This report, among other things, reviews the results of operations of LNC Consolidated, LNC’s four business segments and Other Operations; LNC’s consolidated investments; and consolidated financial condition including liquidity, cash flows and capital resources. Historical financial information is presented and analyzed. This report and other written or oral statements made by LNC or on LNC’s behalf may contain forward-looking statements. Where appropriate, factors that may affect future financial performance are identified and discussed. Certain statements made in this report are “forward-looking statements” within the meaning of the Securities Litigation Reform Act of 1995 (“SLRA”). A forward-looking statement is any statement that is not a historical fact and, without limitation, includes any statement that may predict, forecast, indicate or imply future results, performance or achievements, and may contain words like: “believe”, “anticipate”, “expect”, “estimate”, “project”, “will”, “shall” and other words or phrases with similar meaning. LNC claims the protection afforded by the safe harbor for forward-looking statements provided by the SLRA.
• the Company (e.g., acquisitions and divestitures of legal entities and blocks of business - directly or by means of reinsurance transactions);
• financial markets (e.g., interest rates and securities markets and stock and bond market performance);
• LNC’s ability to operate its businesses in a relatively normal manner;
• debt and claims-paying ratings issued by nationally recognized statistical rating organizations; and
• the risk that LNC could have to accelerate amortization of deferred policy acquisition costs if the market deteriorates;
• whether necessary regulatory approvals are obtained (e.g., insurance department, Hart-Scott-Rodino, etc.) and, if obtained, whether they are obtained on a timely basis;
include additional factors which could impact LNC’s business and financial performance. Moreover, LNC operates in a rapidly changing and competitive environment. New risk factors emerge from time to time and it is not possible for management to predict all such risk factors.
Further, it is not possible to assess the impact of all risk factors on LNC’s business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements. Given these risks and uncertainties, investors should not place undo reliance on forward-looking statements as a prediction of actual results. In addition, LNC disclaims any obligation to update any forward-looking statements to reflect events or circumstances that occur after the date of this report.
Other challenges that LNC anticipates include intensifying competitive pressures and growing uncertainty created by emerging legislative and regulatory responses to recent events in the financial services marketplace. In this fiercely competitive and highly uncertain financial marketplace, LNC intends to continue to distinguish itself by consistently delivering product excellence while maintaining pricing discipline and prudent risk management, by continuing to extend its distribution reach while keeping a sharp focus on effective cost management, and by continuing to expand the power of the Lincoln Financial Group brand.
As it executes on these key strategic drivers, LNC has its long-term focus on the emerging opportunity that will occur as the baby-boomer generation reaches retirement age. LNC intends to capitalize on that opportunity
Establishing adequate liabilities for LNC’s obligations to its policyholders requires assumptions to be made regarding mortality and morbidity. The effect of variances in these assumptions is discussed within the Lincoln
Retirement and Life Insurance segments. In addition, refer to the discussion of personal accident and disability income reserves included within the Acquisition and Divestiture discussion of the disposition of LNC’s former Reinsurance segment within Other Operations. As discussed within the Lincoln Retirement segment, one of the liabilities is the reserve for Guaranteed Minimum Death Benefits (“GMDB”). A key assumption affecting the accounting for GMDB is the performance of equity markets. Sensitivity to changes in equity market performance upon GMDB and LNC’s net income is discussed under the heading “First Quarter 2004 Guidance for the Effects of Equity Market Volatility”. The accounting for GMDB reserves will change in 2004, as a result of new guidance affecting guaranteed benefits. See the topic “New Accounting Pronouncements” and the disclosure under the heading “Statement of Accounting Position 03-1.”
Pursuant to the accounting rules for LNC’s obligations to employees under its various retirement and welfare benefit plans, LNC is required to make a large number of assumptions, such as the future performance of financial markets and the composition of LNC’s employee workforce in the future. LNC’s accounting for its employee plans is discussed in detail within Note 6 Employee Benefit Plans, which is included in the notes to consolidated financial statements.
As LNC responds to an ever-changing business environment and continues to adapt its organizational and operational structures, the frequency of necessary restructuring activities increases. Establishing reserves for the expected costs of these restructurings requires a variety of estimates and assumptions. The accounting for LNC’s restructurings is set forth within Results of Consolidated Operations and within Results of Operations for each affected business segment, as well as within Note 12 Restructuring Charges included in the notes to consolidated financial statements.
Continued access to capital markets and maintenance of favorable debt and insurance financial strength ratings are critical to LNC’s future success. LNC’s liquidity, in a wide variety of areas, is inherently dependant upon continued access to capital and maintaining adequate ratings. Detailed discussion of LNC’s access to capital markets, liquidity status and ratings are contained within Review of Consolidated Financial Condition.
Finally, it is LNC’s policy to provide disclosure of commitments or guarantees so that its financial statements present as complete a picture of LNC’s financial condition as possible. The vast majority of these commitments or guarantees relate to LNC’s life insurance and retirement businesses and, as such, are reflected on LNC’s balance sheet. Any off-balance sheet commitments or guarantees that LNC is subject to are disclosed within Review of Consolidated Financial Condition and Note 7 Restrictions, Commitments and Contingencies which is included in the notes to consolidated financial statements.
On pages 19 through 58, the results of operations of LNC consolidated, LNC’s four business segments and Other Operations are presented and discussed. Pages 58 through 72 discuss LNC’s consolidated investments. Pages 72 through 80 discuss LNC’s consolidated financial condition including liquidity and cash flow, and capital resources. Pages 81 through 89 provide LNC’s quantitative and qualitative disclosures about market risk. Please note that all amounts stated in this “Management’s Discussion and Analysis” are on an after-tax basis except where specifically identified as pre-tax.
Net income for 2003 increased significantly from 2002. A key driver of 2003 results was the favorable performance of the equity markets. In 2003, the S&P 500 index increased 26.4%, compared to a decline of 23.4% in 2002. The increase in the equity markets positively affected net income through increased fee revenue, favorable changes on the amortization of deferred acquisition costs and lower costs associated with reserves and benefits for guaranteed minimum death benefits. The impact of the equity markets is discussed in more detail within the discussion of results of operations by business segment.
LNC’s losses from credit markets as reflected in the realized loss on investments and derivatives were $163.8 million lower in 2003 compared to 2002. This improvement was reflective of the improvements in the credit markets as LNC did not experience the same level of effect from declines in value and write-downs of fixed maturity securities available-for-sale. Additional details on LNC’s investment performance are provided in the Consolidated Investment section on page 58.
In 2002, LNC reported losses of $199.1 million related to reserve increases on the business sold through indemnity reinsurance to Swiss Re. In 2003, LNC recorded additional charges on this business, but significantly less than in 2002. The accounting for these charges and the effect on LNC’s results in the future is more fully described in the Acquisition and Divestiture section.
The increase in consolidated revenues includes the $371.5 million reclassification of trading account securities and the significant reduction in realized losses on investments and derivative securities. Excluding these items, consolidated revenues were slightly higher than 2002. This largely reflects the timing of equity market effects on average account values and assets under management, which declined during 2002 and through the first half of 2003, and did not recover to previous levels until the end of the fourth quarter of 2003. Net investment income was level with 2002 as declining investment yields substantially offset growth in investment securities.
Consolidated expenses (exclusive of restructuring charges, reserve increases on business sold through reinsurance and federal income taxes) decreased from 2002. The favorable effects of equity markets on DAC and PVIF amortization and unlocking, and on the level of GMDB reserves were primarily responsible for this improvement. Spread management through lower crediting rates on interest-sensitive and contractholder deposit funds also contributed to the improvement. The increase in restructuring charges in 2003 was a result of expense initiatives undertaken by LNC during the year to improve operational efficiencies. Additional details on this activity are provided in the restructuring charge section on page 28.
Consolidated revenue decreased primarily due to the reduction of revenue of $1,699.4 million (pre-tax), excluding realized losses on investments, from the disposition of the Reinsurance segment in 2001. Another contributor to the decline in revenue was the increase in realized losses on investments noted above. Included in 2002 revenue was a full year of the amortization of the deferred gain on indemnity reinsurance compared to amortization for one month in 2001. The Lincoln Retirement and Lincoln UK segments experienced decreased fee income due to the negative impact that 2001 and 2002 equity market declines had on average variable annuity (Retirement) and unit-linked (Lincoln UK) account values. The Investment Management segment had decreased investment advisory fees and other revenue and fees as a result of lower retail and institutional assets under management during 2002. The decrease in assets under management resulted primarily from declining equity markets.
Consolidated expenses (excluding goodwill amortization, restructuring charges, reserve increases on business sold through reinsurance and federal income taxes) decreased largely due to the sale of LNC’s reinsurance business to Swiss Re in the fourth quarter of 2001. Expenses for the operations of the former Reinsurance segment, excluding goodwill amortization were $1,503.7 million in 2001. Expenses were negatively affected by the decline in the equity markets, which resulted in negative unlocking of DAC and PVIF in the Lincoln Retirement, Life Insurance and Lincoln UK business segments, increased reserves and payments for GMDB in the Lincoln Retirement segment.
For 2002, LNC reported a tax benefit of $102.7 million on a pre-tax loss of $53.8 million. This unusual relationship between tax and pre-tax earnings results from the fact that LNC has tax-preferred investment income that does not change proportionately with the change in consolidated pre-tax earnings. LNC’s tax-preferred investment income is primarily the result of dividend received deductions attributable to LNC’s allocable share of dividend income generated by equity securities held within the Retirement segments’ separate accounts. See note 4, Federal Income Taxes, to the consolidated financial statements for more details.
Key measures of LNC’s success are its deposits, net flows and assets under management as presented in the table below. Deposits are the result of sales of LNC’s products and represent the money put into LNC’s products each year. Net flows represent the deposits net of withdrawals, payments on death and surrenders. Assets under management include LNC’s investment securities as well as those assets belonging to third parties but managed by LNC’s businesses.
(1) For additional detail of deposit and net flow information see the discussion of the Results of Operations by Segment starting on page 31.
FIRST QUARTER 2004 GUIDANCE FOR THE ESTIMATED EFFECT OF EQUITY MARKET VOLATILITY
During 2003, LNC provided guidance on the estimated effect of equity market volatility on its quarterly results. As discussed below, LNC will adopt the GMDB reserving provisions of Statement of Accounting Position 03-1 “Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and For Separate Accounts” (“the SOP”) effective January 1, 2004. LNC does not expect the initial adoption of these rules to materially change the aggregate level of GMDB reserves that existed at December 31, 2003. However, it is probable that changes in future equity markets will have different effects on LNC’s GMDB reserves under the rules of the SOP than was the case under LNC’s prior approach to GMDB reserving. In
addition, LNC is now hedging some of its GMDB exposure. LNC’s current GMDB hedging program is intended to reduce the effect on GAAP earnings of increases in GMDB reserves that is created by drops in the equity markets. LNC is continuing to evaluate how the new rules of the SOP, combined with the GMDB hedging program, will affect future GMDB reserve fluctuations due to changes in equity markets. In addition, LNC is studying the inter-relationship between the fluctuations in DAC amortization and the fluctuations in GMDB reserves. Once LNC has completed these analyses, LNC intends to provide guidance regarding the effects that changes in equity market performance can be expected to have on LNC’s earnings.
In January 2003, the Financial Accounting Standards Board (“FASB”) issued initial guidance under Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”), which requires the consolidation of variable interest entities (“VIE”) by an enterprise if that enterprise has a variable interest that will absorb a majority of the VIE’s expected losses if they occur, receive a majority of the entity’s expected residual returns if they occur, or both. If one enterprise will absorb a majority of a VIE’s expected losses and another enterprise will receive a majority of that VIE’s expected residual returns, the enterprise absorbing a majority of the losses shall consolidate the VIE. A VIE is an entity in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. In response to concerns raised by LNC and others in the Insurance and Investment industries with respect to the initial guidance, the FASB significantly modified several key aspects of the rules in a revised interpretation issued in December 2003. LNC adopted the final FIN 46 rules on December 31, 2003.
Prior to the issuance of the revised guidance, FIN 46 would have required LNC to include the gross amount of all fees earned by LNC for managing Collateralized Debt Obligation (“CDO”) pools in the analysis of expected residual returns. As discussed in LNC’s third quarter form 10-Q filing, under the initial requirements of FIN 46, LNC may have been required to bring onto the consolidated balance sheet approximately $1.2 billion of invested assets underlying the CDOs and approximately $1.5 billion of liabilities owed by the CDO issuer to third party investors. Because of changes made by FASB to the initial interpretation in December of 2003, these amounts were not reflected on LNC’s balance sheet when LNC adopted FIN 46 on December 31, 2003. As explained below, under the revised guidance LNC is not treated as the primary beneficiary of these CDOs and will not consolidate the CDO assets or liabilities.
During the fourth quarter of 2003, LNC implemented the FASB’s Derivative Implementation Group Statement 133 Implementation Issue No. B36 (“DIG B36”). DIG B36 provides that the embedded derivatives included within modified coinsurance agreements (“Modco”) and coinsurance with funds withheld (“CFW”) reinsurance agreements must be accounted for separately from the underlying reinsurance agreements.
1A. At the time of adoption, LNC recorded a charge to net income as a cumulative effect of a change in accounting, representing the fair value of the embedded derivatives included in various Modco and CFW reinsurance agreements.
During the fourth quarter and going forward, changes in the fair value of the embedded derivative flow through net income, as do changes in the fair value of the trading account securities, as represented by adjustments 3A and 3B in the table below. For the quarter ended December 31, 2003, the effect of the two new mark-to-market adjustments on net income was $4.2 million pre-tax ($2.7 million after-tax). The table combines the trading account and embedded derivative mark-to-mark accounting with the implementation effects discussed above to demonstrate the effects on the income statement for the quarter ended December 31, 2003 (in millions).
In July 2003, the Accounting Standards Executive Committee (“AcSEC”) of the American Institute of Certified Public Accountants issued Statement of Position 03-1, “Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts” (“the SOP”). LNC will adopt the SOP as of January 1, 2004.
GMDB Reserves. Although there was no method prescribed under generally accepted accounting principles for GMDB reserving until the issuance of the SOP, LNC’s Retirement segment has been recording a reserve for GMDBs. At December 31, 2003, LNC’s GMDB reserve was $46.4 million. Based upon a comparison of the requirements of the SOP to LNC’s established practice of reserving for GMDB, the adoption of the GMDB reserving methodology under the SOP is not expected to have a material effect on LNC’s financial statements.
Sales Inducements. LNC’s Retirement segment variable annuity product offerings include contracts that offer a bonus credit, typically ranging from 2% to 5% of each deposit. LNC also offers enhanced interest rates to variable annuity contracts that are under dollar cost averaging (DCA) funding arrangements. Bonus credits and
Separate Accounts. LNC’s current accounting is consistent with the provisions of the SOP relating to the reporting and measuring of separate account product assets and liabilities as general account assets and liabilities when specific criteria are not met, as well as for the reporting and measuring seed money in separate accounts as general account assets, and for recognizing contractholder liabilities. The adoption of these provisions of the SOP are expected to have no effect on LNC’s financial statements.
