under United Kingdom tax law can only be utilized against its future pension business earnings. At December 31, 1998 and 1997 the deferred tax asset related to these pension business losses was $86,700,000 and $92,000,000, respectively. The valuation allowances shown in the table above reflect managements assessment, based upon all available information, that it is more likely than not that a portion of this deferred tax asset will not be realized. Adjustment to the valuation allowance will be made if there is a change in management's assessment of the amount of the deferred tax asset that is realizable.
At December 31, 1998, LNC had net operating loss carryforwards of $257,000,000 for Federal income tax purposes related to its foreign life reinsurance companies that expire in years 2006 through 2018. Delaware Management Holdings, Inc. ("Delaware"), acquired in 1995, has net operating loss carryforwards for Federal
LNC has declared its intention to reinvest the undistributed earnings of Lincoln UK and will not provide U.S. income tax on these undistributed earnings. At December 31, 1998, for the years covered by this declaration there was a deficit in earnings for Lincoln UK.
The income statement caption, "Underwriting, Acquisition, Insurance and Other Expenses," includes amortization of deferred acquisition costs of $440,000,000; $468,000,000 and $428,500,000 for the years ended December 31, 1998, 1997 and 1996, respectively. An additional $(34,500,000); $(78,200,000) and $(65,200,000) of deferred acquisition costs was restored (amortized) and netted against "Realized Gain (Loss) on Investments" for the years ended December 31, 1998, 1997 and 1996, respectively.
1999 - $112.2 2001 - $115.1 2003 - $ 109.7 2000 - 113.0 2002 - 112.4 Thereafter - 1,190.9
LNC also has access to capital from minority interest in preferred securities of subsidiary companies. In May 1996, LNC filed a shelf registration with the Securities and Exchange Commission that would allow LNC to offer and sell up to $500,000,000 of various forms of hybrid securities. These securities, which combine debt and equity characteristics, are offered through a series of three subsidiaries (Lincoln National Capital I, II and III). These subsidiaries were formed solely for the purpose of issuing preferred securities and lending the proceeds to LNC. The common securities of these subsidiaries 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 subsidiaries to the preferred securityholders on a quarterly basis. The principal obligations of these subsidiaries are irrevocably guaranteed by LNC. Upon liquidation of these subsidiaries, the holders of the preferred securities would be entitled to a fixed amount per share plus accumulated and unpaid distributions. LNC reserves the right to: 1) redeem the preferred securities at a fixed price plus accumulated and unpaid distributions and; 2) extend the stated redemption date up to 19 years if certain conditions are met.
In April 1998, LNC filed a shelf registration with the Securities and Exchange Commission, that would allow LNC to offer and sell up to $1,300,000,000 of various securities, including regular debt, preferred stock, common stock or hybrid securities. This filing included an aggregate of $300,000,000 from a previous filing that had not been utilized. In conjunction with this shelf registration, three additional subsidiaries were added (Lincoln National Capital IV, V and VI) to accommodate the issuance of additional preferred securities. The purpose and terms of these new subsidiaries essentially parallel Lincoln National Capital I, II and III.
In July 1996, Lincoln National Capital I issued 8,600,000 shares or $215,000,000, 8.75% Quarterly Income Preferred Securities ("QUIPS"). In August 1996, Lincoln National Capital II issued 4,000,000 shares or $100,000,000, 8.35% Trust Originated Preferred Securities ("TOPrS"). Both issues mature in 2026 at $25 per share and are redeemable in whole or in part at LNC's option any time after 2001. In March 1998, LNC issued notes of 1) $100,000,000, 6.5% due 2008 and 2) $200,000,000, 7% due 2018. In July 1998, Lincoln National Capital III issued 8,000,000 shares or $200,000,000 of 7.4% TOPrS which mature in 2028 at $25 per share and are redeemable in whole or in part at LNC's option anytime after July 2003. In August 1998, Lincoln National Capital IV issued 9,200,000 shares or $230,000,000 of 7.75% FELINE PRIDES (service
Incentive Plans. LNC has various incentive plans for key employees, agents and directors of LNC and its subsidiaries that provide for the issuance of stock options, stock appreciation rights, restricted stock awards and stock incentive awards. These plans are comprised primarily of stock option incentive plans. Stock options granted under the stock option incentive plans are at the market value at the date of grant and, subject to termination of employment, expire 10 years from the date of grant. Such options are transferable only upon death and are exercisable one year from date of grant for options issued prior to 1992. Options issued subsequent to 1991 are exercisable in 25% increments on the option issuance anniversary in the four years following issuance. A "reload option" feature was added on May 14, 1997. In most cases, persons exercising an option after that date have been granted new options in an amount equal to the number of matured shares tendered. The reload options are granted for the remaining term of the related original option and can be exercised two years after the grant date if the value of the new option has appreciated by 25%.
The fair value of options granted after December 31, 1994, used as a basis for the pro forma disclosures, shown above, was estimated as of the date of grant using a Black-Scholes option pricing model.
of business as described below. Excluding the impact of these acquisitions, net income for 1998 would have been $545,900,000. Statutory net income (loss) for 1998, 1997 and 1996, excluding LNC's foreign life reinsurance companies, was $(1,397,600,000); $299,100,000 and $342,700,000, respectively.
Disability Income Claims The liability for disability income claims net of the related asset for amounts recoverable from reinsurers at December 31, 1998 and 1997 is a net liability of $1,813,400,000 and $1,654,000,000, respectively, excluding deferred acquisition costs. This liability is based on the assumption that recent experience will continue in the future. If incidence levels and/or claim termination rates fluctuate significantly from the assumptions underlying the reserves, adjustments to reserves could be required in the future. Accordingly, this liability may prove to be deficient or excessive. However, it is management's opinion that such future development will not materially affect the consolidated financial position of LNC. LNC reviews reserve levels on an on-going basis.
Group Pension Annuities The liabilities for guaranteed interest and group pension annuity contracts are supported by a single portfolio of assets that attempts to match the duration of these liabilities. Due to the long-term nature of group pension annuities and the resulting inability to exactly match cash flows, a risk exists that future cash flows from investments will not be reinvested at rates as high as currently earned by the portfolio. Accordingly, these liabilities may prove to be deficient or excessive. However, it is management's opinion that such future development will not materially affect the consolidated financial position of LNC.
Insurance Ceded and Assumed LNC's insurance companies cede insurance to other companies. The portion of risks exceeding each company's retention limit is reinsured with other insurers. LNC seeks reinsurance coverage within the
business segments that sell life insurance to limit its liabilities. As of December 31, 1998, LNC's maximum retention was $10,000,000 on a single insured. Portions of LNC's deferred annuity business have also been co-insured with other companies to limit LNC's exposure to interest rate risks. At December 31, 1998, the reserves associated with these reinsurance arrangements totaled $1,608,500,000. To cover products other than life insurance, LNC acquires other insurance coverages with retentions and limits that management believes are appropriate for the circumstances. The accompanying financial statements reflect premiums, benefits and deferred acquisition costs, net of insurance ceded (see note 5 on page 49). LNC's insurance companies remain liable if their reinsurers are unable to meet contractual obligations under applicable reinsurance agreements.
Vulnerability from Concentrations At December 31, 1998, LNC did not have a material concentration of financial instruments in a single investee, industry or geographic location. Also at December 31, 1998, LNC did not have a concentration of: 1) business transactions with a particular customer, lender or distributor; 2) revenues from a particular product or service; 3) sources of supply of labor or services used in the business or; 4) a market or geographic area in which business is conducted that makes it vulnerable to an event that is at least reasonably possible to occur in the near term and which could cause a severe impact to LNC's financial condition.
UK regulatory authorities have completed a review of Lincoln UK selling practices. This review does not include matters related to the pension product mis-selling investigations. Management is currently working with the regulators to address compliance issues that have been raised in the course of this review. The extent of corrective measures and potential disciplinary actions, if any, that may result from this review are actively being discussed with the regulatory authorities. It is not possible to provide a meaningful estimate of the potential outcome of this matter at the present time. However, it is management's opinion that the resolution of these matters will not materially affect the consolidated financial position of LNC.