FASB Financial Staff Position No. FAS - 106-1 Medicare Prescription Drug Improvement and Modernization Act of 2003.
In August 2001, the FASB issued Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“FAS 144”), which supersedes Statement of Financial Accounting Standards No. 121, and the accounting and reporting provisions of APB Opinion No. 30. FAS 144 was effective for fiscal years beginning after December 15, 2001. LNC adopted FAS 144 on January 1, 2002 and the adoption of the Statement did not have a material impact on the consolidated financial position and results of operations of LNC.
Two of the three different restructuring plans implemented by LNC during 1999 were not completed as of December 31, 2000. The two outstanding plans were those relating to the discontinuance of HMO excess-of-loss
During 2000, LNC implemented restructuring plans relating to 1) the downsizing and consolidation of the operations of Vantage Global Advisors, Inc. (“Vantage”); 2) the exit of all direct sales and sales support operations of Lincoln UK and the consolidation of its Uxbridge home office with its Barnwood home office, and 3) the downsizing and consolidation of the investment management operations of Lincoln Investment Management. All expenditures and write-offs for the Lincoln Investment Management restructuring plan were completed in the third quarter of 2002 and $0.4 million of the original reserve was released. The release of the reserve was primarily due to LNC’s purchase and ultimate sale of the vacant office space on terms, which were favorable to what was included in the original restructuring plan for rent on this office space. As of December 31, 2003, the remaining balance is for the Lincoln UK plan and is expected to be utilized in the completion of the plan.
On October 29, 2002, LNC and Swiss Re settled disputed matters totaling about $770 million that had arisen in connection with the final closing balance sheets associated with Swiss Re’s acquisition of LNC’s reinsurance operations. The settlement provided for a payment by LNC of $195 million to Swiss Re, which was recorded by LNC as a reduction in deferred gain. As a result of additional information made available to LNC following the settlement with Swiss Re in the fourth quarter of 2002, LNC recorded a further reduction in the deferred gain of $51.6 million after-tax ($79.4 million pre-tax), as well as a $9.4 million after-tax ($8.3 million pre-tax) reduction in the gain on the sale of subsidiaries.
As part of the dispute settlement, LNC also paid $100 million to Swiss Re in satisfaction of LNC’s $100 million indemnification obligation with respect to personal accident business. As a result of this payment, LNC has no further underwriting risk with respect to the reinsurance business sold. However, because LNC has not been relieved of it legal liabilities to the underlying ceding companies with respect to the portion of the business indemnity reinsured by Swiss Re, under FAS 113 the reserves for the underlying reinsurance contracts as well as
The combined effects of the 2002 settlement of disputed matters and exited business reserve increases reduced the $723.1 million after-tax ($1.1 billion pre-tax) deferred gain reported at closing by $44.9 million after-tax ($69 million pre-tax). During 2002, LNC amortized $47 million after-tax ($72.3 million pre-tax) of deferred gain. This includes the amortization of deferred gain from the sale of the direct disability income business in 1999. An additional $1.3 million after-tax ($2 million pre-tax) of deferred gain was recognized due to a novation of certain Canadian business during 2002.
Through December 31, 2003, of the original $2.0 billion in proceeds received by LNC, approximately $560 million was paid for taxes and deal expenses and approximately $1.0 billion was used to repurchase stock, reduce debt, and support holding company cash flow needs. LNC also paid $195 million to Swiss Re to settle the closing balance sheet disputed matters and $100 million to satisfy LNC’s personal accident business indemnification obligations. The remaining proceeds have been dedicated to the ongoing capital needs of The Lincoln National Life Insurance Company.
The Lincoln Retirement segment, with principal operations in Fort Wayne, Indiana and Hartford, Connecticut, and additional operations in Portland, Maine, and Arlington Heights, Illinois, provides tax-deferred investment growth and lifetime income opportunities for its clients through the manufacture and sale of fixed and variable annuities. Through a broad-based distribution network, Lincoln Retirement provides an array of annuity products to individuals and employer-sponsored groups in all 50 states of the United States. Lincoln Retirement distributes its products through LNC’s wholesaling unit, LFD, as well as LNC’s retail unit, LFA.
Statement of Financial Accounting Standard No. 97, “Accounting by Insurance Companies for Certain Long-Duration Contracts & Realized Gains & Losses on Investment Sales” (“FAS 97”) requires that acquisition costs for variable annuity contracts be amortized over the lives of the contracts in relation to the incidence of estimated gross profits. Estimated gross profits on variable annuity contracts vary based on surrenders, fee income, expenses and realized gains/losses on investments. The amortization is adjusted retrospectively (DAC
LNC currently offers minimum guarantee features with certain variable annuity products, which include various types of guaranteed minimum death benefit features (“GMDB”) and a recently introduced guaranteed minimum withdrawal benefit (“GMWB”). The GMWB feature was introduced during 2003. In light of the favorable performance of the equity markets since the introduction of the GMWB feature, LNC held no reserves for GMWB liabilities as of December 31, 2003. Further discussion of the current structure of LNC’s GMWB feature, as well as related hedging activities, is presented after the following discussion of the various types of GMDB features that LNC offers.
The reserves for the GMDB are a function of the net amount at risk (“NAR”), mortality, persistency, and incremental death benefit M&E expected to be incurred over the period of time for which the NAR is positive. At any given point in time, the NAR is the difference between the potential death benefit payable and the total account balance, with a floor value of zero (when account values exceed the potential death benefit there is no amount at risk). As part of the estimate of future NAR, equity market growth rates with a reversion to the mean assumption are utilized, which are consistent with those used in the DAC valuation process. If a flat 9% equity market growth rate had been used instead of the reversion to the mean rate, the December 31, 2003 GMDB balance would have been $15.0 million lower on a pre-tax basis and net income would have been $9.8 million higher on an after-tax basis. This compares to the fourth quarter 2002 change to the reversion to the mean assumption, which resulted in an increase to GMDB reserves and reduced net income by $21.5 million. At each valuation date, projections of account values and NAR followed by the computation of the present value of expected NAR death claims using product pricing mortality assumptions less expected GMDB M&E revenue during the period for which the death benefit options are assumed to be in the money are made for every variable
annuity contract with a GMDB benefit feature. If equity market returns exactly match LNC’s reversion to the mean rate and actual mortality and lapse experience is as assumed, the GAAP reserve plus interest and GMDB M&E revenue would exactly cover the future expected GMDB payments as they arise.
A decline in the equity markets results in increased GMDB reserves and benefit payments which negatively effects Lincoln Retirement’s income, while an increase in the equity markets results in a decrease in GMDB reserves and benefit payments which favorably effects Lincoln Retirement’s income. Although there was no method prescribed under generally accepted accounting principles for GMDB reserving until the issuance of the SOP, which LNC will adopt effective January 1, 2004, LNC has used a method that recognizes that there is an amount at risk that will result in future payments and that over time the equity market growth will reduce the payment stream. This approach results in a reserve that is expected to cover future GMDB payments, net of future GMDB fee income. Due to strong equity market performance, at December 31, 2003, LNC’s GMDB NAR was $1.5 billion and the GAAP reserve was $46.4 million. This is a significant decrease from the $4.6 billion in NAR and GAAP reserve of $84.5 million at December 31, 2002. The reserve for statutory reporting was $58.9 million at December 31, 2003 compared to $144.1 million at December 31, 2002, reflecting the more conservative market performance and mortality assumptions that are required to be used under statutory reporting.
LNC has variable annuity contracts containing GMDB’s that have a dollar for dollar withdrawal feature. Under such a feature, withdrawals reduce both current account value and the GMDB amount on a dollar for dollar basis. For contracts containing this dollar for dollar feature, the account holder could withdraw a substantial portion of their account value resulting in a GMDB that is multiples of the current account value. LNC’s exposure to this dollar for dollar risk is somewhat mitigated by the fact that LNC does not allow for partial 1035 exchanges on non-qualified contracts. To take advantage of the dollar for dollar feature, the contract holder must take constructive receipt of the withdrawal and pay any applicable surrender charges. LNC will report the appropriate amount of the withdrawal that is taxable to the IRS, as well as indicating whether or not tax penalties apply under the premature distribution tax rules. LNC closely monitors its dollar for dollar withdrawal GMDB exposure and works with key broker dealers that distribute LNC’s variable annuity products. As of December 31, 2003, there were 589 contracts for which the death benefit to account value ratio was greater than ten to one. The NAR on these contracts was $43.9 million. Effective May 2003, the GMDB feature offered on new sales is a pro-rata GMDB feature whereby each dollar of withdrawal reduces the GMDB benefit in proportion to the current GMDB to account value ratio.
During 2003, the Lincoln Retirement segment developed a hedging strategy designed to mitigate the income statement volatility caused by falling equity markets associated with the introduction of the Principal Securitysm Guaranteed Minimum Withdrawal Benefit and LNC’s various GMDB features. (See the discussion below under the heading “Net Deposits” for details of LNC’s Principal Securitysm Guaranteed Minimum Withdrawal Benefit.) At December 31, 2003, there was no hedge in place for the GMWB, as there was no required reserve for this feature due to the favorable performance of the equity markets since the feature was introduced. LNC’s GMDB hedging program is designed to mitigate the equity market volatility associated with the GAAP reserves for this benefit. At December 31, 2003 account balances covered in this hedging program combined with account balances for which there is no death benefit represent approximately 45% of total variable annuity account balances. LNC expects to continue expanding the coverage of its GMDB hedging program on an opportunistic basis, as the underlying account values increase due to equity market appreciation. This hedging program reflects the benefit designs of the segment’s products and has been effective to date. LNC continues to evaluate various hedging tools and opportunities as it considers additional benefits, product features, and alternative hedging strategies.
As discussed earlier, LNC will adopt the GMDB reserving provisions of the SOP effective January 1, 2004. Although LNC does not expect the initial adoption of these rules to materially change the aggregate level of GMDB reserves that existed at December 31, 2003, it is probable that changes in future equity markets will have different effects on LNC’s GMDB reserves under the rules of the SOP than was the case under LNC’s prior approach to GMDB reserving. In addition, LNC is now hedging some of its GMDB exposure. LNC’s current GMDB hedging program is intended to reduce the magnitude of increases in GMDB reserves that is created by drops in the equity markets. LNC is continuing to evaluate how the new rules of the SOP, combined with the GMDB hedging program, will effect future GMDB reserve fluctuations due to changes in equity markets. In addition, LNC is studying the inter-relationship between the fluctuations in DAC amortization and the fluctuations in GMDB reserves. Once LNC has completed these analyzes, LNC intends to provide guidance regarding the effects that changes in equity market performance can be expected to have on LNC’s earnings.
The Retirement segment utilizes reinsurance in the management of the fixed annuity business. The reinsurance arrangements are on a modified coinsurance basis, which results in LNC retaining the assets supporting the business and sharing in the risks associated with the fixed annuity business with the reinsurer. At December 31, 2003, the amount of business reinsured represents approximately 20% of the gross fixed annuity account values exclusive of the fixed portion of variable annuity contracts. During 2003, LNC received notice of
(1) Cumulative Effect of Accounting Changes for 2003 results from the recording in the fourth quarter of 2003 the embedded derivative for Modco reinsurance arrangements resulting from implementation of DIG B36. The 2001 changes relate to the transition adjustment of $(3.6) million recorded in the first quarter of 2001 upon adoption of FAS 133 and the adjustment of $(3.7) million recorded in the second quarter of 2001 upon adoption of EITF 99-20. (Refer to New Accounting Pronouncements section for further discussion of these items.)
* Excludes the effects of equity markets on realized gains (losses) on investments and derivative investments, market adjustment for trading securities, and reinsurance embedded derivatives/trading securities and cumulative effect adjustment.
The restructuring charges for 2003 were incurred in connection with the combining of the Lincoln Retirement and Life Insurance operations and the consolidation of fixed annuity operations formerly located in Schaumburg, Illinois into Fort Wayne, Indiana. For further details on these restructuring charges, refer to the restructuring charge section on page 28.
below the levels reported in the comparable 2002 quarters. This explains why, despite the strong overall equity market performance experienced for the year, fee revenue for 2003 lagged behind revenues reported for 2002.
However, because equity market performance in 2003 exceeded the expected market performance used in LNC’s DAC assumptions, favorable retrospective unlocking and net changes in amortization for DAC and PVIF were reported for 2003. Equity market performance also drove decreases in GMDB reserves and benefit payments resulting in favorable effects on net income. In addition, the annual review of the various assumptions underlying DAC, PVIF, and GMDB calculations resulting in prospective unlocking which increased net income by $1.5 million in 2003. This compared to a large negative impact from prospective unlocking in 2002.
Decreased earnings from investment partnerships resulted in a negative variance of $21.7 million compared to 2001. Partially offsetting the negative variances were $17.6 million from higher investment margins. Overall investment spreads on fixed annuity products (excluding the impact of the policy loan interest adjustment and investment income earned on invested capital supporting the segment which includes investment partnerships) were relatively flat between years: 2.04% in 2002, excluding an adjustment to interest on policy loans, versus 2001.
Average fixed annuity account values increased significantly in 2002 increasing net income. The increase in fixed annuity account values was due to the positive net cash flows for fixed annuities, reflecting strong sales of the StepFive®, Lincoln Select and Lincoln ChoicePlusSM Fixed annuity products in 2002.
Lincoln Retirement’s product deposits, withdrawals and net flows were as follows:
LNC’s sales in 2003 of individual variable annuities were driven by the introduction of the Principal Securitysm benefit in June of 2003. Lincoln ChoicePlussm variable annuity gross deposits were up 13% and American Legacy variable annuity gross deposits were up nearly 3% compared to 2002 as a result of guaranteed minimum withdrawal benefit (GMWB) feature of the Principal Securitysm benefit. This benefit offers the contractholder a guarantee equal to the initial purchase payment (or contract value, if elected after issue), adjusted for any subsequent purchase payments or withdrawals. To receive the full amount of the guarantee, annual withdrawals are limited to 7% of the guaranteed amount. Withdrawals in excess of the 7% maximum in any contract year are assessed any applicable surrender charges, and the guaranteed amount is recalculated. The annual charge for this benefit is 0.45% of the guaranteed amount (less withdrawals), assessed on a quarterly basis. The charge is waived five years after the start or resetting of the guarantee amount, as long as the cumulative payments since election or reset are less than 10% of the current guarantee amount. The benefit may also be cancelled at any time five years after election or reset. If cancelled, the benefit may be reelected after one year, if available. As of December 31, 2003, less than 10% of deposits that elected this feature have elected automatic withdrawal benefits at the 7% level. Principal Securitysm is available on new and existing variable annuity contracts in nearly all states for most LNC individual variable annuity products.
The decrease in individual fixed product sales is the result of declining interest rates and competitive pressures in 2003. With the decline in interest rates over the last few years, it has been more difficult to offer rates that were competitive in the marketplace and still allow LNC to achieve targeted spreads on the fixed annuity products. LNC’s approach in 2003 and into 2004 is to approach the fixed annuity marketplace on an opportunistic basis where LNC intends to only offer products with rates that are consistent with LNC’s required spreads. During 2001 and 2002, the poor performance of the equity markets, resulted in an increase in sales of fixed annuity products. LNC’s fixed annuity sales in 2001 through 2002 were bolstered by product offerings that were introduced in 2001 including the Lincoln Select Fixed Annuity and the StepFive® Fixed Annuity. The guarantees of the StepFive Fixed Annuity made it an important product for LNC in the Financial Institutions channel. New product offerings launched in 2002 in the Financial Institutions channel included AccelaRate and ChoiceGuarantee.
In 2003, LNC experienced an increase in deposits in the employer-sponsored business as a result of increased deposits in variable and fixed products within the Alliance program. The Alliance program enables the Retirement segment to sell a multi-manager mutual fund based product within the employer-sponsored marketplace. Deposits of the Alliance program were $969 million in 2003, an increase of 77% from deposits of $547 million in 2002. A significant portion of the deposits, $337 million, came in the first quarter of 2003 from a large number of enrollments from employer-sponsored plans.
One of the key assumptions in pricing a product is the account persistency, often referred to as the lapse rate. The lapse rate compares the amount of withdrawals to the retained account values. One way to measure a company’s success in retaining assets is to look at the overall level of withdrawals from period to period. However, this alone does not tell the whole story. By comparing actual lapse rates to the rates assumed in designing the annuity product, it is possible to gauge the impact of persistency on profitability. Overall lapse rates were 9.01% in 2003, 10.47% in 2002 and 9.72% in 2001. In all three years, overall lapse rates have been more favorable than the level of persistency assumed in product pricing. In addition, as described above, LNC experienced an increase in deposits within the Alliance program offered within the employer-sponsored marketplace. The persistency of the employer-sponsored business tends to be higher than in the individual annuity marketplace as employer-sponsored products involve systematic deposits and are part of an overall employee benefit plan which are generally not subject to the level of exchange activity typically experienced in the individual marketplace.
President Bush’s tax legislation has not provided a pass through of reduced rates on qualified dividends or long-term capital gains for non-qualified annuities, as is the case for other financial services products, such as mutual funds. The long-term impact of this for the annuity industry is unknown. However, LNC expects that the income guarantee provided within an annuity will continue to be viewed as a significant benefit. The guaranteed living and death benefits offered within annuity products are not found in any other investment vehicle. Because of the equity market volatility over the last few years, in LNC’s experience, the demand for these benefits appears to have outweighed any potential detrimental impact of tax law changes. LNC believes that the guarantees within an annuity should continue to drive annuity sales. In addition, LNC continues to support tax legislation that recognizes and rewards the long-term nature of annuity investments and the unique benefit payout alternatives that are only available from annuity products.
Economic and market conditions, and the level of interest rates have been volatile over the past several years. This volatility and uncertainty in the marketplace has impacted fixed and variable annuity sales for both the industry and Lincoln Retirement. Customer behavior has been influenced by these factors as well as by the introduction of new products and product features, including the very popular living benefits products.
The Life Insurance segment, with principal operations in Hartford, Connecticut, and Fort Wayne, Indiana, with additional operations in Schaumburg, Illinois, creates and protects wealth for its clients through the manufacture and sale of life insurance products throughout the United States. The Life Insurance segment offers universal life (“UL”), variable universal life (“VUL”), interest-sensitive whole life (“ISWL”), term life (“Term”) and corporate-owned life insurance (“COLI”). A majority of the Life Insurance segment’s products are distributed through LFD and LFA.
The Life Insurance segment offers a broad portfolio of life insurance products. In addition to Term, the segment offers three distinct permanent insurance product types: Universal Life, Variable Universal Life and Interest Sensitive Whole Life. Within these product types are wealth accumulation and wealth transfer specific products, including single life and survivorship versions of all three. Insurance riders such as return of premium, lapse protection, and long-term care benefit provisions are available with certain products. The long-term care benefit is available in the UL MoneyGuard product. In addition, the segment offers both UL and VUL versions of COLI. This allows the segment to effectively align its portfolio of products with the primary affluent market segments and to also provide products that perform under a variety of market conditions.
FAS 97 requires that acquisition costs for UL policies and VUL policies be amortized over the lives of the contracts in relation to the incidence of estimated gross profits, consistent with the treatment noted previously for variable annuities. Factors affecting estimated gross profits are mortality (net of reinsurance ceded), investment margins and expense margins. For the Life Insurance segment, based on the current mix of life insurance in-force on the books, the factors that have the most significant impact on estimated gross profits are mortality experience (net of reinsurance), premium and policy persistency, and interest margins. Each of these sources of profit is, in turn, driven by other factors. For example assets under management and the spread between earned and credited rates drive investment margins; net amount at risk drives the level of Cost of Insurance charges and reinsurance premiums. Market movement, which has the greatest impact on DAC amortization for the Retirement segment relative to its variable annuity block of business, has less impact on DAC amortization for the Life Insurance segment.
Mortality experience (mortality assessments less net death benefits and mortality-related retrospective DAC unlocking) in 2003 was favorable relative to 2002. The improvement in mortality resulted from lower death benefits and favorable unlocking relative to 2002. Volatility is expected from mortality risk, but LNC attempts to lessen the impact of volatility on earnings by reinsuring approximately 90% of the mortality risk on new business written by the Life Insurance segment.
The decrease in net income was due to a number of factors and excluding the amortization of goodwill in 2001, was $46.9 million or 19% lower in 2002 than in 2001. The primary variances are displayed in the net income variance table above. Mortality experience in 2002 was less favorable relative to 2001. Investment yields declined at a faster pace than reductions in crediting rates, which reduced the interest rate margin on interest sensitive products by 24 basis points and the investment yield on traditional products by seven basis points resulting in a reduction to income of $10.5 million. In addition, earnings from investment partnerships were lower in 2002 than 2001 and resulted in a negative variance of $6.7 million.
Total sales as measured by first year premiums increased from 2002. The sales growth for UL was driven by sales of MoneyGuard, a UL product with a long-term care rider, and strong growth in other fixed UL products. Despite the equity market turnaround, sales of VUL continued to decline in 2003. The dollar decline in VUL sales has been more than offset by the dollar increase in UL sales. UL accounted for 89% of total retail UL/VUL sales in 2003 versus 79% of those sales in 2002.
Growth in account values reflects positive net flows, net of fees assessed to the policyholders of approximately $300 million, interest earned on UL and interest sensitive whole life and the effect of a strong equity market recovery on VUL account values. The increase in net flows was driven by the sales of UL products.
Permanent repeal of the estate tax after 2010 continues to be debated by the federal legislature. The outlook for permanent repeal remains highly uncertain. To date, LNC has not experienced any significant change in life insurance sales as a result of the changes in estate tax laws enacted in 2001. Total survivorship sales as a percent of overall sales were flat at 22% of total retail first year premiums in 2002 and 2003. LNC’s life insurance products are designed to support a wide variety of financial planning needs such as business succession, charitable giving and fringe benefit planning, not just management of estate tax exposure.
The Application of the Valuation of Life Insurance Policies Model Regulation (“AXXX”) was developed to clarify statutory reserve requirements for particular policy designs under the NAIC Valuation of Life Insurance
LNL is actively exploring strategies to lesson the burden of increased AXXX reserves. Strategies include both reinsurance and capital markets solutions that provide for risk transfer and associated reserve and surplus relief. (See Contractual Obligations and Off-Balance Sheet Arrangements Part II page 77.)
LNC expects 2004 will be another challenging year for the Life Insurance Segment. On the positive side, the improvement in the equity and credit markets seen in 2003 should bode well for sales to the affluent market (an area of focus for LNC) as well as the degree to which policyholders seek reductions in coverage. However, current new money rates are approximately 150 basis points below existing portfolio yields. As a result, the segment may need to take further action to lower crediting rates to reduce the impact on interest rate margins. As stated earlier, with approximately 25% of fixed account values for interest-sensitive lines of business already at their minimum guaranteed interest rate, LNC’s ability to lower crediting rates is somewhat limited.
There was substantial pricing pressure in 2003, particularly with respect to products with secondary guarantees. It is uncertain as to whether there will be a return to more rational pricing in the market in 2004. As discussed above, the segment uses reinsurance to manage the mortality risk. There was also pricing pressure in 2003 in the reinsurance market. While the segment has, for the most part, factored the higher reinsurance prices into product pricing, all indications are that the reinsurance marketplace may continue to tighten. Further price increases to cover this would only add to existing competitive pressures.
During the first quarter of 2003, the Investment Management segment implemented a new system for calculating the amortization of DAC consistent with the system and methodology utilized by the Lincoln Retirement and Life Insurance segments. The DAC is related to the annuity based 401(k) Director product. The segment’s DAC asset was $91.8 million as of December 31, 2003.
The Investment Management segment has a deferred dealer commission asset of approximately $39.3 million as of December 31, 2003 relating to upfront sales commissions paid to brokers for the sale of “Class B” shares of Delaware retail mutual funds. The asset is amortized over the estimated period of time that it is expected to be realized or recovered from future cash flows in the form of asset-based distribution (“12b-1”) fees from the mutual funds or contingent deferred sales charges (“CDSCs”) from shareholders who redeem shares during the CDSC period. The estimate of future cash flows from these sources was positively impacted by the equity markets’ improvement in 2003.
In accordance with SFAS 144 “Accounting for the Impairment or Disposal of Long-Lived Assets”, should the estimated undiscounted future cash flows from 12b-1 fees and CDSC’s drop below the carrying value of the deferred dealer commission asset, then an impairment write-down would be required to be recognized. In that event, the amount of the impairment write down would be computed by comparing the carrying value of the deferred dealer commission asset to the discounted value of the future 12b-1 and CDSC cash flows. As of December 31, 2003, the estimated undiscounted future 12b-1 and CDSC cash flows exceeded the carrying value of the deferred dealer commission asset. LNC monitors the Net Asset Values (“NAVs”) of the underlying retail mutual funds to determine if a write-down of the deferred dealer commission asset would be required. LNC is also monitoring potential regulatory changes concerning 12b-1 fees, and possible effects on the recoverability of the deferred dealer commission asset.
Within the segment there are two items, in addition to the fees from assets under management, which are affected by changes in the equity markets. These are two unrelated items that currently tend to move in opposite directions. First, the segment has invested capital, referred to as seed capital, for the start-up of products. These investments are accounted for in a method consistent with trading securities with changes in market value reported through net income. After the funds reach a certain threshold, the seed capital will be returned to LNC. The second item, moving in an opposite direction to the changes in value of the seed capital, are the changes in value of the deferred compensation liability for Delaware employees. Deferred compensation is further discussed within Note 6 Employee Benefit Plans in the notes to the consolidated financial statements.
1) Cumulative Effect of Accounting Change relates to 2001 adoption of EITF 99-20.
As discussed in the critical accounting policies section, the segment implemented a new system for calculating changes in DAC. Included in the impact from 2003 DAC unlocking is $2.6 million of positive unlocking from refinement of the methodology during 2003. As described in the equity markets section, the segment’s net income was positively impacted in 2003 by the equity markets through an increase in value of the seed capital, which was partially offset by increased expense on the deferred compensation liability.
Managing expenses is important to the success of the Investment Management segment. The increase in operating and administrative expenses in 2003 over 2002 was primarily related to incentive compensation and
expenses impacted by both net flows and markets. In 2002, the segment benefited from a release of accrued compensation of $4.2 million resulting from the resignation of the segment’s CEO. As part of LNC’s overall expense management initiatives the segment incurred restructuring charges in 2003. Additional details on this activity are provided in the “Restructuring Charges” section.
Excluding the effect of goodwill amortization in 2001, net income decreased approximately $8.6 million in 2002. The decrease in income was primarily a result of declines in the equity markets reducing retail and institutional assets under management and the resulting lower revenues earned on the assets under management. Positive net cash flows in 2002 partially offset the negative effect of the equity markets on assets under management and revenues. Additional positives were reduced operating and administrative expenses from cost containment efforts and the release of the former CEO’s accrued compensation.
Investment performance has shown strong improvement in Delaware’s retail business. According to the 2003 annual Barron’s/Lipper mutual fund family survey published in February 2004, Delaware finished in the middle of the group of companies for the ten-year ranking, close to the top-quartile for the five-year results and number 4 out of 75 fund families for the one-year rankings. Delaware’s ranking in 2002 was 20 out of 81.
In addition to overall fund family performance, Delaware closely monitors the relative performance of individual funds. Fund performance is compared to a benchmark group of peer funds having similar investment characteristics and objectives. In addition, performance in various key categories as independently evaluated by Lipper is also used by Delaware in measuring its fund’s performance. The following table summarizes the 2003 performance for the largest 25 retail funds in the Delaware Investments Family of Funds (the Delaware Investments Family of Funds does not include mutual funds managed by Delaware for certain LNC affiliates or other third parties).
The Lincoln UK segment is headquartered in Barnwood, Gloucester, England, and is licensed to do business throughout the United Kingdom (“UK”). The segment is primarily involved in managing a closed-block of business in the UK. The segment has not written any significant new business since 2000, except for accepting new deposits on the existing block of business as well as offering new products to existing policyholders. The segment is focused on retaining its existing customers and managing its expenses. The segment’s product portfolio principally consists of unit-linked life and pension products, which are similar to U.S. produced variable life and annuity products
Result of Operations: Lincoln UK’s financial results, account values, in-force and exchange rates were as follows:
The decline in the UK equity markets described in the critical accounting policies resulted in lower average unit-linked account values and lower fee revenue. The equity market decline also increased the amortization of DAC and PVIF assets and deferred revenue, DFEL.
In 2002, Lincoln UK sold its former Uxbridge home office and recognized a realized gain on the transaction of $5.5 million ($7.9 million pre-tax) which is included in realized gain on investments. Excluding this gain, Lincoln UK’s realized gains (losses) decreased $12.9 million from 2001. The impact of realized gains (losses) in both years was a result of sales relating to the realignment of the investment portfolio in order to better match invested assets with the liabilities they support.
During 2004, Lincoln UK will continue to focus on protecting and enhancing the value of its customer base, evaluating new income streams and delivering business excellence through quality people and business processes. The segment continues to maintain reserves established in 1997 and 1999 for misselling activities. Payments and expenses for these activities have generally been in line with the established reserves. During 2003, the regulatory authority in the UK confirmed that there is a time limit for policyholders to make claims which should further limit Lincoln UK’s exposure to this issue. The segment remains subject to volatility in the equity markets and changes in the foreign currency exchange rate between the U.S. dollar and the British pound sterling. Significant changes in either could cause net income to fluctuate period to period.