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
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, Commodity risk, credit risk, increased liabilities associated with certain reinsurance agreements, foreign exchange risks and fluctuations in the FTSE and S&P indexes. In addition, LNC is subject to the risks associated with changes in the value of its derivatives; however, such changes in value generally are offset by changes in the value of the items being hedged by such contracts. Outstanding derivatives with off- balance-sheet risks, shown in notional or contract amounts along with their carrying value and estimated fair values, are as follows:
Interest Rate Cap Agreements. the interest rate cap agreements, which expire in 1999 through 2006, entitle LNC to receive quarterly payments from the counterparties on specified future reset dates, contingent on future interest rates. For each cap, the amount of such quarterly payments, if any, is determined by the excess of a market interest rate over a specified cap rate multiplied by the notional amount divided by four. The purpose of LNC's interest rate cap agreement program is to protect its annuity line of business from the effect of rising interest rates. The premium paid for the interest rate caps is included in other investments ($9,300,000 as of December 31, 1998) and is being amortized over the terms of the agreements. This amortization is included in net investment income.
Swaptions. Swaptions, which expire in 1999 through 2003, entitle LNC to receive settlement payments from the counterparties on specified expiration dates, contingent on future interest rates. For each swaption, the amount of such settlement payments, if any, is determined by the present value of the difference between the fixed rate on a market rate swap and the strike rate multiplied by the notional amount. The purpose of LNC's swaption program is to protect its annuity line of business from the effect of rising interest rates. The premium paid for the swaptions is included in other investments (amortized cost of $16,200,000 as of December 31, 1998) and is being amortized over the terms of the agreements. This amortization is included in net investment income.
Financial Futures Contracts. LNC uses exchange-traded financial futures contracts 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.
Interest Rate Swap Agreements. LNC uses interest rate swap agreements to hedge its exposure to floating rate bond coupon payments, replicating a fixed rate bond. An interest rate swap is a contractual agreement to exchange payments at one or more times based on the actual or expected price, level, performance or value of one or more underlying interests rates. LNC is required to pay the counterparty to the agreements the stream of variable coupon payments generated from the bonds, and in turn, receives a fixed payment from the counterpart, at a predetermined interest rate. The net receipts/payments from interest rate swaps are recorded in net investment income. LNC also uses interest rate swap agreements to hedge its exposure to interest rate fluctuations related to the anticipated purchase of assets to support newly acquired blocks of business. Once the assets are purchased the gains resulting from the termination of the swap agreements will be applied to the basis of the assets. The gains will be recognized in earnings over the life of the assets.
Foreign Exchange Forward Contracts (Foreign Subsidiary). LNC has used foreign exchange forward contracts, which are traded over-the-counter, to hedge the foreign exchange risk assumed with its investment in its U.K. subsidiary, Lincoln National (UK). The foreign exchange forward contracts obligated LNC to deliver a specified amount of currency at a future date at a specified exchange rate.
Call Options. LNC uses both FTSE index and S&P 500 index call options. Call options which expire in 1999 through 2006, provide LNC with settlement payments from the counterparties on specified expiration dates. The payment, if any, is the percentage increase in the index, over the strike price defined in the contract, applied to the notional amount. The purpose of LNC's FTSE call option program is to offset the cost of increases in the liabilities of certain single premium investment contracts which are tied to the FTSE index. The purpose of LNC's S&P 500 call option program is to offset the increase in its liabilities resulting from certain reinsurance agreements which guarantee payment of the appreciation of the S&P 500 index on certain underlying annuity products. The premium paid for the S&P 500 index call options is included in other assets ($16,800,000 as of December 31, 1998) and is being amortized over the terms of the agreements. This amortization is included in net investment income.
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, commodity swaps, call options, put 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, 1998, the exposure was $53,000,000.
Investment Commitments. Fair values for commitments to make investments in fixed maturity securities (primarily private placements), mortgage loans on real estate and real estate are based on the difference between the value of the committed investments as of the date of the accompanying balance sheets and the commitment date. These estimates would take into account changes in interest rates, the counterparties' credit standing and the remaining terms of the commitments.
Separate Accounts. Assets held in separate accounts are reported in the accompanying consolidated balance sheets at fair value. The related liabilities are also reported at fair value in amounts equal to the separate account assets.
All of the issued and outstanding series A preferred stock is $3 Cumulative Convertible and is convertible at any time into shares of common stock. The conversion rate is eight shares of common stock for each share of series A preferred stock, subject to adjustment for certain events. The series A preferred stock is redeemable at the option of LNC at $80 per share plus accrued and unpaid dividends. 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 $1,554,000 at December 31, 1998.