Activity that is not included in the major business segments is reported in Other Operations. Other Operations includes the operations of LFA and LFD and operations not directly related to the business segments, unallocated corporate items (i.e., corporate investment income, interest expense on corporate debt, unallocated overhead expenses, and the amortization of the gain on the sale of the reinsurance business).
Critical Accounting Policy - FAS 113 Reserve Development on Business Sold through Indemnity Reinsurance
(1) Cumulative Effect of Accounting Changes for 2003 results from the recording in the fourth quarter of 2003 the embedded derivative for Modco reinsurance arrangements resulting from implementation of DIG B36. The cumulative effect of accounting changes for 2001 relates to the transition adjustment of $(0.5) million recorded upon adoption of FAS No. 133 and the adjustment of $(2.2) million recorded upon adoption of EITF 99-20. (Refer to page 23 for further discussion of these items.)
The net loss for 2003 was lower than 2002 due primarily to smaller reserve adjustments for the personal accident and disability income business sold to Swiss Re. These adjustments are described in more detail within the Acquisition and Divestiture section. The net loss in 2003 also includes the effects of fourth quarter implementation of DIG B36, which required the recording of an embedded derivative of $295.7 million pre-tax related to modified coinsurance and coinsurance with funds withheld reinsurance arrangements included within
the reinsurance operation that LNC sold to Swiss Re. Investment securities supporting these arrangements were reclassified at the beginning of the fourth quarter from available-for-sale to trading, resulting in pre-tax income of $285.5 million.
Net income for 2001 included eleven months of income from the operations of the former Reinsurance segment. In 2002, LNC reported a gain on the sale of its investment (included in realized gains on investments) in an international marketing company associated with LNC’s former Reinsurance segment, which was partially offset by a true-up in 2002 of estimated taxes related to the gain on sale of reinsurance subsidiaries sold in 2001.
The net loss in 2001 in Other Corporate included a restructuring charge related to the consolidation of operations and the reduction of excess space in LNC’s Fort Wayne, Indiana operations resulting from LNC’s divestiture of its reinsurance operations.
LFA’s increased net loss for 2002 included the effects of changes in the value of LFA’s liability for deferred compensation and variable annuity contract. The combined effect was an increased loss of $6.7 million in 2002 compared to 2001. In addition, in 2002 the Fringe Benefit operation (“FBD”) was moved from LFA to the Retirement segment. In 2001, FBD had a loss of $2.2 million that was included in LFA’s results. Excluding the net effect of the deferred compensation liability, the annuity and FBD, LFA’s net loss for 2002 increased $6.7 million over 2001. One of the contributors to the increased loss was that LFA’s sales during the fourth quarter 2002 did not reflect the typical seasonal fourth quarter increase over the prior three quarters of the year as had been seen during the fourth quarter of the previous four years. This deviation from the prior trend in sales resulted in a decrease in revenues for 2002 relative to 2001.
The following table presents consolidated invested assets, net investment income and investment yield.
As of December 31, 2003 and December 31, 2002, $2.3 billion, or 7.0%, and $2.1 billion, or 6.6%, respectively, of all fixed maturity securities available-for-sale were invested in below investment grade securities (less than BBB). This represents 5.4% and 5.3% of the total investment portfolio at December 31, 2003 and December 31, 2002, respectively. When viewed on a cost basis, below investment grade securities held at December 31, 2003 and December 31, 2002 represented 7.3% and 8.4%, respectively, of fixed maturity securities.
Securities Available-for-Sale: Securities that are classified as “available-for-sale” make up 91% of LNC’s fixed maturity and equity securities portfolio. These securities are carried at fair value on LNC’s balance sheet. Because the general intent of the “available-for-sale” accounting rules is to reflect shareholders’ equity as if unrealized gains and losses were actually recognized, it is necessary for LNC to consider all related accounting adjustments that would occur upon such a hypothetical recognition of unrealized gains and losses. Such related balance sheet effects include adjustments to the balances of deferred acquisition costs, policyholder commitments and deferred income taxes. Adjustments to each of these balances are charged or credited directly to shareholders’ equity as part of LNC’s “available-for-sale” accounting. For instance, deferred acquisition costs are adjusted upon the recognition of unrealized gains or losses since the amortization of deferred acquisition costs is
Mortgaged-Backed Securities: LNC’s fixed maturity securities include mortgage-backed securities. The mortgage-backed securities included in LNC’s investment portfolio are subject to risks associated with variable prepayments. This may result in these securities having a different actual cash flow and maturity than expected at the time of purchase. Securities that have an amortized cost greater than par and are backed by mortgages that prepay faster than expected will incur a reduction in yield or a loss. Those securities with an amortized cost lower than par that prepay faster than expected will generate an increase in yield or a gain. In addition, LNC may incur reinvestment risks if market yields are lower than the book yields earned on the securities. Prepayments occurring slower than expected have the opposite impact. LNC may incur disinvestment risks if market yields are higher than the book yields earned on the securities and LNC is forced to sell the securities. The degree to which a security is susceptible to either gains or losses is influenced by 1) the difference between its amortized cost and par, 2) the relative sensitivity of the underlying mortgages backing the assets to prepayment in a changing interest rate environment and 3) the repayment priority of the securities in the overall securitization structure.
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, 2003, 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. See Note 3 to the consolidated financial statements for additional detail about the underlying collateral.
million in 2003, 2002 and 2001, respectively. Prior to the amortization of acquisition costs, provision for policyholder commitments and investment expenses, net pre-tax realized losses were $7.4 million, $401.5 million, and $212.0 million in 2003, 2002 and 2001, respectively.
The gross realized gains on fixed maturity and equity securities were $364.5 million, $181.2 million and $223.2 million, in 2003, 2002, and 2001, respectively. Gross realized losses on fixed maturity and equity securities were $396.8 million, $609.9 million and $459.7 million, respectively. Included within losses are write-downs for impairments of $252.8 million, $321.5 million and $252.9 million in 2003, 2002 and 2001, respectively.
While losses from sales and impairments occurred in a number of sectors, approximately 51.4% of gross realized losses for 2003 were attributable to losses incurred on asset-backed securities (“ABS”), the electric utilities and airlines sectors, and Parmalat. Losses incurred on ABS investments included securities collateralized by manufactured housing receivables as well as Collateralized Debt Obligations (“CDOs”).
Deterioration in the underlying collateral pools of other ABS investments during 2003 led to decreased expectations of future cash flows. As a result, additional losses of $66.3 million were realized on various ABS holdings, including CDOs. This deterioration in collateral pools primarily occurred in the first half of 2003 and quarterly losses on CDOs decreased throughout 2003. Amortization, sales and impairments have reduced LNC’s CDO exposure from 1.6% of invested assets at December 31, 2002 to 1.3% of LNC’s invested assets at December 31, 2003 as measured on a cost basis, with over 90% of the CDOs remaining investment grade. The unrealized loss position on the CDO portfolio has been reduced to approximately $12.0 million, compared to $47.2 million at the end of 2002. Any further deterioration or additional realized losses in the CDO portfolio will depend on economic factors such as economic growth, corporate profitability and future asset default rates. Cash flow testing of the CDO portfolio as required under EITF 99-20 supports the conclusion that these unrealized losses are temporary. A full recovery of principal and interest is expected under the current economic environment.
Fair values for private securities are estimated by (1) a matrix process that employs discounting expected future cash flows using a current market rate applicable to the coupon rate, credit quality, industry sector and maturity of the investments; (2) third party-supplied prices or secondary market transactions; and (3) applying professional judgment to arrive at the fair value based upon prices of public or non-public securities of similarly situated issuers. The fair value for all private securities was $4,875.8 million and $4,601.3 million at December 31, 2003 and 2002, respectively, representing about 11.4% and 11.5% of total invested assets, respectively.
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, as well as the provisions for write-downs on fixed maturity and equity securities are disclosed within the notes to the accompanying consolidated financial statements (see Note 3 to the consolidated financial statements).
Unrealized Gains and Losses - Available-for-Sale Securities: At December 31, 2003 and 2002, gross unrealized gains on securities available-for-sale were $2,054.4 million and $2,402.5 million, respectively, and gross unrealized losses on securities available-for-sale were $218.8 million and $735.4 million, respectively. At December 31, 2003, gross unrealized gains and losses on fixed maturity securities available-for-sale were $2,027.1 million and $217.1 million, respectively, and gross unrealized gains and losses on equity securities available-for-sale were $27.3 million and $1.7 million, respectively. At December 31, 2002, gross unrealized gains and losses on fixed maturity securities available-for-sale were $2,355.3 million and $690.9 million, respectively, and gross unrealized gains and losses on equity securities available-for-sale were $47.2 million and $44.5 million, respectively. Part of the change in unrealized gains and losses from December 31, 2002 to December 31, 2003 resulted from the reclassification of securities from available-for-sale to trading that was previously discussed. The great majority of the remaining unrealized gains and losses can be attributed to changes in interest rates, which have created temporary price fluctuations. However, within the portfolio of securities with unrealized losses are certain securities that LNC has identified as exhibiting indications that the decline in fair value may be other than a temporary decline in value.
For total publicly traded and private securities held by LNC at December 31, 2003 and 2002 that were in unrealized loss status, the fair value, amortized cost, unrealized loss and total time period that the security has been in an unrealized loss position are presented in the table below.
LNC has no concentrations of issuers or guarantors of fixed maturity and equity securities. The composition by industry categories of securities subject to enhanced analysis and monitoring for potential changes in unrealized loss status, held by LNC at December 31, 2003 is presented in the table below.
The composition by industry categories of all securities in unrealized loss status, held by LNC at December 31, 2003 is presented in the table below.
The composition by industry categories of all securities in unrealized loss status, held by LNC at December 31, 2002 is presented in the table below.
* The unrealized losses for Lincoln UK Equity Securities are primarily related to participation policies in the Lincoln UK segment. Gain and losses on securities supporting this business are credited to the policyholder when incurred and do not affect net income of LNC.
Unrealized Loss on All Below-Investment-Grade Available-for-Sale Fixed Maturity Securities: Gross unrealized losses on all available-for-sale below-investment-grade securities were $86.0 million at December 31, 2003, representing 39.3% of total gross unrealized losses on all available-for-sale securities. Generally, below-investment-grade fixed maturity securities are more likely than investment-grade securities to develop credit concerns. The remaining $132.8 million or 60.7% of the gross unrealized losses relates to investment grade available-for-sale securities. The ratios of market value to amortized cost reflected in the table below are not necessarily indicative of the market value to amortized cost relationships for the securities throughout the entire time that the securities have been in an unrealized loss position nor are they necessarily indicative of these ratios subsequent to December 31, 2003.
Unrealized Loss on Fixed Maturity Securities Available-for-Sale in Excess of $10 million: As of December 31, 2003, LNC held fixed maturity securities available-for-sale with gross unrealized losses of $10 million, or greater, as discussed below:
in increased recognition of both investment gains and losses, as portfolio risks are adjusted through sales and purchases. As discussed below, this is consistent with LNC’s classification of its investment portfolios as available-for-sale.
The asset-liability management process is more concentrated within the annuity blocks of business given market-sensitive liabilities. The retail and employer-sponsored orientation of LNC’s core products reduces liquidity risk as liabilities tend to be less sensitive to movements in the markets. LNC does not manufacture or distribute institutional spread products such as guaranteed investment contracts, the direct sale of funding agreements, and the issuance of medium term notes secured by insurance company funding agreements.
2001 LNL Dividends: LNL paid dividends of $495 million to LNC during 2001. In the first quarter 2002, LNL received approval from the Commissioner to reclassify total dividends of $495 million paid to LNC in 2001 from LNL’s earned surplus to paid-in-capital. This change plus the increase in statutory earned surplus from the indemnity reinsurance transaction with Swiss Re resulted in positive statutory earned surplus for LNL at December 31, 2001.
2003 LNL Dividends: During 2003, LNL received prior approval from the Commissioner and paid dividends of $200 million. As occurred in 2001, the dividends approved and paid while statutory earned surplus was negative were classified as a reduction to paid-in-capital. Statutory earnings for 2003 together with a reduced dividend payment, resulted in a positive earned surplus position at December 31, 2003.
After giving consideration to $600 million in securities issued in 2002 through 2004 detailed below, LNC has $600 million of remaining authorization under the shelf registration to issue various securities, including debt securities, preferred stock, common stock, warrants, stock purchase contracts and stock purchase units of LNC and trust preferred securities of four subsidiary trusts. The net proceeds from the sale of the securities offered by this shelf registration are expected to be used by LNC for general corporate purposes, including repurchases of outstanding common stock, repayment or redemption of outstanding debt or preferred stock, the possible acquisition of financial services businesses or assets thereof, and working capital needs. Cash funds are also available from LNC’s revolving credit agreements and through LNC’s commercial paper program (see Note 5 to the consolidated financial statements).
The following summarizes debt and financing activity during the three-year period ended December 31, 2003.
• On November 19, 2001, LNC issued 6.9 million shares of 7.65% Trust Preferred Securities (“TRUPS”) ($172.5 million) through Lincoln National Capital V. In conjunction with the $172.5 million TRUPS issue, LNC executed a $172.5 million notional amount interest rate swap that effectively converted the 7.65% fixed rate coupon on the TRUPS into a LIBOR-based floating rate obligation.
• On December 7, 2001, LNC issued $250 million 6.20% ten-year senior notes.
• On June 3, 2002, LNC issued $250 million 5.25% five-year senior notes. In conjunction with the $250 million debt issue, LNC executed a $100 million notional amount interest rate swap that effectively converted the 5.25% fixed rate coupon for that portion of the bond into a LIBOR-based floating rate obligation the bond.
• On September 4, 2003, LNC issued 6 million shares of 6.75% Trust Preferred Securities ($150 million) through Lincoln National Capital VI.
Repurchase Activity: The table below details LNC’s share repurchase activity and the status of existing Board authorizations. Repurchase activity in 2001 and 2002 reflects the decision to use a portion of the proceeds from the sale of Lincoln Re to Swiss Re for share repurchases. LNC suspended its stock repurchase program during 2003 and focused on building capital and protecting the company’s strong credit ratings after experiencing difficult capital market conditions in 2002. LNC expects to return to share repurchase in 2004 with the amount and timing dependent on trends in key capital ratios, rating agency expectations, the generation of free cash flow, and the relative attractiveness of alternative uses for the capital.
Issuance Activity: In 2001 LNC settled mandatory stock purchase contracts issued in conjunction with the FELINE PRIDES financing. This action resulted in the issuance of 4.6 million shares of LNC stock at $49.67 per share. Investors had the option of settling the purchase contract with separate cash or by having the collateral securing their purchase obligations sold. Investors who held the Trust Originated Preferred Securities (“TOPrS”) as collateral for the purchase contracts were permitted to enter into a remarketing process with proceeds used to settle the contracts. The 2001 remarketing failed, resulting in the retirement of $225 million of the TOPrS. A total of $5 million of two-year TOPrS remained outstanding, representing investors who chose to settle with separate cash and hold onto their TOPrS until maturity on August 2003. The remaining $5 million in TOPrS were retired August 2003.
On December 7, 2001, Swiss Re acquired LNC’s reinsurance operation for $2.0 billion. In addition, LNC retained the capital supporting the reinsurance operation. After giving affect to the increased levels of capital needed within the Life Insurance and Lincoln Retirement segments that results from the change in the ongoing mix of business under LNC’s internal capital allocation models, the disposition of LNC’s reinsurance operation freed-up approximately $100 million of capital. The transaction structure involved a series of indemnity reinsurance transactions combined with the sale of certain stock companies that comprised LNC’s reinsurance operation. Approximately $560 million of the proceeds from the transaction were used to pay taxes and associated deal costs and approximately $1.0 billion was used to repurchase stock, reduce debt, and support holding company cash flow needs. LNC used $295 million to pay the fourth quarter 2002 settlement with Swiss Re (see the Divestiture disclosure on page 30 for details regarding the settlement with Swiss Re). The remaining proceeds were dedicated to the ongoing capital needs of LNL.
The following tables highlight significant sources and uses of cash flow at the holding company during 2001 through 2003. The tables focus on significant and recurring cash flow items and exclude the effects of certain financing activities, namely the periodic issuance and retirement of debt and cash flows related to LNC’s intercompany cash management account (see Alternative Sources of Liquidity page 80). Taxes have been eliminated from the analysis as a tax sharing agreement is in place with LNC’s primary subsidiaries resulting in a modest impact on net cash flows at the holding company. Also excluded from this analysis is the modest amount of investment income on short-term investments of the holding company. (See also Schedule II - LNC Parent Company Only Statement of Cash Flows.)
LNC cash flow is driven largely by the dividend capacity and surplus note interest payments of LNL. LNL dividend capacity is impacted by factors influencing LNL’s risk-based capital and statutory earnings performance. As risk-based capital and statutory earnings improve, the insurance subsidiary’s dividend capacity
to the holding company increases. See the discussion in the Insurance Company Liquidity and Cash Flow section on LNL dividends to LNC. In recent periods, Delaware Investments and LNC’s UK operations have contributed significant free cash flow. Improved financial performance at Delaware and LNC’s decision to run-off significant blocks of business in the UK are driving improved cash flow and the return of capital to the holding company.
LNL ended the year with statutory Net Gain From Operations of $375.3 million and a positive Unassigned Surplus of $155 million. LNL now qualifies for the “ordinary dividend” process with the Indiana Department of Insurance (“IDOI”) requiring only notification to the IDOI of dividend payments as opposed to requiring formal approval for the dividend. Dividend capacity is largely dictated by insurance regulations in the company’s state of domicile, for LNL the Indiana Department of Insurance. Insurance companies domiciled in the state of Indiana follow the so-called “greater-of” rule on statutory dividend capacity. Provided Unassigned Surplus is positive (after giving effect for the dividend request), the cumulative total of all dividends paid in the past 12 months cannot exceed the greater of 10% of Statutory Capital and Surplus (LNL capital and surplus was $2.76 billion at December 31, 2003) or statutory operating earnings for the previous year-end (2003 statutory operating earnings were $375.3 million for LNL). LNL paid $200 million in cumulative dividends for the 12 months ended December 31, 2003. It is important to note that, regardless of the particular state regulations, LNC takes into account the overall health of the business, capital quality, and business and environmental risk in determining statutory dividend strategy.
(1) The amount includes a maximum annual increase related to the CPI.
(2) The annual cost is based on a per policy charge plus an amount for other services provided. The amounts quoted above are the estimated fees as the actual cost will depend on the number of policies in force and the applicable inflation rate for the each period. During 2003 this contract was converted to an evergreen arrangement, cancelable upon a six-month notice. The total cost shown relates to the next ten years.
In addition to the contractual commitments outlined in the table above, LNC periodically funds the employees’ defined benefit plans. For 2003 and 2002, LNC contributed $56.6 million and $66.5 million respectively to U.S. pension plans. LNC expects to contribute between $9 million and $27 million to its U.S. defined benefit pension plans and $6 million to its U.S. post-retirement benefit plans during 2004. These amounts include anticipated benefit payments for non-qualified plans. The majority of contributions/benefit payments are made at the insurance company subsidiary level with little holding company cash flow impact. (See Note 6 - Employee Benefit Plans to the consolidated financial statements.)
As of December 31, 2003, LNC’s senior debt ratings were Moody’s at A3 (“Upper Medium Grade”), Standard and Poor’s at A- (“Strong”), Fitch at A (“Strong”) and A.M. Best at “a-” (“Strong”), and LNC’s commercial paper ratings included Moody’s at P-2 (“Strong”), Standard and Poor’s at A-2 (“Satisfactory”) and Fitch at (“Very Strong”).
On average, LNC’s commercial paper borrowing rates have increased 0.20% per annum since LNC was downgraded to an A-2/P-2 issuer. However, historically there have been times of greater volatility in commercial paper borrowing rates for an A-2/P-2 issuer with the spread above A-1/P-1 rates ranging from 0.10% to 0.50%. During such times of greater volatility, LNC may experience difficulty in placing longer-term commercial paper (defined as 30-90 day maturities), and as a result, experience increased short-term financing costs.
In order to maximize the use of available cash, the holding company maintains a facility where subsidiaries can borrow from the holding company to meet their short-term needs and can invest their short-term funds with the holding company. Depending on the overall cash availability or need, the holding company invests excess cash in short-term investments or borrows funds in the financial markets.
Total shareholders’ equity increased $464.1 million during the year ended December 31, 2003. The table below provides a reconciliation of shareholders’ equity from December 31, 2002 to December 31, 2003 (in millions).
Investment real estate is carried at cost less accumulated depreciation. Depreciation is provided on a straight-line basis over the estimated useful life of the asset. Cost is adjusted for impairment when the projected
LNC recognizes all derivative instruments as either assets or liabilities in the consolidated balance sheet at fair value. The accounting for changes in the fair value of a derivative instrument depends on whether it has been designated and qualifies as part of a hedging relationship and further, on the type of hedging relationship. For those derivative instruments that are designated and qualify as hedging instruments, LNC must designate the hedging instrument based upon the exposure being hedged-as a cash flow hedge, fair value hedge or a hedge of a net investment in a foreign operation. As of December 31, 2003 and 2002, LNC had derivative instruments that were designated and qualified as cash flow hedges, fair value hedges and hedges of a net investment in a foreign operation. In addition, LNC had derivative instruments that were economic hedges, but were not designated as hedging instruments under Financial Accounting Standards No. 133 (“FAS 133”).
For derivative instruments that are designated and qualify as a cash flow hedge, the effective portion of the gain or loss on the derivative instrument is reported as a component of other comprehensive income (“OCI”) and reclassified into net income in the same period or periods during which the hedged transaction affects net income. The remaining gain or loss on the derivative instrument in excess of the cumulative change in the present value of designated future cash flows of the hedged item (hedge ineffectiveness), if any, is recognized in current income during the period of change. For derivative instruments that are designated and qualify as a fair value hedge, the gain or loss on the derivative instrument as well as the offsetting loss or gain on the hedged item attributable to the hedged risk are recognized in current income during the period of change in fair values. For derivative instruments that are designated and qualify as a hedge of a net investment in a foreign operation, the
gain or loss is reported in OCI as part of the cumulative translation adjustment to the extent it is effective. For derivative instruments not designated as hedging instruments, the gain or loss is recognized in current income during the period of change.
Property and Equipment. Property and equipment owned for company use is carried at cost less allowances for depreciation. Provisions for depreciation of investment real estate and property and equipment owned for company use are computed principally on the straight-line method over the estimated useful lives of the assets.
Other Revenues and Fees. Other revenue and fees principally consists of amounts earned by LNC’s retail distribution arm, Lincoln Financial Advisors (“LFA”) from sales of third party insurance and investment products. Such revenue is recorded as earned at the time of sale.
Deferred Acquisition Costs. Commissions and other costs of acquiring universal life insurance, variable universal life insurance, unit-linked products, traditional life insurance, annuities and other investment contracts, which vary with and are primarily related to the production of new business, have been deferred to the extent recoverable. The methodology for determining the amortization of acquisition costs varies by product type based on two different accounting pronouncements: Statement of Financial Accounting Standards No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments” (“FAS 97”) and Statement of Financial Accounting Standards No. 60, “Accounting and Reporting by Insurance Enterprises” (“FAS 60”). Under FAS 97, acquisition costs for universal life and variable universal life insurance and investment-type products, which include unit-linked products and fixed and variable deferred annuities, are amortized over the lives of the policies in relation to the incidence of estimated gross profits from surrender charges, investment, mortality net of reinsurance ceded and expense margins, and actual realized gain (loss) on investments. Past amortization amounts are adjusted when revisions are made to the estimates of current or future gross profits expected from a group of products. Policy lives for universal and variable universal life policies are estimated to be 30 years, based on the expected lives of the policies and are variable based on the inception of each policy for unit-linked policies. Policy lives for fixed and variable deferred annuities are 14 to 18 years for the traditional, long surrender charge period products and 8 to 10 years for the more recent short-term, or no surrender charge products. The front-end load annuity product has an assumed life of 25 years. Longer lives are assigned to those blocks that have demonstrated favorable experience.
Policy sales charges that are collected in the early years of an insurance policy have been deferred (referred to as “deferred front-end loads”) and are amortized into income over the life of the policy in a manner consistent with that used for DAC. (See above for discussion of amortization methodologies.)
account of LNC’s insurance subsidiaries during 2001 through 2003 ranged from 4.00% to 7.00%. For traditional life, group health and disability income products, benefits and expenses, other than deferred acquisition costs, are recognized when incurred in a manner consistent with the related premium recognition policies.
Goodwill and Other Intangible Assets. Prior to January 1, 2002, goodwill, as measured by the excess of the cost of acquired subsidiaries or businesses over the fair value of net assets acquired, was amortized using the straight-line method over periods of 20 to 40 years in accordance with the benefits expected to be derived from the acquisitions. Effective January 1, 2002, goodwill is not amortized, but is subject to impairment tests conducted at least annually.
Other intangible assets for acquired insurance businesses consist of the value of existing blocks of business (referred to as the “present value of in-force”). The present value of in-force is amortized over the expected lives of the block of insurance business in relation to the incidence of estimated profits expected to be generated on universal life, variable universal life and investment-type products acquired, (i.e., unit-linked products and variable deferred annuities) and over the premium paying period for insurance products acquired, (i.e., traditional life insurance products). Amortization is based upon assumptions used in pricing the acquisition of the block of business and is adjusted for emerging experience. Accordingly, amortization periods and methods of amortization for present value of in-force vary depending upon the particular characteristics of the underlying blocks of acquired insurance business.
Other intangible assets for acquired Investment Management subsidiaries include institutional customer relationships, covenants not to compete and mutual fund customer relationships. These assets are still required to be amortized on a straight-line basis over their useful life for periods ranging from 6 to 15 years depending upon the characteristics of the particular underlying relationships for the intangible asset.
With respect to its insurance and investment contract liabilities, LNC continually reviews 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 changes occur.
Postretirement Medical and Life Insurance Benefits. LNC accounts for its postretirement medical and life insurance benefits using the full accrual method.
Foreign Currency Translation. LNC’s foreign subsidiaries’ balance sheet accounts and income statement items are translated at the current and average exchange rates for the year, respectively. Resulting translation adjustments are reported as a component of shareholders’ equity. Other translation adjustments for foreign currency transactions that affect cash flows are reported in comprehensive income.
Reclassifications. Certain amounts reported in prior years’ consolidated financial statements have been reclassified to conform with the presentation adopted in the current year. These reclassifications have no effect on net income or shareholders’ equity of the prior years.
Accounting for Variable Interest Entities. In January 2003, the Financial Accounting Standards Board (“FASB”) issued initial guidance under Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”), which requires the consolidation of variable interest entities (“VIE”) by an enterprise if that enterprise has a variable interest that will absorb a majority of the VIE’s expected losses if they occur, receive a majority of the entity’s expected residual returns if they occur, or both. If one enterprise will absorb a majority of a VIE’s expected losses and another enterprise will receive a majority of that VIE’s expected residual returns, the enterprise absorbing a majority of the losses shall consolidate the VIE. A VIE is an entity in which no equity investors have the characteristics of a controlling financial interest or have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. In response to concerns raised by LNC and others in the Insurance and Investment industries with respect to the initial guidance, the FASB significantly modified several key aspects of the rules in a revised interpretation issued in December 2003. LNC adopted the final FIN 46 rules on December 31, 2003.
LNC currently manages seven Collateralized Debt Obligation pools (“CDOs”), and of these, there are five where the asset management fees paid to LNC no longer contain performance based incentives. As a result, LNC is not considered the primary beneficiary of these VIE’s. LNC’s maximum exposure to loss in these five CDOs is an investment in a small portion of the senior debt issued by one of these CDO pools, which had a carrying and estimated fair value of approximately $3 million, at December 31, 2003.
For the other two CDOs, LNC still has the right to earn performance-based fees above the base asset management fees. These performance-based fees are considered variable fees for purposes of performing the analysis of expected residual returns. In addition, LNC also holds investment interests in these CDOs. However, in these two CDOs, LNC has determined that the expected variability in its fees and the level of other LNC interests in the CDO, are currently below the level that would result in LNC being treated as the primary beneficiary. Future changes in the interest held by the third party investors in these two CDO pools, relative to LNC’s interest, will require retesting of LNC’s potential status as primary beneficiary. LNC will continue to disclose its variable interests in these two CDO pools. LNC’s maximum exposure to loss is its investment in these two CDO pools, which had a carrying value of approximately $14.5 million, and an estimated fair value of approximately $13.9 million, at December 31, 2003.
Accounting for Modified Coinsurance. FASB’s Derivative Implementation Group Statement 133 Implementation Issue No. B36 (“DIG B36”). DIG B36 provides that the embedded derivatives included within Modco and CFW reinsurance agreements must be accounted for separately from the underlying reinsurance agreements.
The SOP provides guidance related to the reporting and disclosure of certain insurance contracts and separate accounts, including guidance for computing reserves for products with guaranteed benefits, such as guaranteed minimum death benefits (“GMDB”), and for products with annuitization benefits such as guaranteed minimum income benefits. In addition, the SOP addresses the presentation and reporting of separate accounts, the capitalization and amortization of sales inducements, and secondary guarantees on universal-life type contracts.
excess DCA interest are considered sales inducements under the SOP and, as such, are to be deferred as a sales inducement asset and amortized as a benefit expense over the expected life of the contract. Amortization will be computed using the same methodology and assumptions used in amortizing DAC.