LNC has stock options outstanding which were issued at prices that are above the current average market price of LNC common stock. In the event the average market price of LNC's common stock exceeds the issue price of stock options, such options would be dilutive to LNC's earnings per share and will be shown in the table above. Also, LNC has purchase contracts outstanding which require the holder to purchase LNC common stock by August 16, 2001. These purchase contracts were issued in conjunction with the FELINE PRIDES financing. The common shares involved are not currently dilutive to LNC's earnings per share and will not be dilutive in the future except during periods when the average market price of LNC's common stock exceeds a stated threshold price of $111.45 per share.
In October 1996, LNC purchased a block of group tax-qualified annuity business from UNUM Corporation's affiliates. The bulk of the transaction was completed in the form of a reinsurance transaction, which resulted in a ceding commission of $71,800,000. The ceding commission, along with $67,000,000 to cover expenses associated with the purchase, represents the present value of business in-force and accordingly has been classified as an intangible asset. LNC's assets and liabilities increased $3,200,000,000 as a result of this transaction.
On January 2, 1998, LNC acquired of a block of individual life insurance and annuity business from CIGNA Corporation for $1,414,000,000. Additional funds ($228,500,000) were required to provide additional capital for the Life Insurance and Annuities segment to support this business and to cover expenses associated with the purchase. Funding used to complete this acquisition was from the proceeds of the sale of the property-casualty business in 1997 (see note 11 on page 65). This transaction was accounted for using purchase accounting and, accordingly, operating results generated by this block of business after the closing date are included in LNC's consolidated financial statements. At the time of closing, this block of business had liabilities, measured on a statutory basis, of $5,500,000,000 that became LNC's obligation. LNC also received assets measured on a historical statutory basis, equal to the liabilities. Subsequent to this acquisition, LNC announced that it had reached an agreement to sell the administration rights to a variable annuity portfolio that had been acquired as part of the block of business acquired January 2, 1998. This sale closed on October 12, 1998 with an effective date of August 1, 1998. The application of purchase accounting to this block of business, net of the administration rights sold, resulted in goodwill and other intangible assets of $807,000,000 and $464,000,000, respectively. Pursuant to the terms of the acquisition agreement LNC and CIGNA are in the final stages of agreeing to the value of these assets and liabilities. Any changes to these values that may occur in future periods will not be material to LNC's financial position. In connection with the completion of this acquisition, LNC recorded a charge to its Life Insurance and Annuities segment during the first quarter of 1998 of $20,000,000 ($31,000,000 pre-tax). This restructuring charge covered certain costs of integrating the existing operations with the new block of business.
On October 1, 1998, LNC acquired a block of individual life insurance from Aetna, Inc for $1,000,000,000. Funding used to complete this acquisition was primarily from public securities offered in 1998 (see note 5 on page 51). This transaction was accounted for using purchase accounting and, accordingly, the operating results generated by this block of business after the closing date are included in LNC's consolidated financial statements. At the time of closing this block of business had liabilities measured on a statutory basis, of $3,300,000,000 that became LNC's obligation. LNC also received assets, measured on a historical statutory basis, equal to the liabilities. In August of 1998, LNC announced that it had reached an agreement to sell the sponsored life business acquired as part of the Aetna block of business. This sale closed on October 14, 1998 with an effective date of October 1, 1998 at a sales price of $99,500,000. During 1997, after deducting the sponsored life income statement amounts, the Aetna block produced premiums and fees of $227,800,000 and earnings of $65,000,000 on a basis of generally accepted accounting principles (prior to adjustments required by purchase accounting). The initial application of purchase accounting to this block of business, net of the sponsored life business resulted in goodwill and other intangibles of $220,000,000 and $871,000,000, respectively. Additional analysis of this block of business may result in a change in the amounts or the shifting of amounts between goodwill and other intangible assets.
This proforma financial information is not necessarily indicative of the actual results that would have occurred had the purchases been made on January 1, 1997 or of the results which may occur in the future.
As noted above, LNC has been involved in a series of divestitures and acquisitions during the last few years. These changes, along with on-going and increasing competitive pressures within the business LNC operates in, led to a decision to initiate an organizational/expense review. This review, which centered around the size and make-up of the parent company, was completed in the fourth quarter of 1998. As a result, LNC recorded a restructuring charge of $14,300,000 ($22,000,000 pre-tax) in the fourth quarter of 1998 to provide severance for the personnel that were eliminated and to cover costs associated with the resulting excess office space and equipment.