LNC currently defers bonus credits as part of the DAC asset and reports the amortization of bonus credits as part of DAC amortization. Upon adoption of the SOP, LNC will reclassify bonus credits from DAC to deferred sales inducements on its balance sheet and report deferred sales inducement amortization as part of benefit expense. Prior period balance sheet and income statement line item presentation will be reclassified to conform to the new basis of presentation.
Separate Accounts. LNC’s current accounting is consistent with the provisions of the SOP relating to the reporting and measuring of separate account product assets and liabilities as general account assets and liabilities when specific criteria are not met, as well as for the reporting and measuring seed money in separate accounts as general account assets, and for recognizing contract holder liabilities. The adoption of these provisions of the SOP are expected to have no effect on LNC’s financial statements.
Universal Life Contracts. LNC’s Life Insurance segment offers individual and survivor-life universal life insurance products that provide a secondary guarantee to the contract holder, commonly referred to as a no-lapse guarantee. This feature permits a policy that would normally terminate, if the net cash value were to fall below zero, to remain in force as long as the conditions of the no-lapse provision are met. LNC’s analysis of this benefit indicates that this feature should be considered insignificant, as newly defined by the SOP. In general, LNC does not expect to record an additional liability for its current secondary guarantee offerings. However, in the event that an additional liability is required under the SOP for certain of LNC’s current secondary guarantee features, LNC would not expect the adoption of the SOP to have a material effect on its financial statements.
LNC understands that throughout the life insurance industry a wide variety of interpretations and approaches to the application of the SOP to fixed and variable universal life contracts have recently begun to emerge. Industry-wide concern over this inconsistency in interpretation has become so great that on February 18, 2004 the American Council of Life Insurers (“ACLI”) submitted a letter on behalf of the industry to the Chairman of AcSEC, requesting a delay of the effective date for the SOP, as it applies to universal life insurance, until such time that guidance for these implementation matters can be made available. If AcSEC decides to address these industry-wide concerns and issue new guidance, LNC’s current estimates of the expected effects of the adoption of the SOP could change.
FASB Financial Staff Position No. FAS - 106-1 Medicare Prescription Drug Improvement and Modernization Act of 2003. In December 2003, the Medicare Prescription Drug Improvement and Modernization Act of 2003 (“the Medicare Act”) became law. Beginning in 2006, the Medicare Act provides various alternatives that could result in an offset to some portion of the costs of prescription drug benefits provided to retirees. In January 2004, the staff of the FASB issued Financial Staff Position No. FAS 106-1 (“FSP 106-1”), which permits a sponsor of a post-retirement health care plan that provides retiree prescription drug benefits to make a one-time election to defer accounting for the effects of the Medicare Act.
Due to these uncertainties and expected immaterial impact, LNC has elected to defer accounting for the effects of the Medicare Act. Having made this deferral election, FSP 106-1 prohibits LNC from accounting for the effects of the Medicare Act until such time as either final FASB guidance is issued or a significant event occurs that would require a remeasurement of plan assets and obligations. Accordingly, the measures of accumulated post-retirement benefit obligation and periodic post-retirement benefit cost in LNC’s financial statements for the year ended December 31, 2003 do not reflect the effects of the Medicare Act.
In compliance with the transition provision of FAS 142, LNC completed the first step of the transitional goodwill impairment test during the second quarter of 2002. The valuation techniques used by LNC to estimate the fair value of the group of assets comprising the different reporting units varied based on the characteristics of each reporting unit’s business and operations. A discounted cash flow model was used to assess the goodwill of the reporting units within LNC’s Lincoln Retirement, Life Insurance and Lincoln UK segments. A valuation technique combining multiples of revenues, earnings before interest, taxes, depreciation and amortization (“EBITDA”) and assets under management was used to assess the goodwill in LNC’s Investment Management segment. The results of the first step of the tests indicate that LNC does not have impaired goodwill. In accordance with FAS 142, LNC has chosen October 1 as its annual review date. As such, LNC performed annual valuation reviews during the fourth quarter of 2003 and 2002. The results of the tests performed as of October 1, 2003 and 2002 indicate that LNC does not have impaired goodwill.
Accounting for Derivative Instruments and Hedging Activities. Effective January 1, 2001, LNC adopted Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“FAS 133”) on a prospective basis. The transition adjustments that LNC recorded upon adoption of FAS 133 on January 1, 2001 resulted in a net loss of $4.3 million after-tax or $0.02 per share ($6.6 million pre-tax) recorded in net income, and a net gain of $17.6 million after-tax or $0.09 per share ($27.1 million pre-tax) recorded as a component of Other Comprehensive Income (“OCI”) in equity. Deferred acquisition costs of $4.8 million were restored and netted against the transition loss on derivatives recorded in net income and deferred acquisition costs of $18.3 million were amortized and netted against the transition gain recorded in OCI. A portion of the transition adjustment ($3.5 million after-tax) recorded in net income upon adoption of FAS 133 was reclassified from the OCI account, Net Unrealized Gain on Securities Available-for-Sale. These transition adjustments were reported in the financial statements as a cumulative effect of a change in accounting principle.
For total traded and private securities held by LNC at December 31, 2003 that are in unrealized loss status, the fair value, amortized cost, unrealized loss and total time period that the security has been in an unrealized loss position are presented in the table below.
Securities available-for-sale that were deemed to have declines in fair value that were other than temporary were written down to fair value. The fixed maturity securities to which these write-downs apply were generally of investment grade at the time of purchase, but were subsequently downgraded by rating agencies to “below-investment grade.” Factors considered by LNC in determining whether declines in the fair value of fixed maturity securities are other than temporary include 1) the significance of the decline, 2) LNC’s ability and intent to retain the investment for a sufficient period of time for it to recover, 3) the time period during which there has been a significant decline in value, and 4) fundamental analysis of the liquidity, business prospects and overall financial condition of the issuer. Based upon these factors, securities that have indications of potential impairment are subject to intensive review. Where such analysis results in a conclusion that declines in fair values are other than temporary, the security is written down to fair value. See Note 8 (Fair Value of Financial Instruments) to the consolidated financial statements for a general discussion of the methodologies and assumptions used to determine estimated fair values.
The allowance for losses is maintained at a level believed adequate by LNC to absorb estimated probable credit losses. LNC’s periodic evaluation of the adequacy of the allowance for losses is based on LNC’s past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay (including the timing of future payments), the estimated value of the underlying collateral, composition of the loan portfolio, current economic conditions and other relevant factors. This evaluation is inherently subjective, as it requires estimating the amounts and timing of future cash flows expected to be received on impaired loans that may be susceptible to significant change.
As of December 31, 2003 and 2002, LNC had restructured mortgage loans of $63.6 million and $4.6 million, respectively. LNC recorded $4.7 million and $0.4 million of interest income on these restructured mortgage loans in 2003 and 2002, respectively. Interest income in the amount of $5.8 million and $0.4 million would have been recorded on these mortgage loans according to their original terms in 2003 and 2002, respectively. As of December 31, 2003 and 2002, LNC had no outstanding commitments to lend funds on restructured mortgage loans.
As of December 31, 2003, LNC’s investment commitments for fixed maturity securities (primarily private placements), mortgage loans on real estate and real estate were $578.2 million. This includes $205.8 million of standby commitments to purchase real estate upon completion and leasing.
The carrying value of fixed maturity securities available-for-sale, mortgage loans on real estate and real estate investments which were non-income producing totaled $133.0 million and $37.3 million at December 31, 2003 and 2002, respectively.
During the fourth quarter of 2001, LNC completed a securitization of commercial mortgage loans. In the aggregate, the loans had a fair value of $209.7 million and a carrying value of $198.1 million. LNC received $209.7 million from the trust for the sale of the loans. A recourse liability was not recorded since LNC is not obligated to repurchase any loans from the trust that may later become delinquent. Servicing fees of $0.2 million and $0.2 million were received in 2003 and 2002, respectively. The transaction was hedged with total return swaps to lock in the value of the loans. LNC recorded a loss on the hedge of $10.1 million pre-tax and a realized gain on the sale of $11.6 million pre-tax resulting in a net gain of $1.5 million pre-tax. Upon securitization, LNC did not retain an interest in the securitized assets; however, LNC later invested $14.3 million of its general account assets in the certificates issued by the trust. This investment is included in fixed maturity securities on the balance sheet.
During the third quarter of 2003, LNC completed a securitization of commercial mortgage loans. In the aggregate, the loans had a fair value of $182.2 million and a carrying value of $167.3 million. LNC received $182.2 million from the trust for the sale of the loans. A recourse liability was not recorded since LNC is not obligated to repurchase any loans from the trust that may later become delinquent. Servicing fees of $0.03 million were received in 2003. The transaction was hedged with interest rate swaps to lock in the value of the loans. LNC recorded a gain on the hedge of $7.8 million pre-tax and realized a gain on the sale of $14.9 million pre-tax resulting in a total net gain of $22.7 million pre-tax. LNC did not retain an interest in the securitized assets.
Net cash received for Federal income taxes in 2003 was $65.0 million due to the carry back of 2002 tax losses. Cash paid for Federal income taxes in 2002 and 2001 was $382.9 million and $57.6 million, respectively.
At December 31, 2003, LNC had net operating loss carryforwards for Federal income tax purposes of $282.6 million for its foreign life reinsurance company, Lincoln National Reinsurance Company (Barbados) (“LNR Barbados”) that expire in 2014 and 2018. LNC also had net capital loss carryforwards of $147.9 million that will expire in 2007. In contrast to the net operating losses of LNR Barbados, the net capital losses can be used to offset capital gains of any affiliate in future LNC consolidated U.S. tax returns. Accordingly, LNC believes that it is more likely than not that the capital losses will be fully utilized within the allowable carryforward period.
LNC has been identified by the Internal Revenue Service (“IRS”) as a coordinated industry taxpayer requiring annual audits. The audits from tax years through 1995 have been completed and these years are closed. LNC is currently under audit by IRS for years 1996-2002. LNC does not anticipate that any adjustments that might result from such audits would be material to LNC’s consolidated results of operations or financial condition.
Reinsurance transactions included in the income statement captions, “Insurance Premiums” and “Insurance Fees”, are as follows:
* The reinsurance activity for the year ended December 31, 2001 includes the activity of the former Reinsurance segment for the eleven months ended November 30, 2001 and the activity related to the indemnity reinsurance transaction with Swiss Re for the one month ended December 31, 2001. The reinsurance activity for 2003 and 2002 excludes activity related to the indemnity reinsurance transaction with Swiss Re.
Realized gains and losses on investments and derivative instruments on the Statements of Income for the year ended December 31, 2003, 2002 and 2001 are net of amounts restored or (amortized) against deferred acquisition costs of $(50.2) million, $115.0 million and $112.9 million, respectively. In addition, realized gains and losses for the year ended December 31, 2003, 2002 and 2001 are net of adjustments made to policyholder reserves of $48.4 million, $27.3 million and $10.5 million, respectively. LNC has either a contractual obligation or has a consistent historical practice of making allocations of investment gains or losses to certain policyholders and to certain reinsurance arrangements.
Future estimated amortization of other intangible assets is as follows (in millions):
The U.S. commercial paper outstanding at December 31, 2003 had a weighted average interest rate of 1.2%.
In July 2003 LNC redeemed the $200 million 7.40% Trust Originated Preferred Securities (“TOPrS”) issued by Lincoln Capital III and guaranteed by LNC. A loss of $3.7 million ($5.6 million pre-tax) related to unamortized issuance costs was reported in 2003 related to the redemption. This expense is included in the income statement caption “Interest and debt expense.” In September, Lincoln Capital VI, a wholly-owned
In April 2002, a new shelf registration statement was declared effective by the Securities and Exchange Commission. The new shelf registration totaled $1.2 billion (including $402.5 million of registered but unissued securities from previous registration statements). After giving consideration to the $250 million 5.25% five-year senior notes issued in June 2002 and the $150 million retail trust preferred securities issued in September 2003 by Lincoln Capital V, LNC had at December 31, 2003 $800 million remaining under the shelf registration to issue debt securities, preferred stock, common stock, warrants, stock purchase contracts and stock purchase units of LNC and trust preferred securities of two affiliated trusts. The net proceeds from the sale of the securities offered by this shelf registration and the applicable prospectus supplement(s) are expected to be used by LNC for general corporate purposes, including repurchases of outstanding common stock, repayment or redemption of outstanding debt or preferred stock, the possible acquisition of financial services businesses or assets thereof, investment in portfolio assets and working capital needs. See Subsequent Event footnote on page 158.
LNC maintains three revolving credit agreements with a group of domestic and foreign banks totaling $536 million. One agreement, in the amount of $300 million, expires in December 2005 and the second agreement, in the amount of $200 million, expires in February 2007. The Lincoln UK agreement was renewed in January 2004 for $18 million maturing in January 2005. All three agreements provide for interest on borrowings based on various money market indices. Under all three agreements, LNC must maintain senior unsecured long-term debt ratings of at least S&P A- and Moody’s A3 or be restricted by an adjusted debt to capitalization ratio. At December 31, 2003, LNC had no outstanding borrowings under the agreements. During 2003, 2002 and 2001, fees paid for maintaining revolving credit agreements amounted to $0.5 million, $0.6 million and $0.7 million, respectively.
LNC sponsors three types of unfunded, nonqualified, defined benefit plans for certain U.S. employees and agents: supplemental retirement plans, a salary continuation plan, and supplemental executive retirement plans.
The supplemental retirement plans provide defined benefit pension benefits in excess of limits imposed by Federal tax law.
On December 1, 2001, Swiss Re acquired LNC’s reinsurance business. This transaction resulted in the immediate recognition of a one-time curtailment gain on post-retirement benefits of $6 million pre-tax and additional expense of $1.4 million pre-tax related to pension benefits for a net curtailment gain of $4.6 million pre-tax. This net curtailment gain was included in the realized gain on sale of subsidiaries for the year ended December 31, 2001. Due to the release of the pension obligations on these former LNC employees, there was a $16 million gain in the pension plan that was used to offset prior plan losses.
LNC has elected to defer accounting for the effects of the Medicare Act. Accordingly, the measures of accumulated post-retirement benefit obligation and periodic post-retirement benefit cost in LNC’s financial statements for the year ended December 31, 2003 do not reflect the effects of the Medicare Act.
LNC uses a December 31 measurement date for its U. S. pension and post-retirement plans.
Information for U.S. pension plans with accumulated benefit obligations in excess of plan assets is as follows:
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, 2003 and 2002, plan assets were under the projected benefit obligations by $79.0 million and $62.7 million, respectively, and were included in other liabilities in LNC’s balance sheet. Net pension costs for the foreign plan were $6.8 million, $10.0 million and $7.4 million for 2003, 2002 and 2001, respectively. See above (U.S. plans) for discussion of the minimum pension liability adjustment for the non-U.S. defined benefit pension plan.
LNC’s contribution to the defined contribution money purchase plan is equal to 7.5% per annum of a participant’s eligible compensation, while its contribution to the previous profit sharing plan of Delaware was equal to an amount, if any, determined in accordance with a resolution of the Board of Directors. Each plan year’s contribution is allocated in the proportion that the plan compensation of each eligible participant bears to the total plan compensation of all eligible participants for such plan year. Compensation is defined as all of an eligible participant’s plan year earnings and is subject to the limitation of Section 401(a) of the Internal Revenue Code of 1986, as amended. For 2003, 2002, and 2001 the contribution to the defined contribution money purchase plan was based on 7.5% of the eligible compensation for the years ended December 31, 2003 and December 31, 2002 and for the nine-month period ended December 31, 2001, respectively. For the profit sharing plan’s fiscal year ended March 31, 2001, the Board issued a resolution authorizing a 15% per annum contribution to the plan. Expense for the 401(k) and profit sharing plans amounted to $36.1 million, $22.6 million and $27.0 million in 2003, 2002 and 2001, respectively.
compensation plan. LNC makes matching contributions to these plans based upon amounts placed into the deferred compensation plans by individuals who have reached the contribution limit under the 401(k) plan. The amount of LNC’s contribution is calculated in a manner similar to the employer match calculation described in the 401(k) plans section above. Expense for these plans amounted to $28.7 million, $1.7 million and $0.6 million in 2003, 2002 and 2001, respectively. These expenses reflect both LNC’s employer matching contributions of $6.4 million, $9.4 million and $6.3 million, as well as increases (decreases) in the measurement of LNC’s liabilities under these plans of $22.3 million, $(7.7) million and $(5.7) million for 2003, 2002 and 2001, respectively.
In the fourth quarter of 2001, LNC began investing in a variable annuity contract with investment options that are similar to the investment options within the deferred compensation plan, with the objective of partially mitigating the earnings effects created by changes in the value of LNC’s deferred compensation plan liabilities. At December 31, 2001, $50 million had been invested with an additional $10 million invested in June of 2002. The value of the deferred compensation liability and the variable annuity are both marked to market through net income. There is a direct correlation of the movement in value of the variable annuity contract with the movement in value of the equity portion of the deferred compensation liability. Income (expense) for the change in value of the variable annuity contract was $14.7 million, $(12.8) million and $2.8 million in 2003, 2002 and 2001. The value of the variable annuity contract at December 31, 2003, 2002 and 2001 was $64.7 million, $50 million and $52.8 million, respectively.
In the fourth quarter of 1999, LNC modified the terms of the deferred compensation plans to provide that plan participants who selected LNC stock as the measure for their investment return would receive shares of LNC stock in satisfaction of this portion of their deferral. In addition, participants were precluded from diversifying any portion of their deferred compensation plan account that is measured by LNC’s stock performance. As a result of these modifications to the plans, ongoing changes in value of LNC’s stock no longer affect the expenses associated with this portion of the deferred compensation plans.
Stock-Based Incentive Compensation Plans. LNC has various incentive plans for employees, agents and directors of LNC and its subsidiaries that provide for the issuance of stock options, stock incentive awards, stock appreciation rights, and restricted stock awards. Prior to 2003, these plans were comprised primarily of stock option incentive plans.
Effective January 1, 2003, LNC’s stock-based employee compensation plan was revised to provide for performance vesting, and to provide for awards that may be paid out in a combination of stock options, performance shares of LNC stock and cash. This plan replaced the LNC stock option plan; however, the separate stock option incentive plans established by Delaware Investments U.S., Inc. (“DIUS”) and DIAL Holding Company, Inc. (“DIAL”) as described below, will continue. Awards under this plan for 2003 consisted of 322,827 10-year LNC stock options, 781,376 performance share units that could result in the issuance of LNC shares, and cash awards. As of December 31, 2003, 204,316 stock options and 708,063 performance share units
Total compensation expense for LNC incentive plans involving stock options, including the Delaware stock option incentive plans discussed below, for 2003, 2002, and 2001 was $51.5 million, $59.9 million, and $63.6 million, respectively.
the plan agreements. Fair market value is determined on a semi-annual basis by the outside appraiser. Additionally, shares acquired upon exercise, provided they have been held for more than six months and are vested, may be “called” by Holdings, DIUS or DIAL, as applicable, at the most recent determined fair market value per share.
At December 31, 2003, DIAL had 10,000,000 shares of common stock outstanding. Information with respect to the DIAL incentive plan involving stock options is as follows:
Stock Appreciation Rights Incentive Plan. LNC has in place a stock appreciation right (“SAR”) incentive program for agents that do not meet the stringent definition of a common law employee. The SARs under this program are rights on LNC stock that are cash settled and become exercisable in 25% increments over the four year period following the SAR grant date. SARs are granted with an exercise price equal to the market value of LNC stock at the date of grant and, subject to termination of employment, expire five years from the date of grant. Such SARs are transferable only upon death.
LNC’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. As a result of negative statutory earned surplus, LNL was required to obtain the prior approval of the Indiana Insurance Commissioner (“Commissioner”) before paying any dividends to LNC until its statutory earned surplus became positive. During the first quarter of 2002, LNL received approval from the Commissioner to reclassify total dividends of $495 million paid to LNC in 2001 from LNL’s earned surplus to paid-in-capital. This change plus the increase in statutory earned surplus from the disposition of LNC’s reinsurance operations through an indemnity reinsurance transaction with Swiss Re resulted in positive statutory earned surplus for LNL at December 31, 2001.
In general, a dividend is not subject to prior approval from the Commissioner provided LNL’s statutory earned surplus is positive and the proposed dividend, plus all other dividends made within the twelve consecutive months prior to the date of the proposed dividend, does not exceed the standard limitation of the greater of 10% of total statutory earned surplus or the amount of statutory earnings in the prior calendar year. Dividends of $710 million were paid by LNL to LNC in the second quarter of 2002. These distributions were made in two installments. The first installment of $60 million was paid in April. The second installment of $650 million was paid in June. As both installments exceeded the standard limitation noted above, a special request was made for each payment and each was approved by the Commissioner. Both distributions represented a portion of the proceeds received from the indemnity reinsurance transaction with Swiss Re. As a result of the payment of dividends plus earnings in 2002, LNL’s statutory earned surplus was negative as of December 31, 2002. Due to the negative statutory earned surplus as of December 31, 2002, any dividend(s) paid by LNL in 2003 were subject to prior approval from the Commissioner.
Dividends of $200 million were paid by LNL to LNC in three quarterly installments during 2003. A special request was made for each payment and each was approved by the Commissioner. As occurred in 2001, $164.2 million of dividends approved and paid while statutory earned surplus is negative were classified as a reduction to paid-in-capital. Due to statutory earnings and favorable credit markets, LNL expects to be able to pay dividends in 2004 without prior approval.
Following allegations made by the U.K. Consumers’ Association (an organization which acts on behalf of consumers of goods and services provided in the U.K.) concerning various selling practices of CFPL, LNC conducted an internal sample review of ten-year savings plans sold by CFPL during the period September 1, 1998 to August 31, 2000 and, following discussions with the U.K. regulator, it was agreed that LNC would write to all customers with a ten-year savings plan sold by CFPL to determine whether the sales of those policies were appropriate. The agreed upon redress process was concluded in September of 2003, with offers of redress to approximately 5,400 contractholders, and payment of a $762,600 fine for the mis-selling of ten-year savings plans by CFPL covering the period between September 1, 1998 and August 31, 2000.
Recently, there has been a significant increase in federal and state regulatory activity in the industry relating to numerous issues including market timing and late trading of mutual fund and variable insurance products and broker-dealer access arrangements. LNC, like many others in the industry, has received requests for information from the SEC and a subpoena from the New York Attorney General’s Office seeking documentation and other information relating to these issues. LNC is in the process of responding to these requests and continues to cooperate fully with the regulators.
Total rental expense on operating leases in 2003, 2002 and 2001 was $67.1 million, $67.0 million and $79.4 million, respectively. Future minimum rental commitments are as follows (in millions):
In February 1998, LNL signed a seven-year contract with IBM Global Services for information technology services for the Fort Wayne operations. In February 2004, LNL completed renegotiations and extended the contract through February 2010. Annual costs are dependent on usage but are expected to range from $55.0 million to $60.0 million.
On June 3, 2002, LNC announced an agreement with the Philadelphia Eagles to name the Eagles’ new stadium Lincoln Financial Field. In exchange for the naming rights, LNC agreed to pay $139.6 million over a 20-year period, through annual payments to the Eagles which average approximately $6.7 million per year. The total amount includes a maximum annual increase related to the Consumer Price Index (“CPI”). This future commitment has not been recorded as a liability on LNC’s balance sheet as it is being accounted for in a manner consistent with the accounting for operating leases under Statement of Financial Accounting Standards No. 13, “Accounting for Leases.”
LNC agreed to outsource its human resources administration functions, including payroll, to IBM on September 29, 2003. The contract is for a term of 10 years and the annual cost is based on per check and per employee charge. The total costs over the life of the contract are estimated to be $46 million and annual costs over the next five years are estimated to decline from $5.3 million to $4.5 million. The actual cost will depend on the number of active employees and the applicable inflation rate for the period concerned.
LNC’s insurance companies cede insurance to other companies. The portion of risks exceeding each company’s retention limit is reinsured with other insurers. LNC seeks reinsurance coverage within the businesses that sell life insurance to limit its liabilities. As of December 31, 2002, LNC’s retention policy is to retain no more than $10 million on a single insured life. For 2003, the retention policy was changed to limit retention on new sales to $5 million. Portions of LNC’s deferred annuity business have been reinsured on a Modco basis with other companies to limit LNC’s exposure to interest rate risks. At December 31, 2003, the reserves associated with these reinsurance arrangements totaled $2.4 billion. To cover products other than life insurance, LNC acquires other insurance coverages with retentions and limits that management believes are appropriate for the circumstances. The accompanying financial statements reflect premiums, benefits and deferred acquisition costs, net of insurance ceded (see Note 5). LNC’s insurance companies remain liable if their reinsurers are unable to meet contractual obligations under applicable reinsurance agreements.
Certain LNC insurance companies assume insurance from other companies. At December 31, 2003, LNC’s insurance companies provided $84.5 million of statutory surplus relief to other insurance companies under reinsurance transactions. Generally, such amounts are offset by corresponding receivables from the ceding company, which are secured by future profits on the reinsured business. However, LNC’s insurance companies are subject to the risk that the ceding company may become insolvent and the right of offset would not be permitted. LNC’s reinsurance operations were acquired by Swiss Re on December 7, 2001. The transaction structure involved a series of indemnity reinsurance transactions combined with the sale of certain stock companies that comprised LNC’s reinsurance operation. Under the indemnity reinsurance agreements, Swiss Re reinsured certain liabilities and obligations of LNC. Because LNC is not relieved of its legal liability to the ceding companies, the liabilities and obligations associated with the reinsured contracts remain on the balance sheets of LNC with a corresponding reinsurance receivable from Swiss Re.
LNC maintains $550 million in bank agreements to issue standby letters of credit on behalf of subsidiaries of LNC and for the benefit of third parties. These letters of credit support LNL’s reinsurance needs and specific treaties associated with LNC’s reinsurance business, which was acquired by Swiss Re on December 7, 2001 (see Note 11 for further discussion of this transaction). Letters of credit are primarily used to satisfy the U.S. regulatory requirements of domestic clients of the former Reinsurance segment who have contracted with the Reinsurance subsidiaries not domiciled in the United States. The letter of credit allows the cedents to take credit for reinsured reserves on their statutory balance sheets. At December 31, 2003, there was a total of $455.7 million in outstanding bank letters of credit supporting six separate reinsurance treaties.
and certain mortgage loans. LNC’s funds withheld and embedded derivative liabilities include $1.8 billion and $0.3 billion, respectively, related to the business reinsured by Swiss Re.
State guaranty funds assess insurance companies 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.
LNC maintains an overall risk management strategy that incorporates the use of derivative instruments to minimize significant unplanned fluctuations in earnings that are caused by interest rate risk, foreign currency risk, equity risk, and credit risk. LNC assesses these risks by continually identifying and monitoring changes in interest rate exposure, foreign currency exposure, equity market exposure, and credit exposure that may adversely impact expected future cash flows and by evaluating hedging opportunities. Derivative instruments that are currently used as part of LNC’s interest rate risk management strategy include interest rate swaps and interest rate caps. Derivative instruments that are used as part of LNC’s foreign currency risk management strategy include foreign currency swaps and foreign exchange forwards. Call options on LNC stock and financial futures are used as part of LNC’s equity market risk management strategy. LNC also uses credit default swaps as part of its credit risk management strategy.
By using derivative instruments, LNC is exposed to credit and market risk. If the counterparty fails to perform, credit risk is equal to the extent of the fair value gain in the derivative. When the fair value of a derivative contract is positive, this generally indicates that the counterparty owes LNC and, therefore, creates a payment risk for LNC. When the fair value of a derivative contract is negative, LNC owes the counterparty and therefore LNC has no payment risk. LNC minimizes the credit (or payment) risk in derivative instruments by entering into transactions with high quality counterparties that are reviewed periodically by LNC. LNC also maintains a policy of requiring that all derivative contracts be governed by an International Swaps and Derivatives Association (“ISDA”) Master Agreement.
LNC and LNL are required to maintain minimum ratings as a matter of routine practice in negotiating ISDA agreements. Under the majority of ISDA agreements and as a matter of policy, LNL has agreed to maintain
financial strength or claims-paying ratings above S&P BBB and Moody’s Baa2. A downgrade below these levels would result in termination of the derivatives contract at which time any amounts payable by LNC would be dependent on the market value of the underlying derivative contract. In certain transactions, LNC and the counterparty have entered into a collateral support agreement requiring LNC to post collateral upon significant downgrade. LNC is required to maintain long-term senior debt ratings of S&P BBB- and Moody’s Baa3. LNC also requires for its own protection minimum rating standards for counterparty credit protection. LNL is required to maintain financial strength or claims-paying ratings above S&P A- and Moody’s A3 under certain ISDA agreements, which collectively do not represent material notional exposure. LNC does not believe the inclusion of termination or collateralization events pose any material threat to its liquidity position.
As of December 31, 2003 and 2002, LNC had derivative instruments that were designated and qualified as cash flow hedges, fair value hedges, hedges of a net investment in a foreign operation and derivative instruments that were not designated as hedging instruments. See Note 1 to the consolidated financial statements for detailed discussion of the accounting treatment for derivative instruments. For the year ended December 31, 2003 and 2002, LNC recognized a net loss of $2.0 million after-tax and a net gain of $2.5 million after-tax, respectively, in net income as a component of realized gains and losses on investments and derivative instruments. These gains (losses) relate to the ineffective portion of cash flow hedges, the change in market value for derivative instruments not designated as hedging instruments, and the gain (loss) on swap terminations. For the year ended December 31, 2003 and 2002, LNC recognized a loss of $6.3 million after-tax and a gain of $6.8 million after-tax, respectively, in OCI related to the change in market value on derivative instruments that are designated and qualify as cash flow hedges. In addition, for the year ended December 31, 2001, $3.5 million after-tax was reclassified from unrealized gain (loss) on securities available-for-sale to unrealized gain (loss) on derivative instruments, both in OCI. This reclassification relates to derivative instruments that were marked to market through unrealized gain (loss) on securities available-for-sale prior to the adoption of FAS 133.
LNC also uses interest rate swap agreements to hedge its exposure to interest rate fluctuations related to the forecasted purchase of assets for certain investment portfolios. The gains (losses) resulting from the swap agreements are recorded in OCI. The gains (losses) are reclassified from accumulated OCI to earnings over the life of the assets once the assets are purchased. As of December 31, 2003, there were no interest rate swaps hedging forecasted asset purchases.
Call Options on LNC Stock. LNC uses call options on LNC stock to hedge the expected increase in liabilities arising from stock appreciation rights (“SARs”) granted on LNC stock. Upon option expiration, the payment, if any, is the increase in LNC’s stock price over the strike price of the option applied to the number of contracts. Call options hedging vested SARs are not eligible for hedge accounting and both are marked to market through net income. Call options hedging nonvested SARs are eligible for hedge accounting and are accounted for as cash flow hedges of the forecasted vesting of SAR liabilities. To the extent that the cash flow hedges are effective, changes in the fair value of the call options are recorded in accumulated OCI. Amounts recorded in OCI are reclassified to net income upon vesting of SARs. LNC’s call option positions will be maintained until such time the SARs are either exercised or expire and LNC’s SAR liabilities are extinguished. The SARs expire five years from the date of grant.
Total Return Swaps. LNC used total return swaps to hedge its exposure to interest rate and spread risk resulting from the forecasted sale of assets in a securitization of certain LNC mortgage loans in 2001. A total return swap is an agreement that allows the holder to protect itself against loss of value by effectively transferring
Interest Rate Swap Agreements. LNC uses interest rate swap agreements to hedge the risk of paying a higher fixed rate interest on junior subordinated debentures issued to affiliated trusts and on senior debt than would be paid on long-term debt based on current interest rates in the marketplace. LNC is required to pay the counterparty a stream of variable interest payments based on the referenced index, and in turn, receives a fixed payment from the counterparty, at a predetermined interest rate. The net receipts/payments from these interest rate swaps are recorded as an adjustment to the interest expense related to the debt being hedged. The changes in fair value of the interest rate swap are reported in the consolidated statement of income in the period of change along with the offsetting changes in fair value of the debt being hedged.
Foreign Currency Forward Contract. LNC uses foreign currency forward contracts to hedge a portion of its net investment in its foreign subsidiary, Lincoln UK. The foreign currency forward contracts obligate LNC to deliver a specified amount of currency at a future date at a specified exchange rate. All gains or losses on the foreign currency forward contracts are recorded in OCI and remain in accumulated OCI until such time that Lincoln UK is sold or liquidated. The foreign currency forward contracts outstanding at December 31, 2003 terminate in 2004.
Interest Rate Swap Agreements. LNC used a forward starting interest rate swap agreement to hedge its exposure to the forecasted sale of mortgage loans. LNC was required to pay the counterparty a predetermined fixed stream of payments, and in turn, received payments based on a floating rate from the counterparty. The net receipts/payments from these interest rate swaps were recorded in realized gain (loss) on investments and derivative instruments. As of December 31, 2003, there were no forward starting interest rate swap agreements.
Interest Rate Cap Agreements. The interest rate cap agreements, which expire in 2006 through 2008, 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 provide a level of protection for its annuity line of business from the effect of rising interest rates. The interest rate cap agreements provide an economic hedge of the annuity line of business. However, the interest rate cap agreements are not linked to assets and liabilities on the balance sheet that meet the significantly increased level of specificity required under FAS 133. Therefore, the interest rate cap agreements do not qualify for hedge accounting under FAS 133.
Derivative Instrument Embedded in Modified Coinsurance and Coinsurance with Funds Withheld Arrangements. LNC is involved in various Modco and CFW reinsurance arrangements that have embedded derivatives. The change in fair value of the embedded derivative, as well as the gains or losses on trading supporting these arrangements, flows through net income. This embedded derivative is not eligible for hedge accounting treatment under FAS 133.
LNC has used certain other derivative instruments in the past for hedging purposes. Although other derivative instruments may have been used in the past, any derivative type that was not outstanding from January 1, 2002 through December 31, 2003 is not discussed in this disclosure. Other derivative instruments LNC has used include spread-lock agreements and put options. At December 31, 2003, there are no outstanding positions in these derivative instruments.
Additional Derivative Information. Income and (expenses) for the agreements and contracts described above amounted to $28.6 million, $23.0 million and $3.5 million in 2003, 2002 and 2001, respectively. The increase in income for 2002 and 2003 was primarily because of payments received on interest rate swaps.
based on: 1) quoted market prices for foreign currency exchange contracts and financial futures contracts; 2) industry standard models that are commercially available for interest rate cap agreements, swaptions, spread-lock agreements, interest rate swaps, commodity swaps, credit default swaps, total return swaps and put options; 3) Monte Carlo techniques for the equity call options on LNC stock. These techniques project cash flows of the derivatives using current and implied future market conditions. The cash flows are then present valued to arrive at the derivatives’ current fair market values; and 4) Black-Scholes pricing methodology for standard European equity call options.
Junior Subordinated Debentures Issued to Affiliated Trusts. Fair values for junior subordinated debentures issued to affiliated trusts are based on quoted market prices.
Guarantees. LNC’s guarantees include guarantees related to industrial revenue bonds, real estate partnerships and mortgage loan pass-through certificates. Based on historical performance where repurchases have been negligible and the current status of the debt, none of the loans are delinquent and the fair value liability for the guarantees related to the industrial revenue bonds, real estate partnerships and mortgage loan pass-through certificates is insignificant.
The carrying values and estimated fair values of LNC’s financial instruments are as follows:
* Total derivative instruments for 2003 are composed of $82.5 million and $352.3 million on the consolidated balance sheet in Derivative Instruments and Reinsurance Related Embedded Derivative, respectively.
The Investment Management segment, with principal operations in Philadelphia, Pennsylvania, offers a variety of asset management services to retail and institutional clients throughout the United States and certain foreign countries. Its product offerings include mutual funds and managed accounts. It also provides investment management and account administration services for variable annuity products, 401(k), “529” college savings plans, pension, endowment, trust, and other institutional accounts. Retail products are primarily marketed by LFD through financial intermediaries including LFA. Institutional products, asset management products, are marketed by a separate sales force within Delaware, which works closely with pension consultants.
Lincoln UK’s principal operations are in Barnwood, Gloucester, England, and it is licensed to do business throughout the United Kingdom (“UK”). Lincoln UK manages, administers and accepts new deposits on its current block of business and accepts new business for certain products. Lincoln UK’s product portfolio principally consists of unit-linked life and pension products, which are similar to U.S. produced variable life and annuity products.
Financial data by segment for 2001 through 2003 is as follows:
* Other Items include Realized Gain (Loss) on Investments and Derivative Instruments, Sale of Subsidiaries, Market Adjustment on Trading Securities, and Market Adjustment for Reinsurance Embedded Derivative/Trading Securities
(1) Revenues for the Investment Management segment include inter-segment revenues for asset management services provided to the other segments of LNC. These inter-segment revenues totaled $101.2 million, $97.7 million and $105.0 million for 2003, 2002 and 2001, respectively.
LNC has outstanding one common share purchase (“Right”) on each outstanding share of LNC’s common stock. A Right will also be issued with each share of LNC’s common stock that is issued before the Rights become exercisable or expire. If a person or group announces an offer that would result in beneficial ownership of 15% or more of LNC’s common stock, the Rights will become exercisable and each Right will entitle its holder to purchase one share of LNC’s common stock for $100. Upon the acquisition of 15% or more of LNC’s common stock, each holder of a Right (other than the person acquiring the 15% or more) will have the right to acquire the number of shares of LNC common stock that have a market value of two times the exercise price of the Right. If LNC is acquired in a business combination transaction in which LNC does not survive, each holder of a Right (other than the acquiring person) will have the right to acquire common stock of the acquiring person having a market value of two times the exercise price of the Right. LNC can redeem each Right for one cent at any time prior to the tenth day after a person or group has acquired 15% or more of LNC’s common stock. The Rights expire on November 14, 2006. As of December 31, 2003, there were 178,212,455 Rights outstanding.
Adjustments to deferred acquisition costs and amounts required to satisfy policyholder commitments are netted against the Deferred Acquisition Costs asset line and included within the Insurance Policy and Claim Reserves line on the balance sheet, respectively.
Details underlying the change in “Net Unrealized Gain on Securities Available-for-Sale, Net of Reclassification Adjustment” shown on the Consolidated Statements of Shareholder’s Equity are as follows:
The combined effects of the 2002 settlement of disputed matters and exited business reserve increases reduced the $723.1 million after-tax ($1.1 billion pre-tax) deferred gain reported at closing by $44.9 million after-tax ($69 million pre-tax). An additional $1.3 million after-tax ($2 million pre-tax) of deferred gain was recognized in net income, due to a novation of certain Canadian business during 2002. During 2003, LNC amortized into net income $49.3 million after-tax ($75.8 million pre-tax) of the deferred gain.
Through December 31, 2003, of the original $2 billion in proceeds received by LNC, approximately $560 million was paid for taxes and deal expenses and approximately $1.0 billion was used to repurchase stock, reduce
Because of ongoing uncertainty related to personal accident and disability income businesses, the reserves related to these exited business lines carried on LNC’s balance sheet at December 31, 2003 may ultimately prove to be either excessive or deficient. For instance, in the event that future developments indicate that these reserves should be increased, under FAS 113 LNC would record a current period non-cash charge to record the increase in reserves. Because Swiss Re is responsible for paying the underlying claims to the ceding companies, LNC would record a corresponding increase in reinsurance recoverable from Swiss Re. However, FAS 113 does not permit LNC to take the full benefit in earnings for the recording of the increase in the reinsurance recoverable in the period of the change. Rather, LNC would increase the deferred gain recognized upon the closing of the indemnity reinsurance transaction with Swiss Re and would report a cumulative amortization “catch-up” adjustment to the deferred gain balance as increased earnings recognized in the period of change. Any amount of additional increase to the deferred gain above the cumulative amortization “catch-up” adjustment must continue to be deferred and will be amortized into income in future periods over the remaining period of expected run-off of the underlying business. No cash would be transferred between LNC and Swiss Re as a result of these developments.
As noted above, effective with the closing of the transaction, the Reinsurance segment’s results for the eleven months ended November 30, 2001 and the year ended December 31, 2000 were moved into Other Operations.
In 1999, LNC implemented three different restructuring plans, with those plans relating to the discontinuance of HMO excess-of-loss reinsurance programs (“HMO Reinsurance”), and the streamlining of Lincoln UK’s operations not completed as of December 31, 2000. The aggregate charges associated with these two unrelated restructuring plans totaled $9.7 million after-tax ($14.9 million pre-tax) and were included in Underwriting, Acquisition, Insurance and Other Expenses on the Consolidated Statement of Income for the year ended December 31, 1999. These aggregate pre-tax costs include $6.3 million for employee severance and termination benefits and $8.6 million for other costs relating to exiting business activities. Through December 31, 2001, actual pre-tax costs of $3.7 million were expended or written-off for the HMO Reinsurance restructuring plan. During the fourth quarter of 2000, $1.0 million (pre-tax) of the original charge for the discontinuance of HMO excess-of-loss restructuring plan was reversed. During the fourth quarter of 2001, the remaining restructuring reserve of $0.2 million relating to the HMO excess-of-loss reinsurance programs was transferred to Swiss Re as part of its acquisition of LNC’s reinsurance operations.
During 2000, LNC implemented restructuring plans relating to 1) the downsizing and consolidation of the operations of Vantage Global Advisors, Inc. (“Vantage”); 2) the exit of all direct sales and sales support operations of Lincoln UK and the consolidation of its Uxbridge home office with its Barnwood home office; and 3) the downsizing and consolidation of the investment management operations of Lincoln Investment Management (“LIM”). The Vantage restructuring charge was recorded in the second quarter, the Lincoln UK restructuring was recorded in the third and fourth quarters, and the LIM restructuring charge was recorded in the
fourth quarter of 2000. The Vantage plan was completed in the fourth quarter of 2001 and the LIM plan was completed in the third quarter of 2002. All expenditures and write-offs for the LIM restructuring plan were completed in the third quarter of 2002 and $0.4 million of the original reserve was released. The release of the reserve was primarily due to LNC’s purchase and ultimate sale of the vacant office space on terms, which were favorable to what was included in the original restructuring plan for rent on this office space. The remaining restructuring reserve for the Lincoln UK plan is for lease payments on closed sales offices. The following table provides information about the 2000 restructuring plans.
During 2001, LNC implemented restructuring plans relating to 1) the consolidation of the Syracuse operations of Lincoln Life & Annuity Company of New York into the Lincoln Retirement segment operations in Fort Wayne, Indiana and Portland, Maine; 2) the elimination of duplicative functions in the Schaumburg, Illinois operations of First Penn-Pacific, and the absorption of these functions into the Lincoln Retirement and Life Insurance segment operations in Fort Wayne, Indiana and Hartford, Connecticut; 3) the reorganization of the life wholesaling function within the independent planner distribution channel, consolidation of retirement wholesaling territories, and streamlining of the marketing and communications functions in LFD; 4) the reorganization and consolidation of the life insurance operations in Hartford, Connecticut related to the streamlining of underwriting and new business processes and the completion of outsourcing of administration of certain closed blocks of business 5) the planned consolidation of the Boston, Massachusetts investment and marketing office with the Philadelphia, Pennsylvania investment and marketing operations in order to eliminate redundant facilities and functions within the Investment Management segment 6) the combination of LFD channel oversight, positioning of LFD to take better advantage of ongoing “marketplace consolidation” and expansion of the customer base of wholesalers in certain non-productive territories and 7) the consolidation of operations and space in LNC’s Fort Wayne, Indiana operations.
During the second quarter of 2002, Lincoln Retirement completed a review of its entire internal information technology organization. As a result of that review, Lincoln Retirement decided in the second quarter of 2002 to reorganize its IT organization in order to better align the activities and functions conducted within its own organization and its IT service providers. This change was made in order to focus Lincoln Retirement on its goal of achieving a common administrative platform for its annuities products, to better position the organization and its service providers to respond to changing market conditions, and to reduce overall costs in response to increased competitive pressures. The following table provides information about this restructuring plan.